Sunday, November 23, 2014

The Other Financial Crisis

NEWPORT BEACH – Two variants of financial crisis continue to wreak havoc on Western economies, fueling joblessness and poverty: the one that we read about regularly in newspapers, involving governments around the world; and a less visible one at the level of small and medium-size businesses and households. Until both are addressed properly, the West will remain burdened by sluggish growth, persistently high unemployment, and excessive income and wealth inequality.

The sovereign-debt crisis is well known. In order to avert a likely depression, governments around the world engaged in fiscal and monetary stimulus in the midst of the global financial crisis. They succeeded in offsetting nasty economic dislocations caused by private-sector deleveraging, but at the cost of encumbering their fiscal balances and their central banks’ balance sheets.

While sovereign credit quality has deteriorated virtually across the board, and will most probably continue to do so, the implications for individual countries vary. Some Western countries – such as Greece – had fragile government accounts from the outset and tipped quickly into persistent crisis mode. There they remain, still failing to provide citizens with a light at the end of what already has been a long tunnel.

Other countries had been fiscally responsible, but were overwhelmed by the liabilities that they had assumed from others (for example, Ireland’s irresponsible banks sank their budget). Still others, including the United States, faced no immediate threat but failed to make progress on longer-term issues. A few, like Germany, had built deep economic and financial resilience through years of fiscal discipline and structural reforms.

It is not surprising that policy approaches have also varied. Indeed, they have shared only one, albeit crucial (and disappointing) feature: the inability to rely on rapid growth as the “safest” way to deleverage an over-indebted economy.

Greece essentially defaulted on some obligations. Ireland opted for austerity and reforms, as has the United Kingdom. The US is gradually transferring resources from creditors to debtors through financial repression. And Germany is slowly acquiescing to a prudent relative expansion in domestic demand.

So much for the sovereign-debt crisis, which, given its national, regional, and global impact, has been particularly well covered. After all, sovereigns are called that because they have the power to impose taxes, regulations, and, at the extreme, confiscation.

But the other credit crisis is equally consequential, and receives much less attention, even as it erodes societies’ integrity, productive capabilities, and ability to maintain living standards (particularly for the least fortunate). I know of very few Western countries where small and medium-size companies, as well as middle-income households and those of more limited means, have not experienced a significant decline in their access to credit – not just new financing, but also the ability to roll over old credit lines and loans.

The immediate causes are well known. They range from subdued bank lending to unusually high risk aversion, and from discredited credit vehicles to the withdrawal of some institutions from credit intermediation altogether.

Such credit constraints are one reason why unemployment rates continue to rise in so many countries – often from already alarming levels, such as 25% in Greece and Spain (where youth unemployment is above 50%) – and why unemployment remains unusually high in countries like the US (albeit it at a much lower level). This is not just a matter of lost capabilities and rising poverty; persistently high unemployment also leads to social unrest, erosion of trust in political leaders and institutions, and the mounting risk of a lost generation.

Indeed, unemployment data in many advanced countries are dominated by long-term joblessness (usually defined as six months or more). Skill erosion becomes a problem for those with prior work experience, while unsuccessful first-time entrants into the labor force are not just unemployed, but risk becoming unemployable.

Governments are doing too little to address the private credit debacle. Arguably, they must first sort out the sovereign side of the crisis; but it is not clear that most officials even have a comprehensive plan.

Policy asymmetry is greatest for the countries most acutely affected by the sovereign-debt crisis. There, the private sector has essentially been left to fend for itself; and most households and companies are struggling, thus fueling continued economic implosion.

Other countries appear to have adopted a “Field of Dreams” – also known as “build it and they will come” – approach to private credit markets, In the US, for example, artificially low interest rates for home mortgages, resulting from the Federal Reserve’s policy activism, are supposed to kick-start prudent financing. The European Central Bank is taking a similarly indirect approach.

In both places, other policymaking entities, with much better tools at their disposal, appear either unwilling or unable to play their part. As such, action by central banks will repeatedly fail to gain sufficient traction.

In fact, only the UK is visibly opting for a more coordinated and direct way to counter the persistent shortfalls stemming from the private part of the credit crisis. There, the “Funding for Lending Scheme,” jointly designed by the Bank of England and the Treasury, seeks “to boost the incentive for banks and building societies to lend to UK households and non-financial companies,” while holding them accountable for proper behavior.

The UK example is important; but, given the scope and scale of the challenges, the proposal is a relatively modest one. The program may stimulate some productive credit intermediation, but it will not make a significant dent in what will remain one of the major obstacles to robust economic recovery.

Proper access to credit for productive segments is an integral part of a well-functioning economy. Without it, growth falters, job creation is insufficient, and widening income and wealth inequality undermines the social fabric. That is why any comprehensive approach to restoring the advanced countries’ economic and financial vibrancy must target the proper revival of private credit flows.

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    1. Commenteddavid horton

      MR. El-Erian,
      I like what you say but disagree about one of your major points. Banks want to lend money badly and every man in the bank is searching for someone to borrow the money who will pay it back. The problem is there is a big lack of demand, too much capacity, almost no expansion for new plants and equipment (cheap used buildings and equipment are everywhere). There are vacant buildings of all kinds available and people who need cash are, for the most part, risky. The strong business owners are not expanding but being careful and not needing cash.
      I don't see it as lenders holding onto their money in an unintelligent way.
      This overcapcity of labor, buildings, equipment will have to be worked off before we see significant changes.

    2. CommentedFrank Aten

      I'm not buying the counterfactual of "in order to avert a likely depression". There has been a slowdown in private sector debt accumulation but no actual pay down (except losses on mortgages by banks....very little). The process was poor risk management on every level from every sector.

      Government, wallstreet and man himself is not as smart as they think they are....realizing that is the first rule of risk management.

    3. CommentedJorge Simao

      Good comment, Paul!
      The problem with government driven demand, is that being great in principle is sub-optimal in practice -- as the gov. can not really know if an investment of x$ will produce a growth >x%. Thus lots of wast can happen. Also to get the x$ in the first place gov. needs to tax it to business and people -- which reduces competitiveness and demand, which as the goal in the first place.
      An additional problem is effects of (implicit) corruption or favoritism, in which money is spend in projects that favor more a small (semi-corrupt) elite rather the the average man.
      An alternative approach, it for the state can inject more money in the system, directly or implicit with lending more -- ie. quantitive easing, but this tends to depreciate the currency (lower the exchange rate) which makes imports more expensive and increases inflation, which is usually a problem.
      The first approach is bad because taxes tend to hit harder more the common man, and may increase unemployment and kill demand. The second approach distort the markets, and favors more banks and financial institutions.
      So, as I see it, the solution is neither credit and banking institutions nor too much state investment. The state should simple setup regulations that allow small companies and free enterprise to growth organically. Moreover, the state should impose very strict restrictions on max. interest rate banks and financial institutions put end-users (business and consumer) -- e.g. if it lends at <1% is should impose a max end-user interest rate of max. 5%.
      But, in practice, neither of these two things happen. Political elites are too inter-winded with economical and financial ones.
      Even in democracy, societies are not driven by rational/scientific analysis of best practices and outcomes, but simply by struggle between interests groups -- with limited ability or motivation to pursue the goal of the commons.
      Smart and virtuous people and business thrive not because of the state or financial institutions, but rather in spite of them.
      Personally, it took me almost 40years of age to learn to be simultaneously realistic and not fatalist about life. :o)

        CommentedTooScaredToUse MyRealName

        "The problem with government driven demand, is that being great in principle is sub-optimal in practice -- as the gov. can not really know if an investment of x$ will produce a growth >x%."

        Come on - neither can a private business or individual!

        Oh...except for mega-financial entities able to blackmail governments with threats of crashing the whole system and the global economy along with it. A look back at history shows that every financial crash has at its core the same kinds of massive frauds that generated the 2008 crash. Government should simply assume history has repeated itself and act accordingly.

        Every failing bank, hedge fund, etc. should go immediately into receivership for as long as it takes to trace down the legitimacy of every transaction. In the meantime, there should be a national bank that, for instance, collects all mortgage and credit card payments until the auditing process is finished. Had this been the system, the outrageous level of risky business transacted would never have happened.

        Being where we are, though, what will help?

        The Federal Reserve should withdraw the $16T support under the zombie financial system and distribute it equally to every man, woman and child in the US over the next year. Given levels of private debt, much of it will pay down debt to these same banks. Some will start businesses, others pay for college or deferred purchases. What could be a more free-market solution?

    4. CommentedPatrick Kelley

      For the past twenty years the US congress has, in an effort to counter-act fraud by a few, eliminated access to the capital market for small manufacturers. If I want to purchase a new machine for my small manufacturing business I need capital not a loan. By the time I place an order for the machine receive it, install it, hire and train employees to run it, get product out to the market place and finally receive some revenue, more than a year will have elapsed. If the macine was purchased with a loan, the lender would want to receive monthly payments begining in the first month that the loan was executed. yet there will be no income stream from the machine for over a year. I would default on the loan. El-Erian and others that operate in the billion dollar plus world simply do not understand small manufacturing. Credit will not create jobs. Small manufacturers need access to the capital market. Forget about venture capital. VC's are interested only in businesses that will generate huge rates of return over very short time frames! I know. I've tried that route. We need to create a capital market for small businesses if we are to create new jobs.

    5. CommentedPaul A. Myers

      Let me add a simple example: place $1 million of new construction contracts with a contractor, he does to the dealer and buys an additional pick-up truck. Place $10 million, the wife buys a Lexus!

    6. CommentedPaul A. Myers

      As a CPA I work with small businesses in California's Inland Empire. Lack of credit is a minor problem; lack of business is a major problem. If the government ups demand by placing public works contracts and takes similar initiatives, then businesses can take the contracts, the order books, the purchase orders to the bank and get working capital financing. Once the bank sees a higher flow of business, they can provide equipment financing.

      Asking banks to finance business that is not there is to put the cart in front of the horse.

      Everything starts with a dollar of new orders hitting a business, not with putting an extra dollar of loan capacity into a bank. One would have thought some people in the US governing an financing sectors might have figured this out by now. Build a highway: that sets you on the road to prosperity.

      Putting a big government shoulder to pushing up demand is what is needed.

    7. CommentedCarol Maczinsky

      It is as simple as that: no one needs to sacrifice anything to spent more. So it is completely meritless to argue for growth spending (with money others, your creditors, would be insane to give you). You don't need political idealists to support and advocate for political corruption, because it just happens, but sure there may be persons willing to defend corruption. But that isn't a just cause. You don't need an ideology for environmental destruction, industry does it for free if they get their way.

      Restoring fiscal confidence, trust, reliability, prudence is more important. It is what made Prussia under Frederick William I a European super power. So better not cide the North and the Germans in particular but change Southern habits.

    8. CommentedJorge Simao

      Discussions about the financial crisis seams to always be moving across two extremes in a nearly Schizophrenic dance -- credit is the problem so there is a need to austerity; or, diametrically opposed to that, credit is the solution and there need to plenty of it.
      Both approach have proven again and again to be wrong -- ie.the right approach is neither. In the real-world is very difficult to predict rates of growth, and specially growth translated into monetary revenue. However, this is contrary to what banks assume to be that case, by playing with very high and unrealistic interest rates -- ie. share of the growth payed back to the crediting entity.
      Business and households should rely on realistic and organic-driven growth. That is, use the revenue of recent activity to bootstrap further growth in a sustainable and sometimes necessary reversible manner (i.e give two steps forward, one backward).
      In practice, banks and credit are a problem, not because of the lending being conceptually wrong. But simply because the greedy and unrealistic expectation of banks to what interest rates should be.
      If banks get money with <1% interest rate from central/government authorities (ie. central bank), the only decent and reasonable thing for them to do is to lend to a max. 5% rate. However, this is not the practice. Values of 18%, 20%, 25%, or even 30% up to 40-50%, are not uncommon. Business and households should also be pardon of dept, or at least the interest rate, if they can not pay back. However, laws and regulation pardon the depth to banks but never to business and households. Again, this show how the financial system is perverse, and serves nobody except itself. Trying to portrait financial institutions in a benign away was credible in the 90s or a few years ago. But this days, is just ludicrous and offensive to everybody's intelligence.

        CommentedMoritz G€d1g

        When it is so simple:
        If there is too much debt, there is too much credit.
        In order to reduce one we must reduce the other.
        Simply raise the inheritance tax for 50 years and the debt and demand problem is solved.

    9. Commenteddonna jorgo

      EXELLENT for me is one of the best column ..
      ok i am allways agree with EL-ERIAN..

        CommentedMoritz G€d1g

        That can only be because he told you what you wanted to hear. I can not even start to comment the inconsistencies of this article.