Sunday, April 29, 2012
An economy starved of credit will struggle to grow
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What can I say about Britain being “officially back in recession”? Apart from the fact that no quantity of salt is big enough to be applied to these preliminary estimates, I am not going to spend too much time on them.

I have done it before, most notably three weeks ago, and so have plenty of others since the gross domestic product figures came out. The hope has to be that pinches of salt are being liberally applied by others.

After the figures, the CBI said manufacturers were at their most optimistic for two years, while Nationwide building society said consumer confidence was its strongest for nine months. Will this survive the headlines?

Even if it does, the economy is plainly weak. One way of looking at it is with reference to the GDP numbers. In 2009, the third quarter was initially reported as a 0.4% fall and the fourth quarter a 0.1% rise.

Now the data shows rises of 0.2% and 0.7% respectively, a big shift, partly because of technical changes to the calculations. It is not certain the latest GDP figures will undergo a similar revision.

Were they do so, however, the drop in GDP in the fourth quarter of 0.3% would become growth of 0.3%, while the latest quarter’s would go from minus 0.2% to plus 0.4%. The point is not whether the numbers will be revised precisely this way.

It is that even if they are, they will point to an economy growing only weakly. By this time in a normal recovery growth would be 3% or so. The underlying growth most economists think is happening now is much weaker, perhaps only 1%.

The government’s fiscal tightening is a factor. You cannot hike taxes and cut spending without impacting growth. But a deficit of 11% of GDP had to be tackled.

Labour’s so-called balanced plan for deficit reduction would not have survived the scrutiny of the ratings agencies and the markets, as was clear at the time of the May 2010 election. It cannot be regarded as a viable alternative.

To the extent it would have pushed sterling down further, inflation would have gone up more, further squeezing household real incomes and condemning the economy to even weaker demand.

Not everything George Osborne did on the fiscal side was right, as was clear long before the unforced errors of the March 21 budget. There was too much “it is going to be brutal” bravado when the coalition took office. The hike in Vat to 20% was an in your face, “we’re all in this together” tax hike at a time when some Gordon Brown stealth taxation might have been better.

The solution to weak growth does not, however, reside with fiscal policy. It does lie with a supply of credit that is woefully insufficient to support a decent recovery.

Last week the Bank of England produces its latest Trends in Lending report. It showed that bank lending to businesses was down 3% over the latest 12 months, continuing a fall that began in the early part of 2009. Lending to small businesses is down roughly 10% in the latest 12 months. Figures from the British Bankers’ Association show a similar picture.

It is not unusual for lending to firms to be weak in the aftermath of a recession. Banks become risk-averse. After the recession of the early 1990s, when they suffered large losses on their small firm loan books, business lending was also negative.

We have, however, now gone beyond the point at which business lending should be turning positive. In the 1990s it was two and a half years into the recovery. This recovery is now near its third anniversary and business lending continues to fall inexorably.

It is not just business lending. A good proxy for mortgage lending is the number of mortgage approvals for house purchase. Once it seemed this was one thing we did not have to worry about. From their low point in the final three months of 2008, approvals soared by 92% by the end of 2009.

Then, however, they dropped back and are now 8% below late 2009 levels and 58% below the pre-crisis peak. Some would say this is no bad thing. But an active housing market supports consumer spending and employment. Its absence is a significant drag on the economy.

Why is this happening? Some of it reflects the banks’ usual switch to risk-aversion after a recession. Some of it is due to the loss of some players, notably foreign (including Irish) banks. which were active in the small firm and mortgage markets.

Much of it, however, is due to the official response, from the government, the Financial Services Authority and the Bank of England. When the crisis hit, the authorities recognised credit was the lifeblood of a modern economy. Allowing banks to fail, and credit collapse, would have made the recession we had look like a tea party.

Unfortunately, the same logic was not applied to the recovery. Instead of ensuring an adequate supply of credit for a sustained upturn, the response has been to lock the stable door on the crisis after the horse has bolted. The authorities have been so busy acting to prevent the next crisis they ignored the need to shake off this one.

So we have had the Bank winding down its special liquidity scheme and the recommendations of the Vickers commission speedily reported and officially accepted. Last month the financial policy committee, the new “macro-prudential” regulator in the Bank, urged Britain’s banks “to raise external capital as early as feasible”.

We need a stable and safe banking system. But the authorities’ actions, together with evidence that Britain is going further than international counterparts, adds up to what banking analysts call “regulatory overkill”. It is an important reason for chronic lending weakness.

“Policy made without reference to the impact of its implementation is highly likely to deliver sub-optimal economic outcomes – in this case, costing the UK significant economic growth without any material uplift in financial stability in return,” says Alastair Ryan, banking analyst at UBS.

“The UK now has a well-capitalised, well-funded banking system that is raising prices and shrinking lending – and will need to keep doing more of both as the regulatory agenda expands.”

So we have a situation in which the Bank has undertaken £325 billion of quantitative easing, an exercise in monetary easing notable for its entire lack of impact on credit growth. The Treasury’s credit easing plan for small firms looks too small to make a difference.

Unless somebody in authority gets to grips with the conflicts between regulation and growth, and realises a credit-starved economy will always struggle, we can only expect more disappointing GDP figures.