This is long but is the essential bit of his argument, I think.
Nathan Lewis:
Last week, we talked about how credit losses lead to shrinkage of the bank's capital base. Typically, when banks have capital impairment (losses), there is much hue and cry that lending will shrink as a result, leading to recession. This is based on a very simple multiplication: banks typically have about 10:1 leverage. Their assets (mostly loans) are typically about 10x their capital base. So, this simple line of thinking goes, if capital shrinks by 20%, then loans must also shrink by 20% to keep the ratio in line. And indeed, the BIS capital ratio requirements mandate that large banks not get too far out of line regarding these ratios.
Oh my GAAAD! Horror! We're doomed!!!!
But banks don't really work like that. This is a subset of a broader group of theories, that an economy can be managed by a sort of mechanical top-down monetarist approach. The "money multiplier" was another of these ideas, as is the old "MV=PT" theory which actually dates from the 17th century, if not earlier. They are all based on the idea that there is some amount of "money" (or capital), and everyone jumps up and down like puppets depending on this one quantity variable. Thus, if banks have capital, then they create loans according to some sort of inevitable mechanical multiplication function, and if they don't have capital then loans shrink by the same inevitable mechanical multiplication function.
The world doesn't work like this at all. Just think of why borrowers and lenders get together in the first place. The borrower thinks: "If I borrow this money, then I can invest in an asset (or business) that, over time, will produce an effective return on capital greater than the rate of interest on the debt, and I'll make a profit." OK, that's a little technical, but the basic story is that the borrower sees an opportunity to put capital to use. The lender is thinking almost the same thing: "If I lend this money, I can enjoy a return on assets (the interest on the loan, minus credit risk) greater than the interest paid on my borrowing (which is the interest paid to depositors mostly), and thus enjoy a profit." In other words, it's a win-win situation, as it would have to be or nobody would do it voluntarily....
To summarize, lending is not driven by capital, rather capital is driven by opportunities in the lending business. Probably every businessman understands this, as it is true not only of banks but of practically any industry.
A good example of this appeared in Japan. In the 1990s, we were hearing the same baloney about how banks couldn't lend because they didn't have enough capital, and if there was more capital, then banks would lend more, and the economy would recover. There was a major failed bank called Long Term Credit Bank of Japan. The government thought it would use this bank as an experiment. They effectively nationalized the bank and sold it to some foreign (US mostly) investors, who effectively made a new bank out of it. (The new bank is called Shinsei Bank, which means "New Life". Poetic bank names were very popular in the 1990s in Japan.) Now there was a brand-new fully-capitalized bank without all the bad-loan difficulties of the other major banks. Plus, this brand-new bank had (supposedly) best-quality management, namely those New York sharpies who were going to show us all the most sophisticated pratices in the financial industry. This new bank would then make all the loans that the other banks "couldn't" make, because they were capital impaired. With more loans, the economy would recover.
Right?
Wrong. Actually, at the time, there was very little demand for borrowing, because of the poor economy. The poor economy was caused, in large part, by monetary instability in the form of horrible deflation, plus various tax hikes. Debt is very painful in a monetary deflation. Most of the healthier companies had all the debt they wanted, and more, and didn't see many expansion opportunities (requiring more borrowing) in the environment of unstable money and high taxes. Most of the weaker companies nobody wanted to lend to, nor did they want to borrow either, as they were spending all their time trying to figure out ways to escape the burden of their past debts. In fact, the existing large banks were, at the time, searching very hard for good lending opportunities, from which they could make the profit to pay for their losses on their existing bad debts, and not finding many. All of this was represented in very low interest rates (high prices), for both government and good-quality corporate debt, which shows an excess of buyers (lenders) compared to sellers (borrowers).
So, what happened to Shinsei Bank? For the first couple years, it didn't do a thing. The lending market was, in fact, very competitive, and virtually all the demand for debt was satisfied at very good prices for the borrower (low interest rates), and rather poor terms for the lender (narrow net interest margin and low profitability). Later on, as the monetary issue was resolved (reflation), investment opportunities arose again, and both banks and borrowers got together to take advantage of them.
The New York sharpies still made out very well, however, mostly because of cushy terms given to them from the government. So, in the end, the real opportunity was not in the wonderful lending opportunities. The real opportunity was the chance to get a very cushy deal from the Japanese government. And how did they get this cushy deal? Because of the idea that there would be some wonderful lending boom and economic recovery if the government gave them a cushy deal.
That is one reason why we see these arguments again and again during these "bad debt" events. The economists at the big brokerage houses blah blah about it constantly. Some of the economists are aware of the scam (a little bit), but most are just useful idiots. At the end of the day, they act like amoebas that swim toward a source of sugar. (If they weren't idiots, they wouldn't be useful.) The useful idiots understand, at some limbic level, that if they talk the blah blah, they keep getting paid. The journalists pick up on it and magnify it. (Most journalists have an inferiority complex, making them unwilling to challenge anyone who makes more than they do, which is about everybody, and amount to badly paid useful idiots.) After years and years of this blah blah, the politicians relent.
Probably the scammers themselves (in this case the foreign investors) believe the story. Why not? They aren't economists either, but they can smell a good deal, and if they can also Play an Important Part in the Revival of the Japanese Financial System, well, that's fine too, and maybe they'll get an honorary degree or something out of it.
And who is pushing this idea today? Why, it's the economists of Goldman Sachs! I am soooo surprised!
$2 trillion lending crunch seen Goldman Sachs economist says mounting credit losses could force banks to significantly scale back their lending.
The money multiplier is a (Keynesian) mathematical equation meant to model the effects of banking and central banking on the economy. It's based on the philosophy that you can model the economy like a machine, and is basically about the extent to which a bank can have an impact on macroeconomic performance (in either direction), and hence justification for helping banks out with their "bad debt" problems -- shrinking capital base -> less loans -> economic slowdown -> gimme cash now!
Yeah, that's what I'm saying, the banks are more than that, and in fact are more than something that simply borrows and lends at different rates contrary to what Lewis is trying to imply.
But it's the same thing, no? The difference between the interest paid
to depositors and the interest paid
by borrowers is the bank's margin. It's multiplying money in the same sense that any other business multiplies money:
"If I borrow this money, then I can invest in an asset (or business) that, over time, will produce an effective return on capital greater than the rate of interest on the debt, and I'll make a profit."
