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An important monetary inflection point

This chart shows Commercial & Industrial Loans by all U.S. banks, a good measure of borrowing by small and medium-sized businesses—those too small to access the credit markets directly. It reflects both the appetite for credit among smaller businesses and the willingness of banks to extend credit. This measure of lending fell by 25% from the end of 2008 until hitting a low last September. It has now moved up a bit, and shows flat growth since last August. Bottom line: the great develeraging and credit contraction that began in the wake of the financial crisis of 2008 has apparently ended.

Many have argued that deleveraging is a major factor limiting the economy's ability to grow, but I disagree. I note that the economy grew strongly starting in mid-2003 even as bank credit continued to contract, and the recent recovery started in mid-2009 even as bank credit was in free-fall. The extension of credit by itself cannot create growth (you can't grow an economy by printing money, you can only "grow" prices), but bank credit can facilitate growth by making the economy more efficient; by channeling funds from savers to borrowers in ways that individuals could not manage by themselves. Rising bank credit can also signal rising confidence, and that is symptomatic of an improving economic climate.

If, as it appears, bank lending is once again starting to expand, I think that reflects a combination of factors: businesses have finished deleveraging; businesses feel confident enough about the future to expand their borrowings; and banks feel confident enough about the economic climate to expand their lending activity. Put another way, this chart shows that the demand for money has passed an important inflection point—instead of rising, it is now beginning to decline. (If money demand is strong, then the demand for loans is weak; if money demand is weak, then the demand for loans is strong. On the margin, businesses now want to be "short" money instead of being "long" money.) So there is a combination of factors at work here that reflects an improving economic climate (more confidence on the part of banks and businesss) and a change in the monetary dynamics of the economy (the beginnings of a decline in money demand). With the Fed still very willing to extend credit to the economy, and the economy now becoming more willing to borrow, monetary policy could start gaining "traction" in a meaningful way: both economic growth and inflation are likely to pick up.

HT: David Gitlitz

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