Thursday, April 16, 2009

The Reset, pt II

Let me fill in a couple gaps from my last post. Much of the economic commentary over the last couple of weeks at least has been focused on the banks. Are they solvent or not? In this context it's important to emphasize that even though we are obviously in difficult economic times, the nature of the problems is different than it was as recently as six months ago. At that time, it looked like there was a decent chance all lending and most other economic activity would come to a screeching halt. We should count ourselves fortunate that that didn't happen.

Numerous commentators have complained that in spite of all the government help the banks have gotten, they are still not lending in the volume we would like to see, instead they are ratholing the money away to shore up their balance sheets. This is true, but it's only half the picture at best. Because we are in a recesssion, the demand for credit from creditworthy borrowers is contracted as much as the supply. The quality borrowers that do want credit are able to get it on reasonable terms.

Therefore let's ignore the banks for a while. Frankly we don't know whether the banks are solvent or not. They are fine on a cash flow basis now. Whether or not they fail in the future depends on the extent to which there will be too many defaults in the their loan portfolio, on loans which have been performing up till now.

What we really need is a sector shift, a trend toward the production of goods and services which will be valuable in the future, and may not have been in the past.

Edit: in an important way, we can't help the banks anyway. More than most industries, in finance perception is reality. That is, whether or not the banks actually are insolvent, they are perceived to be insolvent at the moment at least. They are having serious problems borrowing from anyone else except the government. Therefore they have a strong incentive to hoard the capital they do have. If the government gives more financial support, that will help the perception as well as the reality, but only to an extent. Many of our bigger banks, especially Citi, have glommed together so many things and made so many deals, that it's very difficult to get a definitive handle on their financial status. And in this environment, what you don't know definitely can hurt you. Therefore the banks' financial conditions needs to be simpler as well as stronger, and that takes time.

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