Banks vs SME's: Who's the economy after all?

The title of Wikipedia's article on the crisis stars with a word which sums it it all up: Financial. What this means is that unlike others mishaps of the past, this time the trouble was mainly brought by financial institutions who could no longer survive. And since banks are not just like any other institution in the economy (in the sense that they provide the service of moving funds from one place to another, addition to lending) their importance was not big news to most (it was to some who believed that rescuing them was bad. Truth is, if Bernanke hadn't then we would be far worse than the 1930's).

In Europe, even though some of the troubles in the periphery are attributed to excess government spending, the truth is that the financial sector has also been a major cause of pain in at least half the economies in the EU (note that it has also been a problem in the UK, Germany, the Netherlands and Belgium, countries which do not often get the bad publicity of being in trouble). As in the US, governments in the EU rushed to save the banks, in most of the times with good reason. Yet, the emphasis on the banking sector has not stopped there; policymakers' preferences shifted to paying more attention on what the banks need instead of what is necessary for 99% of Europe's businesses: SMEs.

Unlike large businesses, who usually have ties with multiple banks, usually both domestic and abroad and have open lines of credit reaching hundreds of millions, SME's are faced with small business loans and very small credit balances. The increased capital requirements forced on banks and the now extremely picky procedure for securing a loan has brought many SME's to their knees. As the number of loans to the private sector is reduced, the SME owner finds himself without any sources of funding; while the data show that banks are doing better with regards to their loan portfolio, the market has in fact been suffocating.

The sad truth is that while we favour the survival of banks, we should remember that these institutions are mere intermediaries; it is true that the economy will freeze if banks collapse, but the same will occur if more and more SME's bankrupt day after day. Big businesses do not see their lines of credit diminished, but those who count the continuance of their day-to-day operations on checks who take days to clear, struggle with the reality of dying any time soon. Troubles are many, starting from the number of days required for a check to either be returned or cleared varies significantly among countries, (when it could essentially be done in less than a day in most), the increased fees required by banks to either send money abroad (even though SEPA is a major improvement) or to maintain certain accounts and finally the lack of any additional funding are major causes of headaches for people who do not have.

Since the emphasis is on the banks and not on the businesses, confidence that the economy will do better in the future is hard to build. How can the average Joe (and it is on his spending and his investment that we really count on) be convinced that things are doing better when he sees his company in the red, his friends and associates losing money and the business environment he lives in become harsher every day? We cannot de-emphasize the importance of banks but banks are nothing more than a small part of the economy; and since lending is limited (even in the best case scenario) we cannot be just focus on them and expect everything to go better.

I've said it before: we are at the ZLB so monetary policy is out of the question and our governments are constrained on spending making fiscal policy is not an option. All we are left with is confidence; yet, it cannot be raised if banks will not lend and make life miserable for millions across the continent. Yes, we need banks for the economy to move; but banks and the economy need businesses even more if we are ever going to see better days.

Deflation, Inflation and Expectations

That dis-inflationary pressures have been observed in the Eurozone over the past year is nothing new. They have been so common elsewhere in the world (for example Japan or the US) that news of higher inflation are now being heralded as the dawn of a new, happier era (even though some are more exaggerated than other). Even though deflation has expanded to other measures of prices, the main focus is that we are moving towards higher inflation, with deflation no longer being an issue of concern; at least that's what the ECB is saying.

Trouble is, almost no-one sees it the same way. Tim Hartford, for example, notes that the persistence of low inflation may mean trouble for borrowers, leading to more bankruptcy risk and, God forbid, more non-performing loans to banks. In addition, what I fear most is that low inflation, just like high one, can be embedded in expectations and remain for much longer than we would normally expect, with all the known consequences. This is not just a doomsday scenario; expectations matter much more than we most of the time think when it comes to policy.

A simple example of how much expectations matter is what is usually referred to as reflexivity, a theory that simply put, means that we are in fact creating a part of the world we are trying to forecast; a very similar notion to what has been known as the Lucas Critique in economics. As the world of economics is not governed by the hard rules of physics, what people believe about the future will in fact affect it. In addition, the only way they can make an educated guess on the future is by viewing current events and basing their judgement on experience, meaning that in a way, the future affects the past as well (to be more precise, expectations about the future affect what we do now). 

This is what has been going on at the moment: people see low inflation and have every right to expect low inflation since no measures have been taken against it (the rate cut in late 2013 was really nothing special). It can be seen in the consumer expectations:

Italy's Consumer Confidence Sales (Feb) M/M 97.5 vs. Exp. 98.5 (Prev. 98.0)
— Fabrizio Goria (@FGoria) February 25, 2014

This is led by something more than just expectations about the inflation rate. Peter Praet, (aka Captain Obvious) noted "Weak demand and high unemployment could also be playing a role". You don't say! This is exactly how inflation falls: lower supply of loans from banks means lower demand (for the monetarists out there this means reduced money velocity ); adding high unemployment to that equation means even lower demand. This is not a matter of what affects what; it's a matter of everything affecting everything as, whether policymakers like it or not, people are the economy. It is only if we can convince them that are going to get better that they will.

Here is where the ECB is wrong: people, even subconsciously, trust what you do and not what you claim. As Lech Walesa once said "The supply of words in the world market is plentiful but the demand is falling". Saying we are not in danger from deflation or dis-inflation does not change anything, unless you get people to believe it. And if they are rational (and on average they are as they can see what goes on in the real world), then they won't buy it that easily.