The other financial crisis

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The other financial crisis

Two variants of financial crisis continue to wreak havoc on Western economies, fueling joblessness and poverty: the one that we read about regularly in newspapers, involving governments around the world, and a less visible one at the level of small- and medium-sized businesses and households. Until both are addressed properly, the West will remain burdened by sluggish growth, persistently high unemployment and excessive income and wealth inequality.

The sovereign debt crisis is well known. In order to avert a likely depression, governments around the world engaged in fiscal and monetary stimulus in the midst of the global financial crisis. They succeeded in offsetting nasty economic dislocations caused by private-sector deleveraging, but at the cost of encumbering their fiscal balances and their central banks’ balance sheets.

While sovereign credit quality has deteriorated virtually across the board, and will most probably continue to do so, the implications for individual countries vary. Some Western countries - such as Greece - had fragile government accounts from the outset and tipped quickly into persistent crisis mode. There they remain, still failing to provide citizens with a light at the end of what already has been a long tunnel.

Other countries had been fiscally responsible, but were overwhelmed by the liabilities that they had assumed from others (for example, Ireland’s irresponsible banks sank their budget). Still others, including the United States, faced no immediate threat but failed to make progress on longer-term issues. A few, like Germany, had built deep economic and financial resilience through years of fiscal discipline and structural reforms.

It is not surprising that policy approaches have also varied. Indeed, they have shared only one, albeit crucial (and disappointing) feature: The inability to rely on rapid growth as the “safest” way to deleverage an over-indebted economy.

Greece essentially defaulted on some obligations. Ireland opted for austerity and reforms, as has the United Kingdom. The U.S. is gradually transferring resources from creditors to debtors through financial repression. And Germany is slowly acquiescing to a prudent relative expansion in domestic demand.

So much for the sovereign debt crisis, which, given its national, regional and global impact, has been particularly well covered. After all, sovereigns are called that because they have the power to impose taxes, regulations, and, at the extreme, confiscation.

But the other credit crisis is equally consequential, and receives much less attention, even as it erodes societies’ integrity, productive capabilities and ability to maintain living standards (particularly for the least fortunate). I know of very few Western countries where small- and medium-sized companies, as well as middle-income households and those of more limited means, have not experienced a significant decline in their access to credit - not just new financing, but also the ability to roll over old credit lines and loans.

The immediate causes are well known. They range from subdued bank lending to unusually high risk aversion, and from discredited credit vehicles to the withdrawal of some institutions from credit intermediation altogether.

Such credit constraints are one reason why unemployment rates continue to rise in so many countries - often from already alarming levels, such as 25 percent in Greece and Spain (where youth unemployment is above 50 percent) - and why unemployment remains unusually high in countries like the U.S. (albeit it at a much lower level). This is not just a matter of lost capabilities and rising poverty; Persistently high unemployment also leads to social unrest, erosion of trust in political leaders and institutions, and the mounting risk of a lost generation.

Indeed, unemployment data in many advanced countries are dominated by long-term joblessness (usually defined as six months or more). Skill erosion becomes a problem for those with prior work experience, while unsuccessful first-time entrants into the labor force are not just unemployed, but risk becoming unemployable.

Governments are doing too little to address the private credit debacle. Arguably, they must first sort out the sovereign side of the crisis; But it is not clear that most officials even have a comprehensive plan.

Other countries appear to have adopted a “Field of Dreams” - also known as “build it and they will come” - approach to private credit markets, In the U.S., for example, artificially low interest rates for home mortgages, resulting from the Federal Reserve’s policy activism, are supposed to kick-start prudent financing. The European Central Bank is taking a similarly indirect approach.

In both places, other policy making entities, with much better tools at their disposal, appear either unwilling or unable to play their part. As such, action by central banks will repeatedly fail to gain sufficient traction.

In fact, only the U.K. is visibly opting for a more coordinated and direct way to counter the persistent shortfalls stemming from the private part of the credit crisis. There, the “Funding for Lending Scheme,” jointly designed by the Bank of England and the Treasury, seeks “to boost the incentive for banks and building societies to lend to U.K. households and non-financial companies,” while holding them accountable for proper behavior.

The U.K. example is important; But, given the scope and scale of the challenges, the proposal is a relatively modest one. The program may stimulate some productive credit intermediation, but it will not make a significant dent in what will remain one of the major obstacles to robust economic recovery.

Proper access to credit for productive segments is an integral part of a well-functioning economy. Without it, growth falters, job creation is insufficient and widening income and wealth inequality undermines the social fabric. That is why any comprehensive approach to restoring the advanced countries’ economic and financial vibrancy must target the proper revival of private credit flows.

* The author is CEO and co-chief investment officer of the global investment company PIMCO.

by Mohamed A. El-Erian
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