How Can We Get The Economy Moving? Create New Banks

Since the financial crisis began, the U.S. has put $23.7 trillion in cash and guarantees to rescue failed institutions and create or save jobs. While the White House argues that this has saved or created 3.3 million jobs, the simple fact remains that 8.4 million have vanished since the recession began in December 2007.

And with the economy growing at a 1.6% clip in the second quarter, it is far short of the 2.5% rate that Nobel Prize-winning economist Paul Krugman says is needed to keep the unemployment rate from rising above its already high 9.5%.

Banks Are Hoarding Not Lending

The reason all this government spending isn't boosting the economy is simple: It's going into the coffers of banks that hoard it instead of lending it. To get the economy moving again, the government either needs to lend it directly to consumers and businesses or to create new banks -- unencumbered by the bad loans that are causing the old banks to hoard capital.

How so? The theory behind pumping money into the economy in a deep recession is simple: Get the cash into consumers' hands and they'll spend it. The resulting boost in demand will increase the sales of companies that produce products to meet it. The companies will have to hire more people, and the newly employed workers will spend their paychecks. This will further spike demand, and the spark of government stimulus will set off a firestorm of economic growth.

What Could Possibly Go Wrong?

Why isn't this working? A key part of the plumbing is clogged up. The banks that got us into this mess in the first place are extremely risk-averse. They are taking the nearly free money the government is providing them and investing it in risk-free assets like Treasury bills.

According to the Federal Deposit Insurance Corporation (FDIC), in the first quarter of this year, all FDIC-insured institutions had a total of $9.2 trillion in deposits, up 2.7% from the first quarter of 2009. During that period, banks' holdings of securities -- 61% of which are U.S. government securities -- rose 14.7% to $2.5 trillion.

Yet loans made by these banks have dropped while the quality of the loans has worsened. The FDIC reports that between the first quarters of 2009 and 2010, total loans and leases fell 3% from $7.7 trillion to $7.5 trillion. Reserves to protect against those loans going bad skyrocketed 35% from $194 billion to $263 billion. Meanwhile, the value of the loans for which borrowers weren't making payments soared 40% from $292 billion to $409 billion -- representing 28% of banks' equity capital, up from 21% the year before.

Business Got Squeezed

Interestingly, the fall in total loans and leases masked a surprising result -- consumers were getting far more loans while businesses and construction firms got squeezed. How so?

The FDIC reported that during that same period, loans to individuals climbed 32% to $1.38 trillion while credit card loans rocketed up 78% to $718 billion. But it seems consumers aren't spending their money -- the savings rate rose to 6.4% in June 2010.

Meanwhile, commercial and industrial loans tumbled 17% to $1.19 trillion and construction loans dropped 26% to $418 billion. And this drop in loans to companies that would hire people is impeding a recovery in the job market.

How to Unclog The System: Create New Banks

There's no way to break through this clog in the financial system's plumbing. Instead we need to bypass it. One way to do that is for the government to make loans directly to consumers and businesses. In theory, the government could hire loan officers who operate in much the same way as they do in commercial banks. But my hunch is that would not fly politically.

So we could go with a suggestion I first made on DailyFinance's sister site, BloggingStocks, on Oct. 7, 2008 -- create new banks. These new banks would be unburdened by all the bad loans of the incumbent banks and thus would be in a better position to make loans due to their clean balance sheets. This idea wasn't greeted with a chorus of approval.

But in February 2009, Stanford economist Paul Romer seemed to buy into it soon after I spoke about it on KCRW radio. He helpfully ran some numbers and estimated that if the government capitalized these banks with $350 billion of then-available Troubled Asset Relief Program (TARP) money at a 9-to-1 ratio of loans to capital, it would create $3.5 trillion in lending capacity.

Infrastructure Bank

And on Sunday, Laura Tyson -- an economics professor at the University of California, Berkeley, and former chairperson of Bill Clinton's Council of Economic Advisers -- suggested creating a new infrastructure bank. Her idea would "invest in things like interstate high-speed rail that require coordination among states and attract private co-investors in projects like toll roads and airports that generate dedicated future revenue streams."

Since we've tried all the conventional ways, and they haven't worked well enough, creating new banks is an idea whose time has come for getting the economy moving.