The policy pendulum looks set to swing back to dealing with credit flow in the banking system. With so many policy proposals floating around internationally, I would be very interested to hear current views on the best policy course for the government.
Taking it as given that there has been a severe contraction of new credit, how much is due to: (i) a collapse in the demand for credit as firms and households repair balance sheets; or (ii) a collapse in the supply of credit?
Under (ii), is the main reason for the decline in supply: (a) the declining creditworthiness of potential borrowers; or (b) the risk aversion of bankers as they teeter on the edge of insolvency?
It seems to me that if the contraction is mainly driven by some combination of (i) and (ii a), the government would be wise to limit the additional fiscal commitment. A large package would further tighten the fiscal solvency constraint and force a more rapid fiscal correction.
The case for a large package seems more compelling if the credit contraction is being driven by the caution of the bankers. Whatever the size of the package, what is the proper balance between re-capitalisation, insurance for new credit flows, troubled asset purchases, etc?