Another round of scares is under way. According to the headlines and columnists, over-indebtedness is supposed once more to threaten comprehensive, worldwide bank failure. Officialdom and the media are again considering whether to demand that the banks raise (yet more!) capital. Officialdom and the media are on the ‘more bank capital’ warpath, as if that were the solution to every macroeconomic problem under the sun. Well, more bank capital is not the solution to every macroeconomic problem under the sun. On the contrary, in the transition to a world with higher capital/asset ratios in the banking system, the growth of bank balance sheets and hence of the quantity of money (broadly-defined) is likely to come to a complete halt. Indeed, unless interest rates are zero and/or operations such as ‘quantitative easing’ are being conducted, the quantity of money may even fall. The wider result is therefore a macroeconomic malaise which may last several years, as events since late 2008 have demonstrated. Does anyone actually check the data? Do top officials and opinion-formers look at the figures of banking system capital in the leading advanced economies? In today’s e-mail I present the data for the total-equity-to-total- assets ratio of US commercial banks, i.e., the banks regulated by the Federal Deposit Insurance Corporation and the Federal Reserve. My source is banal, the St. Louis Fed’s economic database (commonly known as ‘FRED’). It takes only a few minutes to establish that the ratio is higher today than at any point since the FRED’s current series started in 1988. I am confident that the ratio is indeed higher than for at least 30 years, since in the early 1980s the equity-to- assets ratios of several of the leading US money center banks were under 3%. (I am not kidding.) America’s banks are further from ‘bustness’ than they have been for well over a generation.
Another 25 basis point rise in the European Central Bank’s repo rate to 1 ½% has angered politicians in the Eurozone’s periphery. The contrast between business conditions in the core countries (particularly Germany) and the periphery has become extreme. Greece, Ireland and Portugal are likely to suffer further falls in output in 2011, giving them a period of macroeconomic austerity longer and harsher than at any time since the 1930s. Yet the central bank responsible for the management of their currency is putting interest rates up, not down. In the following note I discuss statements in the ECB’s June Monthly Bulletin, which defend the stagnation or semi-stagnation in the M3 money measure since late 2008. I argue that the ECB’s description of this stagnation/semi- stagnation as a benign ‘unwinding of accumulated liquidity’ is disingenuous in the extreme. On the contrary, the crash in money growth in late 2008 was sudden and unforeseen. If its deflationary macroeconomic results had not been countered by a collapse in short-term interest rates to virtually zero, the Eurozone would have suffered a recession even worse than that which was actually recorded. Further, the ECB’s ‘exit from non-standard measures’ in 2010 is largely to blame for the severity of the core/periphery imbalance at present. The worry for the future is that the ECB is unconcerned, first, about the slowness of money growth for the Eurozone as a whole and, secondly, about the sharp declines in the quantity of money and associated macroeconomic trauma in the smaller peripheral economies (especially, Greece, Ireland and Portugal). If the central bank in a multi-nation monetary union gears monetary policy to the needs of only one country in that union (i.e., Germany), it will lose popular support and legitimacy in the remaining countries.
In my weekly e-mail of 27th April I emphasized that, as in the USA’s Great Depression of the 1930s, its Great Recession of the last few years has been accompanied by a collapse in the growth of the quantity of money. As that note observed, the annual growth rate of M3 – which peaked in the high teens in late 2008 – had crashed to a negative value less than two years later. Last summer M3 was still dropping. The weakness in money growth had been associated for some quarters with a disappointingly sluggish recovery. In early November 2010 Fed chairman, Ben Bernanke, announced a ‘QE2’ programme. Heavy purchases of long-dated US Treasuries (with five or more years to redemption), amounting to $600b., were meant to boost the US economy. (Bernanke – best known in academic circles for his work on ‘the credit channel’ – did mention in Congressional testimony that the asset purchases would increase the quantity of money. However, a fair comment is that, like the institution he represents, he is rather puzzled by the mechanisms by which changes in the quantity of money affect economic activity.) This weekly e-mail updates the analysis in late April. The central points are twofold. First, the last few months have seen a welcome return to positive growth, if at a low rate, in broad money on the M3 measure. (And, indeed, macroeconomic conditions haven’t been too bad, although they have hardly been brilliant.) Second, the upturn in M3 growth has been due – entirely – to QE2. US banks’ cash assets have soared, reflecting the Fed’s operations. But their risk assets have been static since the start of QE2, with the need to comply with higher capital/asset ratio regulations undoubtedly being the main restrictive influence. The further message is that – unless banks’ propensity to acquire risk assets strengthens after the end of June – US broad money will again stagnate. That will continue to hold back the recovery.
As in the USA’s Great Depression of the 1930s, its Great Recession of the last few years has been accompanied by a collapse in the growth of the quantity of money. Analysis of money data – in the USA, as in other countries – is bedevilled by institutional arcana, as well as the extreme difficulty of differentiating erratic shocks from underlying trends. In my work I emphasize broadly-defined money, including all relevant bank deposits, although I concede that this notion is itself ambiguous and elusive. In the USA my preference is for the M3 money measure which the Federal Reserve stopped publishing in March 2006. Fortunately, an alternative series is prepared by the Shadow Government Statistics research company and I am using its data in the present note. For all the data problems, the M3 numbers published by SGS tell an alarming story. The annual growth rate of M3 – which peaked in the high teens in late 2008 – had crashed to a negative value less than two years later. On the historical record, more or less constant growth in the quantity of money – at a moderate but positive rate – is a condition of macroeconomic stability. Last summer M3 was still dropping. Although the Federal Reserve denies that it pays any attention to broad money, the weakness in money growth had been associated for some quarters with a disappointingly sluggish recovery. In early November Fed chairman, Ben Bernanke, announced a ‘QE2’ programme. Heavy purchases of long-dated US Treasuries (with five or more years to redemption), amounting to $600b., were meant to boost the US economy. The present note surveys the evidence of QE’s effects. It shows that – as would be expected with a QE programme – banks’ cash holdings have increased dramatically, in fact pretty much in line with the targeted amount. But US banks’ non-cash assets have fallen a little since last October and showed no meaningful sign of returning to growth. When QE2 ends, M3 is likely for some quarters to grow very slowly or not at all.
Central banks and regulators continue in the advanced countries (i.e., members of the Bank for International Settlements in this context) to believe that the answer to the Great Financial Crisis is to make banks safer (i.e., with higher capital/asset ratios, more cash and liquidity, less inter-bank funding, etc.). The resulting demands that ‘banks clean up their balance sheets’ and raise more capital have caused banks to shrink their balance sheet totals. In late 2007 and 2008 this led to a collapse in money growth, with the predictable consequences of asset price weakness and recession. By late 2010 interest rates had been close to zero in many countries for over 18 months and monetary conditions showed signs of stabilization. But in the Eurozone the European Central Bank had in early 2010 started to take a tough line with banks in the PIGS group (Portugal, Ireland, Greece, Spain), demanding that these banks repay their borrowings from it. Deposits left the banks in these countries, and were instead lodged with banks in better- regarded countries such as Germany and France. A macroeconomic divergence had already opened up in the Eurozone between the periphery countries (i.e., the PIGS, with banking systems heavily indebted in the inter- bank market) and the core countries (i.e., Germany, the Netherlands, etc., with many banks having net claims on other banks). The ECB’s attitude caused this divergence to widen, and both Greece and Ireland were forced into sovereign ‘bail-out’ arrangements with the EU/Eurozone. Portugal is clearly the next in the firing line. But the critical country is Spain, because its banking system and national debt are too large to be accommodated within the European Financial Stability Facility, currently limited to 440b. euros. Macroeconomic conditions have not been too bad in Spain in recent quarters, but officialdom’s latest demands for more strongly capitalized banks may cause another fall in the quantity of money and a second dip into recession.
Is the quantity of money in the USA still falling? The question is basic, with the financial markets speculating about a possible “quantitative easing” announcement at the next Federal Reserve meeting (on 3rd November) and (almost certainly) reliable press reports suggesting $500b. of Fed purchases of government securities. In fact, the latest money data show a fairly clear-cut return to positive growth in the US M2 aggregate. The American banking system still has worries about bad debts and capital adequacy, but the worst of the crisis is behind it. Given that Fed funds rate is virtually zero, the case for another round of Fed asset purchases is far from convincing, but the $500b. figure looks pretty definite. Assuming US broad money growth runs at, say, 3% - 6% in the next few quarters, 2011 should see at least trend growth in demand and output, and indeed probably above-trend growth. The USA will not suffer a double-dip into another recession. The sudden change in US monetary trends is noteworthy, particularly given that Eurozone broad money growth is now also in positive territory. The main explanation for the US pattern is similar to that in the Eurozone, that the banks are purchasing significant amounts of government securities. In the six months to mid-October US commercial banks’ holdings of Treasury and agency securities have climbed by $150b.-$200b. or, at an annualised rate, by 20% - 30%. They have also been buying more mortgage-backed securities (and also some non-MBS securities), as default concerns start to fade. Banks are not yet expanding their loan portfolios. The American banking system is now convalescing and is likely to grow its balance sheet over coming quarters. 2011 should see above-trend US growth. It is important to public debate that the coming macroeconomic improvement is not attributed to Obama’s fiscal splurge. But there is a high risk of Stiglitz, Krugman & Co. claiming that the vast budget deficit is responsible for the better numbers.
Return of positive money growth in the USAAs with the similar pattern now emerging in the Eurozone, the media have overlooked a clear change in monetary trends in the USA. In the three months to 18th October the USA’s M2 measure of money has grown at an annualised of about 8%. Positive money growth has now returned for roughly three or four months, which may not sound long. But this development needs to be set in the wider context, with banks again reporting profits on a fairly consistent basis (despite continued loan write-offs) and the clarification of the Basle III rules. The M3 measure – arguably superior in macroeconomic analysis to M2 – has also at least stabilized and may even be growing. Using the data supplied by Shadow Government Statistics, it rose from $13,903b. in June to $14,007b. in September, giving an annualised growth rate of 3%. The almost 18-month period of broad money stagnation – which lasted, in rough terms, from January 2009 to June 2010 – appears to be over.
With good reason the USA’s financial markets did not like the latest statement, on 10th August, from the Federal Open Market Committee. Some analysts had been led by Mr. Bullard’s paper (or pre-paper) in the forthcoming September/October Federal Reserve Bank of St. Louis Review into believing that the Fed was on the verge of endorsing full-scale, red-in-tooth-and-claw ‘quantitative easing’, with vast purchases ($500b.+) of long-dated Treasuries financed by the issue of yet more cash reserves to the banks. Carried out correctly, the effect of such purchases would be to boost
- the interesting measure of US broad money (i.e., M3) by over 1% for each $150b.of Treasuries bought, and
- the monetary base by an even larger % amount.
Huge controversy has beset the Bank of England’s so-called ‘experiment’ in Quantitative Easing. Critics have alleged that ‘the money supply’ – which, amazingly, they sometimes equate with banks’ cash reserves – has doubled, quadrupled or whatever, and that ‘excessive monetary growth’ is one reason for the current upward blip in inflation. Liam Halligan of Prosperity Capital Management has been perhaps the most vocal of these critics in his column in The Sunday Telegraph. This is a strange line of argument when many businesses are still struggling to recover from one of the UK’s worst post-war downturns. Nevertheless, the Bank’s decision to pause QE is widely supported. In this note I accept the original rationale for QE, that action was essential in early 2009 to pre-empt a possible collapse in ‘the quantity of money’ as usually understood (i.e., a deposit-dominated quantity such as M4). I then consider whether this rationale still has any validity in early 2010. If banks’ risk assets (i.e., their loans to the private sector, mostly) fall in coming months, the quantity of money is also likely to decline. If that decline were at a significant rate (say, 3% or more at an annualised rate), a double-dip recession would not come as a surprise. My review of the evidence is that banks’ risk assets are indeed in danger of falling in coming months. January saw a shockingly large drop in banks’ unused credit commitments. If a fall in bank lending were to happen, the Bank of England must be prepared to resume large-scale asset purchases in order to keep the quantity of money stable. Indeed, ideally it should try to ensure that the quantity of money is growing at a moderate pace. (It would be even better if the Treasury were willing – frankly and deliberately – to monetize part of the budget deficit with the aim of delivering positive, but low money growth. I am not in favour of rapid money growth. Of course not.) If QE is dead, long live QE!
Eurozone M3 fell by 0.1% in October, after a similar marginal decline in September. The Eurozone’s measure of broad money – at one time supposed to be lynchpin of European monetary policy – has barely changed for a year. (In fact, the increase in the 12 months to October was 0.3%.) This is the lowest rate of money growth, if “growth” it can be called, since the introduction of the euro in 1999. In fact, if a Europe- wide money aggregate could be compiled on a continuous basis since the 1930s (and for historical reasons this is of course impossible), the annual rate of money change in continental Europe is at present the lowest since the 1930s. Helped by the end of heavy de-stocking, output is recovering in the leading Eurozone economies (i.e., Germany and France), although growth remains at a beneath-trend rate. But in the so-called PIIGS (Portugal, Italy, Ireland, Spain and Greece), business surveys have been deteriorating since the summer. In their recent public statements the leading figures in the European Central Bank have shown no concern about this deterioration. They seem determined to do nothing particular either i. To raise broad money growth, or ii. To help the PIIGS. Sure enough, given the treaties that govern the workings of the Eurozone, the ECB cannot discriminate in any way in favour of the PIIGs and has to emphasize, for example, that the Stability and Growth Pact applies to all members. There is a growing possibility that the weakest member of the Eurozone – which is undoubtedly Greece – may leave the Eurozone. But in what circumstances might that occur? And what would be the knock-on effects to the next weakest members (i.e., Spain, Portugal and Ireland)? And what will the inevitable tensions in 2010 between the ECB and the PIIGS mean for the euro against other currencies?
Over the long run the rates of increase in money and nominal GDP are similar, although not identical, in all economies. (Money is to be understood predominantly as bank deposits.) Money is created when banks expand their balance sheets by acquiring assets (e.g., by lending more to the private sector or purchasing government securities); it is destroyed when banks shrink their balance sheets by shedding assets. If banks shed more assets than they acquire, the quantity of money is very likely to fall. Falls in the quantity of money, if they last long enough, imply contractions in nominal GDP. At present banks across the advanced world are net shedders of assets because of regulatory pressure on them to raise capital/asset ratios. This pressure – which arises largely from catastrophic official policy decisions in October 2008 – is the main explanation for the severity of the global slump in 2009. The blunders of October 2008 have had their most extreme effect in the UK. In fact, by January/February 2009 the outlook had become so bad that a radical policy shift – towards the large-scale deliberate creation of money by the state – was essential. This was the purpose of the Bank of England’s programme of quantitative easing. Happily, the Monetary Policy Committee decided at this week’s meeting to extend QE by a further £25b. Unhappily, recent money data show that QE’s creation of money is still being offset by the destruction of money as banks (and their customers) try to comply with officialdom’s efforts to boost capital/asset ratios.