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Inspired by a post by Mark Perry, I put together this chart using the latest data from the Federal Reserve. As I have noted several times before, the popular notion that the economy is at great risk because bank lending has stopped dead in its tracks is completely erroneous. Lending by all commercial banks now stands at an all-time high, and is up 9.2% in the past 12 months. I've drawn a trend line on the chart which is instructive. Over the past 36 years, bank credit has increased by a compound annual rate of 8.4% per year, only slightly faster than the 7% per annum increase in nominal GDP.
I don't see how this adds up to the assertion, as many claim, that a massive credit expansion is the root cause of our current crisis. Our current problems have nothing to do with a shortage of money or too much credit; rather, it is all about a shortage of buyers and a lack of confidence. And that in turn is being driven by the fear of defaults triggered by falling housing prices. Once prices stop falling and/or the market prices in the full extent of the likely losses, the crisis can begin to wind down. I think we're already in the early stages of that process.
14 comments:
Do these statistics pick up increased leverage that originated through the so-called "shadow banking system"?
You misunderstand the Austrian theory that credit expansions cause recessions, apparently.
The theory demonstrates that a credit expansion changes the price relationship between capital goods and consumption goods and causes other relative price distortions. In a market economy, it is relative prices determine which investments are going to be more profitable, and therefore drive entrepreneurial decisions.
The continuation of projects dependent on an inflationary credit expansion requires an ever accelerating growth in credit availability.
Your chart is very much consistent with this Austrian Schoool theory. Why are people screaming that lending is "frozen up"? Well, because the screamers need ever more credit or their projects fail -- and the system cannot continue to accelerate indefinitely.
Contrary to your praise for all the Fed/government actions to improve "liquidity," I believe the last thing this economy needs is yet another goose of liquidity. That will only introduce yet more relative price distortions and cause more capital consumption.
Scott: It appears that two people are posting with the name of "tom."
The second post is mine, the first is not ... unless I have started posting notes a sleep walking state.
Tom Burger
Tom (1): Not sure what you're referring to. But the chart only picks up lending by "banks" not lending by other private entities. Banks are the only ones who can create money; other people can lend, but only lend money they already have.
Tom (2): Our disagreement over Austrian theory goes back a long way and I doubt we'll settle it. I don't see a credit expansion as the source of all the economy's ills. I think it was the Federal Reserve's choice of an interest rate target that was too low. Regardless, right now the Fed MUST accommodate the system's enormous appetite for money otherwise they risk a real implosion. If they don't withdraw their reserve additions as money demand subsides, then I agree we'll be in a real mess.
Scott,
Perhaps you can help me understand the impact of the shadow banking system relative to total bank credit.
I had thought that shadow banking vehicles, SIVs, borrowed short and lent long. The SIVs only held a small amount of capital relative to their outstanding debt, and thus they were highly leveraged (10 or 15:1 according to wikipedia). So far, this involves no money creation. However, every SIV also had backstop agreements with a bank or banks, and those banks did not account for potential SIV liabilities on their books. All this worked fine until the SIVs ran into trouble and had to invoke their backstop agreements with the banks. This forced the banks to place the SIVs on their books as a negative asset, thereby reducing their net asset levels and forcing them to compensate by increasing reserves.
If the above understanding is correct, then it seems that the shadow banking system liability should have been on the books of the real bank's that provided the backstops, but wasn't. Thus, this excess credit does not show up on your total bank credit chart. The various recent Fed/Treasury programs that have pumped money into the system have compensated for the hit the banks have taken from bringing their SIV liabilities onto their books and allowed bank credit to get somewhat back on the track (your historical line).
Mark
Mark: it's easy to get confused over the issue of credit, so I try to stick to the basics. The Fed controls bank reserves, and until recently they were well-behaved. That determines the ability of the banking system to create money. My favorite measure of money is M2. M2 has also been relatively well-behaved, growing about 6% per year for the past 3-4 years. And total bank credit/lending has also been well-behaved as my chart here shows. No sign in these numbers of excessive money creation. So whatever the SIVs and the banks have been doing, whatever the amount of leverage that some people have been using, they have not affected the monetary fundamentals by any obvious amount.
The use of gigantic leverage by some just concentrates and magnifies their risk; it's not necessarily inflationary, and it doesn't necessarily magnify the risk of the banking system. Of course, if the whole system is rocked by a shock like the housing price collapse, then lots of leverage can wipe out people pretty fast and margin calls are a part of this. But since money was never created in the leveraging up process, it isn't destroyed in the deleveraging process. The Fed's efforts to pump in reserves are designed to offset the system's increased demand for safe assets, and as such are not inflationary.
Enough rambling, I have probably missed your point anyway.
I think you partially addressed my point. I suppose I could rephrase the essence of my point by saying the real banks enabled, to a degree, the shadow banks to create credit. As long as the shadow banks operated trouble free, the real banks did not account for the shadow banks on their books.
From a macro standpoint, I can see how you view the credit generated by the shadow banks as non-systemic. You point out that M2 has been well behaved, and inflation has been relatively well behaved. But I wonder if these measures truly captured the monetary picture. For example, M3 is no longer published by the Fed, but shadowStats.com shows that it started to explode in 2005, hitting a peak growth rate around 17% in early 2008 before cooling towards today's 13% growth rate.
Also, I wonder if the GDP consumption deflator and CPI have been correctly measuring inflation. In particular, as housing prices rose rapidly in recent years, it seem the renters equivalent calculation in the CPI did not capture the rising prices.
I agree Scott, we are never going to close the theory gap with blogging; maybe even more extensive discussions wouldn't help.
Just to add to my point for your consideration and any other readers, the growth rate of 6% in money supply is ample to distort relative prices and set off the boom phase postulated by the Austrian economists.
An important point made by Mises, Hayek, and others is that the macro economics thinking (by Keynes, Fisher, and others) behind the so-called neo-classical economics obscures what is actually happening. During this cycle, for example, a large percentage of the new money (created by banks via the credit mechanism) went into residential construction and into speculative demand for securities tied to real estate mortgages. That's a huge increase in demand (number of dollars of demand) within a particular economic sector.
Think about the hedge funds levered 30-1 which were buying up the MBS (and other related financial products). The only way the resulting prices for houses and for securities could be maintained was with an ever accelerating increase in the dollar amount of credit.
The theory includes many subtlties associated with the Austrian capital theory developed first by Bohm-Bawerk, but it takes book length exposition to make those points clear.
To Mark Gerber's point, I would just say that the SIVs contributed to the leveraged demand for financial products and were part of the price distortion process. They didn't add directly to the money supply except as banking customers.
Tom Burger
For what it's worth, Scott, I want to offer a two paragraph quote from Hayek's book Prices and Production. This work was completed in 1931 and a second edition was published in 1935 -- so Hayek was writing during the Great Depression while the facts were quite fresh. Just food for thought, give the parallel to our times, and our current Fed behavior.
Here is Hayek:
“… up to 1927, I should indeed have expected that – because during the preceding boom period prices did not rise but rather tended to fall – the subsequent depression would be very mild.
But, as is well known, in that year an entirely unprecedented action was taken by American monetary authorities, which makes it impossible to compare the effects of the boom on the subsequent depression with any previous experience. The authorities succeeded, by means of an easy-money policy, inaugurated as soon as the symptoms of an impending reaction were noticed, in prolonging the boom for two years beyond what would have otherwise have been its natural end. And when the crisis finally occurred, for almost two more years, deliberate attempts were made to prevent, by all conceivable means, the normal process of liquidation. It seems to me that these facts have had a far greater influence on the character of the depression than the developments up to 1927, which from all we know, might instead have led to a comparatively mild depression in and after 1927.”
This is the only reason for my pessimism. I believe that Bernanke is applying central banking ideas which are inconsistent with the historical facts. Furthermore, I think our Fed and the government have now used these same tactics from the 1920s and 30s, together with our now totally fiat money to prolong the boom for not just a couple of years, but for at least seven or eight years -- maybe longer, depending on how you view the 1990s policies.
And, of course, the Fed and the Treasury show every intention of continuing the easy money policies indefinitely. Our authorities are once again experimenting with radical ideas, and they still believe the solution to our recession is the same set of policies that caused the problem in the first place -- on steriods.
Tom Burger
Tom, I don't disagree with the thrust of your post, but I do think there are some nuances which you are missing. The current crisis, we both agree, is largely the result of the Fed being overly accommodative. They kept interest rates too low for too long, and this set off a predictable response: a falling dollar, rising gold price, rising real estate prices, and rising commodity prices.
It may seem that the Fed is once again accommodative, but that is not necessarily the case. The dollar is rising, gold is falling, commodities are falling, and real estate is falling. Some argue that we are now in a deflation. I don't agree, but I also don't think that the Fed is making a mistake right now. That they have erred enormously I agree, but given the circumstances, I think they are forced to be accommodative once again. What they are doing today is not necessarily inflationary, even if it is the same thing they did yesterday which was inflationary. That is another way of saying that a 1% interest rate may be very inflationary one day, but not inflationary at all another day. Do you follow me?
I understand what you are saying, Scott. That is the standard central bank argument: if prices are stable or falling, the central banks think that is a green light for stepping on the monetary accelerator.
I am just pointing out that the Austrian School theories disagree stenuously with that argument. The equation of exchange does not describe reality. You can't harmlessly counteract falling prices by adding money to the economy. The new money injections will once again change RELATIVE prices and distort the economy in counter productive ways.
On top of this problem, we also have the Fed and Treasury actions destroying the profit/loss incentive in the economy. Investment directions are increasingly being determined by politics. The very last thing this economy needs is another round of forced investments in housing or a further extension of leveraged speculation in mortgage backed securities -- or any of the rest of the alphabet soup products from the credit boom now gone bust.
Tom Burger
Tom: I just think it's too soon to say that recent money injections will cause inflation, but I'm very aware that inflation is the major risk here. And I wish we didn't have a Fed that thinks it can fine tune the economy by changing the funds rate; that is simply a prescription for having problems such as we have today.
And I wish we didn't have Treasury bailing people out right and left (especially the auto companies!).
But unfortunately we are stuck with this. So we have to cope and we have to understand what is happening. I don't see any easy solution for the investor here, other than trusting that we won't all end up tumbling down a black hole.
Tom: I just think it's too soon to say that recent money injections will cause inflation, but I'm very aware that inflation is the major risk here. And I wish we didn't have a Fed that thinks it can fine tune the economy by changing the funds rate; that is simply a prescription for having problems such as we have today.
And I wish we didn't have Treasury bailing people out right and left (especially the auto companies!).
But unfortunately we are stuck with this. So we have to cope and we have to understand what is happening. I don't see any easy solution for the investor here, other than trusting that we won't all end up tumbling down a black hole.
Mark: sorry for the late response. I think that M3 has lost its significance. I don't mourn its passing. M2 is the only monetary aggregate that, in my view, has demonstrated any semblance of stability vis a vis the economy over the years. M3 is easily distorted by new types of money.
As for the GDP deflator, I do believe it does a good job measuring inflation over multi-year periods (but not over shorter time frames). And believe it or not, the CPI seems to almost always overestimate inflation. That's the same conclusion that Boskin arrived at.
As for rents vs housing prices: I think that is a legitimate question. I think the problem occurs because when housing prices are rising, no one wants to rent, and everyone wants to buy (and rent out what they have bought) and therefore rents tend to be depressed. So when housing prices rise a lot, rents don't, and the CPI tends to understate inflation. Going forward, as housing prices fall, rents will tend to increase because everone will prefer to rent rather than own, and that will cause reported CPI inflation to rise. Everything works out over longer periods in other words.
But the CPI always suffers from being a relatively small and fixed basket of goods and services. It's always better to use the GDP or PCE deflator.
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