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					ecoNomic Updates                                                                           November 3, 2009




Credit and the global recovery
There is a wide consensus that a primary cause of the financial crisis was excessive
                                                                                           economic research
lending. Too much credit was available to too many borrowers on too easy terms. The
flow of credit was unsustainable, and the crash seems – with hindsight – inevitable.       Bill Cheney
                                                                                           Chief Economist
                                                                                           617-572-9138
So now what?                                                                               bcheney@mfcglobalus.com

                                                                                           Oscar Gonzalez
First, it seems obvious that the flow of credit needs to be tightened (either
                                                                                           Economist
quantitatively or by a higher price), and indeed this has already happened. Hopefully,     617-572-9572
the worst is behind us in the sense that any positive economic growth rate should          ogonzalez@mfcglobalus.com

make borrowers marginally more creditworthy and lenders marginally less gun-shy,
so that the flow of new lending can edge upward rather than continue declining.

Second, however, is the issue of the amount of credit outstanding. One school of thought argues that this was
and still is excessive, and needs to be much lower. If you buy this logic, then there is all sorts of pain still to come
as banks, households and businesses will all be constrained by the process of deleveraging. If small businesses in
particular can’t get new credit lines or roll over their old ones, then the economy could easily face another leg down.
Given the commonly quoted factoid that 10% of American businesses fail each year in normal times, a credit crunch
that limited the growth of both the survivors and the replacements would lead straight back into another recession.

I do not find this story compelling. It’s not obvious that the amount of credit outstanding is or was a meaningful
benchmark of anything, nor does it have any predictive mean-reversion properties. Of course the stock of credit
is related to the flow of new loans, but in no way does the need for a reduced flow of credit logically imply that
the amount outstanding needs to drop by any particular amount over any particular period. It seems to me more
reasonable that the aggregate level of credit will simply evolve as debts are written off, repaid or rolled over. It may
be the indicator that gets reported, but I don’t see it as an important focus of analysis or policy. What we should care
about is that the availability of new credit is not unduly constrained, for which we do not, unfortunately, have a clear
source of data beyond the Fed’s survey of senior loan officers.


Implications:
Good News
The macroeconomic implications of these alternative views are very different. If the amount of credit has to shrink,
then almost certainly the medium-term outlook for the economy is grim. But if I’m correct that all we need is a
reduced flow of credit compared to the pre-crisis bubble period, then the economy can perk along at whatever
growth rate is supported by other macro considerations. Presumably that means somewhat above trend while the
slack in the economy diminishes, and then something close to long-term potential growth.

Bad News
One area where the amount of credit outstanding is a serious object of analysis is bank capital. If the asset-backed
market is largely gone, and most of the flow of new lending has to stay on banks’ balance sheets, then existing

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ecoNomic Updates                                                                                              November 3, 2009



lending institutions may not have enough capital to                           raised to open new banks, while government policy
support the amount of new credit that the economy                             has directly bolstered bank capital and is now working
needs in order to grow. The natural implication of this                       to grease the flow of credit to home-buyers and small
would be that the price of credit will rise enough to                         businesses. However, government intervention may
attract new capital into lending (not necessarily banks),                     also discourage or delay financial innovation. And if a
since there will be lots of profits to be made competing                      capital-short banking system restricts its lending even
with capital-constrained banks. And there certainly is                        temporarily, a dislocation in the normal process of
plenty of money around looking for promising returns                          growth in jobs, incomes and spending might be enough
on investment.                                                                to derail the entire recovery; time is of the essence in
                                                                              sustaining an expansion. Identifying the qualitative issues
However, this scenario will take time, and it’s hard                          doesn’t help in pinning down the size and the timing
to know how much. Given that Wall Street is full of                           of each process. We’re still betting that there will be
creative minds hungry for profit opportunities, the                           enough lending capacity to enable a moderate economic
whole problem could in principle be just a hiccup. We                         expansion. But we could be wrong.
have already heard stories of private equity capital being

   U.s. commercial bank assets: amounts outstanding, down only to the pre-recession boom level so far
                                1700                                                                                     7400

                                1600                                                                                     7200




                                                                                                                                Total Loans & Leases
                                1500                                                                                     7000
               C&I Loans ($b)




                                1400                                                                                     6800

                                1300                                                                                     6600

                                1200                                                                                     6400
                                                                                    Commercial & Industrial Loans
                                1100                                                                                     6200
                                                                                    Loans & Leases
                  1000                                                                                                   6000
                        Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09
              Source: Federal Reserve Board of Governors


                                      Net percent of banks tightening standards is falling, but still above zero
                                100

                                 80            Small
                                               Large & medium
                                 60
            Net % tightening




                                 40

                                 20

                                  0

                                -20

                                -40
                                 Q1



                                           Q1



                                                    Q1



                                                            Q1



                                                                   Q1



                                                                           Q1



                                                                                     Q1



                                                                                              Q1



                                                                                                       Q1



                                                                                                                    Q1
                                90



                                          92



                                                   94



                                                           96



                                                                  98



                                                                          00



                                                                                    02



                                                                                             04



                                                                                                      06



                                                                                                                08
                                19



                                         19



                                                  19



                                                          19



                                                                 19



                                                                         20



                                                                                  20



                                                                                            20



                                                                                                     20



                                                                                                              20




              Source: Federal Reserve Board of Governors




2 EU.P.110309.MW
ecoNomic Updates                                                                                                                              November 3, 2009




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