An important argument at the moment is whether or not the so-called credit channel exists. When central banks carry out quantitative easing, and even more so in the case of a “credit easing” policy like the one George Osborne announced recently, a major reason for it is that they are trying to reduce the price (i.e. the real-terms interest rate) and increase the supply of loans to businesses. This being their effective cost of capital, this should encourage them to invest, and thus to increase aggregate demand. This is the New Keynesian account; the monetarist one is that creating an expectation of future inflation creates a disincentive to hold onto cash.
But there is a criticism of the credit channel that works like this: as banks actually create credit, they are only loosely constrained by its supply. Instead, they supply just as much as their customers demand. If the customers are businesses, they are more likely to worry whether their new venture is a good one or not. If it’s a winner, whether it’s a winner with a carrying cost of 4% or 6% isn’t a primary consideration. If it’s a loser, it’s a loser no matter what the interest rate. The bank operates in one of two states – essentially, risk-loving or risk-averse. In the risk-loving state, it expands its balance sheet as fast as its customers demand credit. In the risk-averse state, it digs in and hoards cash. Therefore, there is no credit channel, and the transition between the two states is something like the Minsky model of financial crisis.
Now, I responded to Daniel Davies (who made exactly this argument on the blog he is still keeping private – surely it is time for an Occupy Dsquared movement) on the grounds that if a big, price-insensitive buyer like a central bank can cause a dramatic turnaround in the market for Swiss francs, it could by the same logic flip the bank from state 2 back to state 1 if it went in hard enough.
Here is a data point: the refusal rate for British SMB loans tripled from 2007 to 2010. This could be used in either sense – the credit channel side would argue that this shows that, yes, the supply of credit to the business sector has been choked off, the demand first side would argue that SMB lending is a terrible business to be in at the moment because there’s no demand for their products. The problem is, however, to what extent agency is with the sell- or the buy-side.
On the other hand, the UK business sector excluding finance and real estate was a net saver through the boom years; surely that’s got to be a problem.