Tag: money

The Federal Reserve vs. Small Business

Given all the attention that the Federal Reserve has garnered for its monetary “stimulus” programs, it’s perplexing to many that the U.S. has been mired in a credit crunch. After all, conventional wisdom tells us that the Fed’s policies, which have lowered interest rates to almost zero, should have stimulated the creation of credit. This has not been the case, and I’m not surprised.

As it turns out, the Fed’s “stimulus” policies are actually exacerbating the credit crunch. Since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy. This has been the case particularly for smaller firms in the U.S. economy, known as small and medium enterprises (“SMEs”).

To understand the problem, we must delve into the plumbing of the financial system, specifically the loan markets. Retail bank lending involves making risky forward commitments, such as extending a line of credit to a corporate client, for example. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market – a market operating with positive interest rates and without counterparty risks.

With the availability of such a market, banks can lend to their clients with confidence because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, however, the interbank lending market is not functioning as it should. Indeed, one of the major problems facing the interbank market is the so-called zero-interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, there is virtually no yield be found on the interbank market.

In consequence, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. As a result, thanks to the Fed’s zero-interest-rate policies, the interbank market has dried up (see the accompanying chart).

 

Without the security provided by a reliable interbank lending market, banks have been unwilling to scale up or even retain their forward loan commitments. This was verified in a recent article in Central Banking Journal by Stanford Economist Prof. Ronald McKinnon – appropriately titled “Fed ‘stimulus’ chokes indirect finance to SMEs.” The result, as Prof. McKinnon puts it, has been “constipation in domestic financial intermediation” – in other words, a credit crunch.

When banks put the brakes on lending, it is small and medium enterprises that are the hardest hit. Whereas large corporate firms can raise funds directly from the market, SMEs are often primarily reliant on bank lending for working capital. The current drought in the interbank market, and associated credit crunch, has thus left many SMEs without a consistent source of funding.

As it turns out, these “small” businesses make up a big chunk of the U.S. economy – 49.2% of private sector employment and 46% of private-sector GDP. Indeed, the untold story is that the zero-interest-rate trap has left SMEs in a financial straightjacket.

In short, the Fed’s zero interest-rate policy has exacerbated a credit crunch that has been holding back the economy. The only way out of this trap is for the Fed to abandon the conventional wisdom that zero-interest-rates stimulate the creation of credit. Suppose the Fed were to raise the Fed funds rate to, say, two percent. This would loosen the screws on interbank lending, and credit would begin to flow more readily to small and medium enterprises.

Iran’s Inflation Statistics: Lies, Lies and Mehr Lies

The Mehr News Agency is now reporting that Iran’s annual inflation rate has reached 31.5%. According to the Central Bank’s official line, Iran’s annual inflation rate has bumped up only 1.3 percentage points from February to March.

Never mind that this official inflation statistic is well below all serious estimates of Iran’s inflation. And yes, Iran’s official inflation statistics are also contradicted by the overwhelming body of anecdotal reports in the financial press.

Since September 2012, I have been estimating Iran’s inflation rate – which briefly reached hyperinflation levels in October 2012 – using a standard, widely-accepted methodology. By measuring changes in the rial’s black-market (read: free-market) U.S. dollar exchange rate, it is possible to calculate an implied inflation rate for Iran.

When we do so, a much different picture of Iran’s inflation emerges. Indeed, Iran’s annual inflation rate is actually 82.5% – a rate more than double the official rate of 31.5% (see the accompanying chart).

As I have documented, regimes in countries undergoing severe inflation have a long history of hiding the true extent of their inflationary woes. In many cases, the regimes resort to underreporting or simply fabricating statistics to hide their economic problems. And, in some cases, such as Zimbabwe and North Korea, the government simply stops reporting economic data altogether.

Iran has followed a familiar path, failing to report inflation data in a timely and replicable manner. Those data that are reported by Iran’s Central Bank tend to possess what I’ve described as an “Alice in Wonderland” quality and should be taken with a grain of salt.

The UK’s Capital Obsession

Last Thursday, Mervyn King, the outgoing governor of the Bank of England, called for yet another round of recapitalization of the major UK banks. For some time, I have warned that higher bank capital requirements, when imposed in the middle of an economic slump, are wrong-headed because they put a squeeze on the money supply and stifle economic growth. So far, bank recapitalization efforts, such as Basel III, have resulted in financial repression – a credit crunch. It is little wonder we are having trouble waking up from the current economic nightmare.

So why would Mr. King want to saddle the UK banking system  with another round of capital-requirement increases, particularly when the UK economy is teetering on the edge of a triple-dip recession? Is King simply unaware of the devastating unintended consequences this would create?

In reality, there is more to this story than meets the eye. To understand the motivation behind the UK’s capital obsession, we must begin with infamous Northern Rock affair. On August 9, 2007, the European money markets froze up after BNP Paribas announced that it was suspending withdrawals on two of its funds that were heavily invested in the US subprime credit market. Northern Rock, a profitable and solvent bank, relied on these wholesale money markets for liquidity. Unable to secure the short-term funding it needed, Northern Rock turned to the Bank of England for a relatively modest emergency infusion of liquidity (3 billion GBP).

This lending of last resort might have worked, had a leak inside the Bank of England not tipped off the BBC to the story on Thursday, September 13, 2007. The next morning, a bank run ensued, and by Monday morning, Prime Minister Gordon Brown had stepped in to guarantee all of Northern Rock’s deposits.

The damage, however, was already done. The bank run had transformed Northern Rock from a solvent (if illiquid) bank to a bankrupt entity. By the end of 2007, over 25 billion GBP of British taxpayers’ money had been injected into Northern Rock. The company’s stock had crashed, and a number of investors began to announce takeover offers for the failing bank. But, this was not to be – the UK Treasury announced early on that it would have the final say on any proposed sale of Northern Rock. Chancellor of the Exchequer Allistair Darling then proceeded to bungle the sale, and by February 7, 2008, all but one bidder had pulled out. Ten days later, Darling announced that Northern Rock would be nationalized.

Looking to save face in the aftermath of the scandal, Gordon Brown – along with King, Darling and their fellow members of the political chattering classes in the UK – turned their crosshairs on the banks, touting “recapitalization” as the only way to make banks “safer” and prevent future bailouts.

In the prologue to Brown’s book, Beyond the Crash, he glorifies the moment when he underlined twice “Recapitalize NOW.” Indeed, Mr. Brown writes, “I wrote it on a piece of paper, in the thick black felt-tip pens I’ve used since a childhood sporting accident affected my eyesight. I underlined it twice.”

I suspect that moment occurred right around the time his successor-to-be, David Cameron, began taking aim at Brown over the Northern Rock affair.

Clearly, Mr. Brown did not take kindly to being “forced” to use taxpayer money to prop up the British banking system. But, rather than directing his ire at Mervyn King and the leak at the Bank of England that set off the Northern Rock bank run, Brown opted for the more politically expedient move – the tried and true practice of bank-bashing.

It turns out that Mr. Brown attracted many like-minded souls, including the central bankers who endorsed Basel III, which mandates higher capital-asset ratios for banks. In response to Basel III (and Basel III, plus), banks have shrunk their loan books and dramatically increased their cash and government securities positions (both of these “risk free” assets are not covered by the capital requirements imposed by Basel III and related capital mandates).

In England, this government-imposed deleveraging has been particularly disastrous. As the accompanying chart shows, the UK’s money supply has taken a pounding since 2007, with the money supply currently registering a deficiency of 13%.

 

How could this be? After all, hasn’t the Bank of England employed a loose monetary policy scheme under King’s leadership? Well, state money – the component of the money supply produced by the Bank of England – has grown by 22.3% since the Bank of England began its quantitative easing program (QE) in March 2009, yet the total money supply, broadly measured, has been shrinking since January 2011.

The source of England’s money-supply woes is the all-important bank money component of the total money supply. Bank money, which is produced by the private banking system, makes up the vast majority – a whopping 97% – of the UK’s total money supply. It is bank money that would take a further hit if King’s proposed round of bank recapitalization were to be enacted.

As the accompanying chart shows, the rates of growth for bank money and the total money supply have plummeted since the British Financial Services Authority announced its plan to raise capital adequacy ratios for UK Banks.

 

In fact, despite a steady, sizable expansion in state money, the total money supply in the UK is now shrinking, driven by a government-imposed contraction in bank money. So, contrary to popular opinion, monetary policy in the UK has been ultra-tight, thanks to the UK’s capital obsession.

Despite wrong-headed claims to the contrary by King, raising capital requirements on Britain’s banks will not turn around the country’s struggling economy – any more than it will un-bungle the Northern Rock affair. Indeed, this latest round of bank-bashing only serves to distract from what really matters – money.

Where’s Iran’s Money?

Since I first estimated Iran’s hyperinflation last month , I have received inquiries as to why I have never so much as mentioned Iran’s money supply. That’s a good question, which comes as no surprise. After all, inflations of significant degree and duration always involve a monetary expansion.

But when it comes to Iran, there is not too much one can say about its money supply, as it relates to Iran’s recent bout of hyperinflation. Iran’s money supply data are inconsistent and dated. In short, the available money supply data don’t shed much light on the current state of Iran’s inflation.

Iran mysteriously stopped publishing any sort of data on its money supply after March 2011. Additionally, Iranian officials decided to change their definition of broad money in March 2010. This resulted in a sudden drop in the reported all-important bank money  portion of the total money supply, and, as a result, in the total. In consequence, a quick glance at the total money supply chart would have given off a false signal, suggesting a slump and significant deflationary pressures, as early as 2010

While very dated, at least Iran’s state money, or money produced by the central bank (monetary base, M0), is a uniform time series. The state money picture, though dated, is consistent with a “high” inflation story. Indeed, the monetary base was growing at an exponential rate in the years leading up to the end of the reported annual series.  No annual data are available after 2010 (see the chart below).

Iran is following in Zimbabwe’s well-worn footsteps, trying to throw a shroud of secrecy over the country’s monetary statistics, and ultimately its inflation problems. Fortunately for us, the availability of black-market exchange-rate data has allowed for a reliable estimate  of Iran’s inflation—casting light on its death spiral .

Is Turkey Golden?

Recently, Moody’s Investors Service took some wind from Turkey’s sails, when it declined to upgrade Turkey’s credit rating to investment grade. Moody’s cited external imbalances, along with slowing domestic growth, as factors in its decision. This move is in sharp contrast to the one Fitch made earlier this month, when it upgraded Turkey to investment grade.   Moody’s decision not to upgrade Turkey, and its justification, left me somewhat underwhelmed – given how well the Turkish economy has done in recent years.

Since the fall of Lehman Brothers, Turkey’s central bank has employed a so-called unorthodox monetary policy mix. For example, a little over a year ago, it began to allow commercial banks to purchase gold from Turkish citizens and allowed banks to count gold to fulfill their reserve requirements. Incidentally, this was a remarkable success – from 2010-2012, the Turkish banking sector’s precious metal account increased by over 7 billion USD.

For all the criticism its unconventional monetary policies have garnered, the Central Bank of the Republic of Turkey has, in fact, produced orthodox, golden results. Indeed, as the accompanying chart shows, the central bank has delivered on the only thing that really matters – money.

Turkey’s economic performance has been quite strong (despite some concerns about inflation and its current account deficit) . Turkey’s money supply has been close to the trend level for some time, and it currently stands 2.41% above trend. This positive pattern is similar to that of many Asian countries, who continue to weather the current economic storm better than the West.  And, it stands in sharp contrast to the unhealthy economic picture in the United States and Europe – both of which register significant money supply deficiencies.

So, why would Moody’s not follow Fitch’s lead and upgrade Turkey to investment grade? To understand this divergence, one should examine Turkey’s recent current account activity. Since late 2011, Turkey’s current account has rebounded somewhat (see the accompanying chart).

But, if gold exports are excluded from the current account (on a 12-month rolling basis), a rather significant 47% of this improvement, from the end of 2011 to September 2012, magically disappears.

Where is this gold going? Well, a quick look at the accompanying chart shows just how drastically exports to Iran and the UAE have surged this year.

Taken together, the charts indicate that Turkey is exporting gold to Iran, both directly and via the UAE , propping up their current account in the process. This has put Turkey and the UAE in the crosshairs of proponents of anti-Iranian sanctions.   Those who beat the sanctions drum are now seeking to impose another round of sanctions, aimed at disrupting programs such as Turkey’s gold-for-natural-gas exchange. This proposal clearly highlights some of the problems associated with sanctions, specifically the unintended costs imposed on the friends of the U.S. and EU in the region. Indeed, Dubai has already taken a hit, with its re-exports falling dramatically as a result of the sanctions.

What is the U.S. to do – go against Turkey, its NATO ally? Believe it or not, some in the Senate are allegedly considering such a wrong-headed move.

If these proposed sanctions are implemented, then Moody’s pessimistic outlook on Turkey may turn out to be not so far from the mark, after all – and Turkey will have no one but its “allies” to blame.

From the Bank of Canada to Threadneedle Street – Finally

On July 1st 2013, Bank of Canada Governor Mark Carney will assume the position of Governor of the Bank of England . Will Carney’s hat-switching be good for the UK? At present, one thing is certain; Carney has delivered to Canada the one thing that matters – money .

A quick comparison of the money supply in Canada to that of the UK shows the stark differences in the health of their respective money supplies  (and thus, of their respective economies).

 

 

The Canadian money supply has managed to stay near trend throughout the post-Lehman era. In fact, the Canadian total money supply is currently 0.5% above trend, while the UK’s money supply is a dismal 12.1% below trend – no wonder the UK keeps flirting with recession. Although Canada’s GDP growth rates are less than stellar, they are above the average of the 34 OECD nations . Indeed, Canada’s overall economic outlook is much stronger than that of the UK .

In his new position, Carney will face the formidable challenge of turning around the UK’s slumping money supply. Regardless of Carney’s success in Canada, we will have to wait and see if he’ll be able to pull it off on the other side of the pond.

Slumping Money Supply (Not Austerity) Plunges Hungary Into Recession

Hungary is in a recession, again. According to the chattering classes, as well as many analysts and financial reporters, fiscal austerity is the cause of Hungary’s slump.

Nonsense. Hungary’s recession results from its slumping money supply.

When monetary and fiscal policies move in opposite directions, the economy will follow the direction taken by monetary (not fiscal) policy – money dominates. For doubters, just consider Japan and the United States in the 1990s. The Japanese government engaged in a massive fiscal stimulus program, while the Bank of Japan embraced a super-tight monetary policy. In consequence, Japan suffered under deflationary pressures and experienced a lost decade of economic growth.

In the U.S., the 1990s were marked by a strong boom. The Fed was accommodative and President Clinton was super-austere – the most tight-fisted president in the post-World War II era. President Clinton chopped 3.9 percentage points off federal government expenditures as a percent of GDP. No other modern U.S. President has even come close to Clinton’s record.

The money supply picture for Hungary seemed to be looking up until late 2011 (see the accompanying chart). Indeed, Hungary’s money supply had nearly returned to its trend-rate level, when it peaked in November 2011. Then, in the course of just over a month, things took a turn for the worse.

First, Moody’s downgraded Hungary’s debt to junk status, and soon thereafter, S&P and Fitch followed suit. Then, the EU and IMF walked out on debt restructuring talks, citing concerns over proposed constitutional changes, which threatened the Hungarian central bank’s independence. Just days later, their fears were confirmed, as the Hungarian Parliament passed the controversial law, merging the central bank with the Financial Supervisory Authority. And, to top it off, Hungary unexpectedly cancelled part of its December debt auction.

When the dust settled, confidence in Hungary’s financial system had been shattered. Despite a 15.9% increase in the supply of state money, the total money supply had plummeted by 4.2% (from November 2011 to January 2012). As the accompanying table shows, this decline in the total money supply was driven by a 9% drop in the all-important bank-money component of the total.

Hungary’s money supply has yet to recover from this perfect monetary storm. And, as if that wasn’t enough, Hungary recently adopted a damaging financial transactions levy.

Money and monetary policy trump fiscal policy. Until Hungary gets its money and banking houses in order, its economy will continue to wallow in recession.

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