The key chart
The key message
A major weakness in the current debate about debt in the “post-Covid world” is the failure to distinguish adequately between different forms of credit.
CMMP analysis, in contrast, draws a clear distinction between productive, “COCO-based” credit and less-productive, “FIRE-based” credit (see “Fuelling the FIRE, the hidden risk in QE”). This enabes a more accurate critique of current macro policy and a better understanding of the implications of unorthodox monetary policy (QE).
The shift towards greater levels of FIRE-based lending pre-dates the introduction of QE, but it was not until July 2016 that this form of credit exceeded COCO-based lending for the first time in the EA. The latest ECB data shows that FIRE-based lending now accounts for 52% of total lending (November 2020) reinforcing my September 2019 message that the “hidden risk in QE is that the ECB is ‘fuelling the fire’ with negative implications for leverage, growth, financial stability and income inequality in the EA.”
COCO- versus FIRE-based lending – the key concepts
In the broadest sense, lending can be spilt into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO” credit (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE” credit (FInancials and Real Estate). Dirk Bezemer (www.privatedebtproject.org) neatly distinguishes between the productivity of these different forms of lending:
- COCO-based lending typically supports production and income formation
- CO: loans to NFCs are used to finance production which leads to sales revenues, wages paid, profits realised and economic expansion. Bezemer notes that these loans are used to realise future cash revenues from sales that land on the balance sheet of the borrower who can then repay the loan or safely roll it over. The key point here is that an increase in NFC debt will increase debt in the economy but it will also increase the income required to finance it
- CO: consumer debt also supports productive enterprises since it drives demand for goods and services, hence helping NFCs to generate sales, profits and wages. It differs from NFC debt to the extent that HH take on an additional liability since the debt does not generate income. Hence the consumer debt is also positive but has a slightly higher risk to stability
- FIRE-based lending typically supports capital gains through higher asset prices
- FI: loans to NBFIs (eg, pension funds, insurance companies) are used primarily to finance transactions in financial assets rather than to produce, sell or buy “real” output. This credit may lead to an increase in the price of financial assets but does not lead (directly) to income generated in the real economy
- RE: mortgage or real estate lending is used to finance transactions in pre-existing assets rather than transactions in goods and services. Such lending typically generates asset gains as opposed to income (at least directly)
Lending in any economy will involve a balance between these different forms, but the key point is that a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.
COCO- versus FIRE-based lending – the evidence from the euro area
At the end of November 2020, COCO-based lending in the EA totalled EUR 5,437bn. This is below the peak level of EUR 5,517bn recorded in January 2009. FIRE-based lending, in contrast, totalled EUR 5,792bn, 26% higher than the outstanding stock as at the end of January 2009. As can be seen in the chart above, FIRE-based lending exceeded COCO-based lending for the first time in July 2016. The current split of total loans is now 52% FIRE-based and 48% COCO-based, compared with respective shares of 45% and 55% in January 2009.
In other words, the shift towards increased FIRE-based lending pre-dates the introduction of QE in the EA. The shift becomes more noticeable in the post-GFC period and may also reflect the fact that NFC debt levels (expressed as a percentage of GDP) had exceeded the threshold level that the BIS considers detrimental to future growth for most of this period (see chart above).
COCO- versus FIRE-based lending – the impact of QE
Nevertheless, as noted back in September 2019, the hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.
As noted above, while COCO-based lending increases absolute debt levels, is also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage.
Similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly.
From a stability perspective, the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers.
Finally, the return from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.
Please note that the summary comments above are abstracts from more detailed analysis that is available separately