Sunday, November 23, 2014

The Great Credit Mistake

LONDON – Before the financial crisis erupted in 2008, private credit in most developed economies grew faster than GDP. Then credit growth collapsed. Whether that fall reflected low demand for credit or constrained supply may seem like a technical issue. But the answer holds important implications for policymaking and prospects for economic growth. And the official answer is probably wrong.

The prevailing view has usually stressed supply constraints and the policies needed to fix them. An impaired banking system, it is argued, starves businesses, particularly small and medium-size enterprises (SMEs), of the funds they need to expand. In September 2008, US President George W. Bush wanted to “free up banks to resume the flow of credit to American families and businesses.”

The stress tests and recapitalizations of US banks in 2009 were subsequently hailed as crucial to the recovery of both the banking system and the economy. By contrast, the European Central Bank’s inadequately tough stress tests in 2010 were widely panned for leaving eurozone banks too weak to provide adequate credit.

In the United Kingdom, banks have been criticized for not lending the reserves created by quantitative easing to the real economy, leading the Bank of England to introduce its “funding for lending” scheme in 2012. In the eurozone, it is hoped that this year’s asset quality review (AQR) and stress tests will finally dispel concerns about bank solvency and free up credit supply.

A “credit crunch” – particularly in trade finance – was certainly a key reason why the financial crisis generated a real economy recession. Taxpayer-funded bank rescues, higher bank capital requirements, and ultra-easy monetary policy have all been vital to overcome credit supply constraints. But there is strong evidence that once the immediate crisis was over, lack of demand for credit played a far larger role than restricted supply in impeding economic growth.

That argument is persuasively made by Atif Mian and Amir Sufi in House of Debt, an important new book that analyzes US data on a county-by-county basis. Mian and Sufi show that the recession was caused by a collapse of household consumption, and that consumption fell most in those counties where pre-crisis borrowing and post-crisis real-estate prices left households facing the largest relative losses in net wealth.

It was in those US counties, too, that local businesses cut employment most aggressively. For SMEs, a shortage of customers, not a shortage of credit, constrained borrowing, employment, and output. And the customers were absent because the pre-crisis credit boom had left them over-leveraged.

In the UK, many business surveys from 2009-2012 told the same story. Poor customer demand was ranked well ahead of credit availability as a constraint on growth.

Economic growth can indeed continue to be severely depressed by a debt overhang even when credit supply is unrestricted and cheap. Many Japanese companies were left overleveraged by the boom and bust in credit and real estate in the 1980s and early 1990s. By the late 1990s, the Japanese banking system was offering companies loans at near-zero interest rates. But, rather than borrow to invest, firms cut investment to pay down debt, driving two decades of stagnation and deflation.

Since 2011, the ECB’s analysis of weak eurozone growth has stressed the negative impact of an impaired and fragmented financial system, with high sovereign-bond yields and funding costs for banks resulting in prohibitive lending terms in the peripheral countries. Major progress in fixing these problems has already been achieved.

The ECB’s latest Monthly Bulletin documents this, citing multiple indicators of improved credit availability and pricing. Nonetheless, the rate of decline in private-sector loans has accelerated over the last year – from -0.6% to -2% – and low demand is acknowledged to be the main driver of depressed credit growth. Simultaneous private deleveraging and fiscal consolidation are restricting eurozone growth far more than remaining restrictions on credit supply.

Despite the ECB’s own evidence, however, the policy focus remains on fixing the credit-supply problem, through the AQR and stress tests, and through the ECB’s own version of a funding for lending scheme, announced on June 5. That reflects a recurring tendency in official policy debates, particularly in the eurozone, to concentrate on fixable problems to the exclusion of more difficult issues.

Fixing impaired banking systems after a crisis is both essential and achievable. Moreover, even when public rescue costs are inevitable, they are typically small change compared to the economic harm wrought by the financial crisis and post-crisis recession. By contrast, a large debt overhang may be intractable unless policy orthodoxies are challenged.

Japan offset private deleveraging in the 1990s by running massive public deficits. The US has pulled out of recession faster than the eurozone, not only – or even primarily – because it fixed its banking system faster, but because it pursued more stimulative fiscal policies.

But fiscal stimulus is constrained within the eurozone, where member countries no longer issue their own currency and “sovereign” debt therefore carries a default risk. Aggressive monetary expansion through quantitative easing is also far more complicated and politically contentious in a currency area with no federal debt for the central bank to buy. To survive and thrive, the eurozone will need to become more centralized, with some common fiscal revenues, expenditures, and debts.

Of course, this scenario implies immensely difficult political choices. But the starting point for debate must be realism about the nature and severity of the problems facing the eurozone. If eurozone policy assumes that fixing the banks will fix the economy, the next ten years in Europe could look like the 1990s in Japan.

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    1. CommentedZsolt Hermann

      I have to admit I don't understand anything from the economical/financial analysis of the article.

      But I think the problem is not economical, financial or even political.
      I think the problem is systemic.

      We created an artificial human bubble within the closed and finite natural system with infinite growth, ever growing credit and then developed our own laws, principles within this bubble and try to keep our life flowing based on these imaginary coordinates.

      But in truth we never left the natural system and we are still bound by its laws of balance and homoeostasis.
      And now the contradiction in between the natural system and our unnatural bubble has reached breaking point.

      Constant credit and quantitative growth is an illusion we stubbornly try to maintain.
      But in nature everything is based on natural necessities and available means/resources.

      The only solution for the deepening crisis is a return to the laws of nature, human society and our lifestyle adapted to them.

    2. CommentedStamatis Kavvadias

      According to Adair Turner, there is very shallow water for endogenous money to float. There is eiter solidarity (aka transfer union of some kind, in the sense of joined responsibilith), or... Steve Keen's solution of some kind of debd jubilee.


    3. CommentedWalter Gingery

      Confirms the view that the Euro-zone had better start getting used to the idea that the only way to restart growth is by forgiving a big chunk of debt.

    4. CommentedTomas Kurian

      Genom of Capitalism -Limits of supply side stimulus.

    5. CommentedJoshua Ioji Konov

      Withe the ongoing Globalization and rising Productivity, with the Chinese industrialization and the Internet the tipping off point of a pro supply economics has come to change Real Economics from a Supply to Demand to a Demand to Supply, and this well formulated article confirms it.

    6. CommentedPaul Daley

      Seems right. But are we at the point yet that we can talk about using bank reserves to write down debt, even as we push for higher reserve ratios? Or can we still only gesture vaguely at "difficult political choices."

    7. Commentedslightly optimistic

      "To survive and thrive, the eurozone will need to become more centralized, with some common fiscal revenues, expenditures, and debts."
      The recommendation is that other countries in the EU, who formed the eurozone, as a matter of necessity should introduce common and no doubt enforceable fiscal policies.
      But London keeps its discretion to ignore its own financial checks and balances, and refuses to take part in the international venture. Doesn't London have to be convinced to change its ways before we can move on internationally?

    8. CommentedNatale Ramondetti (mr)

      Yes, you are completly wright at the moment in Europe the main cause for the lack of demand for credit is the lack of investment, because of the loss situation of so many companies, and consumer demand because more and more people are living with a declining revenue (salary or interest) or have lost their jobs. Now very often the only demand of credit by companies is to cover their operating losses in order to manage their survival constraint altough it may be demanded under a different motivation. The main object of a new policy it should be to help companies to be again profitable. The banking system could help with prolonging the maturity of existing company debts in order to diminish the current amortisation cost . On the other side governments should start investing in useful projects for mantainance of the general structure of their countries in the public interest. This will also employ workers and producing an increase in general demand. It is inconceivable that in Europe so many millions workers are left with nothing to do...Europe is running into a paralysis and extremism will take place.Thanks and regards.