To Punish the Banks Is To Punish Everyone

Tim Congdon Daily Telegraph May 28, 2010

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By Tim Congdon Published: 6:24PM BST 27 May 2010

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Since the escalation of the financial crisis in autumn 2008 policy-makers across the industrial world have slashed interest rates to almost zero and vastly expanded budget deficits. Their hope has been that this combination of monetary and fiscal stimulus would spark sufficiently rapid growth to bring unemployment down. But in both the big areas – the US and the eurozone – the results have been disappointing.

In the US demand and output have been rising, but the gains have not been strong enough to lower unemployment. In fact, unemployment seems to be stuck at just under 10pc of the workforce, almost double the US norm in recent decades. In the eurozone unemployment has been edging up in recent months and has also reached the 10pc figure.

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The persistence of high unemployment in the US has become a central topic of political debate, with the Democrats worried about their prospects in November's mid-term Congressional elections. Unless the unemployment rate starts to fall soon, it will be too late for President Barack Obama to claim that his administration's policies have done anything positive for jobs.

Obama undoubtedly believes that his team has taken forceful action. It has engineered an immense fiscal injection of $800bn (£552bn), enlarged the Federal deficit to an annual figure of $1.5 trillion and so put American public finances on an unsustainable trajectory. Questions are bound to be asked about the economy's insipid response to this supposedly massive "Keynesian" boost.

Why is fiscal policy failing? The trouble goes back to mid-2007, when the wholesale inter-bank market closed. For the previous 50 years banks had found it easy to expand their loans to the private sector, since they could borrow from other banks if they were unable to obtain finance from their own customers. In the easy credit environment their deposit liabilities – the main form of money in a modern economy – grew rapidly. Rapid money growth in turn promoted demand and output, and often led to unacceptably high inflation.

Since mid-2007 the process has gone into reverse. Banks are limiting risk and shedding assets, and the quantity of money – in both the US and the eurozone – has stopped growing or even started to fall. The contraction has been aggravated by regulatory pressures on the banks to increase their capital-to-assets ratios. If the amount of capital is given, banks can raise their capital-to-assets ratio only by reducing their assets. But the fewer assets that banks have on their balance sheets, the smaller must be their deposit liabilities and hence the quantity of money.

The 2010 Economic Report described the $800bn fiscal boost as "the signature element" in the Obama administration's respons

By Tim Congdon Published: 6:24PM BST 27 May 2010

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The 2010 Economic Report described the $800bn fiscal boost as "the signature element" in the Obama administration's response to the Great Recession. But not once did it refer to the quantity of money. The omission is remarkable, since Friedman and Schwartz showed in their classic study A Monetary History of the USA that a drop of 40pc in the quantity of money over four years (ie at an annual rate of about 10pc) was the dominant causal influence on the Great Depression.

What do the latest money data show? The closest modern-day equivalent to the quantity of money in the Friedman and Schwartz work is the "M3" money measure which includes a wide range of bank liabilities. In a bizarre misjudgment the Federal Reserve stopped preparing M3 numbers in 2006.

Fortunately, enough information is published on M3's components for the private sector to make fairly reliable guesstimates of its behaviour. The latest data – from Shadow Government Statistics – are disturbing. In the year to April the M3 quantity of money is down by 5pc, but in the last few months the pace of decline has accelerated. In fact, in the last three months the quantity of money has been sliding by almost 1pc a month – very similar to the pattern in the Great Depression.

Money data are not everything, but here surely is the key to understanding why the US's recovery has been so feeble and its economy has been unable to reduce unemployment. Obama has openly talked about the benefits he expects the US to see from a "shrinkage" of the financial system, including the banks. But can't he and his policy advisers understand that, if the banking system shrinks, the quantity of money must fall?

Both in the US and eurozone, governments must realise that excessive financial regulation undermines banks' ability to grow their balance sheets and the quantity of money. By punishing the banks, they have punished everyone.

Tim Congdon is chief executive of International Monetary Research Ltd.

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Comments: 5

Norrie C comments: "You are joking, right? The banks deliberately and fraudulently made loans that they knew would never be paid back. This was no accident. It was fraud. In doing so they booked all the profits, commissions and bonuses up front and sold the worthless junk onto their clients whilst simultaneously shorting those same deals knowing they'd blow up. They win at both ends" The banks were stuck with a political mandate given by the CRA that they MUST loan to minorities if they loan to anybody else. Thus, the loans were structured and the trash was dumped into Fannie Mae and this was the original plan. This gives the government ownership of the private property of the low class. Nobody at FM or FM complained about this. Here is my approach on this: Meet the Real Villains of the Financial Crisis—the CRA [Community Reinvestment Act], “Affordable Housing” and the US Government http://tinyurl.com/2c49qay This is an attempt to force the 'rich' to provide housing for the 'poor' because the left intend to 'tax the rich' as they always do. The problem this time is that the rich do not have enough money to pick this one up in tax payments. ryckki@gmail.com

Colin has this one. Not only is their public debt outrageous but the mortgage monstrosities Fannie Mae and Freddie Mac hold some untold trillions in toxic assets. Then, we have the commercial real estate problem coming up soon. This is classic debt driven deflation along the Fisher Model. The money supply is prevented from expansion in this environment by the zero bound of the interest rates--they cannot go negative. Credit is lost from falling asset prices and businesses cannot expand due to uncertainty about many things except higher costs from more taxes and fees--those are punitive and a certainty. Andrew is correct in that the US is going to default with inflation because they can never pay off some soon to be 14 trillion in debt. ryckki@gmail.com

"Both in the US and eurozone, governments must realise that excessive financial regulation undermines banks' ability to grow their balance sheets and the quantity of money. By punishing the banks, they have punished everyone. " You are joking, right? The banks deliberately and fraudulently made loans that they knew would never be paid back. This was no accident. It was fraud. In doing so they booked all the profits, commissions and bonuses up front and sold the worthless junk onto their clients whilst simultaneously shorting those same deals knowing they'd blow up. They win at both ends. However, their Ponzi scheme falls over when the ability to service the debt falters even just a tiny bit i.e. when the boom peaks. Suddenly, like Madoff, their scam is laid bare. So what do the governments do? They look at the banks books and are horrified with what they see. They realise if they force Mark to Market (their legal obligation)these institutions are immediately insolvent and that just wouldn't do. So they allow them, complicitly, to lie on their balance sheets and do everything in their power to keep the bubble inflated, for that read 'print money'. Whilst they carry on with this charade the debt remains and the percentage default rises. So, given the maths behind everything I've said above why does ANY of this come as a surprise? How can any results possibly be disappointing? They can only be disappointing if you don't understand maths and relilgiously believe in the god Keynes and that printing more debt will cure a debt problem. Where is the detailed, financially competent criticism? The banking world is insolvent. Governments are terrified and have their collective heads buried in the sand. Default can be the only, mathematically-pre-determined outcome. It can be admitted and managed or it can be natural and brutal. Your choice but remember one thing.. .. You cannot beat the maths.

Why is the world not recovering because in a word debt. The system is awash with bad loans and overly indebted citizens and countries. Until the bad debts are cleared assets values adjust to realistic levels we are going now where - Japan.

You state "In a bizarre misjudgment the Federal Reserve stopped preparing M3 numbers in 2006.". I put to you that this was not a bizarre misjudgement but merely an attempt by the fed to hide the fact that it is manipulating and allowing the inflation of the currency supply.