Is there a credit channel?

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.

5 thoughts on “Is there a credit channel?

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  3. “There was a steep fall in the number of businesses that were successful in their attempts to get loans last year, to 65% from 90% in 2007”

    “The ONS reported that 35% of businesses sought finance in 2007, rising to 42% in 2010”

    From an irresponsibly optimistic 10% rejection rate in 2007, to a (possibly?) irresponsibly pessimistic 35% rejection rate (3.5x worse), with more businesses seeking finance.

    On the other hand, while the economies were booming, almost everything did look good, and there was almost no way to know, without knowing the bubble, which companies would have problems. Now, with slow growth, it’s clear that almost every company will have problems.

    This is a variation on the paradox of thrift.

    Tax credits for greater SME lending, both to banks and non-banks, seems like a reasonable temporary policy to counter the socially excessive risk aversion of current bank lending policy.

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