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<< Previous   of   Next >>   ADVERTISEMENT   CONTACT THE HERALD Mike Benbow, Business Editor benbow@heraldnet.com   Published: Sunday, August 17, 2008 Tighter credit is badly timed for small businesses Small businesses are the ones paying the price for banks' remorse over the credit crisis. There is a reason why monetary policy during an economic downturn is described as pushing on a string. The Federal Reserve can cool down an overheated economy by raising short-term interest rates, but in a slowdown it cannot force banks to lend money when they don't want to. It is probably no accident that the pushing on a string expression gained attention at a congressional hearing during the Great Depression. Marriner Eccles, then chairman of the Federal Reserve, was asked what the central bank could do to help stir the economy out of its lethargy. His answer was that beyond an easy money policy, "…very little, if anything." And Rep. T. Alan Goldsborough said, "You mean you cannot push on a string." As we watch the economy respond to a cascade of negative, but not individually devastating, influences -- the housing bubble bursting, the mortgage credit meltdown, the oil price run-up -- we can see how the behavior of banks will prolong the downturn. Our financial system is emerging from another one of its periodic spells of risk amnesia. President Bush described Wall Street as having a "hangover" and it is not an inaccurate analogy. Certainly, banks are experiencing two of the classic hangover symptoms: pain and remorse. By and large, the powerful combination of the market and Federal Reserve action can deal with the pain. In fact, much of the Fed's monetary policy and actions have been directed toward injecting liquidity into the market to alleviate the pain. The remorse is another matter. When banks awaken and rediscover risk, they typically repent and begin to "get tough" and that is what is happening now. They are tightening credit -- perhaps the worst thing for our economy this side of another spike in energy prices. The Federal Reserve conducts a survey of senior loan officers each quarter, and the recently released July report analyzed responses from 52 domestic banks as well as 21 foreign banks that have branches or other operations in the United States. The Fed report states that "large net fractions of domestic institutions reported having tightened their lending standards and terms on all major loan categories over the previous three months. In particular, the net fractions of banks that had tightened credit standards on consumer loans increased notably relative to the April survey." On the commercial and industrial side, banks are expanding their profit margin by increasing the "spread" -- the difference between the loan rate and their cost of funds -- on loans to large and mid-size firms, but with little change in credit standards since the previous quarter. Small businesses are especially feeling the pinch. In this latest report, 65 percent of domestic banks, compared with 50 percent in the first quarter, "indicated that they had tightened their lending standards on commercial and industrial loans to small firms over the same period." Overall, consumer loans were the biggest target for the banks' remorse-driven toughness. Almost two-thirds of domestic banks indicated that they had tightened credit standards on credit cards and other types of consumer loans. The net result of the banking system's remorse, then, is that the two sectors that have been the source of so much of our economic growth in recent years -- small businesses and consumers -- are now to do penance for the banks' profligate ways. Whether or not this is unfair is a question beyond the scope of economics, but it is certainly dumb. Better credit standards and risk recognition are good things, of course. But, as Ecclesiastes put it, there is a time for everything. And the banks' timing will chill the economy just when it needs to warm up. Even with all the efforts of the Federal Reserve to encourage economic activity, it is extremely difficult to imagine a speedy recovery for our economy in a financial environment where banks are hunkered down and don't want to make loans. Worse, the Fed survey of senior loan officers also made clear that bankers expect the tightening process to continue through the first half of 2009. There was one piece of good news in the Federal Reserve report: Foreign banks doing business in the U.S. are not moving in the same direction. The proportion of these banks reporting that they had tightened credit was actually smaller than it had been in April. Foreign banks could be a significant source of credit, especially for small businesses who find that their U.S. bank no longer returns their phone calls. The Federal Reserve's easing and the commercial banks' tightening are obviously incompatible traveling companions. With any luck, though, the banks' remorse and sudden zeal for others' reform will wear off quickly. Then the Fed can go back to pulling strings instead of pushing them. James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.

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