Weak bank lending thwarting growth in US, euro area

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In the twelve months to January, the lending of U.S. banks to households increased about 3 percent while, over that period, their loanable funds (excess reserves) soared by an incredible 59.4 percent.

Clearly, massive monthly asset purchases by the U.S. Federal Reserve (Fed) were of no great help. The banks' near retreat from their core business (consumer financing), along with sluggish income growth and a large slack in labor markets, weakened all the key pillars of private consumption.

Is it any wonder, then, that the inflation adjusted consumer spending – 70 percent of the U.S. economy – was growing at a rate of 2.2 percent in the first two months of this year, after a lackluster 1.9 percent growth during 2013?

Why are U.S. banks shunning their core business?

The void left by the weak bank lending to consumers has been filled by nonbank financial institutions (finance companies, credit unions, etc.). Lending to households by these companies rose a whopping 9 percent in the year to January, and was 47 percent higher than the amount of consumer loans booked by commercial banks.

Hence an interesting question of monetary policy: Why do banks prefer to keep their huge excess reserves ($2.5 trillion at the last count) at the Fed at an interest rate of 0.25 percent instead of making car loans at 4.4 percent or two-year personal loans at 10.2 percent?

I can take a guess at some answers, but that is irrelevant.

The important public policy issue here is what the Fed makes of all this, and how it intends to solve this well-known problem plaguing the U.S. economy over the last few years.

Monthly asset purchases – on top of a virtually zero percent interest rate – have been a relatively easy part of a sweeping crisis management. The verdict on that policy is given by America's demand, output and employment. It is perhaps time to adjust policy instruments and intermediation techniques to address some apparently structural issues whose solution does not seem to be in the wall of money thrown at the U.S. economy.

I have no doubt that the Fed's highly capable technical staff is fully aware of these problems, and that – given a chance – they could probably come up with specific remedies instead of continuing with an excessive monetary creation.

The euro area is looking at some of these specific measures to revive bank lending and to support a faster recovery. And here is a formidable can-do lineup that says "Europe will move …"

Renzi, Montebourg, Draghi, Weidmann

Renzi (Italy's prime minister) and Montebourg (French economics minister) are bursting with youthful energy and enthusiasm, coupled by the wisdom and experience of a steady pair of hands at the European Central Bank (ECB).

They all seem to be cheered by the German Chancellor Merkel, whose former economic adviser and her handpicked Bundesbank President Jens Weidmann is now advocating a range of more flexible ECB policies to spur demand and employment in the long-suffering euro area.

The ECB's Italian-German duo (Draghi and Weidmann) seem to be leaning toward specific measures of credit policy rather than money printing presses working overtime.

Their analysis appears to be based on the view that credit is cheap and amply available – but that it is not readily accessible in all parts of the euro area and by all categories of borrowers. Also, some channels of financial intermediation are clogged up, and they are trying to figure out how to get around that.

Most of the ECB policy problem is clearly conveyed by the latest batch of euro area monetary statistics. Bank lending to the private sector in the year to February fell 2.2 percent, extending an annual decline of 2.3 percent since last December, in spite of a very easy credit stance offering money market rates of 0.3 percent.

And this is the message contained in the major components of this monetary aggregate.

Bank loans to households in February were slightly down from the year before, while its largest part – the mortgage lending – continued to rise at a rate of 0.6 percent. The biggest problem remains the declining bank lending to the corporate sector, consisting mainly of small- and medium-sized companies. These loans were down at an annual rate of 3 percent in February, showing no improvement over the previous three months.

The ECB is facing a huge challenge. Unclogging the euro area credit channels and spurring bank lending to businesses and households is a difficult task at the time when banks are getting ready for stringent "stress tests" in the run-up to the banking union.

The other issue is a strong euro. Over the last twelve months, the euro rose 6 percent in trade-weighted terms, while the dollar remained roughly stable and the yen declined 12 percent.

This big competitive disadvantage of euro area producers presents a serious problem for the ECB. First, currency appreciation is technically equivalent to monetary tightening. Second, in economies where corporate funding relies mainly on bank loans, as is the case in the euro area, it is of utmost importance to restore the channels of bank lending to the corporate sector to support its competitive position on world markets.

Tensions with Russia about the intractable Ukrainian problem are another difficulty complicating the ECB's task. Sanctions and countersanctions disrupting and restraining the flow of trade and finance is the last thing the continent needs as it tries to emerge from a crippling recession.

Investment thoughts

The Fed's balance sheet expanded $168.4 billion in the first quarter (compared with $230.6 billion in the last three months of 2013), putting America's high-powered money at $3.9 trillion and 32.4 percent above its year earlier level. That is fueling equity markets and lowering the cost of government funding. But in spite of the banks' $2.5 trillion in excess reserves, their lending to households remains too weak to support faster growth of demand and employment.

The Fed's huge liquidity provisions will continue to underpin U.S. equity prices. Danger signals for U.S. stock markets will appear with the first signs of rising inflation pressures. We are not there yet.

The euro area is a similar investment story. Its equity markets will benefit from unfolding recovery, declining labor costs and increasing profit shares. There is also a possibility of further bond market gains as the large debtor countries continue to make progress toward their fiscal consolidation.

Don't forget the gold. The growing excess supply of paper money, increasing geopolitical tensions and central banks' reserve diversifications will keep driving demand for the yellow metal.