Broken transmission mechanisms

By R.A. | WASHINGTON

NEW figures from Europe reveal that both GDP and inflation in the euro area are falling, while unemployment is steadily rising. The mix of pain calls for monetary easing, and at its last policy meeting the European Central Bank did indeed reduce its main interest rate to 0.75%, a record low for the single-currency area. Yet as a recent Free exchange column explained, low ECB rates aren't having the desired effect around the struggling periphery:

In 2008, as the euro zone started to contract, the ECB slashed its main rate from 4.25% to 1%. But because investors were worried about the state of the banks, the returns that banks had to offer on their own bonds rose. This offset the ECB’s easing, so that firms’ borrowing rates fell by less than normal.

When the euro crisis intensified in 2010, the ECB’s influence on interest rates in Spain and Italy waned even further. Banks’ bond yields rose in line with their governments’ cost of borrowing. As predicted by the bank-lending channel, but now as a result of a change that the ECB did not control, the supply of loans contracted. The amount of borrowing in Italy and Spain has started to fall again (see right-hand chart). Some of this may be due to weak demand. But a 2011 study by the ECB suggested that tight credit conditions could take two percentage points off annual growth in the currency area. Recent studies by the IMF and the Bank of Italy concur: credit supply is a big problem.

Tight credit conditions are choking off private-sector growth. To battle this problem, the ECB could take a page from Britain, which has used a "funding for lending" scheme to improve the flow of credit to businesses. In it, banks that raise lending to small and medium-size enterprises can go to the Bank of England and swap their relatively risky assets for ultra-safe government bonds. Those in turned can be used as collateral to obtain cheap bank financing. When all is said and done banks should be healthier and the flow of credit to firms should resume.

But will it work? And what other solutions might address the euro area's monetary difficulties? To discuss the problem we have invited experts from academia and the world of finance to contribute their thoughts, which we will run here over the next few days. Do follow along and add your own contributions in the comments.