Michael Gregory, Senior Economist, BMO Financial Group, posits in the latest issue of Focus that recovery in credit formation has and will be key to economic recovery.
The typically rapid transition from decelerating to accelerating credit growth results in a v-shaped credit cycle, a critical characteristic that effectively fuels economic recovery (Chart 1).
However, the global credit crisis has impaired credit creation processes around the world, particularly in the U.S. and the U.K. The cost of credit to consumers and businesses was initially hoisted higher than it otherwise would have been because of bank funding costs.
Note: Canadian money market spreads have been very healthy, indicating their strong financial position.
Just as the global financial crisis unfolded in four waves (Chart 2), with the latest surge the most damaging, the policy responses by central banks and governments have had four distinct themes, all designed to repair and prime their local credit markets, with the latest tactics targeting the asset root of the problem.
First, policy rates have been cut to historic lows (Chart 3). In cases where rates are already effectively zero (e.g., U.S., Japan), central banks are providing much more liquidity than required to prod banks into loaning out the excess-the essence of "quantitative easing".
Second, some central banks (Fed, BoJ, BoE) are participating directly in local commercial paper markets-which were among the first casualties of the global credit crisis-and purchasing mortgage-backed and other securities.
Despite the "credit easing" measures, banks have not eased up on lending requirements. (Chart 4)
The third policy theme has been to ensure banks have adequate access to capital and other funding at reasonable rates. Governments are guaranteeing bank liabilities and, in some cases, directly injecting capital.
While government is able to use moral suasion to twist banker's arms to lend, it is not able to assuage concerns that the deepening recession could lead to more losses, which is keeping lending tight.
Household deleveraging (Chart 5) means that consumers are starting to save more and spend less, reducing consumption in the economy. Non-financial businesses are doing the same. This reversal in credit formation means deflating assets, and lower capital expenditure.
Thus, the fourth policy theme is to bolster the asset side of balance sheets. This week, the U.K. government introduced an "Asset Protection Scheme" designed to partially protect financial institutions against future credit losses.
In the U.S., there's growing talk of establishing an "aggregator" bank that would purchase troubled assets from banks, as the new Obama Administration is promising action on a "dramatic scale" to strengthen banks and revive credit markets.
The longer the economy stays starved of credit, the greater the risk of a deflationary outcome, with Japan's "lost decade" quickly coming to mind (Chart 6).
You can read the entire report here.
