A new type of tickle down economics

Around the world, economic policy in recent years has been based on a simple belief. If you make sure that all the banks are doing fine, the rest of the economy will eventually follow suit.

That’s what’s behind so called ‘quantative easing’, the cornerstone of the Federal Reserve’s economic policy since the financial crisis. And the Fed’s not alone. The Bank of England and the European Central Bank pursued the same policy in the aftermath of the 2008 financial panic. The Bank of Japan has done it since 2001.

The policy was born out of necessity. With official interest rates set near zero, further interest rate cuts don’t do anything. The theory of quantitative easing is that central banks can stimulate the economy by printing money to buy longer maturing bonds. The holders, of course, are primarily banks and other financial institutions.

That is supposed to help in three ways. First, when banks themselves are in trouble it ensures that they don’t go bust. Second, putting money in the hands of banks and institutions means they can lend more to businesses and households.

Third, the central bank offers more than the otherwise prevailing market rate to induce bondholders to sell. That sends prices up and pushes down yields on those longer term bonds. If all goes well, lower long term interest rates result and actors in the real economy see a greater incentive to borrow and invest.

With employment in the US stalled, the Fed has now turned to a third round of quantative easing, announcing it will buy $40 billion a month of mortgage backed securities. Stated more clearly, the Fed is printing money to buy real estate loans for a little more than they would otherwise fetch.

It’s worth asking whether putting that money into banks now is going to boost the economy.

Back in 2008, when the banks were the source of the problem, quantative easing helped stabilize institutions on the verge of collapse and averted what looked to be a real disaster.

The second time the Fed embarked on quantative easing was in 2010 and 2011 when economic growth slowed to crawl speed. At that time, the biggest effect of the Fed’s policy was on the stock market, sparking a bull charge upwards from financial crisis lows.

But now the banks are doing very well. The problem is a lack of hiring.

Economists think the rising stock market may have had a slight wealth effect, helping to boost consumption at the higher end. But the number of Americans owning stocks has been falling since 2001 when it reached a peak of nearly 60 percent. Today less than half of households own any stocks at all, while the vast majority of stock wealth is concentrated in a small sliver of the population. In contrast, a far greater wealth effect could come from boosting the housing market where two-thirds of Americans own their own home.

Whether quantative easing boosts the broad economy or not hinges on the willingness of banks to lend. If banks get extra funds from bond sales but don’t lend them out to companies and households, it won’t help the economy. Companies and homebuyers may want to borrow at those low, low rates but banks have to agree to take the risk. Big companies can access stock markets and debt markets on their own, but small and medium firms and individual homebuyers have few options.

So how willing are banks to lend right now?

Since the financial crisis, banks have been cutting their risk. They have lent readily to big companies and the most creditworthy individuals, but not to anyone else. That leaves out the vast majority of the population.

According to recent figures from the Fed survey of senior loan officers, lending standards are easing but only in the area where banks have already been lending—big companies and high quality individuals. There’s just one problem. Those companies and individuals have already borrowed as much as they want at historic low rates. They can’t use any more money at the moment.

The Fed’s survey shows that there has been no shift in lending to small and medium firms or consumers with less than perfect credit. In fact, the Fed reported that standards have tightened on both prime and nontraditional mortgages. It seems that a lot of people would like to borrow but are being shut out.

Then where does that leave QE3?

So far the Fed’s announcement of QE3 boosted the stock market. Major indicators like the Dow and S&P are trading near record highs. Bond traders may see a windfall as well. But unless banks change their lending standards, it won’t boost the economy.

Quantative easing is the latest in a long line of trickle down economic policies. Tax cuts for the already wealthy and for the corporate sector have not proven particularly powerful ways to stimulate the broader economy. Those policies have led to growing disparity between haves and have nots. Quantative easing looks like more of the same.