We have been told now for a good five years that the Great Recession was a financial crisis. Nobody would deny that early on in the crisis banks in both the United States and Europe made massive losses in, primarily, real estate. But common sense and basic economic theory simply refute the idea that the financial crisis could have hurled Europe, and most of the Western World, into its deepest recession since the 1930s.
In order to have this major influence on the rest of the economy, the financial crisis must have transmitted its downturn to the real sector through easily identifiable transmission mechanisms. There are three of those:
- Depositors lose what they have in their bank accounts and, as a result, make serious cuts in their spending;
- Banks demand that borrowers pay back large amounts of loans immediately; businesses and households declare bankruptcy because they do not have that cash on hand;
- Bank customers are denied new loans.
The first transmission mechanism was not active in this crisis, with the exception of the Cyprus Bank Heist in 2013. Similarly, the second transmission mechanism was very limited in influencing the economy.
The third transmission mechanism is the most compelling one. If banks make major losses on loans during a short period of time, as happened at the opening of the Great Recession, then their response should be to raise their interest rates sharply in order to severely ration credit and keep it out of the hands of anyone except the absolutely most credit-worthy customers.
Put more broadly, banks would fundamentally restructure their credit rating of customers. Theoretically, borrowers who were previously rated as good-credit customers would now be in the fair credit category, and fair-credit customers would be treated as if they had poor credit. In practice a shift from generous credit supply to strict supply rationing is more complicated, but the inevitable outcome is an excess demand for credit.
The rationing of credit is the dominant change on the credit market. In order to work as a transmission mechanism from the financial sector to non-financial industries and to households, the credit pullback has to be the defining change to the credit market. If households reduced their demand for credit on par with, or in excess of, the reduction in credit supply, then any effects of reduced borrowing in the economy would be traced to a cause outside of the financial sector. Plainly, that cause would be independent of the financial crisis.
If there was a decline in credit supply relative credit demand, then the price of credit would rise. The more drastic the change in lending policies, the faster is the rise in interest rates. Given the rapid development of the crisis early on, and given its depth, it is reasonable to expect that if this crisis was indeed caused by the financial sector, the transmission mechanism would reflect the urgency of the crisis opening. This, in turn, would mean sharp increases in interest rates.
Interest rates would rise across the board. Households and non-financial corporations would be the first to pay higher rates. However, government bond rates would go up as well. Traditionally, Treasury bonds issued by developed countries are for the most part considered to have the lowest possible risk attached to them. But so do many businesses, as well as a segment of households. All things equal, therefore, if banks rationed credit to the general public it is reasonable that they would also demand higher interest rates on Treasury bonds. At the very least, there should be no drop in interest rates on Treasury bonds if banks are very cautious about lending even to low-risk customers.
In reality, interest rates did not at all go the way they should have, if the financial crisis was transmitting its crisis to other sectors. To begin with, Treasury bond rates – which again should have gone up or stayed flat – developed differently depending on what country they were issued by. Figure 1.1 displays trends in the ten-year Treasury bond (or its nearest equivalent) for five EU member states:
Source: European Central Bank
After the Millennium Recession interest rates fall for about four years. The turn upward begins at the height of the growth period between the Millennium and Great Recessions.
This is important: not only do interest rates on corporate loans start rising two years before the current crisis begins, but they also rise gradually, as if the market for corporate credit is gradually turning form a borrower’s market to a lender’s market. The shift is one from a market where supply chases demand to where demand chases supply.
A gradual rise in interest rates over a period of two years is not an indication of sudden panic on the credit market. Furthermore, if banks had suddenly cut off credit at the time when the crisis began, the average corporate-loan rate would have shot up suddenly and significantly just as the crisis began. This did not happen: on the contrary, right as the Great Recession breaks out credit to non-financial businesses is sold at rapidly falling interest rates. From a peak point of 6.98 percent in September 2008 the average rate fell to 3.68 percent in June 2010.
In short, while the European economy was plunging into its deepest recession in 75 years the average interest rate on a bank loan to a non-financial corporation was almost cut in half.
Since then it has remained below 4.5 percent.
While many factors affect interest rates on business loans, the basic mechanics of a free market are never to be ignored. A sharp drop in the price of a product indicates either a sharp increase in supply or a sharp drop in demand. Given that this happens at the opening of a deep recession, the only reasonable explanation is a sharp drop in demand for credit.
When non-financial corporations reduce their demand for credit, it is a sign of rising pessimism on their behalf. The pessimism, in turn, is about their ability to pay back the loan over the next couple of years. Since they pay back their loans out of current revenue, this means that a reduction in credit demand is caused by a reduction in demand for the products put out by non-financial corporations.
In other words: first there was a reduction in real-sector economic activity, where consumers spend money and entrepreneurs invest in their businesses – then there was a decline in demand for credit. The crisis had already begun when banks saw demand for credit drop.
This means that:
- Credit-supply restrictions did not transmit the financial crisis to the rest of the economy;
- Businesses experienced a drop in current and expected future sales and transmitted that pessimism back to the banks;
- The financial industry was not the main cause of the Great Recession.
Where, then, did the financial crisis originate? The answer to that question is in my forthcoming book, Industrial Poverty: Yesterday Sweden, Today Europe, Tomorrow America. Due out late August. Stay tuned.