The Economic Consequences Of Bank Credit Contraction

As well as financing escalating government deficits, central banks face an additional problem of replacing contracting bank credit to the non-financial private sector if a slump is to be avoided. The problem comes at the worst possible time in the bank credit cycle, with commercial banks’ balance sheets as highly leveraged as they have ever been. Banks are already reducing their credit allocations to the non-financial private sector. Yet, as this article points out, it is virtually impossible for central banks to persuade commercial banks to increase their financing of genuine production. This is because they must protect themselves from increasing bankruptcies as pandemic-related support is withdrawn at a time of maximum balance sheet gearing.

The withdrawal of bank credit when post-lockdown consumer demand is unleashed will hamper the production and supply of goods to consumers, driving up high street prices which are already subject to rising commodity prices and other costs. Further monetary inflation will only make the problem worse as the purchasing power of fiat currencies is undermined. But for central banks and governments expanding the quantity of money is the only recourse they have left if they are to defer a full-scale slump.

Introduction

Everywhere, the story is of a sharp economic recovery following the end of lockdowns. The tide of unspent stimulus is expected to flood all major western economies when normal business resumes. 

Furthermore, governments and central banks are going to continue stimulating us back towards economic health. The most extreme version is President Biden’s plans, involving a $1.9 trillion covid relief plan, a $1.8 trillion American Families Plan and a further $2.3 trillion infrastructure plan so far. That’s $6 trillion additional spending to normal mandated spending of about $4 trillion annually on a tax base of only $3.5 trillion. Biden says he will tax the rich to pay for some of it. That has never raised much additional revenue in the past, so it is reasonable to assume it will be all borrowed — nearly all involving inflated dollars.

Other advanced economies are following a similar, if less egregious path. Measuring it all will be GDP, certain to rise substantially later this year. “Growth” will be back. This column has frequently warned readers not to be misled by GDP, which is simply a money total. With all the monetary stimulus everywhere, money totals will obviously increase substantially, rendering the term “growth” in the true economic sense meaningless. If GDP had been invented in the 1920s, the European bloc comprising Germany, Austria, Hungary and Poland would have demonstrated spectacular growth, and a contemporary CPI would have seen “real GDP” more than doubling — even quadrupling or more. A post-WW1 economic miracle would be declared, though the reality was sadly very different. 

That’s the problem with macroeconomics and its statistics. It’s a non-science, which in GDP describes an evenly rotating economy, confusing an economy which is assumed to be unchanging with a dynamic one that advances the human condition. GDP matters to governments because it quantifies their revenue base, which justifies its statist popularity, but it is useless for independent forecasters. Instead, a rationalist approach to economics, understanding that economic laws exist and that they are aprioristic, is the only way to understand the current condition and the dangers from total inflationism. 

The analysis spewing out of investment banks and investment management operations, being entirely macroeconomic, is flawed for these and other reasons and must be ignored in the diligent search for economic and monetary outcomes. It deflects from the real problems: the underlying factors which determine life after the lockdowns end, and the role of banks supplying credit.

Life after lockdowns

When lockdowns end, we can expect those who have accumulated unspent funds will be likely to reduce their cash balances to their more customary levels. But the ending of lockdowns is not a black and white issue. Some countries and regions will emerge later. Others, notably India, are still seeing tragic surges in covid-19. Others in the underdeveloped world are unreported. Many countries are likely to have new travel restrictions imposed upon them, and there is no guarantee that countries that have been slow to roll out vaccinations will not see new waves of new variants. 

We also know that individuals whose bank balances have increased in lockdowns are predominantly members of the middle classes, the cohort which has access to mortgage and consumer finance. And it is its members who are buying houses in the country, building extensions, buying yachts and recreational vehicles. They are the target for advertisers, and the mainstay of the mainstream media. With this readership informing it, the MSM trumpets the recovery prospects. Ignored are the low paid, dependent on government support, having either lost their jobs or likely to do so as the pandemic drags on. Before the pandemic, it was frequently reported that some 70% of Americans and Brits on salaries lived from paycheck to paycheck, representing a threatening black hole for the post-lockdown economy.

With supply chains still in chaos, it is unlikely that goods and to a lesser extent services will be able to supply the predicted unleashed demand. Today, motor manufacturers are being forced to suspend production due to microchip shortages. Manufacturers of all goods and assemblers of components are similarly threatened with supply dislocations. Containers are wrongly positioned to deal with any surge in consumer demand and some industry experts think global logistics won’t be sorted out before the year-end. 

Prices in the high street are already rising more rapidly than before. 

Probably the most important issue dismissed by macroeconomists is the state of the bank credit cycle, which combined with increased trade tariffs against China rhymes with the global economy when it faced similar conditions to those that collapsed Wall Street between 1929-1932. More recently, the US banking system visibly ran out of balance sheet space in September 2019, signalled by a crisis in the repo market. Shortly afterwards from February 2020, liquidity constraints crashed the US stock market, echoing the September-October 1929 phase ninety years before. Figure 1 shows that cycle compared with today, the difference being that in the earlier cycle prices were in gold through the dollar at $20.67 to the ounce, while today’s dollars are pure fiat. 

Ninety years ago, the fiat excesses of bank credit expansion coupled with tariffs increased by the Smoot-Hawley Tariff Act ended up collapsing prices of everything from stocks to commodities. It was that experience that led a raft of economists to conclude that it was the collapse in prices that was the problem, ignoring the obvious fact that it was the consequence of earlier credit excesses coupled with trade tariffs. The subsequent developments of statistics, mathematical economics and macroeconomics in the pre-war years then led to a process of demonetisation of gold to be replaced with pure fiat state-issued currencies.

The monthly addition of $120bn of inflationary QE announced on 20 March 2020 accounts for and explains why the Dow index resumed its rise instead of continuing to follow the 1929-32 pattern. QE is an injection of cash into pension funds and insurance funds, to be spent on risky assets, mostly higher-yielding corporate debt and equities. 

This is a deliberate central bank policy in the belief that a rising stock market bolsters economic confidence, while dismissing the long run consequences. While it has worked so far and has encouraged a continuing bullish outlook, it conceals the underlying situation of a dangerously overvalued stock market at a time when the economic outlook is deteriorating. The fiat bubble is not just restricted to the stock markets. Figure 2 illustrates how a range of prices for different assets have risen since the widespread sell-off into March 2020, when the Fed reduced its fund rate to zero and announced QE of $120bn every month. Prior to that event, prices of all these assets, other than currencies, had fallen. 

Since then, cryptocurrencies have performed spectacularly, followed by commodities and equities. The new version of M2 money supply (M2SL) has increased by 22.8%, sparking far larger price rises in those three former categories, while the dollar lost 11% on its trade-weighted index against other currencies.

We can see that if we are entering a contractionary stage of the bank credit cycle, then any economic recovery will be statistical and not real, because the capital will not be available to finance the pick-up in production. Taking into account the three factors of a narrow base of professional classes drawing down accumulated bank balances, supply chain disruption, and the effects of price inflation on commodities and other costs, economic outcomes may look different from ninety years ago, but the only true difference will be in the money. 

Bank credit is indeed contracting. Conventionally, there are two sources of increased money supply, central bank originated money and bank credit. Historically, the quantity of broad money, which includes the deposit side of bank credit, has been about ten times central bank base money. Following the Lehman failure, when central banks expanded their balance sheets through quantitative easing, this relationship changed due to the excess reserves created. Today in the US the ratio is down to less than four times and still falling. 

Following Lehman’s failure, which marked the beginning of the last downturn in the bank credit cycle, bank credit initially rose but then fell into 2010 as the economy took a hit and outstanding bank lending to the non-financial sector contracted by $731bn, or 10.5%. An initial rise can be explained by a banker’s first reaction to an unexpected crisis, which is to believe it will quickly pass, while immediate demands for credit increase due to the shock and should be supported. 

This time, bank credit and lending to the non-financial sector initially rose as it did in 2009, but since then, it has declined by a little over $500bn as shown in Figure 3. The scale of bank lending is larger than it was following the Lehman crisis by 64%, and the scale of economic problems in the non-financial economy are far greater today. Thus, compared with the past and even without a banking crisis, the withdrawal of bank credit from the productive economy appears to have only just started and has much further to go. We must be forewarned that a combination of increased inflationary financing and state guarantees, inevitably supporting mainly zombie corporations, will have to be accelerated to compensate for the tendency of bank credit to continue to contract and if a debt-deflation slump is to be avoided.

Instead of lending money to risky non-financial customers, in the last year bank balance sheets have been increasingly redeployed into low-risk government and agency debt. This is most notable in the large banks, for which only 61% of their balance sheets are now exposed to non-financials, which compares with 71% in October 2010 at the height of the post-crisis recession. The phrase used for this condition in the 1970s was that the economy was being “crowded out”, with business investment and economic recovery hampered by the monetary demands of government. This time it is government plus a speculating, highly effervescent financial sector doing the crowding out. 

Similarly, we find that bank credit in the UK is slowing. This is shown in Figure 4. The UK economy shares many of the US’s Anglo-Saxon traits and some of its regulatory features. The relative size of the UK’s inflationary support for its economy during the pandemic has been less than that of the US. But with an average balance sheet gearing at 16.8 times for the UK’s three global systemically important banks, the potential contraction of bank credit is far greater than that for the US, whose seven G-SIBs average 11 times.

*********