Project-Syndicate.
LONDON – It is generally agreed that the crisis of 2008-2009 was caused
by excessive bank lending, and that the failure to recover adequately
from it stems from banks’ refusal to lend, owing to their “broken”
balance sheets.
A typical story, much favored by followers of Friedrich von Hayek and
the Austrian School of economics, goes like this: In the run up to the
crisis, banks lent more money to borrowers than savers would have been
prepared to lend otherwise, thanks to excessively cheap money provided
by central banks, particularly the United States Federal Reserve.
Commercial banks, flush with central banks’ money, advanced credit for
many unsound investment projects, with the explosion of financial
innovation (particularly of derivative instruments) fueling the lending
frenzy.
This inverted pyramid of debt
collapsed when the Fed finally put a halt to the spending spree by
hiking up interest rates. (The Fed raised its benchmark federal funds rate from 1% in 2004 to 5.25% in 2006 and held it there until August 2007). As a result, house prices collapsed, leaving a trail of zombie banks (whose liabilities far exceeded their assets) and ruined borrowers.
The
problem now appears to be one of re-starting bank lending. Impaired
banks that do not want to lend must somehow be “made whole.” This has
been the purpose of the vast bank bailouts in the US and Europe,
followed by several rounds of “quantitative easing,” by which central
banks print money and pump it into the banking system through a variety
of unorthodox channels. (Hayekians object to this, arguing that, because
the crisis was caused by excessive credit, it cannot be overcome with
more.)
At
the same time, regulatory regimes have been toughened everywhere to
prevent banks from jeopardizing the financial system again. For example,
in addition to its price-stability mandate, the Bank of England has
been given the new task of maintaining “the stability of the financial system.”
This
analysis, while seemingly plausible, depends on the belief that it is
the supply of credit that is essential to economic health: too much
money ruins it, while too little destroys it.
But one can take another view, which is that demand
for credit, rather than supply, is the crucial economic driver. After
all, banks are bound to lend on adequate collateral; and, in the run-up
to the crisis, rising house prices provided it. The supply of credit, in
other words, resulted from the demand for credit.
Link.
