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The woes of small businesses in Italy and Spain threaten to be the next twist
in the euro saga
May 4th 2013 |From the print edition
MONEY, John Stuart Mill said, is just a machine: a tool for doing things, like
exchanging goods, that take longer without it. Milton Friedman upped the ante:
Because it is so pervasive, when it gets out of order, it throws a monkey
wrench into the operation of all other machines. In Europe things are even
worse. The money machine is so badly out of order it may drive the economies of
Italy and Spain into a depression.
To understand the scale of the problem, look first at the importance of small
businesses in the euro area. Half of America s jobs are in small and
medium-sized firms (SMEs). In Europe such firms play a far bigger role. In
France SMEs employ 60% of workers, in Spain the figure is 67% and in Italy,
80%.
Because small firms do not issue bonds or sell equity in public markets, they
rely on banks for borrowing. And since small firms are so vital, one of the
measures of economic health in the euro area is how cleanly the interest rates
set by the European Central Bank (ECB) feed through to the rates that firms
pay. By that measure, the first eight years of the single currency were
pleasant. If the ECB rate was 2%, firms would pay 4%. The difference between
the two was small and it was stable. It made policy decisions easy: if the ECB
thought the economy was overheating, it could raise its rates, confident that
the rates firms would pay would rise by the same amount.
But that system has broken down (see Free exchange). The stable wedge between
ECB rates and firms borrowing costs has been replaced by an unstable gap that
varies by country. In Germany and France things are still close to how they
were in the good years. The ECB rate has been 0.75%; firms have been paying
around 3.5% to borrow. But in Italy and Spain the wedge has almost tripled in
size, in part because banks there are paying more to borrow. When fears rise,
most recently in response to the mess in Cyprus, funding costs to banks spike
and are then passed on to firms. So SMEs in Spain and Italy must pay over 6% to
borrow; money is tighter there than it was in 2005, even though the ECB s rate
is far lower.
For firms with new ideas, investment becomes more pricey. But even companies
that plan to pay off existing debt are hit. In Italy borrowing by firms is
around 855 billion ($1.3 trillion). A rate above 6% translates into interest
payments of more than 50 billion a year. If Italian rates were the same as
those in France, firms could refinance loans, and interest payments would fall
by 22 billion. Lower borrowing costs would lift profits, which could be used
to invest or pay staff more.
The Italian and Spanish economies are both in recession. With debt-ridden
public sectors, fiscal policy is at best neutral; more probably, it will act as
a drag on growth as governments seek to balance the books for years to come. In
this situation economies need a big monetary boost. Instead, Italy and Spain
are getting more drag. In the first months of 2013 credit supply tightened
again. Facing higher interest rates, Italian firms paid back 10% of their loans
in the past year. In Spain things are even worse: rates are higher still and
total lending has dropped by 15%. These are the data of a depression, in
economies large enough to plunge the whole euro zone into a much deeper crisis.
Spain s economy is almost twice the size of those of Greece, Ireland, Portugal
and Cyprus put together. Italy s is 65% bigger than Spain s.
Whatever it takes
The ECB has already taken too long to act to ease small firms borrowing costs
(it had another chance when it met on May 2nd, as The Economist went to press).
Mario Draghi, its president, has said he will do whatever it takes to save
the euro; what it takes now is fresh support for business lending. Any new
programme must pass three tests. It must be targeted, aiming directly at the
high and volatile funding costs that euro-area banks face. It should be
conditional, tied to SME lending: Britain s central bank, for example, now
offers banks 10 ($16) of funding assistance for every 1 of new loans to SMEs.
And it must be large big enough to make the money machines in Italy and Spain
work properly again.
One option is for the ECB to ease bank access to its existing low-rate funding
window by accepting smaller SME loans as collateral. But that may not be
enough. A bolder move would be to buy SME loans directly from both banks and
non-bank lenders, focusing its purchases where credit supply looks tightest.
The ECB is wary of policies that help one economy more than others. And buying
or swapping assets in this way would mean taking on risk, creating an implicit
transfer from all the taxpayers that prop it up, including German ones. These
measures would also be tricky to unwind. But the alternative, an avoidable
depression in Italy and Spain, is far worse.