Bank lending lies at heart of UK recession risk

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By Roger Bootle

The roller-coaster ride of the British economy over the last 30 years has been accompanied by major fluctuations in monetary growth - and major fluctuations in the attention paid to it.

The first Thatcher government was tied to meeting rates of growth for the M3 measure of the money supply, like Odysseus lashed to the mast to resist the sirens' calls. For a time, wherever M3 led, no matter how painful the consequences, the Government followed. Subsequently, monetary variables were severely downgraded.

And in the current regime the money supply is just one of a range of variables which the Monetary Policy Committee considers when thinking about interest rates.

And it doesn't seem to be a very important one at that. Some argue that this explains why the MPC missed the warnings of higher inflation. Similarly, is it now missing monetary warnings of recession ahead?

In the US the rate of growth of the money supply has collapsed but in the UK money supply appears to be growing strongly. Our leading money supply measure, M4, expanded by 11.5pc in the year to June.

But I wouldn't draw much comfort from this. Cutting away the mumbo-jumbo, the money supply is the ordinary deposit liabilities of banks - the amount that people like you and me, as well as companies and financial institutions, have in the bank.

Movements in this total can be caused by all sorts of changes in the financial system. Accordingly, the numbers need interpretation.

In response to recent turmoil, banks have moved activities on to their balance sheet, which means they now have more explicit liabilities to be included in the money supply measure.

Equally, they have outstanding lending commitments to a number of borrowers and in the most part they have honoured these. As they have lent, so the recipients of the loans have deposited the money and so the money supply has expanded. And since many other sources of finance have closed, borrowers have turned to the banks for funding. Yet this will not necessarily continue.

In the recession stakes, as in so much else, the US is six months to a year ahead of us. The rate of money supply growth is probably set to slow here sharply as well.

But does this matter? For some economists monetarism is a sort of religion. It provides easy explanations and comforting answers. And it is monotheistic, even though its deity appears in a number of different forms.

This religion exercises an iron grip over some of its devotees - although their number has fallen sharply over recent years. Is it set for a revival?

Some of the Old Believers will now be jumping up and down with righteous indignation - and seeking converts.

I am not a believer, old or otherwise, but I often concur with the conclusions of those who are. My view is that the liability side of bank balance sheets is not particularly significant. I do not believe that the "moneyness" of bank liabilities makes them particularly special.

If people have the wealth but don't have the money they are generally able to make transactions by acquiring the readies, through borrowing or transferring other forms of assets.

And the liquidity characteristics of different financial instruments are constantly changing - as you would expect in a vibrant, innovative economy.

This means that the appropriate definition of money is changing also, which makes fixing on one particular definition of the money supply a complete nightmare - as the Conservative government of the 1980s learned all too painfully.

But this does not mean that financial activities do not matter for the real economy. My view has always been that the significant bit of bank balance sheets is on the asset side. It is bank lending which really counts. I may not be a monetarist but I am a creditist.

This may sound like splitting hairs, and the two approaches will often lead to the same conclusion because both sides of the balance sheet must move together. But money and credit aren't always in step, as some bank liabilities don't count as money and not all credit comes from the banks.

This credit view is not some quirk of my own invention. In the traditional Keynesian view of the world, and indeed for Keynes himself, if you had said that bank credit would contract there would be little doubt that this could imply severe economic weakness.

This is highly relevant today. It underlines why property recessions are so dangerous. Sharp falls in the equity market may inflict losses in wealth on millions of people, either directly or indirectly through their pension funds. But such losses, even if they are perceived, may not have a dramatic effect.

By contrast, property losses are super-charged, because they reduce bank capital and thereby impair the banks' ability to lend. In the extreme, they imperil the banking system. This is what happened in America in the 1930s, and in Japan and Scandinavia in the 1990s.

What makes the current situation so much worse than other UK property downturns is that this one is the first to occur in a low inflation world.

House prices fell by 32pc in real terms in the mid 1970s but because of rampant inflation this drop was achieved with hardly any fall in nominal prices. For banks this difference is critical, because bank liabilities are in nominal terms.

Whether a cutback in bank lending results in serious damage to the economy depends upon what the bank credit is financing. If it is financing financial activity, such as management buyouts, then the impact on aggregate demand may be minimal. Asset prices may be lower, and that would have some indirect impact on spending, but the direct connections would be weak.

By contrast, if it finances consumer spending or purchases of plant and machinery, or holdings of stocks, or covers running losses while businesses expand or cope with a downturn, then the real economic impact will be direct.

The banking system is the engine of the economy. Never forget that the Great Depression in America was associated with a collapse of bank lending and the money supply.

Even non-monetarists should be watching the money and banking numbers like a hawk. And if the growth of bank credit slows substantially, let alone contracts, then you should be on guard for an even worse recession than currently looks likely.

Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte. You can contact him at roger.bootle@capitaleconomics.com