The penny is starting to drop. For the past two years, much of the mainstream economics profession has been engaged in a highly politicized but largely futile debate over how best to boost U.K. demand, whether through greater fiscal stimulus or more quantitative easing. But it is now becoming clear the U.K.'s problem is one of supply, not demand, reflecting a weak banking system that is pushing up the price of credit and rationing loans. This requires a very different policy response.
The evidence for this credit supply shock is compelling. Lending growth is very weak, yet lending costs have been rising, hardly compatible with poor demand, notes Goldman Sachs. Lending to businesses fell by an annualized 9.4% in the first quarter of this year. The average interest rate on a 75% loan-to-value mortgage rose by 0.5 percentage point between August 2011 and April 2012 and looks likely to rise higher, reflecting high wholesale bank funding costs and fierce competition for deposits.
True, low U.K. growth can't be blamed only on weak banks. The cost of corporate-bond market funding is also high, suggesting investors have raised their return requirements, noted Ben Broadbent, a member of the Bank of England's Monetary Policy Committee, in a speech Monday. That likely reflects fear of extreme shocks such as a euro collapse.
Even so, other countries such as Germany, France and Belgium are even more exposed to a euro collapse yet have performed better. That may be due to regulatory uncertainty. The U.K. postcrisis policy response has focused on forcing banks to self-insure against extreme shocks, noted the BOE executive director for bank supervision, Andrew Bailey, last week. A lack of clarity over what official sector backstop is likely to be available and on what terms may be encouraging banks and businesses to run with bigger buffers.
Policy makers are far from powerless to tackle these problems. The quickest way to lower funding costs and boost credit supply would be to loosen the U.K.'s ultraconservative liquidity rules to allow banks to invest in a wider range of assets such as covered bonds, corporate bonds and equities. U.K. banks have £550 billion ($862.5 billion) sitting in low-yielding central-bank deposits and government bonds that could be used to fund the real economy.
But the BOE could also buy private-sector assets such as bank bonds and securitizations and offer long-term refinancing facilities similar to those offered by the European Central Bank. And it should end the uncertainty by agreeing to regulate banks according to international capital and liquidity rules rather than insisting they be "super-equivalent."
None of this can stop the euro crisis inflicting grave damage on the U.K. economy if the single currency falls apart. But it might allow the U.K. to grow in the interim.