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Europe s credit crunch - Mend the money machine

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ECB rates and firms borrowing costs has been replaced by an unstable gap that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.