The course of an economy is determined by the course of that economy’s money supply (broadly determined). The relationship between money growth and nominal GDP growth is presented in the accompanying chart. It is persuasive. Indeed, money, not fiscal policy, dominates.
As I listen to all the ad hoc conjectures about the state of China’s economy and its near‐term prospects, I am astounded to never hear anything said about the most important determinant of nominal economic growth: the money supply. The second chart tells the tale. The picture is not a pretty one. China’s money supply growth rate has been slowing down since early 2012. It now is growing at an annual rate of about 10%, which is well below the trend rate of money growth: 17.06%. China is in trouble. Slower money supply growth means that slower nominal GDP growth is already baked in the cake.
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.
When the Basel I accords, mandating higher capital‐asset ratios for banks, were introduced in 1988, they were embraced by the administration of President George H.W. Bush. With higher capital‐asset ratios came a sharp slowdown in the money supply growth rate and — unfortunately for President George H. W. Bush and his re‐election campaign — a mild recession from July 1990 through March 1991.
Now, we have Basel III and its higher capital‐asset ratio requirements being imposed on banks in the middle of a weak, drawn‐out economic recovery. This is one of the major reasons why the recovery is so anemic.
How could this be? Well, banks produce bank money, which accounts for roughly 85% of the total U.S. money supply (M4). Mandated increases in bank capital requirements result in contractions in bank money, and thus in the total money supply.
Here’s how it works:
While the higher capital‐asset ratios that are required by Basel III are intended to strengthen banks (and economies), these higher capital requirements destroy money. Under the Basel III regime, banks will have to increase their capital‐asset ratios. They can do this by either boosting capital or shrinking assets. If banks shrink their assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.
So, paradoxically, the drive to deleverage banks and shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital‐asset ratios.
The other way to increase a bank’s capital‐asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly‐issued bank equity, the investor exchanges funds from a bank account for new shares. This reduces deposit liabilities in the banking system and wipes out money.
We now learn that the Fed, using the cover of the Dodd‐Frank legislation, is toying with the idea of forcing foreign banks that operate in the United States to hold billions of dollars of additional capital (read: increase their capital‐asset ratios).
This will make the credit crunch “crunchier” and throw the U.S. economy into an even more vulnerable position. The last thing the Fed should be doing is squeezing the banks and tightening the screws on the production of bank 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
The Swiss National Bank is conducting a bizarre, contradictory, and potentially dangerous set of monetary policies.
During the past year, the SNB has mandated the imposition of super‐high bank capital requirements. Indeed, the SNB, in its annual Financial Stability Report, even admonished Credit Suisse for not building up a big enough capital cushion. The Swiss capital mandates have caused the rate of growth in money created by Swiss banks (bank money) to plunge.
As can be seen in the accompanying chart, Swiss bank money was 25 percent lower in July 2012 than it was in July 2011. This should be alarming because bank money is, by far, the biggest component of the total money supply. In fact, since the beginning of 2003, bank money has, on average, constituted 89 percent of the total Swiss money supply.
Bank regulations in Switzerland and elsewhere, have resulted in, you guessed it: very tight bank money.
Not being one to sit on its hands, the SNB has turned on its money pumps. Indeed, Swiss state money — the money produced by the SNB — was 305 percent higher in July 2012 than in July 2011.
This explosion in state money has been more than enough to offset the contraction of the all‐important bank money component.
In consequence, Switzerland’s total money supply grew at a 10 percent year‐over‐year rate in July 2012. With double‐digit money supply growth, and overall prices declining, it’s little wonder that prices in certain asset classes, such as housing, are surging in Switzerland.
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.
In my August 2012 Globe Asia column, “Money, Where’s the Money?”, I explained why the global economy is still sputtering, and proposed a partial solution. In short, I called for governments (not central banks) to engage in debt market operations – a way to increase the money supply directly, without increasing the overall level of government debt. A number of readers have since contacted me with questions about the specific example I discussed in my column. The most frequent question was:
“Isn’t your proposal just the same as the Fed’s Operation Twist, where the Fed purchases long‐term government securities from the public and increases high‐powered money?”
The answer is, in short, no – and here’s why:
The first thing that should be noted is that both a central bank and a government can conduct debt market operations. Debt market operations constitute either central bank, or government, transactions with non‐banks, which change the bank deposits held by those non‐banks. There are many combinations of such operations that can be employed, but with all debt market operations of the type I am envisioning, long‐dated debt is replaced with short‐dated debt (and so, in one sense, there would be some similarity with Operation Twist).
In my Globe Asia example, however, the government would conduct the debt market operations with no involvement by the central bank. The government would borrow from private banks and purchase outstanding long‐dated government debt from the public, and then cancel the debt that had been purchased. The result would be an increase in the money supply, with no change in the monetary base. If the government were instead to borrow from the central bank, both base money and broad money would increase – a fundamental difference.
The central bank could engage directly in debt market operations (and several have done so in recent QE operations). But, in this case, the long‐dated bonds purchased by the central bank would end up on the central bank’s balance sheet. The debt would not be canceled out, as it would be if the government was to conduct debt market operations. It is this fact that defines one of the fundamental differences between debt market operations conducted by a central bank and those conducted by a government. A central bank engaged in debt market operations would be left with holdings of long‐dated government debt and be exposed to interest rate risk on those securities. It could incur large accounting losses if interest rates were to rise. This would not be the case if the government conducted debt market operations.