Economic and Financial Developments March 2010

The economy grew at a rapid 6% annual rate in the fourth quarter of last year. For many, news of rapid growth appears inconsistent with widespread job losses, high unemployment rates and widespread bank failures.

Much of the inconsistency stems from the difference between the level of business activity and its change. Changes from very depressed to not quite as depressed may impress economists and statisticians. They don’t impress those struggling to deal with current economic conditions.

There has clearly been some improvement in the business climate. Nationwide, housing prices are up about 5% from their lows last spring. However, prices remain 30% off their highs.

The collapse in home prices has left a quarter of all mortgage holders with negative equity in their homes. Negative equity has meant significant loan losses for banks.

 In addition to the equity decline in their homes, many homeowners face a challenging job market. In spite of the improvement in business activity and increased orders for new business, layoffs continue and companies are reluctant to rehire workers.

There are a number of reasons for the scarcity of jobs. One is that government policies have inadvertently created barriers to job creation.

 Politicians claim that jobs are created when it spends taxpayers’ money. While it’s true that such spending can create jobs, it also destroys them.

 In order for government to spend money it must first tax or borrow the money from those in the private sector. As a result, those in the private sector can’t spend the money they hand over to the government. The resulting lack of private spending negates any positive impact from new government programs.

Government spending also creates financing problems for the private sector. When governments borrow to finance massive deficits they do so by tapping a limited supply of private savings. This reduces funds available to private borrowers.

A lack of funds available to private businesses has made it particularly difficult for many firms to finance their businesses. The challenge is even greater than normal given current pressures on the banking system.

The recession has led to substantial losses at many banks. In an effort to rebuild capital, banks have reduced commercial and industrial loans. These loans are down 20% or more than $300 billion from their peak.

As the banking system continues to suffer from mounting loan losses, banks will continue to reduce loans. While the Great Recession is technically over, the financial stress continues for many banks and their customers.

So long as government policies focus on more spending, private businesses will find themselves at the back of the line when it comes to tapping the limited supply of private savings.

To prepare to meet future financing needs, businesses should maintain close relationships with their community banks. Given the ongoing financial stress, both banks and their customers should explore alternative sources of financing.  Doing so will help them prepare for the opportunities presented as the economic recovery continues.