Central Banks and Credit Loosening Policies: Misguided Actions

Today, both the Chairman and the Vice Chair of the FOMC gave speeches in which they clearly state that a credit crisis led to the downturn in real activity. The statements are not even qualified. From the Vice Chair: “A defining characteristic of the crisis has been a deepening adverse feedback loop in which financial strains have caused economic weakness, which has in turn led to credit losses and heightened financial strains, which then contribute to further economic weakness, and so on.”

I have shown previously that the key dates of the financial crisis were all pre-dated by turning points in the macro data. (Take a look at this post.) In my mind, then, the financial crisis itself was caused by a real deterioration in the real economy rather than the other way around. But central banks and central governments continue to implement policy as if there is nothing wrong with the world but a simple banking crisis. Indeed, Bernanke’s speech is full of measures by which the Fed’s programs have helped resolve the crisis.

Despite all of these actions and all of the rhetoric, no central bank in the world has been able to prove that a credit crisis even exists, let alone whether it started the downturn or resulted from the downturn. In October, Chari, Christiano, and Kehoe published this paper calling into question virtually every fact of the financial crisis. They acknowledge only that the asset-backed commercial paper market and the securitization market failed. A Boston Fed paper seeking to undo their results made very little progress. In their analysis, they show that some subclasses of loans were falling; but, subclasses are not the same as a credit crunch. Indeed, that only subclasses of assets are adversely impacted points much more to a real shock than a financial shock.

I could retrace all of the data in the above publications; but it seems to me that anyone who wants to claim that a financial crisis is of first order importance in the current downturn must first explain the following picture.
This picture shows the level of commercial credit from January 2001 through February 2009. Credit did not fall until November 2008, almost 18 months into the crisis and 11 months into the official recession. Even then, the fall is miniscule and likely has more to do with Federal Reserve lending programs than actual credit (think China). Indeed, credit continued to grow robustly until March 2008 when it turned flat.

Credit does not grow robustly during recessions. People are poor. People think they will be poor for a long time. They do not want to borrow.

For those of you still inclined to quibble, take a look at the same picture during the Great Depression. Credit should actually fall before we start calling it a credit crisis.

The auto sector has felt the impact of the recession more than perhaps any industry outside of the housing sector. New car sales slumped sharply beginning in the very tail end of the 2007. There were lots of speeches given about the lack of credit in the auto sector. The problem is that none of the usual indicators of credit tightening are apparent in the data.

Here is chart of auto loan interest rates at auto finance companies. Interest rates on new car loans did not rise in any meaningful way until the fall of 2008, 9 months after sales dropped. (There is a downward movement in rates at commercial banks.)

Other measures of tightness, such as months to maturity and loan-to-value ratios also remained flat.

Series by series, across many different classes of consumer and business credit, they all look essentially the same, except where evidence of falling prices can be seen. Spreads may have risen in this recession but interest rates did not rise.

Takeaway: There may be a credit crisis. But that crisis is not showing through to either business or consumer lending. Therefore, that crisis cannot explain the large drop in consumption, the large drop in auto sales, of the collapse of the housing market.

Policies designed to resolve the recession via credit intermediation are therefore misguided and destined for failure.