The Fed As a Fix For "Tight Credit" Is a Total Non Sequitur
CNBC reported last week that banking giant Wells Fargo was “stepping away from the market for home equity lines of credit because of uncertainty tied to the coronavirus pandemic.” As always, what Wells Fargo is doing could only surprise an odd subset of society gulled by the Federal Reserve. To anyone else, Wells’s actions are logical. The economy’s on lockdown, which means the ability of borrowers to pay monies back is highly limited.
It’s all a reminder that the Fed’s interest rate machinations aren't very consequential. For one, it can create money, not credit. Credit is a consequence of production. No one borrows money as much as they borrow what money can be exchanged for. Money serves no purpose without production first, which means it’s a consequence as opposed to an instigator.
Second, while the Fed can buy credible interest-bearing instruments from banks with an eye on liquefying the banks, there’s already a liquid market for the assets held by financial institutions. Furthemore, assuming the Fed pushes dollars into banks, they're but a tiny fraction of total credit. What the Fed provides won’t overwhelm the broad rush away from risk among credit sources.
Third, even the banks that the Fed projects its well overstated influence through are shrinking their risk profiles. As the Wells example makes plain, the Fed can’t force easy credit with zero rates of interest. More realistically, the Fed’s low rates of interest are just the central bank confirming what’s true for banks at present: they’ll only lend to the surest of sure things.
To be clear, the Fed is a rate follower, not a rate setter. Banks are aggressively limiting risk, which means they’ll logically pay extraordinarily little for deposits. With all investment and lending, it’s ultimately a spread game. Which brings us to last Friday's column by Wall Street Journal Fed watcher Greg Ip.
Ip made a case that businesses have a solvency problem, as opposed to a liquidity problem. Per Ip, liquidity speaks to a problem of accessing credit, while during solvency crises “companies can’t survive no matter how much they can borrow” on account of limited revenue. Ip might agree that to some degree one is a consequence of the other. Companies experiencing revenue difficulties, or expected to experience revenue difficulties on the way to solvency troubles, will logically experience liquidity problems too.
All of which makes the present situation fairly easy to assess. Lockdowns born of panic by politicians have businesses gasping for air. Restaurants are open, but takeout does not pay the bills. Hotels and airplanes are near empty, while millions of “non-essential” businesses were shut down altogether. They’re insolvent from a revenue standpoint, which renders many illiquid.
Bringing all of this back to the Fed, not only can it not create credit despite what all too many mystics believe, it also can’t just lend money indiscriminately. Ip quotes Fed Chairman Powell as alerting reporters to a truth that few Fed mystics will ever acknowledge: “We can’t lend to insolvent companies. We can’t make grants.” Think about what Powell said, then think some more.
Even as its mission is expanded well beyond its initial role as a lender of last resort to solvent banks, the Fed can’t prop up just any business. Much as banks must lend with an eye on being paid back, the Fed has to be careful too. No doubt Treasury is in place to backstop losses, but what’s that line about “sooner or later you run out of other people’s money”?
Not only can the Fed not alter the lending practices of banks in a major way, not only can it not overwhelm much greater caution among credit providers overall, the Fed on its own can’t reverse the desperation that is the business norm at the moment. Not in the business of giving grants, the Fed can to some degree only lend to businesses that already rate credit.
And if it could make grants, this too wouldn't reverse the desperation. If you're being strangled, a brief reprieve from your strangulation won't alter the end result.
There’s the saying that banks can only lend to individuals and businesses that don’t need the money, and it seems the Fed finds itself in a similar spot. It can’t lend to businesses that lack revenue streams any more than banks or investors can.
It's a reminder of a simple truth that’s been stated over and over since the lockdowns began: the various lending facilities created by the Fed, Treasury, SBA and others are a total non sequitur. They’re the equivalent of a good samaritan offering Vitamin C to someone in the process of stabbing himself.
Businesses don’t have a money problem, nor will money fix their situation. There’s not enough money to prop up all the businesses that presently have little to no revenue. The problem businesses have is that their freedom to produce is presently not there. Since it’s not, they can’t generate revenues which means they can’t generate liquidity.
No business ever has a liquidity problem as is as much as investors with the ability to provide liquidity lose faith in their ability to create revenue. To be clear, liquidity is a consequence. No one, including the Fed, can decree it. Only productive activity that brings with it the promise of near or long-term returns will result in liquidity. In normal times there’s tons of liquidity in Palo Alto, but very little in East St. Louis. If Palo Alto’s exciting entrepreneurs were to move to East St. Louis, there would suddenly be a lot of liquidity there.
At the moment the entrepreneurs and businesses who would normally be a magnet for liquidity based on present revenues, or the expectation of future revenues, are not free to operate. That liquidity is tight at the moment is statement of the supremely obvious.
Crucial is that the Fed can’t fix this. So-called “money supply,” credit, and investment are always and everywhere a consequence of free businesses free to produce. End the lockdowns, and the lack of “money” will no longer be a problem.
