Saturday, October 18, 2014

A Tale of Two Economies -- It Was the Better of Times, It Was the Worst of Times

October 18, 2014

A Tale of Two Economies – It Was the Better of Times, It Was the Worst of Times

As quantitative easing comes to an end (apparently) by the Fed and is taken up by the European Central Bank (ECB), let’s compare the behavior of nominal domestic demand in each central bank’s economy and venture a reason for any differences.

Plotted in Chart 1 are index values of the nominal Gross Domestic Purchases in the U.S. and the eurozone, respectively. Each index is set at a value of 100 for Q4:2008. Since Q4:2008, Gross Domestic Purchases in the U.S. increased a net 18% through Q2:2014 (that is what the index value of 118 indicates). For the eurozone, Gross Domestic Purchases increased a net of only 3% in this same time period. In terms of compound annual growth rates over this period, the U.S. experienced growth of 3.0% and the eurozone, just 0.5%.
Chart 1

Now, let’s examine the behavior of credit created by the central banks and depository institutions in each of these economies. This is credit that is created figuratively out of thin air. When central banks purchase securities in the open market, such as they do when they engage in quantitative easing (QE), they create credit out of thin air. When the depository institution system expands its loan and securities portfolios, it creates credit out of thin air. Credit created out of thin air enables the borrower to increase his/her current nominal spending while not requiring any other entity to reduce its current spending. Plotted in Chart 2 are index values of the sum of central bank and depository institution credit outstanding for the U.S. and the eurozone, respectively. Each index is set at a value of 100 for Q4:2008. Since Q4:2008, U.S. thin-air credit increased a net 28% through Q2:2014, which works out to be a 4.6% compound annual rate. In this same period, eurozone thin-air credit has contracted a net 2%, or at a compound annual rate of minus 0.4%.



Chart 2

The Fed has engaged in QE in three separate phases in recent years, the first of which commenced in Q1:2009. From the end of Q4:2008 through the end of Q2:2014, U.S. thin-air credit increased a net $3.692 trillion, 82% of which was contributed by the Fed. During this same time period, the compound annual rate of growth in depository institution thin-air credit was only 1% rounded. Recall, that the sum of Fed and depository institution thin-air credit grew at a compound annual rate of 4.6% during this 22-quarter period vs. a long-run median annual growth rate of 7.4%. During this period, the ECB has refrained from engaging in QE and eurozone thin-air credit has contracted on net. Had the Fed not engaged in QE, U.S. total thin-air credit growth would have been quite weak, similar to what the eurozone has experienced.

A clue as to why depository institution thin-air credit creation has been weak in both the U.S. and the eurozone can be found in former Fed Chairman Bernanke’s recent revelation that he was unable to refinance his home mortgage. The explanation for weak depository institution thin-air credit creation is not so much related to lack of demand for it, but rather depository institutions’ inability to supply demanded credit. Following the bursting of the residential real estate bubbles in the U.S. and the eurozone, depository institutions experienced a severe “evaporation” of capital. Because of capital constraints, depository institutions were not able to expand their holdings of loans and securities. In the U.S., depository institutions relatively quickly began repairing their capital deficiencies. At the same time, however, regulators increased capital requirements and imposed more stringent liquidity and other regulatory requirements on depository institutions. Thus, while someone with a relatively high, but variable income, similar to Ben Bernanke’s current financial situation, would have had no difficulty in qualifying for a mortgage in 2001, he now has greater difficulty.

If Ben Bernanke had looked at some of the Fed survey data when he was Fed chairman, he would not have been surprised that he might have difficulty refinancing his mortgage once he became a “free agent”.  Plotted in Chart 3 are the responses to the Fed’s quarterly Senior Loan Officer Survey of bank lending terms related to residential prime mortgage applications. As the housing bubble began deflating in late 2007, the percentage of banks tightening their prime mortgage terms began rising, skyrocketing in 2008. Although the percentage of banks tightening their mortgage lending terms tailed off significantly by 2010, the percentage actually beginning to ease their lending terms has only begun to meaningfully rise in 2014.
Chart 3

The Fed conducts another quarterly survey that relates to banks’ willingness to lend, the Survey of Terms of Business Lending. Plotted in Chart 4 are the survey results showing the average rate charged by banks in the survey on all commercial and industrial (business) loans minus the Fed’s target federal funds rate. From Q3:1986 through Q4:2007, the median loan spread was 1.99 percentage points. The median spread from Q1:2008 through Q3:2014 rose to 3.05 percentage points, with the spread in Q3:2014 being 2.61 percentage points. These higher spreads following the financial crisis indicate banks’ inability to supply demanded credit because of capital constraints and/or increased regulatory scrutiny.





Chart 4

In case you hadn’t noticed, I have been attempting to make the case that the Fed’s engagement in QE and the ECB’s lack of QE account for the difference in the performance of the U.S. economy vs. the eurozone economy since 2008. But for all you Keynesians out there, what about federal fiscal policy, in particular federal spending? Some Keynesians (Krugman?) make the argument that the fiscal austerity in the eurozone is what has held back aggregate eurozone economic activity. Contrary to what some op-ed writers in The Wall Street Journal (Wesbury?) might have you believe, there has been fiscal austerity in the eurozone. In the five years ended 2013, the latest complete data I have, eurozone central government nominal spending grew at a compound annual rate of just 1.5%. And again, despite what some other op-ed writers in The Wall Street Journal (editorial board?) might have you believe, there also has been fiscal austerity in the U.S. To wit, in the six fiscal years ended 2014, total federal government nominal spending grew at a compound annual rate of 2.7% compared to a median annual change of 5.5% from FY 1981 through FY 2008. Total U.S. federal government expenditures in FY 2014 were actually $13.5 billion below those of FY 2009! Admittedly, federal government expenditures did soar in FY 2009 vs. FY 2008 because of TARP,  the American Recovery and Reinvestment Act of 2009 (Obama’s fiscal stimulus) and “automatic stabilizers” such as unemployment insurance and food stamps.





The point is that in both the U.S. and the eurozone, there has been fiscal austerity in recent years. Yet, U.S. aggregate domestic demand has been considerably stronger than that of the eurozone. The tale of the two economies is that in one, the U.S., the Fed pursued a QE policy, resulting in the better of times. In the other, the eurozone, the ECB eschewed a QE policy, resulting in the worst of times.

Paul L. Kasriel
Econtrarian, LLC
Senior Economic and Investment Adviser
Legacy Private Trust Co. of Neenah, Wisconsin
1-920-818-0236

Tuesday, September 23, 2014

The Money Multiplier -- A Rite of Passage for the Wrong Reason

September 24, 2014

The Money Multiplier – A Rite of Passage for the Wrong Reason

The last time I taught college-level Money and Banking, over five years ago, the textbook I was  coerced into assigning (but didn’t use) still had a section on the mechanics of how the banking system in a fractional-reserve regime could expand deposits (a component of “money”) by some multiple of cash reserves provided by the central bank. The Federal Reserve Bank of Chicago, one of my former employers, had published a booklet, Modern Money Mechanics, that explained how this process played out. When I was at the Chicago Fed, this was one of the Bank’s “bestsellers”.  In my undergraduate Money and Banking class, there were several questions on the final exam that pertained to the mechanics of this seemingly “magical” deposit-expansion process. I would be willing to wager that to this day, there still are questions on most Money and Banking final exams related to the mechanical process of deposit expansion in the banking system. It is a Money and Banking class rite of passage. Although the money multiplier is a convenient pedagogical tool, I suspect that the underlying economic significance of it is neglected in most classrooms. And that underlying economic significance is that the banking system in a fractional-reserve regime can, along with the central bank, create credit figuratively out of thin air. All kinds of credit, thin-air or not, enable their recipients to increase their current spending on something. But only thin-air credit unambiguously does not require anyone else to simultaneously decrease his/her current spending. Thus, a net increase in the supply of thin-air credit carries the strong presumption that there will be a net increase in total spending in the economy.

Now, for those of you who took a Money and Banking class, let’s review the essence of the money multiplier. For those of you who have not taken the class, let’s catch up. Suppose that there are n separate banks in the banking system, where n is a very large number. Now suppose that the central bank purchases $100 of securities from State Pension Fund that banks at Bank 1. State Pension Fund’s deposits at Bank 1 have increased by $100. Bank 1’s reserve account at the central bank has increased by $100. MegaCorp, who is financing some new capital equipment to be purchased from CoreCapGoods sells some new bonds in an amount of $100 to State Pension Fund. MegaCorp and CoreCapGoods both, coincidentally, bank at Bank 1.  Let’s stop here to consider what has happened to thin-air credit. The central bank purchased $100 of securities from State Pension Fund, paying for these securities with funds created out of thin air. State Pension Fund then used these thin-air funds to purchase $100 of new bonds issued by MegaCorp to finance its new capital equipment purchase. $100 of new thin-air credit has been created by the central bank. Bank 1’s deposits increased by a net $100, owned first by State Pension Fund, then transferred to MegaCorp and then transferred to CoreCapGoods.

Back to the money multiplier. Assume that by law, banks are required to hold as cash reserves at the central bank an amount equal to 10% of the deposits on their books. Further assume for simplicity’s sake, that banks earn no interest on their cash reserves held at the central bank. So, Bank 1 has an additional $100 of cash reserves at the central bank, but because its deposits went up by only $100, Bank 1 is required to hold only $10 more of reserves at the central bank. Bank 1 has an additional $90 of reserves at the central bank that are in excess of what it is required to hold and earn no interest. Now assume that Local Auto Dealer comes into Bank 1 in hopes of getting a loan for $90 to finance its inventory. Because Bank 1 has the capital to support new loans and the loan terms are attractive to both parties, Local Auto Dealer gets its loan, promptly writing a check payable on its account at Bank 1 to Detroit Motor Vehicles, which banks at Bank 2. The issuance of the $90 loan by Bank 1 increases thin-air credit by an additional $90. In total, thin-air credit has increased a net $190 up at this point.
Bank 2 now finds its deposits up by $90 and its reserves at the central bank up by $90. But Bank 2 is required to hold only an additional $9 of reserves at the central bank (10% of the $90 in new deposits), so Bank 2 has $81 dollars in reserves in excess of what it is required to hold at the central bank. It just so happens that VentureCap walks into Bank 2 seeking a loan for $81 to fund the start-up of AppNoOneNeeds. Bank 2 has the capital to support new loans and the loan terms are agreeable to both parties, so VentureCap gets its loan of $81. The issuance of the $81 loan by Bank 2 increases thin-air credit by an additional $81. In total, thin-air credit has increased a net $271 at this point.

AppNoOneNeeds deposits its $81 in start-up funds at its bank, Bank 3. With those $81 in deposits, Bank 3 also receives $81 in reserves at the central bank, of which, it only is required to hold $8.10 (10% of $81). And so on. At the limit of n banks, the initial $100 of reserves created by the central bank in its purchase of securities from State Pension Fund, will have been “multiplied” into $1,000 of new deposits in the banking system ($100/10%), $900 of thin-air credit created by the banking system and $100 of thin-air credit created by the central bank (or a net increase in total thin-air credit of $1,000).

There are all kinds of real-world complications that can reduce or increase the size of the deposit and thin-air credit multiplier – complications upon which Money and Banking final exam questions are famous. Recipients of deposits may not want to redeposit the entire amount, preferring to hold a portion as folding money, i.e., currency. An increase in currency held by the public is a drain on bank cash reserves that lowers the value of the multiplier. In real life in the U.S., only checkable bank deposits are subject to reserve requirements. So, if an entity receives a deposit from some other entity and chooses to hold the funds as a deposit not subject to reserve requirements, the magnitude of the deposit/thin-air-credit multiplier will be increased. Even when banks are not paid any interest on reserves held at the central bank above and beyond what they are required to hold, some banks still desire to hold some “excess” reserves. To the degree that more excess reserves are desired, the magnitude of the deposit/thin-air-credit multiplier will be reduced.

More importantly, in the real world, banks do not behave according to this mechanical deposit/credit multiplier process although the end result of their behavior may be approximated by it. Banks don’t sit around waiting for deposits and reserves to come to them if they have good lending prospects. If a bank is approached for a loan it wishes to make, it does not tell the prospective borrower to come back tomorrow when it might have more funds to lend. Rather, the bank funds the loan by purchasing the necessary funds in some interbank market. Moreover, if banks are constrained by capital adequacy, which they were in the last financial crisis, they cannot support new loan growth even if they have a surfeit of central bank reserves. And, because banks’ required reserves are based on their deposit levels in some previous week, the deposit/bank-credit multiplier is not at all constrained by required reserves in the current week (right, Bob Laurent?).

But I digress. The point I am trying to make is that many Money and Banking professors spend too much time teaching their students the mechanics of the bank-deposit/bank-credit multiplier and not enough time explaining to them the important economic implication of the result of that multiplier – the banking system’s ability to create credit figuratively out of thin air.

To illustrate the economic significance of thin-air credit vs. all other credit, consider Charts 1 and 2. Plotted in both charts are the year-over-year percent changes in nominal Gross Domestic Purchases (Gross Domestic Product + Imports – Exports) from Q2:1953 through Q2:2007. Plotted in Chart 1 are the year-over-year percent changes in the sum of U.S. depository institution (commercial banks, S&Ls and credit unions) credit and Fed credit from Q1:1953 through Q1:2007. This credit sum is a variation of the thin-air credit to which I have referred. Thin-air credit growth has been advanced by one quarter to illustrate the effect of its growth this quarter on Gross Domestic Purchases growth next quarter. The correlation coefficient between thin-air credit growth advanced one quarter vs. Gross Domestic Purchases growth during this period is 0.61 out of a maximum possible 1.00. Plotted in Chart 2 are year-over-year percent changes in total U.S. credit outstanding excluding thin-air credit. This credit aggregate also is advanced by one quarter. The correlation coefficient between non-thin-air credit growth advanced one quarter vs. Gross Domestic Purchases growth is 0.29, less than half that of the correlation with thin-air credit growth.
Chart 1


Chart 2
So, here is my plea to Money and Banking professors. Spend less time teaching the mechanics of the deposit/bank-credit multiplier. Rather, spend more time explaining how this process creates credit figuratively out of thin air and why thin-air credit creation has such an important effect on the business cycle. Who knows? Perhaps one of your students will become a Fed official and can then explain this concept to her Fed colleagues.

Paul L. Kasriel
Econtrarian, LLC
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI

1-920-818-0236

Sunday, September 7, 2014

The Seeds of U.S. Inflation Have Sprouted and Could Be in Full Flower in 2016

September 8, 2014

The Seeds of U.S. Inflation Have Sprouted and Could Be in Full Flower in 2016

I subscribe to the tenet espoused by the late Professor Milton Friedman that inflation is a monetary phenomenon. When I speak of inflation, I include not only the behavior of prices of goods and services but also the behavior of the prices of assets. I believe that a sustained acceleration in the growth of credit created figuratively out of thin air, i.e., the sum of credit created by depository institutions (e.g., commercial banks) in a fractional reserve monetary regime and credit created by the central bank, ultimately will result in the acceleration of prices of goods/ services and/or assets. Chart 1 shows that a sustained acceleration in thin-air credit has commenced. As of July 2014, the latest complete monthly data available, the year-over-year change in the sum of commercial bank adjusted loans, leases, securities (let’s call this bank credit) and commercial bank cash assets (let’s call this Fed credit, which will be explained below) was 9.7%, the fastest growth in this measure since December 2005. Starting in October 2013, year-over-year growth in this thin-air credit measure has consistently been above 8.0% vs. a 41-year median growth rate of 6.9%. Commercial bank cash assets largely are reserve balances held at the Federal Reserve as well as currency held as bank vault cash, both of which are Federal Reserve liabilities or credit created by the Fed figuratively out of thin air. (Commercial bank assets are adjusted for mergers and acquisitions with nonbank depository institutions such as S&Ls).
Chart 1

Also shown in Chart 1 are monthly year-over-year percent changes in commercial bank adjusted holdings of loans, leases and securities, with cash assets excluded. Notice that prior to 2009, the year-over-year percent changes in the two series in Chart 1 moved in close tandem with numerical values also very close, suggesting that the behavior of bank credit dominated the behavior of the sum of bank credit and Fed credit. With the onset of the financial crisis in late 2008, credit created by commercial banks, i.e., loans, leases and securities, contracted. With the extraordinary extension of Fed credit through the discount window and other facilities and the implementation of Fed outright securities purchases (QEI), a large increase in cash assets at commercial banks partially offset the declines in bank credit, keeping the year-over-year changes in the sum of bank credit and Fed credit positive through September 2009, albeit at a diminishing rate of growth.  From October 2009 until early 2011, the year-over-year changes in the sum of bank credit and Fed credit were consistently negative as Fed discount window loans were repaid, QEI was gradually terminated and bank credit continued to contract.

QEIII was initiated in the fourth quarter of 2012 as year-over-year growth in bank credit was slowing. Early in 2014, the Fed began its tapering its QEIII securities purchases. At the same time, year-over-year growth in bank credit picked up and has continued to do so throughout 2014. So, despite the slowdown in growth of Fed thin-air credit, i.e., commercial bank cash assets, with the recent pick up in bank thin-air credit creation, the sum of commercial bank thin-air credit and Fed thin-air credit, is now growing year-over-year at its fastest pace since December 2005.

So, what does this have to do with inflation? Why do I assert that the seeds of U.S. inflation have sprouted? Well, U.S. asset prices have risen rather significantly. This is shown in Chart 2 in which I have charted the holding gains on U.S. household assets – direct and indirect holdings of financial assets and real estate – as a percent of nominal Gross Domestic Purchases (nominal dollar expenditures by U.S. households, businesses and governments on currently-produced goods and services). To smooth the data, I have presented the four-quarter moving average of this ratio.
Chart 2

In the four quarters ended Q1:2014, the latest data available, holding gains of U.S. household assets in relation to nominal Gross Domestic Purchases averaged 9.4%. Holding gains of this magnitude are closing in those experienced during the NASDAQ bubble of the late 1990s and the housing bubble of the mid 2000s. So, asset-price inflation is occurring currently. Hence, my assertion that that the seeds of U.S. inflation have sprouted.

But what about my prediction that U.S. inflation could be in full flower in 2016? The goods/services price data shown in Chart 3 do not indicate any similar current breakout in this kind of inflation as compared with the current breakout in asset-price inflation.
Chart 3

But might there be a breakout in goods/services price inflation in 2016? The historical relationship between thin-air credit growth and goods/services price inflation suggests as much. In the post-WWII era, the gestation period of goods/services price inflation relative to thin-air credit growth has tended to be long – about two years. So, what is happening to thin-air credit today will have its effect on goods/service price inflation in about two years from now, based on historical relationships. My data analysis indicates that in the past 60 years, the highest correlation between the year-over-year percent change in the implicit price deflator of Gross Domestic Purchases and the year-over-year percent change in thin-air credit (i.e., the sum of Fed and depository institution credit) is 0.55 out of maximum possible 1.00, which is obtained when thin-air credit leads the implicit deflator by nine quarters. This result is shown in Chart 4.











Chart 4

Whether the behavior of thin-air credit leads the behavior of goods/services price inflation by nine quarters or five quarters, the point is that it does lead and the lead time is relatively long. Thin-air credit currently is growing and has been growing for about a year at an historically rapid rate. Thus, one should not be sanguine about the prospects for continued mild goods/services price inflation just because this inflation currently is mild.

I said at the outset that my definition of inflation includes both the behavior of goods/services prices and asset prices. I also said at the outset that I believed that this inclusive concept of inflation resulted from monetary factors. Chart 5 shows the historical relationship between percentage changes in thin-air credit and my inclusive definition of inflation. (I wish the statistics gurus at the BLS, Commerce or the Fed would calculate a price index that included both goods/services prices and asset prices. But, given that no such index exists to the best of my knowledge, I have had to construct my own, crude as it is.) To construct my inflation measure, I have added together the four-quarter moving average of household asset holding gains as a percent of nominal Gross Domestic Purchases and the year-over-year percent change in the implicit price deflator of Gross Domestic Purchases. To account for historical lead-lag relationships, the percentage change in the implicit price deflator is lagged by nine quarters while the holding gains measure of asset-price inflation is contemporaneous. For example, the last “inflation” data point plotted in Chart 5 is for Q4:2011, which is the sum of the year-over-year percent change in the Gross Domestic Purchases implicit price deflator for Q1:2014 (remember, it is lagged by nine quarters) and the four-quarter moving average of household asset holding gains as a percent of nominal Gross Domestic Purchases for Q4:2011. Whew! The correlation between thin-air credit growth and “inflation” is 0.41. Although I typically do not get too excited about correlations below 0.50, given the crude nature of my “inflation” variable with one component measured contemporaneously and one component measured with a nine-quarter lag, a correlation of 0.41 is better than a poke in the eye with a stick. Moreover, the chart looks pretty good, save for 1984, which might reflect the oil glut of 1986 (remember, the implicit deflator change is lagged by nine quarters) and 2008, when thin-air credit soared as the Fed opened up the discount window and created other lending facilities to satisfy an increased demand for liquidity in the wake of financial institution solvency issues.
Chart 5

To summarize, as of July, the sum of commercial bank credit and Fed credit had increased 9.7 percent year-over-year despite a sharp slowing in Fed credit growth due to the winding down of QEIII. Growth in thin-air credit of this magnitude is high in an historical context. Persistent growth in thin-air credit of this magnitude typically results in rising inflation – asset-price inflation and/or goods/services-price inflation. The U.S. already is experiencing asset-price inflation. Given its historically long gestation period, a sharp acceleration in goods/services-price inflation is likely to be evident in 2016. Unless growth in commercial bank credit autonomously decelerates and/or the Fed soon takes more aggressive actions to restrain growth in the sum of bank and Fed credit, higher inflation, in the inclusive sense, will be “baked in the cake” over the next couple of years.

One final note. In addition to saying that inflation is a monetary phenomenon, Professor Milton Friedman also said that the lags between monetary variables and inflation are long and variable. Based on my empirical analysis, I agree with his conclusion regarding the long and variable lags. As a result of his analysis, Professor Friedman recommended 60 years ago that Fed policy be conducted so as produce a steady rate of growth in the quantity of some monetary variable. By so doing, the Fed could avoid unintentionally increasing the amplitude of inflationary cycles. Although I may humbly disagree with Professor Friedman’s choice of the monetary variable quantity whose growth rate the Fed should target, 60 years later I still agree with his premise. I believe that if the Fed were to operate such that thin-air credit grew at a steady and “reasonable” rate (its 61-year median growth rate is 7.4%), then the high goods/services-price inflations of the Burns-Fed era and the high asset-price inflations of the Greenspan-Fed era could be avoided. And by avoiding these extreme inflations in the future, we could avoid the extreme recessions in real output that inevitably ensue once the inflation “fevers” break.

Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic and Investment Advisor
Legacy Private Trust Company of Neenah, Wisconsin
1-920-818-0236