Follow The Money

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.

Eventually, a new lending instinct in the banks gains momentum. The central issue is how to fund the early expansion of lending. It is not, as commonly supposed, by drawing down reserves from the central bank and putting them into public circulation. Other things being equal, the banks will retain those reserves as the basis for reorganising their balance sheets. Instead, they redirect their financial resources by reducing the level of government bonds held as assets on their balance sheets, substituting them for more profitable loans.

To the outside observer, there is little change in the rate of increase in the broad money supply, while bond prices fall as the banks sell them in increasing quantities.

Markets have an uncanny knack of discounting the bank selling of bonds from the earliest stages. Interest rates in America have already begun to rise, making short-term bonds, which represent most of the banks’ investments, unattractive. Yields start rising along the yield curve, and the banks who are slow to act find that they have escalating portfolio losses. Inevitably, equity markets turn tail as well, undermined by higher bond yields. Note how talk of valuations misses the point: the point is bank credit is being redirected from financial assets to satisfy traditional loan demand.

Eventually, the loan demands from non-financial SMEs become too persistent and profitable for the banks to ignore, without expanding their balance sheets.

During the expansionary cycle phase, when bond yields are rising and equities falling, business prospects for the non-financials appear much improved. As confidence builds and risk appears to diminish, banks compete to lend. Their base cost, the central bank rate paid on their reserves, is not material. Through the magic of expanding bank credit out of thin air, commercial banks, taken as a whole, can even charge interest at a lower rate than the FFR on loans deemed to be free of risk. In effect, commercial banks decouple themselves from the central banks’ control.

It is only at this stage that measures of total money, such as M2, M3 or true Austrian money supply starts expanding at an accelerating rate.

The Fed is finally forced to step in and raise the FFR sufficiently to bring monetary expansion back under control. The economy is described as “overheating”, with employment full and there are unfilled vacancies. Price inflation will have picked up, and supply bottlenecks appear. Expansion rapidly turns into crisis.

The Crisis Develops

It should be obvious that as interest rates are raised sufficiently to bring demand for credit under control, companies overloaded with debt are the first to fail. A rash of minor failures is enough to change business attitudes. Suppliers tighten up on credit policies with their customers, and banks become cautious. Those relying on debt finance find facilities are withdrawn, insolvency beckons and failures accelerate.

All that’s needed to trigger the crash is a rise in interest rates to slow the expansion of credit. It is a feature of monetary policy that randomness, the principal characteristic of a sound money, free-market economy, is destroyed by credit expansion. Instead of businesses succeeding and failing all the time as individual businessmen continually reallocate capital to where it is most profitably employed, they are motivated instead by the availability of cheap credit. The recovery phase of the cycle sees unprofitable businesses prevented from failing. While central banks profess to use monetary policy as a tool to maintain consumer confidence, they end up bunching all the failures into one great crash.

This Time Could Be A Little Different

We are not at the crisis stage yet, but perhaps at the start of the expansion phase. The dividing line between recovery and expansion is always fuzzy. Insofar as we can judge, Japan, the Eurozone and Britain may be entering the expansionary phase. America is still debateable. The banks everywhere still appear to be cautious with respect to lending to SMEs, though it could be beginning to change.

Unemployment levels in most countries have fallen significantly, even allowing for self-serving government statistics. But wage levels for skilled labour are yet to rise, indicating investment in new production is still in its early stages. Statistics, such as industrial production and consumer demand, are still mixed. However, prices of key commodities, such as copper, have been persistently strong of late, indicating that some improvement in conditions globally is beginning to take place.

Admittedly, demand for raw materials is mostly being driven by China’s mercantilist policies, but we must not overlook the recovery in demand from other sources, particularly the Eurozone, Japan and to the surprise of the Remainers, Britain. This is reflected in stronger currency rates against the dollar, the economic signals for America being less bullish. Furthermore, President Trump is adding to economic uncertainty with his isolationist approach to trade and with his political disposition in general.

So, the rest of the advanced world appears to be moving from recovery into expansion, but America remains stuck in the mire. China and other Asian countries are already expanding. China is a special case, being a mercantilist command economy, but India, Indonesia et al, have been in the expansion phase for some time. Dubai is a good marker for the Middle East, with an extreme building and construction boom that has no memory of the dramatic collapse in 2009, when it was bailed out by Abu Dhabi. It is overdue for the next crisis.

While many emerging economies are generally ahead of the advanced countries in the cycle, it is likely that Europe, Britain and Japan are just moving into expansion. The great opportunity, from which America is excluded, is the development of new markets in Asia, led by joint Chinese and Russian initiatives. The EU, led by Germany, is distancing itself from American sanctions against Russia, with an eye on trade opportunities to its east. Brexit is forcing the UK towards free trade, which is a great business stimulant. And Japan, with most of her industrial investments in mainland Asia, is benefiting too.

These economies are now set to expand, a phase that will end when interest rates are raised to a level sufficient to crash them once more. America, burdened with the accumulation of debt and attitudes to trade that excludes it from much of the expansion elsewhere, might hardly participate in the global expansion phase at all, before being undermined by the next credit crisis.

A weakening dollar is a consequence of these developments. For a world expanding without America, there are too many dollars abroad. Far better to dispose of them for a currency that can be invested in an expanding economy.

Instead of economic expansion, a persistently weak currency is enough to undermine the American bond market bubble. Rising commodity prices expressed in dollars, driven by both a weak currency and Eurasian expansion, inevitably results in American stagflation. The Fed, at some stage, will still have to raise interest rates sufficiently to trigger a credit crisis, even if America never gets the benefit of the expansion phase of the credit cycle.

Quite possibly, falling bond prices will do for the Europeans first because their banks remain highly geared. Presumably the ECB will step in. However, eventually we will have the crash, and embark on the next credit cycle, which is bound to be different from the current one. The constant is always monetary policy. Central banks will again expand the quantity of base money to prevent the destruction of credit. Perhaps they might succeed. Eventually, the dollar and the currencies tied to it will be destroyed by a combination of monetary inflation and loss of confidence. But that’s a story for the next credit crisis when it is upon us.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

MOBILE: +44 7790 419403