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.