EU inflation has fallen to an annual core reading of 0.8 per cent, which is much lower than the ECB was expecting. This reading borders on deflation, and the essential issue is that inflation remains in a downtrend; a downtrend that, if it continues, points at a deflationary situation in Europe. While the trend is normally your friend, as it typically tells you when to buy an asset, a downward trend in inflation is not the friend of any economy. As southern EU countries scramble to regain competitiveness, it is commonly imagined that the various labour markets are forcing wages lower, thereby forcing inflation lower, as shown in diagram 1 below,
Small business credit squeeze
Yet, this is not the only problem, and the downtrend in core inflation seems firmly entrenched.
Specifically, it can be argued that recent bank regulation is now forcing a tightening of credit conditions, as large banks re-price loans to small business.
"So what!", you might say.
However, one needs to realize that small business is a main driver of employment, as well as a portion of final output pricing. So, if these businesses are under pressure, they will ensure that output is priced in a way that clears production. Small business has no choice; either clear output, and keep the bank happy, or maintain old pricing and go out of business. In other words, it is not just the labour market that is forcing prices lower, it is also a small business sector that is now very much paranoid about surviving, in a situation where banks are also fighting to make ends meet, in an environment of structurally tighter credit that followed the GFC.
This is not to say that larger businesses are doing famously, yet the pressure points on funding a business tend to intensify as firm scale diminishes. Banks assess credit risk according to scale, so, all else being equal, banks will assess the credit risk of a small firm as being higher than the credit risk of a large firm. Higher risk means not only higher credit fees and higher interest rates, but also less lending to smaller firms, as they are more expensive to lend to, for a bank, relative to large firms. This lack of availability remains a large concern to the small businesses, who depend on continuity of credit provision, and who relatively limited choice and sophistication, in terms of seeking and sourcing different funding sources.
While the ultimate small business, the employee, remains traumatised, the main employment sector is suffering; it is cutting output price to survive. For many small businesses, the choice is one of losing a small amount of money for the next few years, so as to save the value of the business, or to sacrifice the business and destroy the value of the business by closing. By choosing the former, small business is choosing to hope that things will improve, and the outcome of this choice is that output prices must be cut. Some of this reasoning may go some way to explaining what is going on in terms of trends in EU inflation. Weak labour markets are only part of the story, as bank regulation changes are compounding the problem by tightening credit to the very sector that should be shown the opposite environment at this difficult time.
A similar narrative may be evident in the US, and the Fed is watching inflationary developments with much trepidation, as Chicago Fed President Evans recently observed.
Towards a possible solution
Yes, one would imagine that most would want to see greater bank regulation, more capital, and reduced risk taking, yet the issue is one of timing, with EU and US inflation at worrisome levels; at the junction between disinflation and deflation. With peripheral EU unemployment surging, the time for regulatory change is not now, as one agency of the EU bureaucracy tightens credit, albeit unwittingly, another, namely the ECB, is looking at the outcomes in terms of inflation. Those outcomes are frightening, to say the very least. If the EU surges into an era of deflation, make no mistake, the costs will be high, far higher than delaying necessary regulatory change. While one cannot be sure that this deflationary surge will occur, the trend towards deflation is now entrenched and the reasoning provided above, especially about the emergent credit squeeze of the small business sector, suggests no end is in sight.
Given this threat, one hopes that the bureaucrats now trying to tighten standards in the banking sector will see the need to "back off", and free up credit, thereby delivering small business a well needed break; a break that will stop the deflationary trend while helping to shore up employment.
All this means that banking regulation, like monetary policy, should become much more state dependent, as monetary policy is becoming, at least in the United States. Here, different macro readings are used as “trigger points” for possible changes in monetary policy. Given substantial employment improvements, and an improving trend and level of inflation, one might then, only after these developments, implement much needed reform. In the alternative, by being blind to the plight of the small business person in Europe, and the impact of banking regulation upon these firms, we will wait and watch an ECB, which continue to deny the inevitable; the development of widespread, and entrenched, deflation, while the rest of the EU bureaucracy makes life a living hell for the very sector that is the lifeblood of any free market.
Unfortunately, In the EU, it seems that institutional scale has hijacked the policy agenda.
While this is the cold hard reality of life, at least in times of "normality", if those times ever exist, the problem is that we are cruising way out of "normality"; we are cruising toward a very nasty place. Someone, or some organisation, needs to voice the concerns of small business to avoid a deflationary crisis, and implement a state dependent overhaul of the banking regulatory framework.
Dr Stephen Nash is an author and Cambridge Ph.D. graduate with extensive experience in fixed income markets.