Real economy still not seeing money flow freely

Mon, Jul 27 2009, 10:50 GMT
by Trevor Williams


Despite unprecedented injections of liquidity, monetary growth is still slowing
Since the global financial crisis erupted, central banks around the world have pumped billions into stabilising financial markets. To a large extent this has worked, in terms of currency volatility, money market interest rate spreads, equity and bond markets, there has been a marked improvement. Indeed, the evidence is that investment banks have been restored to health, if burgeoning profits in Q1 and Q2 for those involved in financial market instrument and activity (i.e., advising commercial companies on issuing debt and equity finance, betting on spreads and yields etc) are anything to go by.

There remains evidence that those financial institutions that are less involved in money market activities, in other words facing off to the real economy - in terms of consumer debt finance, credit cards, mortgages and company finance - are not doing so well. Part of the reason appears to be that money is simply not flowing to these areas of the economy. Undoubtedly, some of this is in turn related to a desire by commercial firms and households to raise their saving rate and to pay down debt. But are there other reasons?

What has happening to liquidity?
In the Organisation for Economic Corporation and Development (OECD) area, money supply growth is slowing fast, see chart a. Annual money growth is currently around 7%, down from about 9% in 2008, and likely to decelerate further based on latest trends. This is despite a huge expansion in liquidity by central banks, see chart b. Indexing the size of each central bank’s balance sheets to 100 in January 2007, the Bank of England leads the way with 270 followed by the US Federal Reserve at around 230. The European Central Bank (ECB) has risen to 170 while the Bank of Japan scores slightly less than 100. Overall, excluding Japan, this is a considerable easing of monetary policy by any measure.

Chart A


Chart B

Chart c shows the total stabilisation costs around the world so far in the financial crisis, as estimated by the International Monetary Fund (IMF) as a share of each country’s annual economic output. Costs are highest in Ireland, closely followed by the UK and US. Well behind in spending to stabilise the financial system are Japan, Germany, France and Spain. It could be because these countries are pumping less into their economies, so OECD money supply is weakening. However, it could also be argued that the reason why they are spending less is simply that their economies are less directly affected by the financial crisis, though no less by the economic crisis.

Chart C


Borrowing by households in the top four developed economies is decelerating rapidly…
Charts d, f, g and h reveal what is happening to detailed lending flows in the biggest four developed economies. A disaggregated comparison of trends in bank lending for these countries reveals that lending to non-financial corporations and households has decelerated everywhere apart from Japan. However, there is an anomaly regarding lending to other financial companies where the UK trends are strongly positive but the US, Japanese and EU trends are negative. This is probably attributed to the severity of the securitisation crisis in the UK, accounted for by the large amount of wholesale funding that went on by off-balance sheet vehicles that now require refinancing. This refinancing shows up as increased lending but means little directly for the real economy. What does matter for economic growth is the trend of borrowing by households and companies because this will directly translate into decisions around consumer spending and investment.

Chart D


Chart F


Chart G

In the UK, companies are repaying debt and consumer borrowing growth is easing fast and likely to be in a debt repayment situation if the current momentum persists. In the US and Germany, companies are still borrowing but households are repaying debt. This may partly explain why commercial bank reserves at central banks in the US, EU and UK are rising. It is possible that it is not just that they are hoarding liquidity but that borrowers do not want loans as much as they did.

…suggesting weak economic growth and low inflation could persist for some time
These trends suggest that economic growth is not on the verge of a strong recovery. They also imply that interest rates will stay low for a considerable period of time, and no tightening is in the offing. With output still falling, inflation is not a threat and so there is simply no reason why interest rates cannot remain low. Also, quantitative easing, being implemented most aggressively in the US, UK and Euro area, is another policy tool that seems appropriate. But despite its expansion in recent months, there still appears to be a deceleration underway in money supply growth in the OECD area and in the big four developed economies.