No Need to Worry About a 1930s-Style Depression

Is the U.S. banking system about to collapse? Is a massive credit crunch forcing liquidation and failures? Are we headed for a repeat of the terrible Depression of the 1930s?

I have been asked these questions by reporters many times in the past few weeks. The questions suggest a degree of fear that is unwarranted. Here are some thoughts on these issues.

Banking and financial institutions have been weakened by a combination of excessive regulation, increased competition and big mistakes by some imprudent bankers--especially those who believed that they were “too big to fail.” These losses, for a time, were hidden on some banks’ balance sheets.

If banks were required to mark their assets to market value, they could not have hidden their past losses in hopes of a better day. Determining market value would be difficult for some assets. That means that the requirement would be an improvement but would not bring perfection. It would have the big advantage of making banks and other financial institutions recognize losses when they occur. This would force prompt correction. It is not the only needed reform, but it is important.

Could it work? The stock market marks assets to market every day. That’s why many bank stocks fell drastically this year when losses on bank loans became known. Marking assets to market value is what mutual funds and money market funds must do every day. If banks were required to move gradually from current gimmickry toward market value accounting, the risk of a repeat of the present problems in the financial service industry--including the savings and loans--would be substantially smaller.

Marking to market would be one big step toward a stronger financial system, but it wouldn’t take care of present fears that a credit crunch is making the recession worse. Those fears are overstated. Growth of bank earning assets--loans and investments--is much slower now than during the booming years of the 1980s, but that’s not unusual. It happens in every recession, and it lasts until the Federal Reserve becomes more expansive.

There are a few new wrinkles this time. Three require comment. First, loan losses and writeoffs at some banks may make those banks more cautious than usual. That doesn’t have any effect on total lending; lending shifts to other banks and financial institutions. For example, European banks have been expanding in the U.S. market, offering more loans, as U.S. and Japanese banks shrink.

Second, a new agreement signed by the governments of all the leading countries requires banks to meet new capital requirements by 1992. Several of the largest U.S. banks do not meet the standard; they must increase capital per dollar of assets. To do so, these banks must either sell new shares, retain earnings or shrink their total assets. With earnings and stock prices down, they have chosen to shrink assets.

Once again, this has little if any effect on the total volume of lending; other banks and lenders take up the slack. If that were not so, we would see unused bank reserves piling up on the banks’ balance sheets. That hasn’t happened. If the government wants to help some of the banks that have difficulties meeting the new capital standards, it can ask for a delay. Because Japan’s banks face similar problems, the Japanese government might join in the request.

Third, many of the complaints about a credit crunch come from the real estate and construction industries. These industries always experience wide swings in demand, falling during recessions much faster than industry as a whole but recovering more quickly and more robustly.

Adding to the problem this time is the slump in commercial construction caused by removal of the special tax treatment of commercial construction in the 1986 tax act. Before the tax change, there was much construction activity. In many cities, builders anticipated demand for years to come. The prices of office buildings have fallen, as should be expected when many are empty.

When the market value of the buildings falls below the value of outstanding loans, some of the owners stop paying their mortgages. This puts banks and other lenders at risk, so it is not surprising that they do not lend on the old terms. With prices of commercial buildings falling, lenders demand more equity from the owner-borrower. This is prudent behavior, belated to be sure, but not a credit crunch.

An old-fashioned credit crunch occurred when the Fed suddenly shifted from excessive monetary expansion to excessive contraction. Interest rates soared, and with government ceilings on interest paid to depositors (that have now been removed), the banking system was forced to contract lending quickly. Demand for goods and services fell. Because the change in demand was sudden, businesses found themselves holding excessive inventories, so they borrowed at high rates to finance them and cut back production to get rid of them.

This time is very different. Average growth of bank reserves and money have been slow for several years. There is no surge in interest rates; interest rates are falling. It is nonsense to talk about a credit crunch under these circumstances.

What is happening? The United States is in recession as a result of slower money growth and uncertainties about war in the Middle East and future oil prices. Higher taxes and an apparent shift away from tax policies that encourage economic growth to those that redistribute existing wealth add to the problem by discouraging investment.

Fed policy remains restrictive. Market participants watch interest rates because the Fed watches interest rates. But interest rates are falling because the economy is weak and loan demand is falling. Despite lower interest rates and a recent reduction in the discount rate, year-to-year money growth remains well below the Fed’s announced target for the year.

In the past, Fed members knew only two speeds: too fast and too slow. Many of the members are conscious of the risk that the next round of inflation usually starts in the current recession when the Fed shifts money growth from too slow to too fast. I share that concern. But concern about “too fast” is not a reason for “too slow.”

What is the right speed? In the current quarter, money growth (M2) is about 2% at annual rates. The Fed should get year-to-year money growth up to between 4% and 5% (at annual rates) and keep it there next year. If interest rates and the dollar fall, so be it. When the economy recovers, the dollar will recover too.

Many commodity and land prices have been falling as the economy moves toward a lower rate of domestic price inflation. Lower inflation is the gain we get from the slow money growth of the past few years. The Fed is right to want to hold onto the gains against inflation. Once the oil shock passes through, lower inflation will be visible to all. But the Fed is wrong to remain far below its monetary targets. A 4% to 5% growth rate for money in 1991 will let the economy revive while inflation continues downward.

Banks will continue to fail, but a revived economy will limit failures. In any event, concern about collapse of the banking system is overdone. The Fed showed in 1987, and at other times in recent years, that it learned from its mistake in the 1930s and is unlikely to stand by again as the financial system collapses.