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Spanish prime minister Mariano Rajoy declared that one of the biggest problems in Spain right now is the lack of financing to small and medium enterprises (SME). The solutions proposed are, as always, really easy: the state should guarantee the loans (or at least a portion of the loans) made by private banks and other credit institutions to SME. However, economics is not only the science of the seen, but most of all the science of the unseen, as the great economist Frédéric Bastiat once wrote. The solution proposed by the Spanish government to the lack of lending looks brilliant in its simplicity: if there is a lack of lending caused by “animal spirits”, the state should enter the picture and guarantee the loans given by banks to SME. In this way, more loans will be issued by banks given that the risk of future losses will be shared with the government. Again, “Bravo” to the clear and simple mind that orchestrated this plan. Why did not we think this solution before? Actually someone thought it before and the results were not that brilliant. However, we should analyze form a theoretical point of view this plan. The seen part of the plan is obvious: more lending will be granted to SME, the enterprises will prosper and hire more workers, less unemployment, more votes to the current administration and everyone is happy. Nevertheless, there is an unseen part of this plan: future losses that will be borne not only by banks, but directly by taxpayers that will be the hidden face behind the state guarantees. State guaranteed loans issued by private credit institutions to SME will have the perverse effect of increasing lending to profitable and unprofitable businesses. Given that banks will be able to issue loans without bearing the risk of future losses (risks that will be bore by the government or, truth to be told, by taxpayers), the incentive will be to lend to every SME, profitable or unprofitable, because the volume of lending will be the principal concern of banks and not the capacity of repaying the loan of the enterprises. Credit institutions will lower lending standards, given that the risk of lending will not be on their shoulders. Moreover, they will lend to whatever project every entrepreneur has in its mind, being the project viable or not. The quality of collaterals required to back the loans will be lower and their value inflated in order to increase the volume of loans. Credit analysis criteria will be less stringent and the profitability and future cash flows of entrepreneurial projects will not be a concern for the lending institution, as long as the rewards of the loans will be reaped by the bank, while the losses will be borne by taxpayers. This happened in the past with SBA loans in the United States. The Small Business Administration (SBA) was created in order to increase financing to small businesses in times of crisis. Through the SBA, the government guaranteed all or part of the loans granted to small businesses around the United States. These loans had, in principle, to satisfy strict criteria in order to be guaranteed, but the incentives were exactly the opposite and credit institutions are guided not by strict and bureaucratic criteria, but by the incentives that the system sets. The obvious results of this perverse set of incentives were some scandals like the one of the Business Loan Express (BLE), a credit institution subsidiary of Allied Capital that granted loans to unprofitable or even non-existent businesses. This scandal was discovered and made public by the Hedge Fund manager David Einhorn in his famous short bet against Allied Capital (described in the fantastic book “Fooling Some of the People All of the Time”). The consequence was that taxpayers lost hundreds of millions of dollars being the last guarantor of these loans. Similar problems arised in other sectors of the economy where the government decided to cure the “illness” of the lack of financing. One example is the lack of lending to prime and subprime borrowers and the creation of Fannie Mae and Freddy Mac to cure this problem, with the resulting subprime mortgage crisis exploded in 2007.

The thing is that bureaucrats and many economists do not understand that the lack of lending in a free market facing a crisis has a meaning, like the presence of lending in a market that is in a recovery phase. In a situation where banks are undercapitalized, where there is a lack of savings, where the economy has lived a long period of malinvestments, where enterprises are not profitable and creditworthy, the lack of lending is good, because it is a symptom of the adjustment that the economy needs in order to become once again sustainable. The only sustainable solutions to the lack of lending are:

–       The recapitalization of the banking system

–       Incentives to save and not to consume

–       Open the market to foreign capital and favor the entrance of these foreign capitals

–       Let unprofitable businesses fail and free resources to be used by profitable businesses

–       Let prices of goods and labor to adjust (even if adjust means fall) in order to decrease the cost of production and let the firms be competitive again

–       Give time to these adjustments

Once these things are in place, and the economy adjusts, lending will flow again and SMB will prosper and create jobs. Even if this process takes time and pain, this is the only way to go back to growth and a sustainable economy. State guarantees are not the solution, but the creation of another problem.