Opinion
The great credit mistake
Publish Date: Jun 11, 2014
newvision
  • mail
  • img

By Adair Turner

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.

Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Copyright: Project Syndicate, 2014.
www.project-syndicate.org

 

The statements, comments, or opinions expressed through the use of New Vision Online are those of their respective authors, who are solely responsible for them, and do not necessarily represent the views held by the staff and management of New Vision Online.

New Vision Online reserves the right to moderate, publish or delete a post without warning or consultation with the author.Find out why we moderate comments. For any questions please contact digital@newvision.co.ug

  • mail
  • img
blog comments powered by Disqus
Also In This Section
Poverty and greed: the major culprits of environmental degradation
Our standards of living are based on inexpensive energy in the form of electricity and gasoline powering automobiles that are the major contributors to environmental problems in the world today, but let us not forget that earlier in history; automobiles were actually heralded for solving a distinct...
Climate change: The Impossible deal
For “shall”, substitute “may”. For example, change “countries signing this climate change treaty SHALL state how much they are going to cut their greenhouse emissions” to “countries signing this climate change treaty MAY state how much they are going to cut their emissions if they feel like it, but...
Who really cares about the Ugandan girl?
The UCE and UACE 2014 public examinations are now done with and the other classes are at home for Term Three holidays. The students from the secondary schools especially have flooded our localities. Most conspicuous of them will be the girls; but who cares?...
A delegate conference is not a pilgrimage
At the last NRM delegate’s conference held at Namboole, the National Executive tabled a motion regarding the period at which the holding of a delegate’s conference should be....
Corruption: they that are not corrupt can hurl the stones
So the 2014 Corruption Perceptions Index ranks Uganda 142nd out of 175 countries, according to Transparency International. Based on expert opinion, Transparency International says our level of public sector dishonesty is 26 out of 100. Denmark is the most transparent with a score of 92/100 while So...
The evil of deforestation
Africa is facing very many problems but few have been solved. One of the major ones is environmental degradation through deforestation. Deforestation is having a big impact on the environment....
What is causing the rise in Early child marriages?
Decaying social structures
Poor Education
None of the above
follow us
subscribe to our news letter