Wednesday, October 28, 2009

Deflationary Forces Still Hard At Work

Today will be a quick post on some of the more deflationary forces that have been going on under the surface over the past few months. It has been fashionable of late to speak of how central bank monetary stimulus and government fiscal stimulus has "brought us out of recession." Tomorrow morning we will get US Q3 GDP numbers, and they will surely be positive. The media will sing the "recession is over" tune until they are hoarse. But they will be wrong. As per usual.

To be sure, many companies and individuals have used the relatively favourable conditions in the bond markets to build capital, refinance their debts and a select few are even acquiring new assets and R&D funding. But this is the exception, not the rule.

What is easily seen by casual observers is that governments and central banks went on a shock & awe campaign in a "war against recession." News happened to stop getting progressively worse around the same time, and the layman assumes one caused the other. They conveniently forget that both fiscal and monetary easing started more than a year and a half prior to the March lows in the stock market. So did these policies all of a sudden go from failure to success overnight? Or had the stock market simply gone "too far, too fast" and needed time to sort out the good from bad?

It is my contention, that it has been a mere correction in the mood of investors and not in the actual health of the capital markets. I have discussed my opposition at length to the money multiplier model of monetary expansion used by central bankers. I believe that their models are incorrect. They state that if they (the central bank) is to deposit $1 of newly created 'money' at a member bank (Bank of America, for example), then BofA will then go and lend $10 to others. As has been discovered by numerous economists over the course of the past few decades, this is precisely backward. Banks lend out money first, based on their belief in the ability to make a profit on their loan. Thereafter, they acquire deposits to meet capital requirements. This explodes the myth that any of the Fed's asset swaps or QE has somehow inflated the money supply. They have merely shifted the existing supply around, hoping that in its new home it will multiply. It hasn't. And it won't. Because it can't.

Below is a chart of the past 60 years of commercial and industrial lending measured as a percentage change from the prior year and as a percentage of total GDP. Despite the hockey stick graph that so many like to point to as evidence of impending hyperinflation, the banks that have been given this so-called "printed money" are not lending it. Lending is falling off a cliff to businesses and shows no signs of turning around. (Chart courtesy Econompic Data)

Why aren't they lending? Are they just being greedy and keeping the money for themselves as the many populist cries imply? Or is something preventing them from lending? Glad you asked. For those with a short memory, the panic of 2008 was caused by people defaulting on mortgages. With a 50% rise in the stock market, one would assume that problem has at least dissipated slightly, right? Wrong. Mortgage delinquencies continue rising. See Exhibit A (from Calculated Risk):

That doesn't look like much in the way of improvement to me. Fannie is in the same bind. And the FHA, which has been recruited by the government to pick up the slack in doling out garbage mortgages, is even worse. Below we can see that although home prices may have ticked up in response to HAMP (cash for cabins), foreclosures (blue bars) have not yet caught up to delinquencies (red bars).

What does that mean? It means that banks cannot foreclose on properties fast enough. Alternatively, they may feel that they can modify these loans or that those that are delinquent will get their jobs back in due time. That is wishful thinking. Not even the flaming optimists see employment turning around anytime soon, and banks have already found that more than 60% of loan modifications re-default within mere months. Either way, there is massive supply of homes that are soon to be bank owned and liquidated.

So I suppose that would explain why banks can't do anything with their "excess reserves." Also keep in mind that much of these reserves are on temporary loan from the Fed in exchange for other garbage securities.

But it is not just the banks that aren't lending. Trade Credit is falling sharply also. As defined by Wikipedia:

Trade credit exists when one firm provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate the business if it is managed properly. Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses

Chris Whalen of the IRA Analyst interviewed two of the leading corporate credit ratings firms, Jerry Flum and Bill Danner. Below are some excerpts, but the whole interview is worthy of a read.

The IRA: So what are you seeing at CRMZ in terms of corporate credit, accounts receivable and the data you gather?

Danner: The dollar value of accounts receivable we collect are down sharply. In general vendor credit is down much more than the drop in bank lending.

Flum: Not only that, but you've got to remember that the rate of gain and the expansion of bank lending is down. If trade payables are also down, then there is no grease for the real economy.

Danner: Yes, to put a finer point on it, trade credit is down bigger than bank lending. Remember that commercial receivables are huge, something like 3x commercial bank loans. This is the real economy's lifeblood, but trade credit is down more than the decline in sales and down more than the decline in bank lending, including metrics you guys track on banks like exposure at default ("EAD").
Flum: I have been doing this for 40 years. Started in the financial business after working at a law firm. I got my head handed to me in 1973-74 in my hedge fund and had to learn how markets behave. When I boil what I've learned all down to one factor that drives the markets and an economy, it is debt. Debt vs. GDP, for example. Every dollar of debt moves a future purchase into the present.

The IRA: In a fiat money system, there is no money, only credit.

Flum: Correct, and as credit grows we spend more of it now. So, if you look at debt vs. GDP, we are already at record levels. We can also look at incremental debt vs. incremental GDP. In the 1950s, it took $1.50 in debt to produce an incremental $1 of GDP. Today it takes more than $6 in debt to produce a $1 of GDP, so we are approaching the end of the game. This economic inefficiency is a sign of being closer to the top than the bottom and a new beginning.
The IRA: So the efforts to restore the commercial paper markets and add liquidity to the markets has not trickled-down? The Fed would tell you that they have restored normalcy

Danner: The numbers we are seeing on A/R and trade credit volumes are continuing to get worse, not better. A big part of that is financing.

So much for monetary stimulus. Behind the smoke and mirrors from the central banks and the flashy lights in our financial media, absolutely nothing has been achieved by these measures. That is, if one chooses to ignore the unintended consequences.

But what about the government stimulus measures. Surely the various programs and stimulus cash is having its effect on the economy? Not likely. Again, the models that suggest that this works suffer from a similar affliction: they ignore debt. And in a credit inspired recession, adding more debt does nothing good. Sure, it can be good for some people who are direct recipients of the loot. But for the rest of the taxpayers and businesses, the implied future rate of taxation rises in lockstep. This is something that I have mentioned before, but I had not heard anyone else take up the cause. Until yesterday when I happened upon a fairly wonkish post from Rob Parenteau. In it he makes the same observation:

DoctoRx next considers a contradiction in using policy responses to debt deflation dynamics that require higher government debt. He suggests we best think of the government balance sheet as consolidated with the domestic private sector balance sheet, since Treasury debt is an obligation that ultimately must be paid by taxpayers. This of course is a variant of the Ricardian equivalence argument, whereby fiscal stimulus is deemed to be ineffective at inducing economic growth since the households receiving higher income from deficit spending simply save the entire proceeds in expectation of future tax liabilities of equal magnitude. DoctoRx is probing along similar lines when he observes, “after all, the private sector has to debit its bank account to send the funds to the government in order to buy the debt. All that is really happening is that the private sector had cash, and now the government has the cash with some repayment terms.” Fiscal deficits are, in other words, just an asset swap.
Money and finance are not neutral with respect to real economic outcomes, nor is money simply a veil for real exchange, as is taught in mainstream economics and as is held as holy truth by contemporary central bankers. Read a little Fisher or a little Minsky, and then reflect on recent events. Did we destroy some productive resources, lose some technical knowledge, or otherwise experience an exogenous productivity shock to drop into the deepest recession of the post WWII period, or was the drop in real economic activity in no small part a result of a highly leveraged private financial and nonfinancial sector encountering some very drastic financial conditions as fraudulent loans and fraudulent debt ratings were exposed? Does the government need the private sector’s money to “fund” its expenditures when a) the nonbank private sector cannot create money, and b) the government creates the money the private sector accumulates to pay taxes and buy bonds? Under what conditions can the business sector as a whole accumulate tangible capital without issuing financial liabilities, and are those conditions we observe in the real world around us?

Again, read the entire piece. Have a drink beforehand as it runs deep to the present situation. Parenteau, the Austrians, and followers of Minsky's Financial Instability Hypothesis understand that debt is the problem. They understand that either shuffling it around (as are central banks) or creating more of it (as are governments) is not a viable way to combat credit deflation, while it may 'work' during a run-of-the-mill overcapacity recession.

The equity and commodity markets are acting as if there is no difference between the characteristics of the two separate types of economic contractions, responding as they would to the expected recovery from undercapacity. As we can see from the charts above, the deflationary forces that began the crisis two years ago continue to accelerate.

Bernanke and Geithner are trying to fit a square peg in a round hole. Vegas odds are 1:1 on them succeeding.

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mannfm11 said...

Nice piece. If you have read enough of my stuff, you have to have seen me raise all these issues. I fight this battle at least once a week on Wall street bear, which is strictly a gold bug, mostly inflation to the moon, stock bear site. Maybe I can add something to the stew about the printing money idea. As you well know, money only exists when banks make it available, as they don't need any money to lend money, only to pay other banks for their excess. This is what started this mess, interbank liabilities. In any case, you brushed right against it, the potential losses of the banks. This money does them no good because it is really nothing but an exchange of liabilities between the holder of a bond or mortgage and the Fed. Once done, the fed credit is the banks asset and the bond is the Fed's asset, the holder of the liability being switched. The money can be used to buy the bond if the bank so choose. But, capital is necessary to make a loan. If a bank needs to raise capital, it can only do so out of the money supply in the banking system, upon which the capital takes the form of a former bank deposit and the bank deposit ceases to exist.

I venture that more than likely, the bank would then use the money or should I say Fed credit to reacquire the collateral the Fed took in for the money and the system would be somewhat restored. The big problem would be that fairly high powered money would have been absorbed from the money supply. But, the capacity of banks to make more loans would have been restored. This would be followed by the problem of who is a good credit risk.

The problem of course is something that most cannot understand, that the level of debt is beyond repayment when one considers that spending without incurring more debt would also have to occur. If we misunderstand the implications of this, we will be wrong about deflation. I don't believe we are going to be wrong. Funny thing is I don't believe Bernanke believes it either.

Matt Stiles said...


Can you add an RSS feed widget to your blog? Customize->Add a gadget->Feed

I don't think Bernanke believes it either. He's been given an impossible task and has instead tried simply to manage confidence.

mannfm11 said...

I will do so Matt. I don't have much there recently, but I am working on a description of what deflation is and why we are already in it. We have a good bit of cash and I plan on buying some gold if it gets back to $680 as Prechter says. My experience in that metal has been the 1974 top and later bottom, where it fell to the 50% level. I have been expecting a bottom in the $500 to $550 range based on technical ranges and Gann ideas, like $500 and 50% levels and 2/3 retrace. Paper isn't going to survive this one, though cash will be the last to go.

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