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A Textbook Error in Credit Creation

Money is not passing through the banks to the economy the way some people think it should...

THE CLASSIC textbooks say – correctly – that it is mainly through the process of (private or public) credit creation that money itself comes into being, writes Sean Corrigan for the Cobden Centre.

But those same books are also filled with an outdated depiction of the operation of a fractional reserve system which had long fallen into abeyance, in many of the major countries, even before the post-Crisis orgy of gargantuan over-reserving swamped all such calculation and further blinded those fond of reckoning everything in terms of the 'multiplier' between the monetary base and some broader credit aggregate (which they likewise infuriatingly insist of thinking of as 'money').

For example, from the halcyon days of the early 1960s, when certain important categories of US banks had to hold anything up to 18% of reserves against their net demand deposits, alongside somewhat lower percentages against numerous other classes of liabilities, the progressively less stringent nature of the regulations culminated in Greenspan's reductions of the early 1990s and his ensuing authorization of the regulatory arbitrage involved in so-called 'overnight sweep accounts'. After this, banks could more than satisfy their piffling on-balance sheet needs (as well as avoid even more by exploiting the plethora of off-balance sheet possibilities open to them) by means of nothing more than the notes and coin routinely held in their vaults and ATMs.

Thus was yet another Faustian bargain consummated in an act intended to ward off an existing threat to 'growth' which provoked behavior which would ultimately throw up an even greater one on someone else's beat.

Not long afterwards, the newly-independent Bank of England was allowing its banks to set their own reserve requirements (!) and would even penalize them for being too cautious (sic) in their choice. Nor were the SNB or the BOC too modest to play the game. For its part, the fledgling ECB, under pressure not to make the new, single-currency landscape 'uncompetitive' for the poor darlings with whose care it was entrusted, opted for a derisory 2% levy and then trusted to the horribly-flawed Basel capital regulations to effect any real measure of restraint – with the execrable results with which we are still struggling today!

One consequence of their superficial understanding of a defunct mechanism is that a decisive majority of pundits and policy-makers alike now fears that any degree of credit contraction whatsoever necessarily signals that the economy has crossed the event horizon on its way into the maw of a crushing black hole of unstoppable monetary deflation.

The small kernel of truth around which this canard has been constructed is that where credit has been perniciously turned by the banks into money, the termination of that credit must be reflected back in the stock of money, too. But there is no longer any foundation to the hoary old premise that, just as the fractional reserve process is supposed to be the determining factor in multiplying money up during the expansion, then any later monetary cancellation must cascade through an equal and opposite number of deflationary iterations during the contraction. 

If you doubt this, go out and look for yourself. You will search in vain for a currency area of any note – Turkey, perhaps? Brazil of late? HK? – where there has been much in the way of a nominal decline at all, regardless of how the higher aggregates have behaved.

Thanks to this misapprehension, far too much is being made of the fact that the banks are not today taking the deluge of 'high-powered money' with which they have been presented and multiplying it up with the kind of relish the textbooks suggest they could – and the underconsumptionists and monetary cranks of all stripes say they should. As we all know, they currently rather prefer to park $100s of billions back at the central bank out of distrust for their peers and from fear for their own future funding abilities.

But again, this cavil entirely misses the mark: it is the nature of the entries on the liability side of the commercial banks' balance sheets which constitute money, not those on the asset side, and the ones that count have, in general, been rising.

Granted, the CBs have to be more far aggressive in their actions if they are to provide all the combustible means for a monetary expansion and not just the catalyst for it, as in less troubled times, but that does not mean that they lie powerless, just that their interference must be more nakedly undertaken, more 'unorthodox', if you will. As the merest glance at the size of their balance sheets will show, they have taken up the challenge with unprecedented relish these past few, troubled years: the Fed, the ECB, the BOJ, the PBOC, the BOE, the SNB, the RBA – to name but a few.

Nor has the world changed in any untoward way so that, no matter how much new money is conjured into existence, it will miraculously remain inert – that it will have no influence on either individual prices, nor the general trend of such prices. We thought to have shown enough charts demonstrating the undeniable effect of the Fed's actions these past three years to dispel that particular myth, but, for those of you asleep at the back of the class, here we go again.

In the period since the Lehman-AIG debacle, the Fed has tripled its balance sheet and swelled its security portfolio by a factor of 5 ½. Far from being in vain, this has boosted money supply by 37%, a sustained, double-digit annual pace of increase only seen twice before in the 50-year record: the first in the months which included the last, feverish run to the Crash of '87; the second directly following those same regulatory changes of the mid-90s mentioned above, a relaxation which lead to a sustained outbreak of what its author described with what one hopes was a touch of faux consternation as 'irrational exuberance' and so onto a mania which achieved its apotheosis in the Nasdaq bubble, six, heady years later.

This time, too, after a couple of months' lag as the new money filtered in, the results of the inflation were similarly unequivocal: the S&P rose 40%, the Value Line more than twice that, as junk bond spreads halved. US business revenues grew by more than a fifth, while non-financial profits rose by four-fifths. Aided by a like display of monetary largesse elsewhere, world industrial production bounced 20% from its spring '09 trough to hit a new, all-time high: world trade volumes did likewise with a 27% rebound. Despite the correction of the past six months, commodity prices still stand almost 90% above the levels of three years ago, with oil up 160%, copper up 150%, and gold 145% higher than they were.

In more familiar, macro terms, this period also saw the third-fastest biennial acceleration in the US PPI index in the post-WWII era (places one and two go to the time of the Korean War and the first oil shock), while the yearly US CPI change climbed by no less than 5.7% from its trough to register its fourth largest acceleration in sixty years (being beaten additionally by the second oil shock during that stretch).

So, please, don't tell us money no longer matters, or give us any nonsense about liquidity traps and deferred purchasing behavior amid a deflationary mindset. None of these largely phantom phenomena are able to repeal the laws of economics, period.

What is true, however, is that lately the rate of money creation – and in particular real money creation – has been slowing in most regions outside the US itself – not least in China, Brazil, India, Britain, and the Eurozone. Real money supply matters since it is the volume of goods able to be moved per unit of the medium of exchange which is a primary short-run determinant of activity and, to paraphrase Andrew Dickson White's observations about Revolutionary France's disastrous experiment with a paper currency, money is never so scarce as when there is too much of it.

What he meant was that once people learn to adjust to the inflationary impact of a greater issuance of money, their very anticipation tends to push prices up ahead of its influx. Every buyer still has a seller, but the former becomes ever more keen to be rid of his cash while the latter quotes high, adding a premium for fear of the loss of purchasing power he fears to suffer when he comes to buy, in his turn. Such a psychological reinforcement of the quantity theory reduces the stock of money's real total even faster to leave many of its users short of the means to obtain feed and clothing for themselves, even as the printing presses are running flat out to boost its nominal supply.

In less extreme circumstances, the same features apply. If the Fed manages to put another $10 in your pocket, but its actions simultaneously push the price of groceries up by $15 Dollars, you are inarguably worse off. Thus, we should stop our ears to the prevarications of the state's paid apologists and recognize that, even in the benighted West, the initial inflationary impact of the various, post-LEH stimulus programs was to cause prices everywhere to rise.

And, yes, Mr Keynes, even amid relatively high levels of unemployment and alongside the low utilization of a phantasmagorical concept of utilizable 'capacity'. This embarrassing departure from the canon is simply explained by the fact that the endowment of labor and capital is far more richly heterogeneous than the aggregative simpletons can conceive. Should we be surprised that the total was riddled with far too many errors under the infatuation of the Boom and that these now linger on as hopelessly redundant relics which contribute little or nothing to the functional core upon which we can call.

As those prices continued to rise, they became politically embarrassing enough, in the majority of cases, to see the same pump-priming which had caused them diminished or even partially reversed. Even in Ben Bernanke's 1937-phobic America, 'quantitative easing' has been suspended since June – though its echoes continue to be heard most strongly – pending sufficient excuse for the Mighty Oz to begin hauling again at the levers hidden behind his curtain, probably just in time to aid the incumbent's campaign for re-election.

As we have already discussed in some detail, in the Eurozone, the far less purposeful retardant to ongoing money growth has been the repercussions arising from the belated realization that it is simply farcical for the most intractably indebted Provider States to pretend to guarantee the credit of those banks reduced to friendless penury by earlier buying the debt that same dissipating state issued in order to prop them up, or to compensate – in grand Keynesian, push-me-pull-you fashion – for their enervated retreat from that orgy of uncritical lending which had first undermined them. Here, too, the change in real M1 has been barely positive from some time past.

Thus, in many regions of the world, the inevitable lag between cause and effect has seen a more slowly growing stock of money meet with a higher basket cost of goods. This is a toxic combination with which to confront such sickly economies, one which is now leading to a diminution of demand and, ipso facto, to a deceleration of the pace of those same price rises, as the inflationary impetus behind them slackens. Far from being an idiosyncrasy, this is no more than a normal, cyclical overlay on what are admittedly very abnormal underlying conditions.

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Stalwart economist of the anti-government Austrian school, Sean Corrigan has been thumbing his nose at the crowd ever since he sold Sterling for a profit as the ERM collapsed in autumn 1992. Former City correspondent for The Daily Reckoning, a frequent contributor to the widely-respected Ludwig von Mises and Cobden Centre websites, and a regular guest on CNBC, Mr.Corrigan is a consultant at Hinde Capital, writing their Macro Letter.

See the full archive of Sean Corrigan articles.

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