Follow the money

by Alasdair Macleod, GoldMoney:

Since 2009, equities and other financial assets have climbed a wall of worry. Initially, it was recovery from the threat of a complete financial collapse, before the Fed saved the system once again.

Systemic collapse continued to be on the cards, with European banks at risk of bankruptcy. We still talk about this today. More walls of worry to climb.

The global economy has not imploded, as the bears have consistently warned. Systemic and other dangers still exist. The bears now point to excessive valuations as the reason for staying out of the market. But this misses the point: the general level of asset valuations depends not on fundamentals, but on credit flows. It matters not whether there is cash sitting on the side-lines, or whether speculators borrow to invest, so long as the credit keeps flowing into financial assets. Just follow the money.

It is all about credit, and when you have central banks suppressing interest rates and causing bank credit to expand, they create a credit cycle. Modern credit cycles have existed since Victorian times, the consequence of fractional reserve banking. The cycle varies in length and the specifics, but its basic components are always the same: recovery, expansion, crisis and destruction. Today, central banks reckon their mission is to stop the destruction of credit, and to keep it continually expanding to stimulate the economy.

The economic and financial community fails to understand that the sequence of booms and slumps is not a free market disorder, but the consequence of a credit cycle distorting how ordinary people go about their business. It is a waste of time trying to understand what is happening in the economy without analysing credit flows. It is Hamlet without the Prince. This article walks the reader through the phases of the credit cycle, identifying the key credit flow characteristics, whose starting point we will take to be the end of the great financial crisis. It will conclude with a summary of what this tells us about current credit flows, and prospects for the near future.


The seeds of recovery

In a modern credit-driven economy, central banks see their role as preventing recessions, slumps, and depressions. The need to preserve the banking system, to stop one bank taking out the others in a domino effect, is paramount. To prevent the weakest banks collapsing takes financial support from the central bank by increasing the quantity of base money, while at the same time discouraging banks from calling in loans, particularly from their larger customers.

Central bank priorities will have switched from fear of price inflation ahead of the crisis to fear of deflation. They are still informed by Irving Fisher’s description of how an economic crisis develops from financial flows. When businesses start to fail, banks call in their loans, causing otherwise sound businesses to collapse. The banks liquidate collateral into the market, undermining asset prices in a self-feeding downward spiral. The way to prevent it is to backstop the banks by issuing more money.

We saw this at its most spectacular in the great financial crisis. The Fed effectively wrote open cheques to any bank that needed money, and for some that didn’t. The most important rescue was of Fannie Mae and Freddie Mac, the two private-public entities that dominated the residential property market, with some $5 trillion of agency securities outstanding. The Fed’s initial involvement was to buy up to $500bn of agency debt through quantitative easing, supporting the remaining mortgage debt values and injecting a matching quantity of money into the banks in the form of excess reserves.

This didn’t stop with Fannie and Freddie. AIG, Bear Sterns and Lehman were just a few of the names associated with the crisis. Term Auction Facility, Primary Dealer Credit Facility, Asset-backed Commercial Paper, Money Market Mutual Fund Liquidity Facility, Commercial Paper Funding Facility, and Term Asset-Backed Securities Loan Facility entered the financial language as new rescue vehicles financed with raw money from the Fed.

It wasn’t just the US. Most major jurisdictions were locked into the same credit cycle, and by 2007-08 they were all on the edge of the crisis. Consequently, the financial crisis in America was replicated in the UK and the Eurozone. Including Japan, the sum of the balance sheets of their four central banks increased from about $6.5 trillion to nearly $19.5 trillion today.

The increase in the liability side of central bank balance sheets has been substantially in the reserves of commercial banks. This is the most pronounced feature of the current credit cycle, potentially fuelling substantial levels of bank lending when the banks eventually become more confident in their lending to the non-financial sector.

The recovery phase has now been in place for an extended period, lasting eight years so far. It has been characterised, as it always is, by an increase of financial asset prices. This is partly driven by the suppression of interest rates, which creates a bull market for bond prices, and partly by banks buying government bonds.

Government bonds are always accumulated by the banks in large quantities during the recovery phase of the credit cycle. The shortfall in fiscal revenue and the increased cost-burden on government finances leads to a general demand for credit to be switched from private sectors to governments. For the banks, investing in government debt is a safe harbour at a time of heightened lending risk, further encouraged by Basel regulatory risk weightings. On the back of falling bond yields, other financial assets rise in value, and therefore banks increasingly make credit available for purely financial activities.

In the current credit cycle, the boom in financial assets has been exaggerated by central banks buying government bonds as well. The result is a bond bubble far greater than would otherwise be the case. Consequently, when an economy moves from recovery into expansion, the price effect of the credit flows as they wash out of bonds into lending is likely to be more dramatic than we have ever seen before.

We appear to be on the cusp of this change into a phase of economic expansion for much of the world, though the situation in America is less clear. To understand the implications of this change, we must first examine the underlying credit flows.


Expansion – credit hidden then in plain sight

The stability that returns in the recovery phase, coupled with fading memories of the previous crisis, engenders growing confidence in the non-financial economy, which demands credit in increasing quantities for expansion of production. While interest rates remain suppressed, financial calculations, such as return on capital, make investment in even unwanted production appear profitable. It is the bankers which impede this early demand for money, because they still retain memories of the previous crisis and are determined not to repeat the errors of the past. Furthermore, bank regulators are still closing stable doors long after the horses have bolted.

Banks will have continued lending to big business throughout the recovery phase. Under pressure from large corporates, this lending also extends to their consumers, currently evident with car, or auto loans, financing most of the products of major motor manufacturers. Without this consumer credit, vehicles cannot be sold, and manufacturers would be forced to close factories. That is not where the problem under discussion lies: it is in the other 80% of the economy, the small and medium-size enterprises (SMEs), which the banks see as too risky. However, gradually at first, the banks begin to reassess the risk of lending to non-financial entities relative to owning the government bonds on their balance sheets.

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