True Frugality/Prosperity Too Bitter for U.S. Leaders?

One of the essential elements of the business cycle is that it instructs market participants. When times are too good, immoderate behavior is rapidly rewarded, but soon after is then rapidly punished in the subsequent collapse. When times are bad, those who stored resources against bad times pick up bargains and benefit from their careful attention to economic reality.

The financial crisis of 2007 to 2009 is firmly rooted in overextension of credit to non-worthy borrowers. Clearly the lesson to be learned was "stop lending to poor credit risks; stop lending aggressively." As painful as a recession is, it really does reinforce the message that people must engage in economic behavior that is tied to reality. Unlike bubble behavior, in which people make investment decisions that are unsupported by economic fundamentals.

The collective decisions of consumers and businesses drive the economy. Each individual misallocation of resources hurts the long-term economy, even if in the short run it "feels good" or would seem to increase the velocity of money. When money is scarcer, the quality of these individual decisions rises. That is what generates recoveries.

If you have a recovery that is based on the millions of tiny gains that arise from good resource allocation decisions, then it is a sound one. If your recovery is based on a command-driven push to increase lending in order to restore some measurement of economic activity to a former level, then you are in danger of undermining your own long-term prosperity. Economic lessons in frugality are expensive; they hurt. We should not throw away the benefits of those hard-won lessons.

Are banks presently lending enough? It is a poor question. Better: Are banks meeting the existing demand for loans at prices that repay them for their risk? My sense is that commercial banks are lending appropriately, and if loans outstanding are dropping, it isn't their fault. Demand for loans is low and will stay low while consumers and businesses make prudent decisions based on the hard lessons they just learned.

This concept, that loan demand is dropping and is a good thing seems to be hard to grasp. Some people assume that loan levels are just set by the banks, and currently banks are being mean or trying to inhibit a recovery by failing to lend. This is echoed in the words selected by the interviewer in this video story at Tech Ticker. Mike Shedlock and Peter Atwater make the case that banks are reserving for current risks based on their customers' assessments of economic prospects, and that the building of non-loan assets is a reasonable use for their liquidity and has good historical precedent.

Conclusion: Profits are good now because of the steep yield curve, but consumers are laying a good foundation for a recovery through their credit decisions. There is a risk that this prudence could be short-circuited by governmental action, though my guess (95%) is that lobbying efforts for windfall taxes on banks, and other measures to force new risky lending, will not succeed.