Liquidity Trap: Private Leverage To Hinder Bank Loan Growth

Executive Summary

• Private-sector leverage is too onerous to sustain high levels of new bank loan growth.

• High levels of debt restrict private loan growth, and the government sector uses more resources to bridge the gap.

• Government expenditures are less effective than private-sector lending.

• The result of high private leverage and low bank loan growth will be another expansion of weak economic growth and depressed levels of inflation.

Liquidity Trap: Private Leverage To Hinder Bank Loan Growth

A healthy banking system and strong consumer demand are critical to a robust economic expansion with lasting growth. Money is created in the private sector when a bank's willingness to lend is matched with a customer's demand for a new loan. 

If the banking sector finds new loans too risky or customers don't have an appetite for borrowing, total bank loan growth will fall, and the most productive engine of the economy, the private sector, will take a back seat to the significantly less productive government sector. 

Private sector non-mortgage debt is currently 188% of GDP, the highest level in modern history outside of the 2008 financial crisis. 

Private Sector Non-Mortgage Debt to GDP:

Source: Federal Reserve, BEA, EPB Macro Research

For most of the 2010s economic expansion, the private sector carried about 180% debt to GDP, and the result was the weakest decade of loan growth in over 40 years. 

Low private loan growth, in hindsight, is clearly an issue that stunted economic growth and inflation during the previous economic expansion. 

Bank Loan Growth By Decade:

Source: Federal Reserve, EPB Macro Research

After recessions, bank loan growth almost always declines, and this deleveraging is necessary. The sustained rate of bank loan growth that occurs through the bulk of an economic expansion is critical to sustained economic growth and inflation. 

Currently, bank loan growth is contracting as deposit growth is positive, a common occurrence in a post-recessionary period. 

The strength of the future economic expansion will be dependent on the recovery in bank loan growth. 

When the private sector carried 180% debt to GDP, loan growth was weak by historical standards and economic growth was anemic. Now, private sector debt to GDP is almost 10% higher. Should we expect loan growth to sustainably increase with increased private sector leverage?

Bank Loan Growth & Bank Deposit Growth:

Source: Federal Reserve, EPB Macro Research

The government sector has been flooding the banking system with deposits through QE and fiscal stimulus. 

An increase in bank deposits will generally result in an increase in either bank loans or bank securities. 

In Hoisington Management's most recent quarterly review, Dr. Lacy Hunt outlined the impact of declining loans and increasing deposits. 

As deposits rise, but bank loan growth falls, those deposits will instead flow into securities purchases, most often Treasury/agency paper.

Lacy Hunt on Loan Growth and Deposit Growth:

Source: Hoisington Management

Bank of America CEO Brian Moynihan confirmed this situation. 

If the government sector is going to continue increasing deposits in the banking system, but loan growth is to remain weak, then we will see banks park an increasing amount of money in government securities. 

Bank of America CEO on Lending and Deposits:

Source: Company Transcripts

The declining loan to deposit ratio or increase in government security purchases facilitates more government spending. 

As an increasing amount of resources flow to the government sector as opposed to the private sector, real per capita economic growth declines. 

Loan To Deposit Ratio:

Source: Federal Reserve, FRED

The correlation between government size or government debt and growth has been reviewed dozens of times with consistent results. An increase in government size or increased percentage of resources (land/labor/capital) flowing to the government sector results in a long-term drag to real economic growth. ( Government Size and Growth )

The McKinsey Global Institute conducted a study on debt and deleveraging and outlined the current dynamic between increased liquidity in the banking system but no corresponding increase in bank loans. 

Monetary policy does not work in high debt economies. 

So far, inflation has remained at very low levels, despite record low interest rates and unconventional monetary policies such as quantitative easing. In recent years, many economists have discussed the limited effectiveness of this standard monetary mechanism in a high debt environment. It can work only if banks are willing to lend. Liquidity, they point out, cannot translate into inflation when demand is depressed, the propensity to save is high, and banks are still deleveraging.

McKinsey Global Institute

A liquidity trap is when continuous injections of liquidity into the banking system do not result in an increase in bank lending, which makes the monetary policy transmission mechanism fail.

This situation is called a liquidity trap, in which injections of cash into the private banking system by central banks fail to boost borrowing and hence make monetary policy ineffective.

McKinsey Global Institute

With near-record private sector leverage, without a deleveraging, the economy will remain stuck in a liquidity trap in which monetary policy will fail to reach the real economy, and liquidity will flow back into government securities rather than private loans. 

This liquidity trap will result in a future economic expansion that looks similar to the past decade: weak real economic growth and a pronounced disinflationary trend. Cyclical trends in growth will come and go, but the lasting force or the gravitational pull in the economy will continue to be lower.