Monday, 3 August 2009

Supply and demand: bank loans

Scott Sumner has published a couple of good articles about the difficulty of understanding supply and demand, and Robert Peston's posting today may be an excellent illustration of that.

Robert says:
Here's the great and resonant unknown of the moment.

Is the credit contraction a reflection of less demand from you, me and millions of others? Or are the banks rationing much more than they had been doing?

The answer is - probably - a bit of both.
But does that make any sense? Well, it could - but is it plausible that demand for loans just happens to fall at the same time as the banks tighten their standards? And why would the banks "ration" credit anyway? Professor Sumner might give a simpler explanation.

Occam's razor, as you know, says that the simplest explanation is usually the best. So can we identify a single cause of this phenomenon? Yes we can.

Imagine that there is a stable market for credit in 2007. Then just one thing happens: the supply curve for loans shifts leftwards. This means that a lower amount of loans will be supplied at any given interest rate. Assume that the demand curve stays exactly the same.

The consequence? Loans get more expensive; fewer transactions take place. A new equilibrium is reached, further leftwards along the same demand curve, where a lower quantity of transactions takes place at higher prices.

People might be demanding just as much credit - indeed, they could be looking for more. Some businesses need more working capital and some people want to borrow to replace temporary lost income from unemployment or wage cuts. But if the supply has fallen, then the price of borrowing will go up and the amount will decline.

Why would supply fall? Two reasons. First, if wholesale lending is no longer available. Second, if loans have become riskier - and therefore their cost has gone up. Both of these effects shift the supply curve upwards.

Anecdotally, this is very plausible. Business loan rates seem to be a couple of percent higher than before; credit card interest rates are up; and an acquaintance wanted to top up a personal loan which is currently being paid off at a rate of 6.3%. The quote for the top-up loan? 17.9%.

My view: the problem in 2007 was not that the banks lent too much - it is that they did not take enough deposits. Governments [update: and central banks] have done the right thing in replacing (some of) these deposits through their various liquidity schemes but they haven't replaced the entire quantity. In addition, they can't do much about rising costs caused by loan writeoffs without offering straight subsidies.

Fortunately as the economy stabilises, these costs will reduce, and we're already seeing Chinese banks entering the UK market with lower loan rates than the domestic banks. Let's hope a bit more financial globalisation can help us fix this problem.

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