The Economic Stimulus That Will Cost Us Dearly

Stop blaming the banks for everything: Low interest rates have lost their efficacy.

Since the onset of the great global economic crisis, even though interest rates have been at rock-bottom and governments have been shoring up financial systems worldwide, banks have not stepped up their lending to businesses. If anything, they've been lending less.

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The policy-makers in government don't like that. Even U.S. President Barack Obama has spoken out against the bankers' tight fists. Wall Street pundits and macroeconomic analysts have been tearing out their hair.

Their basic argument is that the banks threw themselves on the mercy of the taxpayer to save them from their own mistakes - and even after that, their executives continued to scandalously withdraw bonuses. Now the banks are being mean with loans and are creating a credit crunch, suffocating small businesses and preventing the economy from recovering.

It's convenient to point fingers at the bankers. The public is right to complain about their past irresponsibility and amateurishness, and present amorality when it comes to bonuses. That's justified. Yet claims that their tight fists are worsening the recession, or at least extending it, are populist nonsense.

It takes two to do the leverage tango

Let's begin with the logical contradiction inherent in that argument. A large part of the crisis was caused by too much being lent to unsound borrowers who used the money to speculate, carry out leveraged purchases of financial assets and recklessly squander on consumption.

Now the opposite claim is being made: The economy is grinding to a halt because there isn't enough lending.

What exactly are the latter grousers demanding? That the banks begin lending irresponsibly again, that they create an artificial wave of credit-fueled consumption that will simply end in another crisis?

Maybe the banks' critics feel that this time it's different. Unlike the case four or five years ago, when the banks would lend to anybody and his dog, this time they're overshot in the other direction: They aren't even lending to solid, healthy borrowers and businesses, thus blocking economic recovery.

The thing is, this isn't true. It takes two to dance the leverage tango.

For banks to extend "good" credit, meaning loans that will be repaid and stimulate economic growth, you need a borrower who sees an economically feasible project that would warrant borrowing.

New projects of the type, whether a new production line or construction project, are what create economic growth and supply what Americans need so badly - jobs.

That's the problem that the U.S. economy is facing, in fact all Western economies. On the one hand, interest rates are low. That theoretically should make lending cheaper and projects economically more feasible. But there's a very high barrier: The West has built up a glut of production capacity over the years. Businesses have no need for more investment.

It doesn't matter whether you're a business that's operating at only partial production capacity, a chain of stores whose sales per square meter have dwindled, or a builder whose homes and offices are standing empty. You're not about to borrow to increase capacity, buy inventory or build more. You aren't going to borrow for a project that won't generate income, or even worse, that will cost money to maintain, for the foreseeable future.

It's a basic rule of investing that you enter a project only when projected returns are higher than the projected returns on projects with a similar risk profile. It doesn't matter whether the project is financed by equity or loans. And the problem is that projects of the type that propel economic growth are in short supply.

No need to borrow

The financial statements of the big corporations demonstrate the point well. Their investments have declined, and by a lot, since the global economic crisis erupted.

Industrial giants such as Caterpillar and Boeing, General Electric and United Technologies, and retailers such as Wal-Mart and Home Depot have slashed investment in equipment and fixed assets. In some cases their investments dropped by half from 2007 to 2009 - and their investment plans for 2010 are even meaner.

These companies are not suffering from a credit crunch. All are blue-chips that could borrow at very low interest rates. All could embark on new projects. It isn't a lack of sources that's stopping them.

What's stopping them has nothing to do with sources, so stop slinging arrows at the banks. The problem isn't sources, it's uses, as they say in economic jargon. These companies have no reason to invest in expanding their activity, since they don't expect a decent return on these investments.

So we see that the business sector has no reason to invest, so the banks have nobody to lend to. But perhaps those nasty banks aren't lending to consumers, thus depressing demand?

Arrant nonsense. Consumer credit spiraled skyward in the years preceding the crisis. It helped create an artificial feeling of wealth that did indeed lead to economic expansion - but the party ended with a hideous hangover, as too many households borrowed beyond their means. Today they're paying for it.

Consumers up to their necks in debt in a weak job market aren't about to borrow, not even at low cost. They aren't going to spend a couple of thou on a new plasma-screen, high-definition television just because it's been marked down, because that's still a couple of thou they can't afford. They won't buy it even at 24 installments, without interest. When income is depressed, people don't feel like spending.

The upshot is that low interest rates have lost their effect on the broad economy.

They aren't causing businesses to invest. They aren't creating jobs.

They are allowing banks to make money through the nose, as long as they can borrow on the cheap and invest the money in government bonds, since they have nobody to lend to.

Low interest rates also allow Washington to pay relatively little on its mushrooming debt, but that just means the problem will grow worse in the future. Also, they enable speculators to operate at low cost, which is inflating commodity prices and financial asset prices. That's the basis for future inflation, dear reader.

Thus, day in and day out, it seems that the efficacy of low interest rates as an economic stimulator is losing its edge, while the long-term damage it will cause is worsening.

The writer is the CEO of Psagot Compass and head of overseas research at Psagot.