End of The Tunnel?

There are signs of optimism around. Cautiously, policy makers and commentators start discussing the shape (and the fragility) of the future recovery.  Martin Wolf on the Financial Times already speculates on the timing of reversal to a normal state of affairs. Wolf is rightly worried by the temptation to reverse policies too fast, a mistake we made already at the end of 2009, when stimulus plans were reversed into consolidation far too soon.

As a rule of thumb, I’d argue that exceptional involvement of governments in the economy should stop when the private sector is ready to take the witness. Stimulus plans and monetary easing should be rolled back once private spending resumes (or is ready to resume), and when the credit market is sufficiently loose. So the question is, how does private sector behaviour fit, within this moderate optimistic mood? Not too well I am afraid… The ECB has released this morning its quarterly Bank Lending Survey. And things really do not seem to get better. Here are some excerpts:

The net tightening of credit standards by euro area banks for loans to enterprises was broadly stable in the fourth quarter of 2012 (…). The net tightening in the fourth quarter of 2012 increased for loans to households for house purchase (…) and for consumer credit (…). The impact of banks’ cost of funds and balance sheet constraints on the net tightening of credit standards remained broadly unchanged, both in the case of loans to enterprises and loans to households. At the same time, risk perceptions contributed to the increase in the net tightening of credit standards on loans to households in the fourth quarter of 2012, while in the case of loans to enterprises the impact of the general economic outlook and of industry-specific risks remained at an elevated level. (…) Looking ahead to the first quarter of 2013, euro area banks expect a similar degree of net tightening in credit standards for loans to enterprises, while they expect a decrease for loans to households (p.1)

In a sentence, credit remained tight both for households and firms, and is expected not to change in the next few months. Concerning demand for credit,

Turning to loan demand developments, euro area banks continued to report a pronounced net decline in demand for loans to enterprises in the fourth quarter of 2012 (-26%, compared with -28% in the third quarter of 2012). As in the previous quarter, according to reporting banks, the net decline in the fourth quarter of 2012 was driven mainly by a substantial negative impact from fixed investment on the financing needs of firms (-31%, compared with -33% in the third quarter of 2012) (…) Looking ahead to the first quarter of 2013, banks expect a less pronounced net decline in demand for loans to enterprises (-11%), while they expect a more pronounced net decline in demand for loans for house purchase (-25%).

Again to summarize, also on the demand side things are not going very well. The crisis is still imposing a serious brake on the private sector’s desired spending (most notably investment).

Two remarks are in order:

1. Among other things, the tightening of credit supply is attributed by banks to the the need to be ready for the new regulatory requirements that are being put in place. The temptation is then to argue for putting on hold the changes in financial sector regulation. Wrong. The answer is to accompany the transition to the new regime compensating the private tightening with looser monetary conditions.
2. In current conditions private demand seems not to be a substitute for public demand, but rather a complement. Austerity is deteriorating economic conditions so that public expenditure reductions are accompanied by decreases in confidence and in private expenditure. On the contrary, sustaining aggregate activity could today prove a winning strategy because it would restore confidence and crowd-in private expenditure.

To summarize, the light at the end of the tunnel is very far. And there are many things we could do to make it vanish altogether.  I am glad that so far our leaders have showed very little complacency. I would like this awareness to evolve into a questioning of austerity policies in Europe. What are the odds?