More Bank Hoarding as Velocity of Money Slows

Posted by urbandigs

Tue Jan 27th, 2009 10:11 AM

A: Watching these St. Louis Fed charts come out is like seeing the scope of this credit crisis right in front of you. Its nutz! On one hand, we can see just how much the banks are keeping on hand as excess reserves (bank reserves in excess of the reserve requirement) that are not being lent out, while on the other we see the M1 multiplier plunge below 1.0! The M1 Multiplier # is officially defined as the ratio between M1 and the adjusted monetary base. But more importantly, the multiplier tells us just how fast the money is moving through the economic system! To see it plunge the way it is, tells me that money is not changing hands as much as it was, is not being multiplied as it was designed to do under a fractional reserve banking system where only 10% is required to held in reserve, and is a sign that credit is contracting! Relating this to a high end housing market like Manhattan, this is not an ingredient for calling any type of bottom.

From RGE Monitor:

Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 percent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode.
Use caution when interpreting that last sentence! Sure, we can see the money supply and prices explode, and that is one reason why I owned gold since the beginning of this crisis, but unless we see wage inflation, positive wealth effect, a strong jobs market, a fixed credit system, and confidence in housing as an asset class of choice again, chances are likely that any price explosion in the near future will be limited to commodities and precious metals; NOT housing.

Lets take a look at the M1 Multiplier's plunge below zero, via the St. Louis Fed data:

m1-mult-fed.jpg

Quite a chart, huh? Now I know what you are saying, what the heck does a chart like this have to do with Manhattan real estate? Well, directly, it has nothing to do with Manhattan real estate; but indirectly and in my opinion, it is a sign of the deflationary pressures that we are currently facing. Fourteen months ago you might have asked what the heck the ABX Index plunge had to do with Manhattan real estate; well, now you know the effect that subprime had on our banking system and overall debt markets. It had EVERYTHING to do with our market, albeit at a lag.

Back to the topic. Banks are hoarding cash in excess reserves because their balance sheets are a mess, their toxic assets are marked at levels way above previous price discovery, they will be forced to raise more capital in an environment where issuing common stock is not an option, the economy is neck deep in the deepest recession in decades, and credit quality of borrowers is deteriorating. Want to see it? Here you go, via the St. Louis Fed data:

excess-reserves-fed.jpg

For a more detailed discussion of excess reserves, read Jeff's piece, "Excess Reserves Go Berserk As Lending Flatlines".

In a fractional reserve banking system, a system that Mish all too often blames as a key role in the current debt-deflation mess, money is multiplied each and every time it is borrowed and then deposited again! It's quite amazing to learn about the physics of our monetary system.

For example, did you know that if ALL DEBTS WERE REPAID, THERE WOULD BE ZERO MONEY LEFT IN THE WORLD? If you pay down your full debt, and pay down your full principal, you are taking money OUT of the system; which only new loans can replace. An extraordinary thought to grasp, and I too am having trouble grasping this concept. This is why we MUST let the system DEFAULT on their debts, via a comment string at Seeking Alpha that seems to hit the nail on the head:
The trouble with our system, which is used everywhere in the world today, is that there is no external source of non-debt money that can be left circulating in the economy when debts are being rapidly paid down. Rapid debt paydown is rapid circulating money supply contraction, as borrowers take money out of the economy to repay principal, which destroys that money. Only new loans can put that money back into the system.

Bank loan defaults help, because the person who defaults has already paid the loan money to someone else to buy a house or a vacation, and the person who 'earned' the money from the defaulting borrower does not have to pay the money back. This leaves 'owned' money in the system, but at the price of bankruptcies and destroyed creditworthiness.
The Mandrake Mechanism is the method of which the fed creates money out of nothing, to convert debt into money.
It's just that simple. First, the Fed takes all the government bonds which the public does not buy and writes a check to Congress in exchange for them. (It acquires other debt obligations as well, but government bonds comprise most of its inventory.) There is no money to back up this check. These fiat dollars are created on the spot for that purpose. By calling those bonds "reserves," the Fed then uses them as the base for creating nine (9) additional dollars for every dollar created for the bonds themselves. The money created for the bonds is spent by the government, whereas the money created on top of those bonds is the source of all the bank loans made to the nation's businesses and individuals. The result of this process is the same as creating money on a printing press, but the illusion is based on an accounting trick rather than a printing trick.
Craziness. To simplify this point, let me ask you a quick question:

Q: IF YOU ARE GRANTED A LOAN OF $10,000 TO BUY A USED CAR, AND YOU PAY THIS MONEY TO AN INDIVIDUAL WHO THEN DEPOSITS THE MONEY IN THEIR BANK, AND THE SYSTEM REPEATS TO ITS THEORETICAL MAX, HOW MUCH MONEY IS CREATED FROM THE ORIGINAL LOAN OF $10,000?

A: $100,000 of new money can be created (10,000/10% reserve requirement)

This is the way our fractional reserve system is designed, to expand the money supply by re-lending out deposits above the reserve requirement. A pyramid built on debt. But in this case, the pyramid seems to be inverted and the system is now collapsing on itself. Between trillions of destroyed shadow banking system wealth, nationalizations, write-downs after write-downs, credit contraction, asset selloffs, auction failures, ponzi schemes, CDS blowouts, fed facilities, rescue packages, slowing velocity of money, hoarding of reserves, etc., call it a Kondratieff Winter!

kondratieff-winter.jpg

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