Date: October 14th, 2011
Cate: Finance

Chronic De-leveraging overwhelms FED monetary base expansion & rate cuts effort

The creation of huge amounts of credit (broad money) was a powerful process which allowed for growth in GDP.  Think of GDP like material running through an economic machine hopefully creating social value.  Credit allows us to bring future savings into the present and spend increasing today’s throughput.

Credit is a function of the cost of money and one’s faith in the future return of that money. Credit like money is ultimately a social belief system. In 2008 the global credit market effectively had a heart attack.  The Federal reserve brought it back to life with cheaper money (low rates), trillions in swap lines and lending facilities. This was effectively like taking the paddles out and jump starting the stopped global economic heart.

The difference between an acute crisis and chronic process.

We experience the world one day at a time and for many one headline at a time.  These headlines often describe acute events or turning points.  The credit meltdown was one such event. The more important economic and political factors are chronic or process in nature. Like paint drying or a forest growing they unfold over time slowly avoiding the daily headlines that would lead to awareness of their potential impacts. These processes are right in front of us, but their slow steady monotonous motion blinds us to their potential impacts for increasing the risks of an acute crisis.

Below is the monetary base of the US showing deposits and currency in circulation.  This is near money. It is short term. You can see how the fed expanded near money since 2008 hoping that by making it more easily available things would get better. The hope was that after first saving the patient’s Lehman liquidity collapse (heart attack) the money multiplier effect would work its magic and keep the credit creation process alive and pumping.  By making near money available and cheap it was hoped far away longer term broad money would be created by the credit market.

Unfortunately it didn’t quite work out like that.  Here is the TCMDO(Total Credit Market Debt Owed) which shows all of the credit in the system including broad money.

The important factor is measuring the effectiveness of FED policy as an economic/credit stimulus is how TCMDO responds as a multiplier of interest rate policy adjustments and expansion of the monetary base.

This last graph shows that the FED is pushing on a string.

The credit market is shrinking as de-leveraging takes over and the FED’s attempts at expanding the credit market become less effective.  Less credit means, less throughput and declines in consumption etc. A central bank is merely a sometimes hand maiden for Credit creation/destruction. Ultimately credit is a free market function. When people don’t perceive opportunity or view themselves as over leveraged they stop lending / borrowing.

Each dollar of base money is stimulating less credit.

If one believes that credit expansion is required to reflate the economy and if one believes credit is generated by expanding the FED balance sheet then whatever expansion plans using multiplier of X in 2008 are likely to use a multiplier of perhaps 2X now. The danger is the likely call for a QE3 that can be justified in the trillions of dollars, the rationalization will be a cheapening of the dollar to help debt holders and domestic exporters while expanding credit supply via an expanded narrow money base.  The other side of the policy coin is of course is fiscal stimulus whereby the govt. spends money on creating economic activities, this is more akin to economic mouth to mouth resuscitation. A likely outcome will be a mix of fiscal and monetary policy over the next 3 years involving increases in federal debt which are purchased largely by the FED.

I am not advocating either policy, but rather suggesting likely outcomes based on historical precedents of fiscal policy and FED behavior. Neither of these actions is good for the dollar as a store of value, but the impacts of de-leveraging, declining GDP and subsequent deflation may give them appeal to many.

Source data is here:

Federal reserve St. Louis Adjusted Monetary Base (BASE)

Federal reserve St. louis Total Credit Market Debt Owed (TCMDO)

Ratio of debt to monetary base .XLS

All work above is property of Thoughtful Capital Group.

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