Ambrose Evans-Pritchard in “Monetarists warn of crunch across Atlantic economies” in the Telegraph points to a troubling development: a fall over last few months in M1 and M2 in the US, UK and EU.
Many have criticized the Fed for “printing money” of late. But the evidence suggests otherwise. First, all of the cash injections that the central bank has undertaken via its alphabet soup of new lending facilities have been met with roughly equal withdrawals though open market operations. Thus the new facilities themselves have not led to monetary expansion.
Second, critics like to point to the Fed’s negative real interest rates as lax monetary policy. In the dot-bomb environment, which was not a credit crisis, that charge is accurate, and that policy helped create our current mess.
But we now have credit contraction. Deleveraging is deflationary. Somewhat loose monetary policy is appropriate. Unlike 2002, banks or securities firms are not going out to create new debt, which is the mechanism by which low interest rates lead to inflation or asset bubbles. Mortgage lending has become dependent on the Federal government via Freddie, Fannie, and the FHA (and the future of that support is now in question). Consumer credit of all sorts is being reined in. Dow Chemical had to go to Warren Buffett to borrow to acquire Rohm & Haas because it could not get funding from banks. Our credit intermediation system is barely functioning.
And oil is now playing a role that is weirdly parallel to gold in 1931. England abandoned the gold standard, which was tantamount to a devaluation. The US stayed on it at that juncture and raised interest rates even though the economy was very fragile. Countries that stayed on the gold standard in 1931 on average suffered a 15% fall in real GDP in 1932.
But gold was not an essential economic input. Oil is, and thus constrains the Fed’s ability to lower rates further (not that it has much leeway at 2%, since most economists regard going below 1% as risking falling into the zero interest rate trap that has enmeshed Japan).
From the Telegraph:
The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.
The key measures of US cash, checking accounts, and time deposits – M1 and M2 – have been contracting in real terms for several months. A dramatic slowdown in Britain’s broader M4 aggregates is setting off alarm bells here.
Money data – a leading indicator – is telling a very different story from the daily headlines on inflation, now 4.1pc in the US, 3.7pc in Europe, and 3.3pc in Britain.
Paul Kasriel, chief economist at Northern Trust, says lending by US commercial banks contracted at an annual rate of 9.14pc in the 13 weeks to June 18, the most violent reversal since the data series began in 1973. M2 money fell at a rate of 0.37pc.
“The money supply is crumbling in the US. There was a very sharp lending contraction in the second quarter lending. If the Federal Reserve is forced to raise rates now to defend the dollar, it would be checkmate for the US economy,” he said.
Leigh Skene from Lombard Street Research said the lending conditions in the US were now the worst since the Great Depression. “Credit liquidation has begun,” he said.
The Fed’s awful predicament does indeed have echoes of the early 1930s when the bank felt constrained to tighten into the Slump in order to halt bullion loss under the Gold Standard. Investors – notably foreigners – dictated a perverse policy. Over 4,000 US banks collapsed. This time a de facto “Oil Standard” is boxing in Ben Bernanke. Benign neglect of the dollar has started to backfire. It is pushing up crude, with multiple leverage.
The monetary picture is highly complex. The different measures – M1, M2, M3, M4 – have all given false signals in the past. Each tells a different tale, and monetarists fight like alley cats among themselves.
The Federal Reserve stopped paying much attention to the data a long time ago. It has abolished M3 altogether. The US economic consensus is New-Keynesian (dynamic stochastic general equilibrium model). Delving into the money entrails is derided as little better than soothsaying.
That attitude, retort monetarists, is the root cause of the credit bubble. The money supply almost always gives advance warning of big economic shifts. Those who track the data are now calling on central banks to move with extreme caution. If the rate-setters overreact to an inflation spike caused by oil and food – or confuse today’s climate with the early 1970s – they may set off an ugly chain of events.
“The data is pretty worrying,” said Paul Ashworth, US economist at Capital Economics. “US lending is shrinking dramatically in real terms, and we know from the Fed’s survey that banks want to tighten further. People are clamouring for higher rates but we think deflation is now the biggest threat. The idea that the Fed should tighten with unemployment soaring is preposterous,” he said. The jobless rate jumped from 5pc to 5.5pc in May.
In Britain, the Shadow Monetary Policy Committee – hosted by the Institute for Economic Affairs, and a refuge for UK monetarists – issued its own alert this week. The focus is on “adjusted M4”, which covers loans to “private non-financial corporations” and may offer the best insight into the health of British business.
The growth rate has dropped from 16.1pc a year ago to minus 0.5pc in April. It is the suddenness of the decline that matters most. The data reeks of recession. Professor Patrick Minford from Cardiff Business School called for an immediate rate cut, arguing that the credit crunch is a more powerful and long-lasting force than the oil inflation.
Professor Tim Congdon from the London School of Economics said the UK was lurching from boom to bust. “Real money growth is virtually nil. The British economy is taking a thrashing and it is going to get worse. Corporate money balances have contracted 3pc over the last three months, which is double digits on an annualised basis. This is a serious squeeze for companies,” he said.
Mr Congdon warned three years ago that surging M4 would lead to a “dangerous” bubble, which is what occurred. He now fears the MPC will react too late as the process goes into reverse.
Roger Bootle from Capital Economics said Britain could be facing a “real economic crisis and a financial collapse. The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown.”
The eurozone is at a later stage of the credit cycle. Even so, house prices are collapsing in Spain, and falling in Germany and France. German industrial orders have dropped for the last six months in a row. A joint IFO-INSEE survey said eurozone growth had stalled to zero in the second quarter.
“Consumer lending has fallen off a cliff. It is contracting in real terms,” said Hans Redeker, currency chief at BNP Paribas. Core inflation has fallen from 1.9pc to 1.7pc over the last year.
Unlike the Fed, the European Central Bank keeps a close eye on money data (though not on real M1, now shrinking). It looks at the broader M3 figures. There is a raging debate in Europe over the signals now being sent by this indicator.
The M3 growth is still 10.5pc, down from 11.5pc in January. However, the data has been badly distorted by the closure of the capital markets. Firms have been forced to draw down existing credit lines from banks, which shows up as M3 growth. (It is the same story with America’s M3 since the collapse of the Commercial Paper market).
“The credit lines are expiring. Companies cannot roll over loans. We are going to see the entire private credit multiplier go into a slowdown,” said Mr Redeker.
Jean-Claude Trichet, the ECB’s president, said last week that the M3 data “overstates the underlying pace of monetary expansion”. The ECB nevertheless pressed ahead with a rate rise to 4.25pc, setting off a storm of protest. This may go down as one of the most unwise monetary decisions of modern times.
The strain on eurozone banks is growing by the day. They bid a record $85bn (£43bn) at the ECB’s last auction for dollars. Only $25bn was available. The spreads on Euribor interbank lending are still at extreme stress levels.
Few disputes that “global inflation” is taking off. Over 50 countries now face double-digit price rises. Ukraine (29pc), Vietnam (27pc), and the Gulf states are out of control, with Russia (15pc), and India (11pc) close behind. China (7.1pc) is on the cusp. Interest rates are still below inflation across much of the emerging world. This is the driving force behind spiralling commodity prices.
The oil spike is already squeezing real wages in the Atlantic region. The debate is whether the Fed, Bank of England, and ECB should squeeze them further, trying to off-set energy rises with a deflationary bust in the rest of the economy. If and when oil peaks in this cycle, they may find inflation crashing faster than they dare to imagine.
The 9th Circle in Dante’s Inferno – starring Judas and Brutus – is a frozen lake. Cold can be more frightful than heat. “Blue pinch’d and shrined in ice the spirits stood,” (Canto XXXIII). Such awaits the victims of debt deflation.