Monday, 17 October 2011

Credit easing explained

Note: this blog post was also published at the Adam Smith Institute blog titled: "Credit easing won't deliver growth"

Upon observing gloomy reports on the UK economic growth figures last month, panic spread through Westminster. The conservatives in power are getting anxious and cannot seem to wait until their long term growth plan starts yielding its first results. Due to public pressure the governing politicians wan't to see growth rising immediately, i.e. they wish to see their reforms yield results now, as their popularity is decreasing at approximately the same rate the unemployment levels are increasing. The latest action proposal, besides quantitative easing, has been a call for credit easing. 
Credit easing implies that instead of a central bank, the government should buy corporate bonds from small and medium-sized businesses and therefore provide them with enough money so that they can start investing and hiring again. It is supposed to be a swift way to deliver credit to businesses and start up economic growth in the short run until the long run stabilization reforms start to yield their expected effects. The idea comes as somewhat revolutionary for the system where the government wishes to create a market for loans and bonds of small and medium-sized businesses (SMBs) thereby removing the dependency of the SMBs to the banks. In times of slow growth, rising unemployment, no signs of a full recovery and record low consumer and investor confidence comes an idea that is supposed to alter the financial sector by decreasing the role of banks in the economic recovery and leaving it up to the government to kick start lending – not with a fiscal stimulus, but with something very similar but yet very unconventional – credit easing.
Since the UK chancellor of the exchequer George Osborne who made the proposal hasn’t yet found a way to enforce the idea several ideas emerge on how this is supposed to be done; (i) buying loans and bonds directly from the SMBs by a government agency; (ii) buying SMB loans from the banks (either by the government or by private investors via government subsidies), securitizing them and selling them off to private investors; (iii) buying the banks’ corporate bonds and thereby reducing their funding costs and creating an incentive for the banks to increase lending; (iv) offer a guarantee on SMBs loans creating confidence so that the banks could be encouraged to lend money to SMBs.
I will go through each of the proposals in order to evaluate the effectiveness of the credit easing plan.

The first proposal implies a simple fiscal stimulus to certain businesses who found themselves in problems and need recapitalization. The problem arising, among many others, is adverse selection. There is no way for a government bureaucrat to determine which companies should get the necessary funding and which companies will have the strength to invest it in potentially prosperous projects. Due to rising uncertainty surrounding the world economy it is questionable why would the firms start increasing production and start hiring again if they anticipate more contraction in the future and higher taxes due to unsustainable deficit and debt levels. Furthermore, can any government bureaucrat honestly provide a better evaluation of who should get government funding? They don’t have any responsibility on distributing the funds and they don’t have any obligation (or knowledge for that matter) to make an effective decision over who gets the funds. This is something that the Keynesists don’t understand. According to Keynes’s theory, more money into the economy from the government will increase aggregate demand since investors will now have enough money to start investing, businesses will use the stimulus they receive to hire more workers and increase production and consumers will be encouraged to start spending on consumer goods, creating more demand for the businesses, and hence restoring economic growth. However, it is unlikely to imagine that by creating a temporary job for a fireman or a teacher will make them spend their salaries on buying a new car or a washing machine. The money will more likely be used to pay off household debts. The consumers will be careful in taking new loans and the banks will be careful in issuing them as long as confidence in the economy is low. On the business side there is a similar effect; the money they receive will be spent on paying off their debt, not an increase in production or higher employment. The stimulus in the form of bond purchases will thus only result in a form of social transfer from the government to politically prominent firms that found themselves in troubles.
The second proposal has similar implications to the quantitative easing policy where someone is supposed to artificially clean the riskier loans off the banks’ balance sheets. There is an additional clause to securitize these risky loans and sell them off as “safe” assets. The government will simply be the middle-man that pools the securities together and gives them a government guarantee which will result in a high rating for the security. These sorts of securities will soon enough become a desirable asset and their demand will increase. An increasing demand will yield more and more securities and more and more credit to businesses – an effect that is in theory a good one. However, due to an increasing demand for these low risk securities it is very likely that the banks will start to decrease lending standards and offer loans to high risk business projects. Knowing the typical regulatory train of thoughts I dare to say the regulators will encourage banks and other institutions to fill up their assets with these securities in order to re-capitalise themselves and become safer.
The idea is strikingly similar to the past decade of mortgage-based securities trading and is very likely to have the same drastic impact on the financial markets once the bad loans start defaulting. Previously it was the government-sponsored enterprises who packed the mortgages into highly rated securities which were sold on the market. More and more of these securities were sold and the demand for their creating became even bigger. The banks decreased their lending standards in order to produce more mortgage loans which were all successfully bought by the GSEs, repackaged and sold back to banks or other institutional investors. The downward spiral was created. Artificial demand for housing brought down the financial system. The artificial demand for business loans might even be more dangerous since the impact on businesses will, unlike the previous crisis, be direct and swift.
The final two propositions sound more plausible than the first two, but still cannot guarantee that the banks will start lending. Buying the banks’ corporate bonds will only have an inflationary effect, similar to the one already done by the central bank (see post on quantitative easing). The effect of buying corporate bonds from banks is very similar to a fiscal stimulus described earlier, only now the money is flowing to the banks, instead of SMBs. It is questionable how wise will such a move be politically, as the public is fired up on banks and demand the government punishes them, not reward them. Government guarantees, despite offering a far greater leverage, are of a similar effect – they cannot persuade banks to start lending and will result only in rising moral hazard. 
In conclusion, credit easing is not very different in effect to a fiscal stimulus or quantitative easing. What is peculiar about the policy is that it’s being proposed by the only government in the West that strictly committing itself to austerity, long-run growth and restructuring of the economy. It is interesting to note here the political economy implication in how poor current economic performance can undermine even the most credible plans made by a government so much that the very same government is ready to take a completely different approach than the one they have advocated so much. This would be a completely missed policy coming from the conservative government as it will undermine their credibility – the basis on which they expect their austerity plan to work. The conservatives are worried about the results of the economy and - typically for politicians – seek immediate impact of their recovery plan. This won’t come so soon. The Treasury has made accurate predictions of when the deficit will start to decrease – in 2014. Commiting every budget until then towards this goal will send a signal to investors that the plan is credible and that the government isn’t looking for short-term fixes but rather a long-run stabilization path. This will sooner than expected (but certainly not in the next few months) yield positive expectations on the UK economy and will increase confidence, which will lead to a gradual increase in investments, consumption, employment and consequently economic growth.

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