The U.S. economy is slowly emerging from recession. There usually are conflicting signals at turning points, and activity remains very weak in some industries and regions. Nevertheless, there is enough evidence to confirm that overall activity bottomed out in the second quarter.
Most economists expect a sluggish recovery; many worry the economy may slip back into recession this year. But the financial markets are sending out a more upbeat message.
The markets tend to be more accurate than sophisticated models when it comes to forecasting the economy. The firmness of equity prices, the steep yield curve, and narrow quality spreads in the bond market are reliable indicators that suggest the recovery could ultimately be much more vigorous than generally anticipated.
Gloom and doom always prevails at the bottom of the economic cycle, and each recession has its own unique reasons for pessimism. This time, there are major fears that there will not be enough credit available to finance a strong expansion against a background of a contracting banking system and a tightfisted Federal Reserve.
Such fears have been fueled by collapsing credit demand, depressed monetary growth, and anecdotal evidence of a bank-induced credit crunch.
The credit crunch has been overstated. The decline in the growth of bank lending has not been too far out of line with the experience of past recessions.
Moreover, it would be reasonable to expect a compensating increase in the supply of nonbank credit if banks were turning away large numbers of potential borrowers. In fact, nonbank credit has weakened even more sharply than bank lending, compared with past cycles.
This suggests that credit growth is falling mainly because demand is weak rather than because supply has been constrained.
Tough Times for Real Estate
Banks clearly are applying stricter criteria for loans, and commercial real estate is under close scrutiny as a result of banks increased caution. That is hardly a surprise because credit risks in the overbuilt real estate sector have soared.
Remember, a credit crunch is when creditworthy borrowers cannot raise financing on reasonable terms. Banks are right to question the future credit quality of most realty businesses.
A credit crunch exists in real estate to the extent that many sound companies are finding it unusually hard to secure finance. The problem is particularly severe in the Northeast.
Strong Borrowers Scarce
Most banks remain eager to lend to consumers and non-realty companies. Unfortunately, there has been a shortage of good-quality borrowers in those areas. The picture should improve in the months ahead.
The corporate sector's need for external finance in the first half of the year was reduced by a vicious cutback in spending on inventories and capital invesment. Inventory liquidation has almost run its course, and many companies will require increased working capital during the next year.
Consumer credit demand is most influenced by the trend in jobs. Employment is stabilizing and should start to grow modestly in the months ahead. That should lead to a gradual recovery in confidence and a desire to borrow and spend.
Lending capacity has been reduced by contraction in the bank and thrift sectors. But that will simply reduce overcapacity, not create a shortage of lenders.
About 40% of the increase in bank lending between 1982 and 1990 was associated with commercial real estate and highly leveraged transactions.
Credit demand in those areas will stay negligible for the foreseeable future. Therefore, the economy no longer needs the massive lending infrastructure that was built up during the credit mania of the 1980s.
Credit Freed for Better Uses
Slower growth in credit is not bearish for the economy if the borrowed funds are used more wisely than in the 1980s.
Mortgages accounted for more than half the growth in private nonfinancial debt during the 1980s' economic expansion.
The explosion in real estate investment, both residential and commercial, represented a serious misallocation of resources because it did not add to the nation's productive potential.
The shakeout in real estate will be painful for many developers, builders, and lenders. The positive aspect is that resources will be freed for increased spending on capital investment that will boost U.S. productivity and competitiveness.
What about the concern that the Fed is not providing enough liquidity to finance an economic expansion? The growth in the broad monetary aggregates is extremely low, and many view that as a sign of an overly restrictive Fed stance.
It is not that simple.
The broad monetary aggregates are being distorted by disintermediation away from depository institutions. A shrinking banking system does not need to attract deposits, and money is shifting into other assets not measured by the monetary aggregates. This is the other side of the contraction in lending opportunities.
Money growth will recover when demand for bank loans increases during the next few months. Significantly, the narrow M1 monetary aggregate, the most sensitive to the economic cycle, is in a clear uptrend.
The weakness in the broad monetary aggregates provides a misleading picture of tight liquidity conditions. Funds have poured into equity and bond mutual funds instead of into bank deposits. As a result, companies are raising increasing amounts of money from the stock and bond markets.
The stance of monetary policy can be most accurately judged by the level of interest rates. The Fed has pushed the federal funds rate down to the lowest level in 14 years. The prime rate, adjusted for inflation, is at the lowest level in more than a decade.
Interest rates are not an obstacle to increased credit demand.
Loans Are Available
The decline in credit growth represents an inevitable reaction to the unprecedented surge in debt during the 1980s.
Banks are behaving more prudently, and that may feel like a credit crunch compared with past lax standards. Nevertheless, loans are available for the vast majority of consumers and non-realty companies.
Overall credit growth will probably remain subdued in the next few years. That will encourage continued consolidation in the banking sector and among other providers of credit.