Pushing on a string

If you recall from one of my posts a few weeks ago, the U.S. is in danger of slipping into what economists call a liquidity trap. A liquidity trap occurs when the Fed tries to pump money (or "liquidity" ) into the financial system, but the banks don't pass it along. The latest indication of this liquidity trap can be found in the results of a Federal Reserve survey of bank executives.

According to the survey, a large proportion of domestic banks reported having "tightened their lending standards and terms on all major loan categories over the past three months." These banks also reduced credit limits on credit card accounts for both prime and nonprime borrowers. About 80% of the tightening came from large banks; only 55% of smaller banks reported tighter standards. About 85% of large banks reported tighter standards for commerial and indutrial loans made to large and mid-sized companies, while 75% reported tighter standards for small companies.

The reason for the tighter standards, of course, is the uncertain economic outlook and the banks' reduced tolerance for risk. But these are exactly the trends the U.S. Treasury and the Federal Reserve are trying to stave off with their massive interventions.

What the survey doesn't mention is that much of the reticence for lending stems from the hyperactive efforts of bank regulators as they audit bank operations. The hypocrisy of the situation is almost unbearable. These are the same regulators who turned a blind eye as the banks gorged themselves on subprime assets during the recent credit bubble. Where were they then?

The point of this post is not to suggest banks should go back to making stupid loans. My point is that we face a fundamental disconnect between monetary policy and regulatory policy--a disconnect that exacerbates the economy's skid toward a liquidity trap. Until this conflict softens, the Fed and the U.S. Treasury are going to be frustrated in their attempts to reignite this economy.