Funding for what?

If you’ve ever wondered how it is that despite getting things so monumentally wrong over the past five years, economists still manage to find work, a brief glance at the newly-refreshed Funding for Lending scheme might enlighten you.

Here is a scheme which, according to most external analysts has so far disappointed. The International Monetary Fund believes that “so far the FLS’s impact has been limited”, the Policy Exchange says: “Funding for Lending isn’t working”, and about the most flattering thing anyone could say about it is that it has at least brought down the cost of borrowing for some mortgage payers, if not lifting actual lending at all.

Indeed, total lending to non-financial companies has dropped by around £10bn a year since the financial crisis started, and lending to small and medium sized businesses (SMEs) is down by around 3% a year.

Now, most people would look at this performance and rather quickly assume that the FLS has been a disappointment, but this is where we get to the big secret about why economists will always land on their feet: the counterfactual.

Withdrawals from the FLS may have been far lower than the big numbers trailed upon its launch; lending to most sectors of the economy may be down, but, comes the response, how do you know what would have happened otherwise? Yes, it’s the counterfactual get-out clause.

You may remember it from the debate over Quantitative Easing, where the Bank of England calculated that the recession would have been far deeper, unemployment far higher, if it weren’t for this radical monetary policy. Honest.

And now the same rationale is being trotted out again over the extended Funding for Lending scheme. Apparently, there is no way to judge whether it will be a success because there’s no way of knowing how the economy would have behaved otherwise.

Given there is no way of knowing whether this policy is or isn’t a success, I suppose the best we can do for the time being is to run through what, precisely it involves. A few bullet points:

–          The key changes are threefold: the scheme will be extended by a year so it ends in January 2015.

–          As with the existing FLS, the carrot here is that the Bank will lend banks cheap money (for which read a 0.25% interest rate above the base rate (eg 0.75% at present) in return for every pound they lend into the economy, within a pre-determined amount.

–          But this time around there is a special incentive to lend to SMEs: banks will get £10 of cheap lending for every £1 they lend to small businesses this year. They get £5 of cheap money for every £1 they lend to SMEs next year.

–          This means that, in theory, that even if a bank reduces its net lending to households, big business and credit providers by £9m this year, it will still qualify for £1m of cheap loans provided it lends out a mere £1m to SMEs this year (£10m quota for the SME loan, -£9m for the rest).

–          Thirdly, the scheme has been extended to other non-bank lenders, for instance finance leasing companies and certain mortgage lenders. In some senses this makes plenty of sense: many small businesses borrow from these smaller lenders. However, given that this will encompass buy-to-let providers such as Paragon and Precise, it will leave the Bank and Treasury open to the accusation of trying to inflate another bubble in the housing market (alongside the Help to Buy scheme).

More broadly, even the extended FLS does little to solve the fundamental problem in the banking sector: that most of Britain’s finance houses are both short of capital and fearful of lending to companies that may not be around to repay them in the future. Another unanswered and possibly unanswerable question in economics today is whether the fall in lending to business is due to demand factors (eg the businesses can’t or don’t want to borrow) or supply factors (banks can’t or won’t lend to them). Even an extended FLS cannot solve this problem.

Ultimately, the best one can say about the newly-extended scheme is that it may make lending to businesses marginally more attractive. However, we may not ever notice the difference. On the downside, it may contribute to a possible new bubble in the housing market (though not as much as Help to Buy), and puts yet more private sector collateral onto the Bank of England’s balance sheet – albeit temporarily.

However, there was another significant piece of news which also came out today which is worth dwelling on for a moment: the Government announced that it has offered a £75m guarantee to Drax Group to help it raise private funding for the conversion of its coal-fired power station to biomass.

This is the first of what are likely to be many projects supported by the UK Guarantees Scheme, which was launched last July. It’s yet more evidence of the Government taking an activist industrial policy one would rarely have associated with a Conservative Chancellor. Some will argue that this smacks of 1970s-style dirigiste policy, but others will point out that most other Governments around the world support their firms and try to attract investment. For Britain not to do so will leave it yet more exposed as the world economy struggles to recover.

And in a sense, that’s perhaps the best way to view both FLS and the Drax story. There is little available finance in the UK; so this is the Government attempting to use both the Bank of England and Treasury’s balance sheets to try to attract investment from overseas, and prevent it leaking out of the UK.