How should policy respond to the credit bust?
The August 2013 issue of the National Institute Economic Review, published on August 2nd, brings together new research by leading economists on the credit cycle - the expansion and contraction of access to credit over the course of the economic cycle. This is arguably the key challenge facing most major economies at present. The authors’ offer an enlightening menu of reforms – contrasting in some cases with the current UK approach.
Claudio Borio suggests that in the short term, policies must address the current level of private debt directly, including bank regulation directed at decisively repairing bank balance sheets (as per Scandinavia in the 1990s), radical use of fiscal policy to repair private balance sheets and awareness of the dangers for monetary and financial stability from holding interest rates too low for too long. In the longer term, there is a need not only for extended policy horizons but also policies to limit financial booms such as macroprudential buffers and embedding asset prices within monetary policy frameworks.
Philip Lane, focusing on the Eurozone and cross border lending, contends that given the common monetary policy, fiscal policy must bear the burden of mitigating credit driven booms and busts in Eurozone countries, possibly including fiscal revaluations (such as taxes on non-traded goods and services) in the boom, offset by the opposite policy in the downturn. Macroprudential policy must be effective in limiting foreign as well as domestic fund inflows.
Constraints on lending to small and medium enterprises (SMEs) has been central to the recent policy debate in the UK and worldwide. Thorsten Beck highlights that at a structural level, cross-country analysis suggests provision of credit to SMEs can be enhanced by appropriate policies inter alia in respect of banking competition, credit guarantees, openness to foreign ownership and credit registries. At a cyclical level, bank regulation may worsen the amplitude of credit cycles for SMEs if it entails higher capital charges for SMEs – as seems implicit in Basel III - and variation over the credit cycle, as was the case with Basel II.
In a largely empirical paper, Angus Armstrong, E Philip Davis, Cinzia Rienzo and Iana Liadze highlight the fact that SME lending in the UK remains tightly constrained despite the length of time since the nadir of the crisis. Their empirical work controls for firm characteristics (including credit worthiness) and excludes discouraged borrowers. They find that tighter capital requirements may have a greater impact on SME lending than on lending to larger firms, while there is no significant recovery in volumes as a consequence of the HMT/Bank of England’s “Funding for Lending” Scheme. They also note the potential damage to UK economic prospects from an ongoing famine of finance for SMEs.
A further empirical paper by Sarah Holton, Martina Lawless and Fergal McCann shows that there is marked cross country variation across the Euro Area in the tightness of credit to SMEs, after allowing for the fundamental influence of credit quality of borrowers and cost of funds to banks. Over their sample, Germany, Belgium and Finland have favourable SME conditions by most measures, whilst Ireland, Spain, Portugal, Italy and the Netherlands have the most stringent credit conditions facing SMEs. While most of these countries would be expected to have difficulties in the current crisis, the inclusion of the Netherlands is perhaps more surprising – we at NIESR suggest it may link to household leverage and some banking weakness in that country (the latest ECB survey suggests an improvement).
Writing as observers of the economy and of financial crises, we note that SME lending remains weak in the UK despite the low level of interest rates. Is there a risk that lending will start to be funnelled into housing, worsening the situation for SMEs, thanks also to recent “Help to Buy” fiscal policies (criticised inter alia by the IMF) boosting the attraction of housing as an investment? Is the prospective reorganisation of banks under Vickers contributing to uncertainty and unwillingness to lend, and could a well structured securitisation programme not offer a viable funding alternative in the meantime? Can a Business Bank fill the gap at the current small scale which is being considered? Perhaps there would be better provision for SMEs if a more sizeable institution in state hands such as RBS were developed into the Business Bank?.
Meanwhile, at a macro level we note that Borio’s short term prescriptions (direct action to repair bank and non bank balance sheets, caution in holding rates low) have not been applied to the UK. Does the UK risk curing the debt problem in an economically destructive way, by arbitrarily benefiting wealthy asset holders and large firms via low rates and QE, at the cost of poorer, non-home owning, households and firms which depend on strong banks? Besides its distributional consequences, could current policies leave the UK economy weaker than before the crisis, owing for example to lack of finance for SMEs? And at what point will low rates and QE begin to generate wider inflationary pressures?
In the Eurozone, it appears that the integrated market in banking services that developed up to 2007-8 is beyond repair, unless there is Banking Union and a major diminution in concern about breakup, since foreign banks in non-crisis countries have withdrawn to their home markets. Meanwhile domestic banks in crisis countries remain unwilling to lend to local SMEs given the competing attraction of sovereign bonds and weak economic prospects. Accordingly, it seems likely that SME lending will remain costlier in countries most affected by the crisis.