November 10, 2007

Banking Deregulation, Unlimited Creation of Credit and Asset Price Bubbles

In "Why We Are Not in a Recession, Yet, and What a Recession Will Look Like" at, Robert Wallach writes about business cycles being created by the Federal Reserve's erratic creation of money, and how this causes asset bubbles.

He is correct in that it is the Fed's policies that are the culprit, but it is not the Fed that is printing the money. In the current surge of money supply growth, it is not the Federal Reserve that is creating new money, but commercial banks and other privately held financial institutions. The Federal Reserve has actually been very stable in their creation of money.

Commercial banks are creating money when they issue new credit. When a bank "gives out" a loan to a private customer, the money is not taken from anywhere. The bank just creates a new deposit, which is covered by nothing except the debtor's promise of paying it back.

Robert Wallach cites the growth of the MZM (money of zero maturity) statistic as a sign of monetary inflation. This figure is now well above $6 trillion. But only a bit more than $800 billion of this figure is actually created by the Federal Reserve. This relatively small amount of high-powered money is the Monetary Base, which Gary North has been referring to. All the rest of this money is actually credit, which is forever in danger of default, though the risk is very small for most of the deposits.

Even though commercial banks have tightened their lending standards, the MZM is growing, probably because of people moving their deposits from long term investment contracts into shorter term accounts, which is shown as a spike in the MZM measure. That the MZM is growing so fast relative to the monetary base is a worrying sign in itself, because such a growth can not go on forever. When people start shifting their money from long term investments contracts into short term deposits, it is a sign of increasing intentions of withdrawal.

When the housing market was inflating, and new credit was created quickly, people put their profits into savings accounts and other long term investments. Now that people can not go any further into debt, they have started to dig into their savings, which puts a strain on the banking system. The MZM, as well as other monetary statistics figures, is actually a liability for the banks. It is a measure of deposits. Increasing short term liabilities at a time of decreasing asset values is not a good environment for the banks.

M3, the widest available money supply statistic, which was discontinued by the Fed in 2006, has also hastened its growth in the last couple of years, now going at well above 10% per year. This means that the creation of new credit has not come to a halt. There might be new bubbles brewing in other asset classes except just houses.

This might also be a sign of financial institutions frantically searching for new sources of profits to cover up their losses in the housing market. In doing so, they are probably taking ever higher risks, with ever higher levels of leverage, because they have less and less to lose.

The wider the gap between the amount of credit and the monetary base, the bigger the eventual crash is going to be. At some point, the game will be whistled to a stop, and a counting of losses will begin. This game has been going on for over 25 years.

The Federal Reserve is duly blamed for encouraging such excess credit creation by the commercial banks. The relative explosion of credit-based money supply was started in the early 1980's, when the reserve ratios were drastically cut in the name of "deregulation". Ever since, the answer to financial troubles has been more easing of restrictions.

Even researchers at the Fed itself have figured that the banks' reserve balances are not much affected by the reserve requirements, which are so small, that the logistics of cash handling itself is a more important restriction. The final detachment from reserve requirements came in 1995, when sweep accounts were taken into use.

When this game with continuously easing rules has been going on so long, what happens when there are no more rules to be eased anymore? We have already seen the Fed giving up on enforcement of section 23A of the Federal Reserve Act, which limits the exposure of depositor insured funds to the more risky broker-dealer units of financial corporations to 20% of the bank's capital. Every time that the banking system has been at risk since the early 1980's, there has been a relaxation of rules, and everything has been fine again for a while. What happens, when there are no more rules to relax, and the system is still in trouble?

These relaxed rules mean in practice that banks can create just as much new credit as they want. The only remaining regulatory restriction is the capital ratio, which is there to protect against actual insolvency. But the capital ratio is severely infected by the mostly symbolic "paper values" of banks' assets. This restriction has also been actively avoided by using off-balance-sheet structured investment vehicles.

Even though it has been mainly discussed as a "liquidity crisis", the
current crisis is in fact a solvency crisis created by simple overextension. In a deregulated competitive environment, occasional bankruptcies all but inevitable. But the whole system is built on the supposed infallibility of major financial institutions.

The Fed's slashing of the federal funds target rate to 1% for a prolonged time created a massive encouragement for banks to increase their lending, without the Fed actually having to print that much new money at all. By extending credit, banks can create not only brand new "assets", but also a lot of new money from nothing at all. This money has in turn the ability to affect the prices of other assets.

The prices of bank assets have been inflated by excess credit. In inflating asset prices,
the banks have also inflated their own capital. Because capital ratio is one of the few remaining constraints to lending, this has allowed the banks to create ever more credit, resulting in ever higher asset price inflation, and a self-reinforcing cycle. With no reserve requirements, the amount of credit has been totally unhinged from the actual amount of money that is created by the Federal Reserve.

The banks have been left holding a mass of assets whose value depends on their own willingness to pay for those assets, either by extending credit for purchases by a customer, or by direct purchases themselves. When that willingness is taken away, these asset prices collapse. Liquidity is naturally constrained in a situation like this, because the sellers of these assets (banks) and the potential buyers (banks) are in fact the same entities. It is a simple case of herd mentality, which is found in the background of every bubble and even a minor business cycle.

So banks have huge holdings of assets, whose values are completely dependent on perpetual growth of credit. But credit can not be extended beyond the debtor's ability pay back. This very hard wall has now been hit, and the value of these loans, as well as the underlying collateral, i.e. the houses, has become questionable.

The credit market is now in a valuation crisis that puts the banks'
solvency into question. Because the reserve ratios are so small, about $300 billion of cash assets against $6600 of deposits, the banks can not survive long without liquidity. They have to be able to quickly sell their assets at a decent price or risk defaulting on their obligations.

But liquidity can only be provided by the banks themselves, because they are the principal creators of money. The Fed has lost its influence. Even a rapid flow of cash from the Fed could be overcome by an even greater withdrawal of credit by commercial banks. There is an actual risk of a complete banking system meltdown. If that risk is realized, we can forget inflation.

This scenario would bring us back to the great depression, with much bigger excesses this time. This is what the bankers, including Bernanke, are really scared about. They are willing to risk serious inflation to avoid that.

The fact that the US dollar is sinking might be a sign of expectations of actual monetary inflation. But there is a delay in the effect of monetary inflation. It takes time for the new money to end up in the pockets of the average consumer, so a severe recession and even nominal deflation can possibly not be avoided.

If an actual solvency crisis in the banking system occurs, there might be a mad dash for cash, with bank runs everywhere, and an associated spike the US dollar's foreign exchange rate.

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