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Unstoppable Credit Contraction


Fed can't stop crisis with inflation.

Steve Saville wrote an interesting article entitled Credit Contraction, Economic Bust, and Deflation. Inquiring minds will want to take a look.

Members of the deflation camp assert that the large-scale contraction of credit happening within the banking system means that deflation is upon us, even if the money supply is expanding. At the same time, another camp is pointing to the breathtakingly rapid growth in M3 money supply as evidence that hyperinflation is a near-term threat. In our opinion, both camps are wrong.

The argument of the first camp can, we think, be summarized as follows: Inflation is an expansion in the total supply of money AND credit, whereas deflation is the opposite (a contraction in the total supply of money AND credit). At the present time the money supply may well be expanding, but this monetary expansion is being more than offset by credit contraction.

So far, so good. That is nearly my exact argument. The only thing I want to add is that credit needs to be marked to market, as opposed to some inflated book value.

The flaw in the above argument can best be explained via a hypothetical example. Consider the case of Johnny, who wants to borrow $1M to buy a house. If Johnny borrows the money from his friend Freddy then the transaction results in a $1M increase in the amount of credit within the economy, but no inflation has occurred. All that has happened is that $1M of purchasing power has been temporarily transferred from Freddy to Johnny. By the same token, when Johnny pays Freddy back there is a contraction of credit, but no deflation. There is also no deflation even if Johnny defaults on his loan obligation to Freddy. In this case Freddy will have made a bad investment, but the money he lent to Johnny will still be somewhere in the economy. The point is that credit expansion is not inherently inflationary and credit contraction is not inherently deflationary.

I feel the flaw in Saville's analysis is that I agree with him! The reason is that he's ignoring the word "net." When Johnny loaned his friend $1 million, money supply (savings) decreased by $1 million but credit expanded by $1 million. In Saville's example there was no "net" expansion of money (savings) or credit. As I see it, we are in "violent agreement."

But what if Johnny, instead of borrowing the million dollars from Freddy, takes out a loan at his local bank and the bank makes the loan by creating new money 'out of thin air'? In this case inflation has certainly occurred. Nobody has had to temporarily forego purchasing power in order for Johnny to gain purchasing power, but the total existing supply of money has been devalued to some extent.

Bingo! That is inflation. No argument in this corner.

The critical difference is that when Johnny borrows from a bank the transaction leads to an increase in the supply of MONEY. Inflation is the increase in the supply of money that SOMETIMES results from credit expansion; it is not credit expansion per se.

In my opinion, the critical difference is that Saville's missing the word "net," conveniently looking at credit all the time, while ignoring money supply the rest of the time.

Skipping ahead:

This leads to the question: is the money supply currently expanding? The answer is yes, but not anywhere near as rapidly as many people think. The chart here reveals that M3 has grown by a mind-boggling 19.5% over the past 12 months, but as was the case during the early 1990s it appears that this broad measure of money supply is currently giving a 'major league' FALSE signal.

I 100% agree with the notion that M3 is giving a false signal. That is the very premise behind my post MZM, M3 Show Flight to Safety.

Our preferred measures of money supply are TMS (True Money Supply) and what we call TMS+ (TMS plus Retail MMFs). TMS and TMS+ currently have year-over-year (YOY) growth rates of around 3% and 6%, respectively. In other words, our assessment is that the current US inflation (money-supply growth) rate is 3-6%. Inflation is still occurring, but at a much slower rate than it was during the early years of this decade.

I do not agree with adding MMFs to TMS as Saville does. I agree with the formulation of TMS and gave my reasons in Money Supply and Recessions.

Furthermore, and it's hard to say who's right or wrong given massive backward revisions in some Federal Reserve reporting and delays in other Fed reporting, but the latest M'/TMS numbers that I come up with (or more accurately, Bart at Now and Futures, on my formulation) are as follows.

Click to enlarge

The above chart is as of April 18, 2008 as reported in MZM, M3 Show Flight to Safety.

Presumably it's the same as TMS. If it's not, one or more data series discrepancies may be at play, and given numerous backdated changes by the Fed as well as delays in reporting sweeps, I am not going to assume which series is correct. Close analysis will show near perfect correlation over time.

Finally, and this is key: Saville has failed to mark credit to market! It is the marking to market process by which I state that deflation is here and now. Please see Deflation In A Fiat Regime? and Now Presenting: Deflation!.

On a side note, the wrongness of M3's current signal is validated by the happenings in the financial world. Inflation-fueled booms generally continue until there is a deliberated or forced slowdown in the inflation rate, that is, the booms continue until the central bank takes steps to rein-in the inflation or until inflation slows under the weight of market forces.

I agree. Those looking at MZM are barking up the same incorrect tree.

It is also worth noting that although inflation is a major driving force behind the commodity bull market, commodity prices are generally still very low in REAL terms. Therefore, while we are anticipating a commodity shakeout over the next few months we think the long-term upward trend in the commodity world has a considerable way to go.

I fail to see how this fits into the debate. Commodity prices may indeed be very low in real (CPI adjusted) terms. Exactly what does that have to do with credit contraction/expansion other than perhaps propose the next bubble may very well be in commodities? If that is indeed the point, then I agree.

In conclusion, it is clear that inflation is still occurring in the US (and pretty much everywhere else, for that matter), albeit at a reduced rate. Furthermore, if it hasn't already done so it is likely that the inflation rate will bottom-out over the coming few months and then embark on its next major upward trend. It is possible that consumers are 'tapped out' and that the commercial banks are about to reduce the rate at which they lend, but the government will never be 'tapped out' and the central bank will always be able to monetise debt.

In conclusion, I see no evidence supporting Saville's conclusion. I feel he's failed to mark credit to market, to state why credit will not contract greater than central banks' attempt to inflate, to account for global wage arbitrage, walk-aways, boomer retirement and a shift away from consumption, $500 trillion of derivatives that can never be paid back and a secular shift from consumption to saving.

I see no explanation of how consumers and businesses are going to pay back debts in a world of declining real wages, wealth concentration at the extreme high end of the spectrum, global wage arbitrage, declining home prices, rising unemployment, overcapacity at every corner, and insane overbuilding of both commercial and residential real estate.

On the other hand, my thesis is simple: The Fed can address liquidity issues not solvency issues, and we are facing a solvency issue. And because of the enormous amount of debt in relation to the pool of real savings, there is no way that debt can be paid back. Debt that cannot be paid back will be defaulted on.
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