08/25/2010 03:25 pm ET Updated May 25, 2011

New Banks Needed

This week news flow continues to indicate an economy that is significantly weakening from an already anemic activity level. There are wide-ranging destructive effects on every sector of the economy, households, businesses, and government. Some of these effects threaten to spiral into negative feedback loops causing further destruction and unpredictable outcomes from economic depression and attendant extreme unemployment, to deflation, to hyperinflation, to currency devaluation. All of these are possibilities. So what to do about it?

The current state of the society reflects the nature of society. I have posted before on the stratification of society into various interest groups which I have compared to the conditions before the revolution in France. We have profound ethical issues confronting us at every turn. There is a lack of trust. Cronyism here in America is alive and well.

Until we attack these underlying causes and conditions in a meaningful way, it is foolish to expect that we will have sustained economic recovery and general prosperity. The seriousness of the situation can be measured by our hopes. What we hope for is a little stimulus, a little inflation, a shift in exchange rates that will make exports more competitive, a return of the consumer to excessive spending, credit expansion. Are these the things that prosperity is made of? No!

Getting much attention in the news these days is the asset price cycle. The immediate manifestations are the recent sharp declines and possible further declines in the prices of residential and commercial property, the manic-depressive stock market, bond price bubbles and collapsing interest rates.

Amid this backdrop, one of the critical factors in an economic recovery will be the availability of credit to worthy businesses and investors. Already there are high net worth investors buying distressed property. Credit terms are tight and buying distressed property is still a risky investment. It is high risk with high potential reward. Facilitating these purchases are record low interest rates for super qualified borrowers. The opportunity for such returns, as usual, is for the rich. Those with idle cash have the opportunity to profit on the distress of others. Further stratification of wealth will be the inevitable result.

One blogger this week sought to find deeper solutions. Eric Haseltine suggests that we quit reacting to the panic of the moment and focus on building up our people in aggregate to create conditions for creative expansions.

Unless we overcome our temporal myopia, we'll continue to put band-aids on this economy and it will continue to deteriorate: in other words, we'll continue to treat symptoms and never go for a complete cure.

And what would such a cure look like? Let's start by looking at disease that afflicts us. The fundamental problem with America's economy is a decline in the capabilities and motivation of our workforce. True economic growth -- not the artificial kind spurred by fiscal policy -- stems from innovations such as Google's search engine that create entirely new businesses and markets. Such innovations grow out of technological advances, which in turn emerge from earlier scientific discoveries.

Alan Greenspan, former Chairman of the Federal Reserve Bank, reinforced this idea when he said "Capitalism expands wealth primarily through creative destruction -- the process by which the cash flow from obsolescent, low-return capital is invested in high-return, cutting-edge technologies."

Ingrained in this approach is the requirement that creative destruction must be followed by investment in new technologies. That requires a functioning financial sector.

John Hussman agrees and fleshes out the arguments further in a previous market update.

If we as a nation fail to allow market discipline, to create incentives for research and development, to discourage speculative bubbles, to accumulate productive capital, and to maintain adequate educational achievement and human capital, the real wages of U.S. workers will slide toward those of developing economies. The real income of a nation is identical its real output -- one cannot grow independent of the other.

Again, note that we must accumulate productive capital. This is a function of effective financial intermediation. Too much financial intermediation has been directed to speculative activity benefitting from market volatility and to the creation and sale of complex and opaque financial instruments that allow high profits from the lack of developed competitive markets and exchanges and frankly the ignorance of the buyers of these instruments. This is exploitative and is not productive capital formation.

So do we regulate such banks or do we start new ones? The first question is, can the banking sector, if it even chose to, provide for the capital needs of the economy. This point/counterpoint article addresses just that, among other topics of the day.

Mish Shedlock in citing the Jerome Levy Forecasting Center and agrees with but refines these particular points in the linked article.

There are various theoretical reasons given for the liquidity trap, but let's just focus on what is happening now and what is likely to happen in the years ahead. Presently, excess reserves are not inducing lending for several reasons, and adding to them further will not make much difference.
  • First of all, banks are capital constrained, not reserve constrained.
  • Second, interest rates could not fall far enough during this business cycle to enable troubled debtors to refinance their way out of trouble, so now banks remain worried about the volumes of bad debt they are carrying and how future loan losses will impinge on earnings and capital.
  • Third, deflationary expectations are beginning to work their way into banks' loan evaluation process on a micro level; in more and more areas, loan officers are looking at households with shrinking incomes and firms with deflating revenues.
  • Fourth, the private sector has too much debt, and many households and firms are trying to reduce debt, especially as more of them worry about deflation in their own incomes or revenues.

Point numbers one and two above are key factors in the financial intermediation part of this economic problem. Banks are capital constrained. Balance sheets are loaded up with problem debt. Future losses are embedded in booked exposures. The banking sector is not sufficiently healthy to support economic expansion or to reverse deflationary pressures.

So the question is how do we evolve? The government has propped up the banking sector, believing systemic impacts of bank failures would trigger a tidal wave of further liquidity contraction and trigger depression. The propping up has not worked. Yes, it has prevented a massive financial system collapse, but it has not supported economic growth. We need creative destruction in the banking sector. Let these existing banks reap the rewards of their policies. Create new banks with new fresh capital, unencumbered by toxic assets, headed by wise risk managers, but ready to lend. The FDIC may not like this because they do not want new competitors to pressure earnings of existing institutions. But the piddling cost of bank resolutions is nothing compared to the destruction of value in a squeezed economy. Fund up the FDIC and let these banks trickle towards failure. If new institutions are in place and ready to go, asset prices will reach clearing level and new investment will recycle assets into productive use. Many assets are already at or near clearing levels. As I said before, high net worth individuals are buying distressed assets. If you combine this recycling with vibrant human capital and a new sense of optimism, now there is something to work with.

The new banks could also have new business models that are supportive rather than exploitative. But that is for another post.