( AP ) - The announcement before Christmas by the world's central banks of further measures to help restore liquidity to money markets was at first greeted with euphoria.
But, as with the US Federal Reserve's August 17 discount rate cut, it was not long before the measures were viewed as likely to be inadequate to deal with the size of the problem. The shift by the Fed to providing term liquidity via auctions has taken a leaf out of the European Central Bank's liquidity management manual. It may help. But with euro-area money markets having remained stressed - even after the extraordinarily big liquidity injections over the year end - it seems that money market liquidity provision alone is unlikely to solve the problem.
Should the financial crisis persist in spite of central banks' best efforts, the general perception is that the European economy would be less vulnerable than the US economy to its effects. That Europe has not generated on a large scale its own subprime asset class, the proximate cause of the recent difficulties, underpins this analysis. While some European banks might have been contaminated with subprime assets, it is argued, the waste is unlikely to be toxic enough to trigger a full-scale credit crunch. At the ECB's December press conference Jean-Claude Trichet, its president, suggested that still-strong bank lending might be an indication that "the supply of credit has not been impaired". The reality is more complicated.
At this stage, the challenge is to gauge the magnitude of the strains in the banking system and the extent to which future lending will be curtailed. The recent strength of bank lending in the euro-area reflects both re-intermediation and the difficulty of raising new finance in capital markets. It is therefore a sign of weakness, not strength, as it places even greater stress on bank balance sheets. A better measure of the credit squeeze is one that combines all capital-raising activities. The rate of increase in capital raised by companies in the previous 12 months in the form of bank loans, net debt and net equity issuance, for example, posted a drop of EU57bn ($83bn) between July and September, the biggest two-month decline since mid-2001, and was followed by only a modest recovery in October.
There are numerous other signs of an emerging credit squeeze. The rates that banks charge on loans have been creeping up despite the ECB having kept its policy rate on hold. Since July, the interest rate charged on loans to companies has increased by 25 basis points. The rate charged on mortgages has gone up by 17bp. Combining these metrics into an overall index, we find that bank credit conditions have tightened sharply and now stand at levels last seen in mid-2004. One hopes the new balance sheet and liquidity constraints facing European banks will not be too great to bear. In making our euro-area forecasts, we have calibrated the short-term effect to be equivalent to about a 75bp rise in interest rates that will be gradually eliminated by the end of 2009. That is more than most central banks and international institutions are assuming, and consistent with much slower bank lending next year. But in assessing the vulnerability of an economy to tighter credit it is necessary to gauge not only the extent to which banks will restrict their lending but also the importance of bank lending for financing economic growth. According to the International Monetary Fund, about 60 per cent of private-sector liabilities in the euro-area and the UK consists of bank loans, while only 40 per cent is debt and equity. The 60 per cent figure for bank loans is higher than that of Japan's economy, where a broken banking system has contributed to more than a decade of poor economic performance. By contrast, bank loans account for only 20 per cent of private-sector liabilities in the US, with the rest accounted for by debt and equity.
This matters a lot. It means that, were banking systems to retrench significantly, the consequences for the economy are likely to be far greater in Europe than in the US. By symmetrical reasoning, however, the European economy is less vulnerable to a capital markets freeze than is the US. The lesson: in the US, watch the markets; in Europe, watch the banks.
The writer is chief European economist at Lehman Brothers