More Bank Hoarding as Velocity of Money Slows
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:
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:
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.The Mandrake Mechanism is the method of which the fed creates money out of nothing, to convert debt into money.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.
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!
Comments (13)
so basically we are fucked?
Posted by paul.b | January 27, 2009 11:04 AM
Actually, the chart you show understates the actual decline in velocity.
Why? Because it does not include the "shadow banking system". If it did, you would see the multiplier skyrocket from 2000 to 2007. So, the actual decline in the "overall" multiplier is much more precipitous than in the chart.
The next question is: will that "overall" multiplier return to historical levels, even if banks start lending. Maybe we should call it the "shadow multiplier".
I would argue that greater regulation (of hedge funds, CDS markets, asset securitizations, ratings, etc.) as well a prolonged aversion to risk will keep this "overall multiplier" depressed for a very long time as compared to 2000-2008, possibly as long as this generation is alive. That's even if we see a bump in the M1 multiplier.
Posted by faustus | January 27, 2009 11:31 AM
Noah....you're being too conservative! Assuming a leverage ratio of 10:1 is nothing. Our major financial institutions are levered well in excess of 30:1 (and perhaps 300:1 when tangible common equity is properly calculated!)
See the web page listed with this comment.
The deeper down the rabbit hole you go, the scarier it gets...
Posted by RW | January 27, 2009 12:34 PM
I find it interesting that money velocity seems to be on a long term downtrend since the mid-80s. It is reasonable to assume this is invertly correlated to the leverage of economic actors balance sheets during the period. Still, the US government became a huge net borrower starting around 82-83. Household in the US did not become net borrower until 98-99 and corporate have had very positive cash balances for most of the 2000s. Still the trend in Money Velocity is down year after year with a rate of decline that seems constant. My unch is this kind of graph is really hard to extrapolate but it does provide an interesting case in point for the current deflationary environment.
Posted by flojo | January 27, 2009 12:37 PM
faustus - hmmm, interesting thought. The destruction of the shadow banking system is so great, happening at lightening speed, that the multiplier effect is plunging more than the chart shows?
Did I get this idea right?
You know, I think we will see the plunge continue for a while longer, but then I think we will see a SPIKE HIGHER, albeit NOT to the point where the original plunge began! At that point, I would expect precious metals to go parabolic?
Thoughts?
And also, I tried to get the ratio from M1 and the Adjusted monetary base to see if it equals under 1, and am I crazy, but it doesnt seem to add up?
Posted by Office - Noah | January 27, 2009 8:32 PM
RW - where would you say they are levered right now? I gotta believe they are on the way down to 10:1 to 12:1 as required by commercial bank holding company regulation to gain access to federal rescue/tarp funds?
Can you do another post on that exact same chart to see the comparison? That would be very interesting if the data is available!!
Thanks
Posted by Office - Noah | January 27, 2009 8:38 PM
Noah - Here's we're I'm coming from. Would like to know what you think.
My issue with the multiplier chart above is that it shows a DECLINING multiplier from 2001 to 2008. But, intuitively, we know that the real economic situation was one of phenomenal monetary velocity during this period. So, this leads me to conclude that the multiplier chart above is not fully representative of the velocity of money, at least not in a way that's meaningful from an analytical standpoint.
So what other measurements/charts should we look at? I'm not entirely sure myself, but I'm pretty confident that the chart above misses the major drivers/measures of "velocity". My suspicion (although I'm not sure how we measure this) is that velocity needs to incorporate in some regard the shadow banking system, securitizations and derivative instruments. I still need to think this through, though.
In any event, it gets back to a pretty fundamental question, which is "What was real monetary power at the peak of the bubble, inclusive of credit, the value of derivative instruments and securitizations?" and then "what multiplier will yield the same monetary power, in the absence of these same securitizations and with significantly diminished derivatives markets?"
That's as much as I can get my head around it after a very heavy steak dinner, a half a bottle of wine and a glass of port.
Posted by faustus | January 27, 2009 10:57 PM
I believe the cause and effect is reversed. Part of the reason the multiplier dropped so much recently is BECAUSE the monetary base was increased dramatically. When you have LOTS of money but the same amount of activity, it takes longer for the money to cycle through all the way. Hence the instant drop in velocity.
Now, once the economy picks up and banks begin to flood the system with credit...well, what WILL happen when people notice that we have twice as much money floating around as before? That'll be interesting!
Posted by Chester | January 28, 2009 2:48 AM
Isn't velocity simply dropping because a big portion of the monetary base in now parked into T-Bonds (not moving...)?
Posted by Anonymous | January 28, 2009 5:44 AM
Ultimately all fiat based money systems are subject to the blind trust and confidence in the government that issues said currency. Arguably the US system although not perfect is the best and most resilient economic and social system on the planet. Until that changes our government will successfully print/inflate its way out of this mess.
Posted by downtobasics | January 28, 2009 4:19 PM
downtobasics - true, I dont see the US dollar ceasing to exist, but destruction may come and major debasement and commodity/metals inflation may arise from it first. I still dont think people get the whole picture, and I certainly dont. I just think this mess is way deeper than most like to admit
Posted by Office - Noah | January 28, 2009 5:42 PM
As far as I can tell, the writer of this article is either joking or has no grasp of some very basic monetary concepts. The reason he has a hard time wrapping his head around some of the things he types is because they are incorrect. If this is not a joke, please be more responsible in your fact and data collection, and then your dissemination of such. This type of dreck being taken as fact drives a lot of bad decisions and self rationalizations of bad monetary behavior.
Posted by Heather | March 19, 2009 12:34 AM
So what other measurements/charts should we look at? I'm not entirely sure myself, but I'm pretty confident that the chart above misses the major drivers/measures of "velocity". My suspicion (although I'm not sure how we measure this) is that velocity needs to incorporate in some regard the shadow banking system, securitizations and derivative instruments. I still need to think this through, though.
Posted by Bactrim | October 31, 2009 6:46 AM