Sunday, May 23, 2010

The Main Street Theory.

1. Banks lend irresponsibly. 2. A credit crunch ensues. 3. Governments pour money into banks to encourage them to . . . . yes, you guessed: lend yet more. 4. Having laughed or cried (take your pick), now for the serious analysis.

Banks are profit motivated. That is, before the crunch they engaged in lending which they thought would maximise profits. Plus, as in any business, the best or most profitable opportunities are exploited first.

Put another way, there are diminishing returns here: the more lending a bank does, the more risky is each succeeding loan.

Before the crunch, aggregate demand was not excessive. Demand for houses was too high. But aggregate demand was not: inflation was not excessive.

Now if the marginal loan is too risky, but aggregate demand is not excessive, doesn’t this tell us that too much bank lending is taking place relative to self financed business ventures or operations?

The above theory supports the “stimulate Main Street not Wall Street” theory. Or put another way, will politicians please repeat the phrase “payroll tax cut” till they are blue in the face?

P.S. Here is some evidence that the total of bank loans and debt is now excessive.

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