2009/10 Rybczynski Prize Essay

The latest financial crisis has underscored the need to better capture the interaction between financial and economic variables in our forecasting models. This is especially important when analyzing investment dynamics, for two reasons. First, among the various components of aggregate demand, investment is especially sensitive to financing conditions. Second, as both the eurozone and the US are rather closed economies, a sustainable recovery hinges on domestic demand, with investment playing a crucial role: investment has become even more strongly correlated with world trade, and can therefore leverage the pull of the current rebound in global commerce into a self-sustaining domestic growth.

In this paper we focus on the eurozone. We carry out an in-depth analysis of financial conditions for Non-Financial Corporations (NFCs), developing and tracking measures of their reliance on external funding as well as the composition and costs of such funding. We then use a two-step E conditions will play a crucial role in driving investment demand going forward.

With eurozone NFCs still heavily dependent on bank lending, the current policy debate is focused on the fragility of the financial sector and the attendant risks of a credit crunch. Little attention however is given to the other side of the equation: our analysis shows that the financial situation of NFCs is uncomfortably precarious, as a period of substantial leveraging has been followed by a collapse in profitability and therefore in debt-servicing ability. It is notable that even the recent sharp curtailment in investment has not been sufficient for firms to increase savings and deleverage. This is particularly dangerous, as it increases the riskiness of NFCs at a time when banks need to be especially cautious. The only support has come so far from a strong decline in financing costs, reflecting both the ECB’s efforts and the more recent rebound in equity markets. Looking forward, it is crucial that financing costs remain at affordable levels while prospects for demand and profitability improve. This would set the stage for a recovery in investment and in GDP growth. Once the economic recovery is more firmly established, firms, however, should probably embark on a process of deleveraging, to avoid getting to the next downturn in as vulnerable a position.

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