There is a saying that it is better to remain silent and be thought a fool than to speak out and remove all doubt. Today, the San Fran Fed's John Williams, and by proxy the Federal Reserve in general, spoke out, and once again removed all doubt that they have no idea how modern money and inflation interact. In a speech titled, appropriately enough, "Monetary Policy, Money, and Inflation", essentially made the case that this time is different and that no matter how much printing the Fed engages in, there will be no inflation. To wit: "In a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid. Over the past four years, the Federal Reserve has more than tripled the monetary base, a key determinant of money supply. Some commentators have sounded an alarm that this massive expansion of the monetary base will inexorably lead to high inflation, à la Friedman.Despite these dire predictions, inflation in the United States has been the dog that didn’t bark." He then proceeds to add some pretty (if completely irrelevant) charts of the money multipliers which as we all know have plummeted and concludes by saying "Recent developments make a compelling case that traditional textbook views of the connections between monetary policy, money, and inflation are outdated and need to be revised." And actually, he is correct: the way most people approach monetary policy is 100% wrong. The problem is that the Fed is the biggest culprit, and while others merely conceive of gibberish in the form of three letter economic theories, which usually has the words Modern, or Revised (and why note Super or Turbo), to make them sound more credible, they ultimately harm nobody. The Fed's power to impair, however, is endless, and as such it bears analyzing just how and why the Fed is absolutely wrong.
First, here is our rule of thumb to determine if someone who talks about money, inflation or monetary policy has even a vague clue of what they are talking about: do a text search for the words: repo, shadow banking, collateral, collateral-chains, rehypothecation, or deposit-free money creation. If not one of those terms appears anywhere, feel free to toss the reading material right into the trash.
The reason for this is that as we will not tire of explaining, conventional monetary theory, as it existed 50, 40 or even 30 years ago changed totally and irrevocably with the advent of shadow banking: financial bank transformation (Maturity, Credit and Liquidity) intermediaries unfunded by deposits, and whose liabilities exist in state of Schrodingerian "moneyness" limbo, as unlike banks they have no [insert term here]-to-deposit ratios of any kinds. As such the liabilities backing the assets shadow banks create out of thin air has the same practical reality as a wave function: the money is there, as long as it is not observed. Any process of observation of what is really beneath the surface leads to an eventual collapse of the Shadow Banking wave function, and with it the credit money that it sustains. As frequent readers will know this is a sizable amount: as of last chick it was just under $15 trillion or just over the total conventional liabilities in circulation!
What is amusing and at the same time tragic is that as the chart above shows, the reason why virtually nobody talks about shadow banking, and not one coherent monetary theory exists to account for its is simple: shadow banking as a relevant phenomenon only appeared in the 1980s and then exploded, hitting a peak of over $20 trillion in liabilities. As such when the bulk of "modern" monetary theories were conceived it was not a factor. Now... it is, and accounts for more than half of the credit money in circulation.
In other words, an appropriate analogy to what happens when virtually anyone defines or tries to explain monetary policy, having been taught using conventional theory, is the same as attempting to understand how an iPod works using the instruction manual for a 19th century record player.
And still they do.
Here is what is happening explained as simply as possible, and paraphrasing what we said last week:
- The reason inflation has not exploded yet, dear Mr. Williams, is that even as the Fed is pumping trillions of reserves into conventional financial intermediaries, shadow banking is continuing to implode at a pace of nearly $100 billion per quarter.
- The continued implosion of shadow banking liabilities is why the Fed will have no choice but to continue stepping in and providing reserves which in turn merely plug a deleveraging hole created as more and more market participants realize the only players left in "capital markets" are central banks, creating a feedback loop, whereby more CB intervention leads to more private capital outflows and so on.
- The disappearance of shadow liabilities which are deposit-free, and thus not a cause of inflationary concern, means their replacement will naturally have to come courtesy of deposit-backed conventional money replacements.
- As deposits soar from their current level of $10 trillion to $20 trillion and so on, as more and more money is printed by the Fed, the threat of hyperinflation becomes all too real, as all shadow banking has done for the past 30 years is merely to buffer the inflationary threat! (a bullet point that none of our endgame: deflation friends seem to grasp)
- Finally, the offset to any actual deflation in the real world, even by the Fed's broken comprehension of modern money creation and monetary pathways is one: CTRL-P. And believe us: puhing CTRL-P takes no effort at all. In fact, the more the 'deflation' out there, the more the CTRL-P pressing. Until one day, hyperinflation, which has always been a phenomenon of terminal loss of confidence in a currency, is the inevitable answer.
And there you have it: this is what Mr. Williams should have discussed when he explained how this time monetary theory is different. He didn't, not because he doesn't get it: we are confident he does, but because he understands that if people begin discussing the real swan in the box, then a light-bulb may go off above the head of some more reputable economist somewhere, and at that point the Fed's little game will be exposed by even the "respected"establishment.
Which is why it won't happen.
Luckily, for those who wish to learn more not less, serendipity will have it that none of than that sole expert on how true modern money creation works, the IMF's Manmohan Singh, has released a key article on VOX just today, which is incalculably more relevant and valuable than any garbage spewed forth by the Fed. The article, is titled, appropriately enough: "The (other) deleveraging: What economists need to know about the modern money creation process." It doesn't explain everything, but at least it attempts to bridge those aspect of shadow money creation that few if anyone dares to speak about in formal circles and among serious people with Ph.Ds, and even Nobel prizes in Economics and Peace.
The (other) deleveraging: What economists need to know about the modern money creation process
Manmohan Singh, Peter Stella, 2 Jul 2012
The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.
One of the financial system’s chief roles is to provide credit for worthy investments. Some very deep changes are happening to this system – changes that surprisingly few people are aware of. This column presents a quick sketch of the modern credit creation and then discusses the deep changes are that are affecting it – what we call the ‘other deleveraging’.
Modern credit creation without central bank reserves
In the simple textbook view, savers deposit their money with banks and banks make loans to investors (Mankiw 2010). The textbook view, however, is no longer a sufficient description of the credit creation process. A great deal of credit is created through so-called ‘collateral chains’.
We start from two principles: credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder. Here is an example.
A Hong Kong hedge fund may get financing from UBS secured by collateral pledged to the UBS bank’s UK affiliate – say, Indonesian bonds. Naturally, there will be a haircut on the pledged collateral (i.e. each borrower, the hedge fund in this example, will have to pledge more than $1 of collateral for each $1 of credit).
These bonds are ‘pledged collateral’ as far as UBS is concerned and under modern legal practices, they can be ‘re-used’. This is the part that may strike non-specialists as novel; collateral that backs one loan can in turn be used as collateral against further loans, so the same underlying asset ends up as securing loans worth multiples of its value. Of course the re-pledging cannot go on forever as haircuts progressively reduce the credit-raising potential of the underlying asset, but ultimately, several lenders are counting on the underlying assets as backup in case things go wrong.
To take an example of re-pledging, there may be demand for the Indonesia bonds from a pension fund in Chile. As since these credit-for-collateral deals are intermediated by the large global banks, the demand and supply can meet only if UBS trusts the Chilean pension fund’s global bank, say Santander as a reliable counterparty till the tenor of the onward pledge.
Plainly this re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, i.e. the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the Indonesian bonds are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.
To get an idea on magnitudes, at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral; since this is pledged for credit, the volume of pledged assets is a good measure of the private credit creation. For the same period, the primary source collateral (from hedge funds and custodians on behalf of their clients) that was intermediated by the same banks was about $3.4 trillion. So the ratio (or re-use rate of collateral) was around 3 times as of end-2007. For comparison to the $10 trillion figure, the US M2 was about $7 trillion in 2007, so this credit-creation-via-collateral-chains is a major source of credit in today’s financial system. Figure 1 shows the amounts for big banks in the US and Europe.
Figure 1. Pledged collateral that can be re-used with large European and US banks
As this process is unfamiliar to many non-specialists, consider another example. Figure 2 illustrates how a piece of collateral (e.g., US Treasury bond) may be used by a hedge fund to get financing from a prime-broker (say, Goldman Sachs). The same collateral may be used by Goldman to pay Credit Suisse on an OTC derivative position where Goldman was ‘out-of-the-money’ to Credit Suisse. And then Credit Suisse may finally pass the US Treasury bond to a money market fund that will hold it for a short tenor (or till maturity). Notice that the same Treasury bond has been used twice three times as collateral for extensions of credit – from the original hedge-fund owner to the money market fund.
Figure 2. An example of a collateral chain
The other deleveraging
Comparing private and traditional money creation, a critical difference is that private credit creation turns on banks’ trust of each other. New credit gets created only if the onward pledging occurs and this depends, for example, on UBS’s trust in Santander as a counterparty in the first example. Due to heightened counterparty risk, onward pledging may not occur and the collateral thus remains idle in the sense that it creates no extra credit.
To put it differently, a key difference between the trade and pledge-collateral credit creation processes is the role of governments. The traditional textbook money multiplier is based on insured deposits and thus largely a creature of government regulation and the central bank’s lender of last resort assurance. The collateral multiplier is very much a creature of the market.1 The multiplier – which essentially measures how efficient illiquid assets can be converted into liquid collateral and thus credit – varies with the extent to which markets views a given asset classes as ‘liquid’ in normal and stressed markets.
This brings us to the key policy point. The ‘other’ deleveraging. In this new private-money-creation process, there are three distinct ways of reducing credit.
- Increase the haircut (like raising the reserve requirement);
- Reduce the supply of assets that can be used for pledging; and
- Reduce the re-pledging of pledged collateral (shortening the collateral chain).
Most recent research has focused on the first. Balance sheet shrinkage due to ‘price declines’ (i.e., increased haircuts) has been studied extensively – including the recent April 2012 Global Financial Stability Report of the IMF and the European Banking Association recapitalisation study (2011).
In this column we raise the flag on the second and (more importantly) the third way. When market tensions rise – especially when the health of banks comes under a shadow – holders of pledged collateral may not want to onward pledge to other banks.
- With fewer trusted counterparties in the market owing to elevated counterparty risk, this leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging.
- In practical terms, the ratio of pledged-collateral (which is a measure of the credit thus created) to underlying assets falls as this onward pledging, or interconnectedness, of the banking system shrinks.
This ratio decreased from about 3 to about 2.4 as of end 2010 – largely due to heightened counterparty risk within the financial system in the present environment. These figures are not rebounding as per end 2011 financial statements of banks – see Table 1 and Figure 1. Indeed, anecdotal evidence suggests even more collateral constraints recently.
Table 1. Sources of pledged collateral, re-use and overall collateral
Source: Velocity of Pledged Collateral – update, Singh (2011)
Consequences of the other deleveraging: The cost of credit
Reduced market interconnectedness, or the trend toward ‘fortress’ balance sheets, may be viewed positively from a financial stability perspective if one simply views each institution in isolation. However, the vulnerabilities that have resulted from the weakened fabric of the market may yet to have become fully evident. Since the end of 2007, the loss in collateral flow is estimated at $4-$5 trillion, stemming from both shorter collateral chains and increased ‘idle’ collateral due to institutional ring-fencing; the knock-on impact is higher credit costs for the economy.
Relative to mid-2007, the primary indices that measure aggregate borrowing cost (e.g., BBB index) are well over 2.5 times in the US and 4 times in the Eurozone. This is after adjusting for the central bank rate cuts, which have lowered the total cost of borrowing for similar corporates (e.g., in the US, from about 6% in 2006 to about 4% at present). Figure 3 shows that for the past three decades, the cost of borrowing for financials has been below that for non-financials; however this has changed post-Lehman. Since much of the real economy resorts to banks to borrow (aside from the large industrials), the higher borrowing cost for banks is then passed on the real economy.
Figure 3. Post-Lehman, borrowing cost for financials are higher than non-financials
Source: Barclays Intermediate, investment grade spreads (1983-2012)
Collateral and monetary policy
Since cross-border funding is important for large banks, the state of the global pledged collateral market may need to be considered when setting monetary policy.
Overall financial lubrication in the US, UK, and the Eurozone, exceeded $30 trillion before Lehman’s bankruptcy (of which 1/3rd came via pledged collateral). Certain central bank actions, such as the ECB’s LTRO, the US Federal Reserve’s qualitative easing and the Bank of England’s asset purchase facility have been effective in alleviating collateral constraints. However, these ‘conventional’ actions, to the extent they merely exchange bank reserves for collateral of prime standing (such as US Treasuries), do not address the issue credit creation via collateral re-pledging (Singh and Stella 2012).
The ‘kinks’ in the red line (Figure 4) M2 expansion due to QE but much of the ‘easing’ for good collateral is deposited with the central banks and is not available to fund lending. As of end-2011, the overall financial lubrication is back over $30 trillion but the ‘mix’ is in favour of money which not only has lower re-use than pledged collateral but much of it ‘sits’ in central banks.
Figure 4. Overall financial lubrication – M2 and pledged collateral
As the ‘other’ deleveraging continues, the financial system remains short of high-grade collateral that can be re-pledged. Recent official sector efforts such as ECB’s ‘flexibility’ (and the ELA programs of national central banks in the Eurozone) in accepting ‘bad’ collateral attempts to keep the good/bad collateral ratio in the market higher than otherwise. But, if such moves become part of the central banker’s standard toolkit, the fiscal aspects and risks associated with such policies cannot be ignored. By so doing, the central banks have interposed themselves as risk-taking intermediaries with the potential to bring significant unintended consequences.
Authors' note: Views expressed are of the authors only and not of the International Monetary Fund.
Copeland, A, A Martin, and M Walker (2010), “The Tri-party Repo Market Before the 2010 Reforms”, Federal Reserve Bank of New York Staff Report No. 477.
EBA (2011), 2011 EU-wide stress test results.
IMF (2012), Global Financial Stability Report, April.
Mankiw, Greg (2010), Macroeconomics, Worth Publishers; Seventh Edition. Shin, Hyun. S (2009), “Collateral Shortage and Debt Capacity” (unpublished note).
Singh, Manmohan (2011), “Velocity of Pledged Collateral – Analysis and Implications”, IMF Working Paper 11/256.
Singh, Manmohan and Peter Stella (2012), “Money and Collateral”, IMF Working Paper No. 12/95