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Inquiring minds are
reading the Quarterly Review
and Outlook by Van Hoisington and Dr. Lacy Hunt. It's an excellent
report so let's take a look at some commentary and charts.
Record Expansion of
the Fed's Balance Sheet and M2
In the past year, the Fed's balance sheet, as measured by the monetary base,
has nearly doubled from $826 billion last March to $1.64 trillion, and
potentially larger increases are indicated for the future. The increases
already posted are far above the range of historical experience. Many
observers believe that this is the equivalent to printing money, and that it
is only a matter of time until significant inflation erupts. They recall
Milton Friedman's famous quote that "inflation is always and everywhere
a monetary phenomenon."
These gigantic increases in the monetary base (or the Fed's balance sheet)
and M2, however, have not led to the creation of fresh credit or economic
growth. The reason is that M2 is not determined by the monetary base alone,
and GDP is not solely determined by M2. M2 is also determined by factors the
Fed does not control. These include the public's preference for checking
accounts versus their preference for holding currency or time and saving
deposits and the bank's needs for excess reserves. These factors, beyond the
Fed's control, determine what is known as the money multiplier. M2 is equal
to the base times the money multiplier. Over the past year total reserves,
now 50% of the monetary base, increased by about $736 billion, but excess
reserves went up by nearly as much, or about $722 billion, causing the money
multiplier to fall (Chart 3). Thus, only $14 billion, or a paltry 1.9% of the
massive increase of total reserves, was available to make loans and
investments. Not surprisingly, from December to March, bank loans fell 5.4%
annualized. Moreover, in the three months ended March, bank credit plus
commercial paper posted a record decline.
click on chart for sharper image
Hoisington is correct
that the Fed is not in control. However, the statement "Thus, only
$14 billion, or a paltry 1.9% of the massive increase of total reserves, was
available to make loans and investments" places the cart in front of
the horse.
The money is available to lend in theory (It's not really for reasons we will
get to in a moment) but banks simply do not want to lend as the pool of
credit worthy borrowers is shrinking. Moreover consumers and corporate
borrowers are showing a huge demand for dollars (a reluctance to borrow and
spend).
Excess reserves are rising because of the
increased demand for money and because banks are preparing in advance for
future writeoffs, not because the increased demand for money means there is
less money to lend. It's important to place the horse in front of the cart.
Nonetheless, it's important to note that "from December to March,
bank loans fell 5.4% annualized. Moreover, in the three months ended March,
bank credit plus commercial paper posted a record decline."
Total Bank Credit
click on chart for sharper image
While not yet negative, total bank credit is plunging. Now conceptualize what
that chart would look like if banks marked that credit to market (my
preferred way of looking at things). No doubt that chart would be deep into
negative territory.
We do not know the full extent of what that chart would look like with credit
marked to market because banks are playing games with level 3 assets, hiding
bad debts in off balance sheet SIVs, and otherwise pretending that many loans
that will never be paid, will be paid back.
Factors
Affecting Banks Unwillingness To Lend
·
Rising
unemployment will cause ...
·
Rising
credit card defaults
·
Rising home
equity loan defaults
·
Rising
mortgage loan defaults
·
Rising
commercial loan defaults
On top of that there is an increased demand for money by cash starved boomers
headed into retirement who finally realize they do not have enough savings.
Excess Reserve Mirage
Factor all of upcoming defaults and much of those
so called Excess Reserves are pure fantasy!
Is it any wonder banks are reluctant to lend? The
irony in this situation is that bank lending is the most responsible it has
been in a decade, and neither the Fed nor Congress is happy about it.
With that let's return to the article with and discussion about M2 and
Velocity.
What about the M2 Surge?
M2 has increased by
over a 14% annual rate over the past six months, which is in the vicinity of
past record growth rates. Liquidity creation or destruction, in the broadest
sense, has two components. The first is influenced by the Fed and its allies
in the banking system, and the second is outside the banking system in what
is often referred to as the shadow banking system. The equation of exchange
(GDP equals M2 multiplied by the velocity of money or V) captures this
relationship. The statement that all the Fed has to do is print money in
order to restore prosperity is not substantiated by history or theory. An
increase in the stock of money will only lead to a higher GDP if V, or
velocity, is stable. V should be thought of conceptually rather than
mechanically. If the stock of money is $1 trillion and total spending is $2
trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged,
velocity then jumps to 3. While V cannot be observed without utilizing GDP
and M, this does not mean that the properties of V cannot be understood and
analyzed.
Click on chart for sharper image
The highly ingenious monetary policy devices developed by the Bernanke Fed
may prevent the calamitous events associated with the debt deflation of the
Great Depression, but they do not restore the economy to health quickly or
easily. The problem for the Fed is that it does not control velocity or the
money created outside the banking system.
In regards to velocity
it is important to understand that falling velocity does not cause
anything to happen. Falling velocity is a result of two phenomena.
1. Increased demand for money
2. Undertaking projects that make no economic sense (i.e. there is negative
cost benefit payback).
Most government sponsored work efforts have a negative payback as do the
various "ingenious monetary policy devices developed by the Bernanke
Fed", as did the lending practices of Fannie Mae, etc.
Moreover those "highly ingenious monetary policy devices" are
guaranteed to prolong the recovery process if not make the ultimate calamity
worse. This is what happened when Japan tried the same measures.
Let's return once again to Hoisington.
Japan Government Debt vs. Economic Recovery
By weakening the
private economy, government borrowing is not an inflationary threat. Much
light on this matter can be shed by examining Japan from 1988 to the 2008 and
the U.S. from 1929 to 1941. In the case of Japan government debt to GDP ratio
surged from 50% to almost 170%. So, if large increases in government debt
were the key to economic prosperity, Japan would be in the greatest boom of
all time. Instead, their economy is in shambles. After two decades of
repeated disappointments, Japan is in the midst of its worst recession since
the end of World War II. In the fourth quarter, their GDP declined almost
twice as fast as that of the U.S. or the EU. The huge increase in Japanese
government debt was created when it provided funds to salvage failing banks,
insurance and other companies, plus transitory tax relief and make-work
projects.
In 2008, after two decades of massive debt increases, the Nikkei 225 average
was 77% lower than in 1989, and the yield on long Japanese Government Bonds
was less than 1.5% (Chart 6). As the Government Debt to GDP ratio surged,
interest rates and stock prices fell, reflecting the negative consequences of
the transfer of financial resources from the private to the public sector
(Chart 7). Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy
actions served to impede, rather than facilitate, economic activity.
click on chart for
sharper image
Other than an occasional putting
the cart in front of the horse syndrome, this was an excellent read by Van
Hoisington and Dr. Lacy Hunt. It's well worth a complete review.
Mish
GlobalEconomicAnalysis.blogspot.com
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