Previously, household consumption was fuelled by easy money from banks. However, the flow of net new lending to households all but dried up as the crisis took hold through 2008. And it has recovered not one bit since then. Some analysts pin the blame on excessively tight credit conditions. Perhaps in response to such concerns, HMT and the Bank of England have joined forces to announce a new ‘Funding for Lending Scheme’ (FLS), with the aim of increasing loans to households and businesses.
The scheme aims to increase the flow of credit by reducing banks’ marginal cost of funding, from around 3.50% on the Bank of England’s preferred measure, to just 0.75% for those banks that manage to boost their net lending to firms and households. The move makes sense if there is a market imperfection that has raised banks’ borrowing costs, preventing notionally profitable and growth-enhancing lending. But we question whether such an imperfection exists.
Moreover, is a greater supply of credit really what is required? While business investment has been weak, the corporate sector does not appear to suffer from a lack of access to funds. Indeed, PNFCs have been in financial surplus for a number of years. On this basis, it seems likely that demand rather than supply, is the predominant factor when it comes to weak UK corporate borrowing.
Surveys of businesses provide further evidence that demand has not played as large a role. The CBI survey of factors affecting investment offers some insight. It confirms that the cost of finance has not been a hindrance for most firms. Instead, a majority of firms report weak demand as the principal reason holding back investment, with worry over a low net return coming in a close second. No wonder. With anaemic growth at home and abroad, it is not surprising that many corporates have opted to sit tight and build up their balance sheets.
By contrast, the FLS may help boost the flow of lending to households, particularly if the incentives facing banks who participate in the scheme cause them to raise the loan-to-value ratios offered on new mortgages. But is that really what we want to see? Household debt, as a share of disposable income, rose dramatically through the early 2000s. It remains extremely elevated, both historically and in comparison to other countries. The UK household sector has begun to address its enormous debt overhang, but it is a slow process. Enticing it to stop now and instead borrow more is, in our view, completely the wrong course of action, even if it manages to boost growth in the short-run.
The housing market is subdued not because banks are irrationally withholding funds from credit worthy individuals, but because housing is overvalued. And housing is overvalued because lenders are failing to write down their bad assets. The solution is not to offer lenders yet more cheap credit, so long as they relax their lending conditions, but to force adjustment in the housing market. That is why we have argued for some time now that the UK needs its own TARP. The BoE should use newly minted notes and coin to purchase not gilts, but rather the bad assets currently sitting on the balance sheets of the major banks. Crucially they should do this at a price reflecting their true market value, forcing them to recognise their losses.