Distributed Economics

Poke around in the entrails of history, and a surprising number of revolutions, and coup’s of one form or the other of etat, can be attributed at least in part to some form of underlying monetary breakdown. Typically the form of breakdown that involves at its heart,too much debt being issued, for the available supply of peasants to support payment of. It would be nice to think that the very least a communist government, formed by and on behalf of the workers and peasants of its country could achieve, would be to avoid that one.

There are two very strange things about the news out of China these days. One, is that there have been clear signs of a loan induced housing bubble for some time now. The other is the succession of increases the People’s Bank of China has made in the required reserve rate for its banks in order to constrain that bubble. The latest increase on May 10th to 17%, follows a raise to 16.5% in February 2010,  and a set of increases over the last couple of years.

According  to the existing Economic theory of how the banking system works, each one of these should have triggered a large contraction in the available money and loan supplies, given that the removal of money from  the system triggered by the reserve increases – is a multiple of the reserve change.

Despite this, there is in China today a rapidly increasing CPI, and a raging housing bubble, alongside  a steadily increasing reserve ratio. The situation gets even worse, if the  underlying non-monetary economy is considered, which in China is one of steadily increasing production. Since production increases cause deflation, as the existing money supply is used to trade and purchase more things, this suggests money and loan supply expansion, rather than the contraction that should have been triggered by the reserve changes.

All of which suggests something has gone very badly wrong indeed, in the Chinese banking system.

Monetary statistics are available on the People’s Bank of China’s web site for the period since 1999.  They are unfortunately not at the same level of detail as the USA, or indeed Iceland.  In particular since there is no break out of the M series components, it’s not possible to know how much debt instrument contamination is present in these series. There is a format change in 2005, and since the number’s don’t quite match up for the different series, the chart below is just for the last 5 years.

Chinese Money Supply

The data for the entire period, assuming that measurement has been reasonably consistent, shows that M1 has increased by approximately 4x in 10 years, about twice the quantitative  increase in the the Dollar and the Euro over the same period. It would also appear from the chart that the process has begun to accelerate.

The data shown is certainly consistent with reports of a credit fueled housing bubble, originating from uncontrolled lending within the banking sector, triggering asset inflation and commercial bank expansion of the money supply. What is perhaps most remarkable about the chart above, is the complete absence of any affects from the reserve increases that the Chinese central bank has been imposing to try and throttle the system back. It has been steadily ratcheting the reserve rate up for the last 3 years, it’s now at 17%, but there has been no corresponding contraction in the money supply. It’s probably the case that the expansion would have been even greater had they not increased the reserve requirements. But still. If economic theory was correct, what the chart should be showing is a massive contraction in the money supply – since changes in the reserve requirements theoretically  have a 10x multiplier effect on the money and loan supplies – and it’s plainly not.

Given the reports of a housing bubble, increasingly lowered lending standards, and CPI, it sounds like this is probably the Equity Capital exploit cutting loose again. Whether this  is because the banks are abusing inter-bank lending mechanisms as occurred in Iceland, or have just figured out they can stuff some form of debt into their equity capital holdings is very hard to say – there simply isn’t the kind of publicly available data to properly analyze the Chinese banking system. Given the repeated increases in the reserve ratio, it seems highly unlikely that any part of this is deliberate government policy though.

Which points to another aspect of this entire problem. Both the exploits discussed here, the Equity Capital exploit, and the Asset backed security loophole, are outlined for a system with full reserve requirements. De facto, the European and American banking systems don’t use reserve requirements for central bank control any more, and rely on market operations. Those don’t in fact work, but as China is currently demonstrating, neither do the textbook, central bank control mechanisms via the reserve requirements either.

The other interesting implication of this, particularly if the expansion continues to accelerate, is that if the Yuan were to be allowed to free float, it would probably depreciate against the Euro and the dollar, rather than appreciate as is being called for by American and European economists.

& won’t that be fun.

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cc Asset Inflation, Empirical Analysis, Exploits, Fractional Reserve System

Today, May 9th, is is 39 days since the Federal Reserve Banks of the United states of America stopped buying Mortgage Backed Securities at the end of March 2010 with TARP funds.

Strictly, as Calculated Risk and others have pointed out, actual purchases won’t finish until mid year, since some payments won’t be settled for a few weeks after purchase. But to all intents and purposes, after a year where credit issuance was held fairly constant courtesy of the US taxpayer, approximately $100 billion dollars of credit is now being removed from the US credit economy each and every month.

This is the backdrop to the Greek crisis. All the time Mortgage Backed Securities are being sold by the Banking system, credit is effectively unlimited. As soon as it stops or slows down though, then credit begins to dry up. The large majority of today’s debtors, be they Governments, companies, or private citizens, don’t plan on repaying their debt, but on continuously renewing it. This works as a strategy while the total quantity of available debt is continuously expanding, as it has been for the last 2 decades, it fails very quickly once any credit contraction sets in. So as the withdrawal of Federal Reserve support for the credit suppliers starts to impact, debt renewal becomes a problem again, and the axe falls on the biggest, weakest, debtors first – in this case Greece.

Not that Greece has ever been a poster child for fiscal responsibility, even before Goldman Sachs decided to help them out with their Euro application, but that brings up a well known problem in engineering, avoiding single points of failure.  Greece has a population of a little over 11 million, and is a member of a currency union of something over 300 million people. If the underlying system regulating that currency union is so fragile that it can be endangered by one, rather small country misbehaving itself, then it’s reasonable to argue that the problem isn’t Greece per se, it’s the system itself.

The singular failure that the creators of the Euro committed,was the failure to completely standardize banking practices across all countries. Although mechanisms exist to regulate the creation of money by banks and countries, there was no separate regulation of debt. Presumably the creators thought that debt was implicitly regulated by the money supply, but unfortunately the introduction of securitized loans had broken that assumption. So within the Euro zone there are countries whose banking systems have issued large amounts of Mortgage Backed Securities such as Belgium and Ireland, and others who haven’t. The increased amount of private, bank originated debt, now competes with Government debt for renewal, and either the amount of total credit available  spirals increasingly out of control, or somewhere, somebody’s debt isn’t renewed. Failure of  debt to be repaid in this system isn’t a matter of borrower whim, it’s a mathematical inevitability.

The US and European  economies, and through them the rest of a highly interlinked global financial system, are now caught in the red queen’s securitization trap. The financial system can’t keep issuing Mortgage Backed Securities without buyers, but it can’t stop either. Stopping triggers the same credit crisis, and the same Fisher debt deflation cascade that was avoided by creating the TARP fund purchase scheme. But continuing, or to be more accurate, restarting federal MBS purchases, simply continues to transfer fractional reserve originated debt from the Banks to the federal government, and from there to the taxpayer.

And while there is no systemic control on the total amount of debt that Banks can originate, the runaway global debt spiral can only continue.

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In memorium: Paraskeui Zoulia, Aggeliki Papathanasopoulou,  and Epameinondas Tsakalis.

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Over in the land of the rising Volcano,  the first full report on a banking system collapse has just been released.

Interestingly, even with a report that goes into a fair amount of detail on the extraordinarily contrived web of lending and borrowing between a small circle of Icelandic  businessmen, the main Icelandic banks, and their overseas Creditors, there seems to have been relatively little attention paid to the problems in the underlying monetary mechanics that allowed it to happen. In particular, the  approximately ten times expansion in the money supply that accompanied the businessmen’s sleight of loan practices, appears to have been overlooked.

Money supply figures for Iceland are available from the Icelandic Central Bank. The following analysis is based on the “Monetary Aggregate” (Peningamagn og tengdir liðir) spreadsheet which is the only statistical series that appears to have been updated since the collapse in September 2008. It labels figures since Sept 2008 as ‘provisional’.

This series covers M1, M2 and M3 statistics up until 2009. As previously discussed, the M series monetary statistics are not an entirely pure measure of the total amount of money in any given monetary system, as they can include some forms of debt instruments. In the Icelandic case, two adjustments need to be made to get a quantitative estimate purely of Icelandic Krona: the removal of Money market accounts from M3 which eventually amount to about 10%, and also foreign currency accounts which are included as part of M2. Foreign currency savings accounts incidentally, as a percentage of krona denominated M2, vary between 15-43% of total M2 over this period – which suggests there are other potential stability issues, especially for small currencies, lurking in the background connected to the fractional reserve banking system.  Iceland’s banking and currency system has never been a haven of price stability.

The issue illustrated here is both scientifically fascinating, and utterly appalling in its eventual effects. Iceland deregulated its banking system in 2001. Two of the banks, Kaupthing [nee Búnaðarbanki] and Landesbanki, were sold to private businessmen, who in at least one case used money borrowed from one bank, to purchase shares in the other. Now let’s think about that for a moment, in the context of fractional reserve banking. You borrow money from one bank, and use it to buy control in another. How does that borrowed money get treated? If – and it seems to have been the case – that money is put into Equity Capital holdings at the second bank, then the total amount  the second bank  can lend, and thereby increase the overall money supply by, has just increased. As a result of a debt somewhere else in the banking system. It’s a feedback loop entirely within the commercial banking system, increasing the money and debt supply, independent of any control by the central bank.

The statistics are divided into two series, with considerably less detail available from the earlier period. We can see from the first series below, that quantitatively the currency was relatively stable up until 1997 when M3 began to diverge from the other measures. Unfortunately, there is no detail in the first series to suggest exactly why.

The second series is over a shorter time period, slightly over 6 years. Although the most dramatic behaviour of the currency is in 2007-8, what happens before then shouldn’t be overlooked. Between September and October 2003 for example, M1 and M2 double.

Iceland is a very small country, of approximately 300,000 people, which is why these effects are so obvious. M2 as shown here is the total amount of bank deposits in the country, aside from longer term time deposits which are counted as part of M3. Iceland, as elsewhere, stores its currency electronically – physical notes are printed as needed. But the size of the country, and the electronic nature of its storage, doesn’t change the quantitative nature of what happened in September 2003.

Looking rather closely at those two months, it looks like there was approximately an 100,000 M.Kr. increase in bank deposits. At a guess, and that’s all it is, the proximate cause of the increase was probably the first payments by the Icelandic banks of the money being lent for the Icelandic Power Companies then latest venture into Aluminium production, to the tune of  $20 million in locally sourced loans. This at some level just represents how fractional reserve banking works, and if nothing else, demonstrates the dangers of making big loans within a small currency base. In terms of nuts and bolts economics, the production of things, the support of livelihoods, and general improvements in living standards,  the loan certainly made sense, in increasing total electrical power available to the economy. It’s the monetary side effects, inflation as a result of a loan, and then presumably deflation as it’s repaid -  although it seems that’s an increasingly old fashioned concept these days  -  resulting purely from the mechanics of the underlying system where the loans are created, that don’t.

The money supply continues to increase over the next 3 years. It’s masked to some extent by the rather dramatic increases in 2007, but M1 doubles by the end of 2006, M2 increases by about 1.8 times, and M3 by a factor of 1.6. CPI Inflation rises from 2% in 2004, to 8% in 2006, and this causes other problems. Icelandic krona loans are index linked, something that was introduced to deal with a previous bout of severe inflation – in fact, i’d guarantee that historically Iceland got severe inflation anytime their power company decided to expand their electricity supply, and borrowed money to finance it. Fractional reserve banking is far from problem free even when it’s not being deliberately exploited.  The increase in the last decade though, had another cause.  In the background of the Icelandic economy, a small cabal of Icelandic businessmen had effectively turned their businesses, in conjunction with their relationships with the owner’s of the three main Icelandic banks, into what appears to have been a co-ordinated exploit of the Equity Capital loophole.

As a result of this, the Icelandic money supply measures double again in the year between January 2007 and September 2008, when the collapse of Lehman Brothers intervenes, and turns Iceland into, were anyone paying any attention to the actual systemic issues behind the credit crises of the early 21st century, the canary in the goldmine.

Doubling the money supply in slightly over a year, is by any standards extraordinary. As is having it increase by an order of magnitude in  7 years. It’s not Weimar levels of increase, but neither is it something that should just be occurring without any comment. It also makes any and all economic statistics for that period from Iceland highly suspect. Money is used as an economic measurement. If the quantity of money is changing, and this isn’t corrected for, it’s akin to trying to measure with an elastic band.

Quantitative changes in the ratio’s between currencies don’t necessarily play themselves out in immediate adjustments to currency trading, the relationships themselves seem to be quite sticky with sudden, abrupt changes. The Icelandic Krona’s exchange rate was relatively stable up until the crisis hit in 2008 in an 80-100 band. The high interest rates being paid because of central bank attempts to control the monetary expansion acted to attract foreign investment, and damp down the quantitative impacts of the increase.  In Iceland as elsewhere, a lot of the quantitative increase in the money supply is essentially getting trapped within the monetary system, which limits the impact on general inflation. Iceland did experience a severe housing bubble though, and there as elsewhere, the shells of uncompleted luxury condominium projects litter the countryside.  What is clear today, is that anybody holding Icelandic Krona at the 2008 rate of 90 to the Euro, has lost about half of their purchasing power with the current, capital control protected rate of 172.

The total quantity of Icelandic M1 and M2 in circulation over the 2003-2009 period in fact increased by about 10 times. Measurements of M2 can’t be compared exactly between countries, because they aren’t consistently defined, but driven by similar systemic factors, US M2 doubled in roughly the same time frame, and the Euro increases by about 50%. This would counterbalance the Icelandic increase to some extent, and any increased production would also have had a counterbalancing deflationary effect.  While it’s also certainly not the case that all currency is local, neither is all currency available for foreign currency trading.

Although the Icelandic Central Bank has been heavily and rightly criticised for its role in this, it has a  simple defense on the behaviour of the monetary mechanics. It followed the Economics textbook. It raised interest rates, to try and control the money supply expansion being created by a business culture that had devolved to simply making as many loans as possible, and extricating the proceeds abroad. All this achieved though, was to attract more foreign currency into the economy in pursuit of higher interest rates. Enabling increased expansion, and more loans, rather than the careful control and regulation suggested by Economics theory.  The Economics textbook is wrong at a very basic level, but since its false assumptions are so embedded and central to the discussion itself, it seems impossible to break its hold on the debate.

But perhaps we can start with a simple question.  In Economics’ textbooks, control of the money supply is consistently described as being solely the responsibility of the Central Bank, and for very good reason. Changes in the total supply of money effect everybody, double the money supply, halve the value of people’s savings. Weimar was just the extreme case.  So perhaps somebody could ask the Icelandic Central bank if they deliberately increased their money supply by ten times over the last 7 years?

And if they didn’t, who did?

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cc Credit Crises, Empirical Analysis, Exploits, Out of Real Time

When debugging complex systems, it can be useful to ask, “What’s missing?”. Especially when looking at  the available monitoring information, which tells you not only what the designers of the system thought it was important to know, but also by omission, what wasn’t. Critical realtime systems, we’re talking Nuclear Power plants and their ilk, are monitored fairly closely, but if the right information isn’t provided to the operator, then that won’t necessarily help all that much.

In this sense, it’s quite interesting that  Economics doesn’t seem to have  a definition of what money is, in any satisfactory, scientific sense. Rather it seems to have various descriptions of what money does. The “Money is a matter of functions four, a medium, a measure, a standard, a store.” dogeral that is found in some textbooks and on Wikipedia is the perfect illustration of this. This is not a definition of what money is, it’s simply a list of the things money is used for. This confusion can also be found in the various measures used to quantify the total amount of money in the Economy, which are variously M0, M1, M2, and depending on which country you’re in M3 or M4.

Interestingly, and perhaps damningly in the context of the current credit crisis, no single, monitored central bank measure appears to completely capture the information that is of most interest today – which is what is the total quantity of money that commercial banks and reserve based savings institutions are allowed to create loans against.

M0/Monetary Base

This is the “narrowest” definition of the money supply. The British, who technically invented the entire system, used to use M0, but since 2006 it’s the “Notes and coins and reserve balances” figure (YWMB43D), whilst the Federal Reserve simply refers to this as the Monetary Base, and reports it in the H3 Aggregate Series.  It is defined as the reserves from the Banks held on deposit by the Central Bank, and the total amount of physical currency. This measure probably made more sense under the Gold Standard than it does now, when a significant number of bank deposits don’t in fact carry a reserve requirement, and physical currency is simply printed to meet day to day demand.

Reserves held at the central bank used to be a very fixed, and important part of the system’s regulation, since this directly controlled lending. In that implementation of the system, the Commercial Banks had to deposit the reserve on deposits they were required to hold behind for each loan (i.e. the 10% fractional reserve requirement), at the central bank. For two simple reasons. It kept them honest, and it gave the Central Bank complete control, and indeed visibility, on the monetary expansion that was occurring. Assuming for example, that the Banks were correctly depositing their reserve on deposits at the central bank, then if that amount started growing, the central bank immediately knew that the loan supply was increasing and vice versa.

Only net transaction accounts in the US Banking system carry a reserve requirement currently, so that part no longer works very well. Even so – when the Federal Reserve saw the non-borrowed reserves drop by 25% in December 2007, and indeed go negative the following month, it was a clear warning sign of major systemic issues. The Bear Stearns collapse into bankruptcy would occur 3 months later in March 2008. How significant it is that there is also a fall in the British reserve measure, beginning in July 2006 and reaching its nadir in September 2007 before an abrupt recovery, is hard to say.

M1

M1 is technically physical currency and checkable deposits. Quite what it will be when it is no longer possible, as it will be and to a large extent already is in Europe, to write a cheque on a bank account, is an interesting question. It’s reported by the Federal Reserve as part of the H.6 dataset, along with its cohort M2, and they also helpfully break out the different components of M1 if you scroll down a little.

Broadly then, it’s physical currency and demand, or instant access checkable deposit accounts, which appear to be the Net Transaction Accounts for which there is still a reserve requirement. I have an HSBC internet savings account, it has no cheque book, pays a (very) small interest rate, and which i can transfer to and from using the Internet at will. Is it classified under M1 or M2? Does it have a reserve requirement? Does that even matter?

The last question is perhaps the most interesting. The answer appears to be both yes and no as it happens. Since reserve requirements are no longer used to directly regulate loan expansion – equity capital does that – then it doesn’t strictly matter if an account has a reserve requirement or not. Except of course, that the Banks can at the moment get quite a nice interest rate from the Federal Reserve on their reserves, which is why reserves so dramatically increased a year ago. Now there’s no correspondingly dramatic shift in the components of M1, so it looks like the Banks just dumped all their spare money onto the federal reserve – which lends some credence to the claim that this has inhibited lending. Except of course, that they’re still as busy as ever creating and  selling Asset Backed Securities.

M2

Strictly, M2 is all of M1 plus Bank savings accounts and Retail Money Funds. The Federal Reserve helpfully breaks out the non-M1 components of M2 as part of its H6 dataset, which makes life a little easier.

Now this is where it gets quite interesting. Retail Money Funds, which were a non-existent category at the beginning of 1959, and peaked in October 2008  at slightly over $1 trillion are around 15% of the total quantity of M2. Retail money funds are funds that generally provide an extremely safe return, that is expected to track the safest form of investment (government securities), and never not return their capital investment. They’re also expected to be very liquid, i.e. you can get your money back more or less on demand. This essentially means that they invest in short term debt securities, although only ones of very high quality. Like triple A rated, insured, top of the tranche Mortgage Backed Securities for example?

Leaving aside the interesting co-incidence that the growth of retail money funds begins in the same period as MBS were introduced (late 1973, sales don’t really kick off until the S&L crisis in the early eighties); just the total quantity of retail money funds indicates that some of them must be in MBS securities. There simply aren’t enough other suitably ’safe’ instruments paying a suitable rate of return otherwise. Which means that some proportion of the M2 money supply measure, is actually debt.

This helps to explain the divergence in the growth between M1 and M2, in the USA and other countries, since thanks to the Asset Backed Security loophole, debt is currently growing faster than money within the banking system. It also i think, provides a measure of proof, that the Central Banks really don’t understand what’s going on in the system these days. Because if they did, they would not publish statistics that obviously confuse money with debt, especially in a system where money is regulating the total quantity of debt, and vice versa. Of course, if they did understand that, then Banks wouldn’t be allowed to hold debt instruments in their equity capital holdings either.

M3

And then there’s M3. Which was somewhat notoriously, and to the great delight of the FRLF, discontinued by the Federal Reserve in 2006. If you want proof that many of the critics of the current banking system also have no idea how it actually works, threads on the Federal Reserves  discontinuance of M3 can be quite enlightening, if for no other reason than their blind assurance that it was a valid measure of the money supply.

But no, if you look at the largest, and towards its end, most rapidly growing components of M3, it’s Institutional Money Funds, followed by something called “RPS”. Institutional money funds are retail money funds writ large, and stuffed with those wonderful top tranche Asset Backed Securities. RPS are,  i believe i’m correct in saying, Repurchase agreements owned by the banks. Repo’s as they’re otherwise called are one of those interesting pieces of financial alchemy, whereby you sell a financial instrument to somebody, for cash, along with a guarantee that you will buy it back at a specified amount sometime in the future. It’s essentially a loan in return for an agreement to buy a loan.

Quite how you can get away with calling that part of any money supply measure, I have no idea.

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cc Credit Crises, Empirical Analysis, Fractional Reserve System

The latest Bank of International Settlement Figures are out for Asset Backed Security Issuance for September 2009. The total amount of outstanding international securitized loans  increased by approximately $1 trillion in the 3 months between June and September 2009. Based on the  USA’s stock market performance this last three months, I wouldn’t expect there to be a drop in issuance this quarter either, especialy since the Federal Reserve Banks are still the buyer of last resort. That puts the world on track for a total increase in issuance this year of around $3 trillion. There are some rather interesting questions hanging around relative valuation of financial instruments given that the unit is american dollars, and the dollar hasn’t being doing well of late, but that doesn’t effect the impact for the USA.

The Federal Reserve  expects to be able to stop buying Mortgage Backed Securities next March. It will certainly be quite entertaining if they try.

The gross figures are quite interesting. They do show that up to this point, securitization is predominantly a problem of developed countries, although issuance is starting to increase in the developing countries. The first credit crisis period also stands out clearly, and stands out as a drop in securitization. So a naive approach to the problem, would be to simply worry about that drop, and find ways to “restart the securitization pipeline”, which is pretty much the policy that has been both advocated and followed over the last year.

Consequently, the Federal Reserve Bank of America, wittingly or unwittingly, has put itself in an interesting situation. They can’t stop buying Mortgage Backed Securities, as soon as they do, the lending pipeline collapses again, and we get Credit Crisis II. Like all sequels, bigger and much worse than the first release. On the other hand, how long can they continue? Especially as the world’s financiers then turn around and just sell more of them. Thereby increasing the total amount outstanding by $1 trillion a quarter.

Any increase in the outstanding amount of Asset Backed Securities, increases the ratio of debt in the system, to money. Money is ultimately what has to be available to pay debt, so as the proportion of debt within the monetary system increases, there is less money to pay more debt. It’s a complex relationship, especially when variable rate interest payments start to get factored in, and it’s fair to say, one that the world’s financial authorities clearly don’t understand very well, if they think increasing the amount of securitized loans is a way out of this.

Outstanding securitization actually peaked in June 2008 at $25,300 trillion, and didn’t return to that peak until June 2009 this year, at $25,900 trillion. We’re now at $26,900 trillion.  However, trying to predict the next crisis point isn’t as simple as looking at the outstanding figures, and going gulp. In the background, the movement of debt instruments into equity capital is also wreaking its own share of havoc.

This is total liabilities and assets for the US Commercial Banks. It is not as simple as liabilities equals deposits, and assets equals loans, since for one thing the equity capital reserve is listed under assets (hence the excess over liabilities.) But it’s close enough for government work. These figures show the other side of the credit crisis, the debt failure induced contraction in the money supply – total deposits, and also the recovery this year, as the securitisation pipeline was restarted.

The contraction in the money supply as debt was removed from the system, either by foreclosure, or by loan repayment – is pure monetary mechanics – it’s a side effect of the other problems in the economy and a consequence of the linkage between money and debt created by the fractional reserve banking process. However, it has its own repercussions. In particular, it worsens the imbalance between money and debt being created by securitization. So in some sense, it’s just as well that didn’t continue too long.

But the price of an at most half trillion dollar increase in the US money supply, appears to have been over $1 trillion of securitized loans. And the money to buy those loans , was provided as a direct claim on the US tax payer. So it would seem, that ignorant of the underlying causes of the problem, the Federal Reserve is failing, to run the red queen’s race, as it tries to stop the housing market in the USA completely collapsing  from a fisher debt deflation.

Quite how long they can continue to sustain the banks with interest payments on their central bank reserves, presumably being funded from the proportion of securitized loans that they are receiving capital and interest repayments on is a very interesting question. What they’re doing to the rest of the economy in the process, even more so.

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cc Credit Crises, Empirical Analysis, Out of Real Time

In the textbook presentation of the Fractional Reserve Banking System, the example of the reserve redeposit process typically shows the expansion from the starting condition of an initial deposit. This is more than slightly misleading. The banking system that we have has been running more or less continuously, depending on which country you’re in, for several hundred years. The expansion from initial conditions can be presumed to be long past.

Theoretically then, we should be in a state where the money and loan supplies are fairly constant, or varying between known limits, and where the total commercial bank debt is 90% of the total money supply, assuming a 10% reserve requirement.

Clearly not in the world we’re living in. Especially the known limit part.

The explanation this blog is exploring, is that the primary reason for this is an interaction between the effects of  allowing loans to be sold in the form of Asset Backed Securities, and using equity capital rather than reserves to control total bank lending.

At the macro-economic level Asset Backed Securities have effectively increased the total amount of loans outstanding in the economy, and have done that within the part of the loan supply that comes from fractional reserve operations, rather than say somebody going out and buying a Corporate bond or government security. The end effect of this is that the ratio of commercial bank originated loans to deposits is no longer a fraction of total deposits, but rather a multiple. For example, in addition to the approximately $10 trillion commercial bank assets (loans to the rest of us)  held by the United State’s commercial banks, must be added the outstanding amount of Asset Backed Securities that have been sold on by the commercial banks. The net outstanding total for Asset Backed Securities for the USA as of June 2009, was $6,5 trillion. Back of the envelope, and assuming that most ABS is held as part of equity capital, then probably at least $5 trillion is being held outside of the commercial banking system, by pension funds, insurance companies, and other entities that need a store of money.

The immediate question this raises then, is how many of these things are there out there, and which currencies or countries are worst effected?

I’m personally convinced you can get a rough idea just by counting building cranes and uncompleted luxury condo blocks in any major city at the moment. Tracking down actual figures is a little tricky. Most Central Banks don’t seem to publish separate statistics on ABS sales, or if they do they’re not readily identifiable. However, the Bank of International Settlements does put out some high level aggregated data. Quite what their source for it is, I have no idea, but it seems to be the best there is at the moment.

The chart above shows the quarterly totals of newly issued debt securities from table 12a, which includes Asset Backed Securities and Pfandbriefe (covered bonds). The data is quite interesting. For one thing, it indicates that the 2008 credit crunch was primarily a failure in issuance of Asset Backed Securities. The drop, early in the year, suggests that at $1 trillion in capacity was removed from the system, which is a lot of loans. Even though the visible symptoms of the credit crunch were in areas like letters of credit, and revolving credit, it was very probably a knock on effect from the removal of Asset Backed security credit. The other takeaway from the chart is the subsequent, central bank and government financed recovery to 2006 levels. Somewhat akin to treating gangrene with a band aid, really.

Working out which are the worst afflicted countries is problematic. Whilst $6.5 trillion is a lot of debt, the USA is a lot of country, and a very powerful economy. Ireland on the other hand, is a rather soggy island on the left hand side of Europe, and they’re currently sitting on $546 billion of the things. With a population of 5 million, that’s just over $100,000 each.

An alternative to normalizing by population is to normalize by GDP. The problem there is that loan financed activity, building luxury condominiums for example, is counted as part of GDP. It’s the Exon Valdez disaster problem again – measured purely by its contribution to GDP, cleaning up an ecologically catastrophic oil spill was economically beneficial because of the extra work and spending it caused. Normalised by population Ireland comes out 4 times worse than the USA, normalised by GDP the USA is twice as bad as Ireland. On either measure, Greece, Iceland, Ireland, the Netherlands, Spain and the United Kingdom, and of course the USA, all stand out. No surprises there.

So where does this all end up? Asset backed securities have proliferated throughout the western developed economies, so almost all countries are involved to a greater or lesser degree. Norway for example, which is sitting on the proceeds from their share of North Sea Oil, has still managed to accumulate an outstanding, per head of population amount of around $35,000. The closest the banking system has ever come to generating this kind of situation before, was probably in 19th century America, a period known for rampant bank failure. There were assorted reasons for this, but a fair amount of it was caused by deliberate fraud, in the form of banks making loans that exceeded their deposits, typically to colluding cronies, sorry, ‘business associates’ of the men controlling the banks. It seems possible that the total loan supply might at some points have exceeded the total money supply in the US during this period, even with the gold standard, but who knows. The American financial system at that period was regarded as a thieves charter by British economists, and even by some Americans.

In our modern age, though it is strictly illegal for individual Banks to lend more than their deposits; Asset Backed Securities have unfortunately managed to allow the entire banking system to do it.

No collusion required.

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cc Empirical Analysis, Lending

Here is a thought experiment. Assume that the money supply is completely constant, there are no loan supply induced fluctuations, the government is behaving itself, and there is simply a fixed quantity of money in the banking system. In a period of steadily rising production, due to technological and social change, what happens to prices?

They go down.

Deflation, to use the technical term, occurs because as more and more things, assets, food, granite kitchen tops, hit the market, there is less and less money available per thing, and the price drops. Or to put it another way, in a world with a constant money supply, if you inflate production, you deflate costs. It doesn’t really have anything to do with the social organisation of production, and it’s  highly debatable if it’s a good or a bad thing in terms of the effect on human behaviour. It’s just  math.

Over the last 20 years, there has been a lot more stuff available, at all levels of society. This is the age of the nail gun. The fully automated factory, and the completely unautomated Indian call centre.  There are more people, producing more things than there have ever been on the face of this planet, so the real question of the age should be, why hasn’t there been massive deflation -  rather than mild inflation, and raging asset inflation.

The simple answer, and the one born out by the central bank statistics is the money supply has been increasing. But that just raises the issue of why? And if we accept the idea that it’s not the central banks, and that is something that is also born out by the statistics, then the question is also who?

Equity capital is at the moment, the only real control on the part of the money supply within the commercial banking sector. To clarify, the chart below shows the difference between the ‘reserve’ of deposits that banks may be required to keep against deposits, and the equity capital that acts as a reserve against loan loss.

Under the Basel treaties, individual banks are required to keep equity capital reserves that are at least 10% of their loans.

Reading the Basel treaties, it’s apparent that their main concern is risk. Basel is all about reducing the risk of any individual bank defaulting, and to achieve that, it mandates equity capital reserve requirements, since it’s the equity capital that gets used when a bank suffers losses to ensure that depositors don’t lose their money. So if the only concern is what happens at individual banks, then it makes sense to  regulate that they have adequate equity capital reserves, and that those reserves are held in safe, secure financial instruments, that also provide the bank with some kind of return to compensate it for the ‘cost’ of maintaining a stack of otherwise useless money. (From the individual bank’s selfish point of view.)

Like mortgage backed securities for example.

41. Loans fully secured by mortgage on occupied residential property have a very low record of loss in most countries. The framework will recognise this by assigning a 50% weight to loans fully secured by mortgage on residential property which is rented or is (or is intended to be) occupied by the borrower.

(Clause 41 of the Basel Capital Accord)

Those were the days. Bet they rewrite that for Basel 3.

In fact, there’s a serious problem with allowing any kind of debt based financial instrument into equity capital, however tempting the associated income stream may be, and that is that as soon as you do, it allows the commercial banks to do the one thing that they’re not supposed to be able to do without central bank involvement – create money.

Consider 2 banks:

Bank A creates a $900 Mortgage Backed Security, and sells $800 of it to the depositor at Bank B for $1000. How much would it really be  worth? I’ve yet to be able to track down how much they sold these things for, but it’s a guaranteed (or at least it was before the loan insurers blew up), financial instrument paying anywhere between 5% and 15% a year for 5-25 years. So $1000 seems like a bit of a bargain. It doesn’t actually matter as long as its more than the underlying loans were made for.

Bank A takes the $100 tranche of the MBS it retained, and uses it to increase its equity capital. It counts it as 50% so it only increases its reserves to $150. It takes the $100 and pays that out as bonuses, which get deposited in its employee’s bank accounts, at its branches. One of the perks of being a bank employee is free banking from your employer, and usually reduced rate loans too.

Assuming the strictest case, i.e. that the deposits at Bank A are being held in net transaction accounts, then Bank A can now lend 90% of its deposits ($990), provided that this doesn’t exceed 10 times its equity capital. The new loan then gets deposited at Bank B.

The end result of all this sleight of loan, is that the total money supply has been increased by $90, and the  total loan supply has been increased by $900 MBS and $90 additional loan capacity in the banking system. This makes for a fairly slow leak as these things go, since it can take months or even years to issue the underlying loans. It’s worth noting that the central bank, who supposedly control the money supply, played  no part at all in any of this. It’s the commercial banking system that is out of control here.

So the money supply is increasing, but this isn’t effecting inflation nearly as much as it should. In fact its masking what would have been some fairly dramatic deflation over the last 20 years due to productivity improvements. Unfortunately however, the total loan supply is increasing much faster.

Which is where the real problem lies.

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cc Asset Inflation, Credit Crises, Prologue

There is a lot of discussion on the net, good and very accurate discussion, about the reserve requirements, and the current almost absence of same. The Eric deCarbonnel post (hat tip Andre. G. and Mickanomics) has a nice summary of the situation in the US. There is one unfortunate problem though with these discussions -  fractional reserve requirements no longer have anything to do with controlling how much money a bank can lend.

What has replaced it, is the regulatory capital requirement. Regulatory or equity capital is a completely separate pile of money that the owners of the bank are required to provide when a bank is started, and maintain at a minimum ratio to their loan book, as the bank is run. The FDIC requires that this be at least $2 million when a bank is founded, plus the anticipated startup costs.  The Basel treaties then specify what percentage or leverage ratio the Bank is allowed to maintain between its equity capital and its loan book, and also what kind of financial instruments the Bank can hold the equity capital in.

There are two things then that control the immediate size of the loan book, of any bank in a Basel treaty conforming country. The amount of money it has on deposit (including savings accounts, and term deposits), and the size of its equity or regulatory capital. The fractional reserve requirement, i.e. the difference between the total amount of money it has on deposit, and the total money it has lent out, is relevant only insomuch as it is not allowed to lend out more money than it has on deposit. Just to ensure that complete confusion reigns, the recommended maximum total capital ratio, ie. the leverage ratio of equity capital to amount being loaned, is 10%. The same as the textbook fractional reserve requirement.

This is the 21st century. Weren’t we supposed to have moon bases by now?

It makes some sense, if you only think about the situation at the individual banks. If a bank makes a loan that doesn’t get paid back, and the loan loss can’t be covered out of profits, then equity capital is there, to in theory, prevent the depositors losing the money in their accounts. This is what is being referred to when there is talk about ‘recapitalizing’ the banks. Obviously too, given that this is all that stands between the depositors, national deposit insurance funds, and significant losses in the case of loan defaults, it’s critical that the equity capital be held in extremely safe forms of financial instruments.  This is why so much of the discussion and rules around equity capital are framed by the risk of default represented by the underlying securities, and the desirability of keeping that as low as possible. Solutions to the current crisis that involve increasing the equity capital are also being floated.

You can see the mental process path that’s being followed here. If banks take a hit to their equity capital, it reduces their loan capacity. If they take a hit that’s bigger than 10%, they have no equity capital left, and then their depositor’s money is endangered. Do everything possible to prevent that happening, the depositor’s money is now safe, and banking can go back to being boring again.

Unfortunately, system design doesn’t work well, when only the individual entities are considered, and not the interactions between them. Concentrating on the risk of individual bank losses, ignores the larger issues being created by a system whose core set of rules, embodies a relationship and an interdependence between loans and the money supply. Especially, if owing to “financial innovation”, some loan instruments are being allowed to masquerade as money.

The simple answer then, to the question  – what is the limit on commercial bank lending? -  is that for any given Bank, it is the  lesser of the total of their deposits (minus a very small fractional reserve requirement that applies only to Net Transaction accounts), or ten times their equity capital. It follows then, that the instantaneous limit for all the Banks, is simply the sum of their deposits, or equity capital allowance.

But that’s merely the instantaneous limit. It tells us  nothing about the way that the system will evolve over time, as loans are made, money is created, loans are repaid and money is destroyed, within the commercial banking sector. Especially within a larger system, that allows debt to be turned into financial instruments, and those instruments to be used as part of the bank’s equity capital.

Or to put it another way, what controls the total amount of equity capital in the system? The old reserve requirement, and its associated commitment to deposit a part of that reserve with the Central Bank, provided the central bank with direct control over the money and loan supplies.  What is the equivalent control over the total quantity of equity capital in the system, since it now effectively regulates the money supply? The quick answer, which will be explored in considerably more detail in the next post, is that there isn’t one.

The regulators were concentrating on local risk at the banks. They appear to have overlooked the systemic risks associated with removing control over the money supply.

The hardest problems to correctly diagnose in distributed systems almost invariably involve two or more concurrent bugs interfering with each other. In the banking system at the moment, we have the Asset Backed Security bug, allowing banks to create an arbitrary quantities of loans; and the Equity Capital snafu, which has essentially introduced a slow leak into the money supply. Next post, i’ll run through a detailed example of how they interwork with each other.

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cc Credit Crises, Fractional Reserve System, Limits

Viewed from a computer scientist’s perhaps somewhat jaundiced perspective, the history of Fractional Reserve Banking and the many changes that have been made to it over the centuries is one of neither careful design, nor careless conspiracy  - careful conspirators typically don’t publish their meeting’s minutes online. Rather it is a history of kludges.

Every time the banking system has blown up, either in the form of some kind of speculative credit bubble, or through a collapse in the value of money through general inflation, the proximate cause has been identified and “fixed”.  Almost inexorably, or so it seems, thereby setting the larger economic system on track for the next problem.

One of the classic problems acknowledged in the textbook implementation of the Fractional Reserve Banking System is the inherent problem in relying on statistical multiplexing of a small reserve to satisfy deposit demands. What happens if a Bank hits a statistical outlier, and more than 10% of the bank’s depositors turn up on the same day asking for funds?  The other 90% of the bank’s deposits is represented by loans, and not immediately available. The probability of this happening depends on a number of factors, but two obvious, and historically relevant ones,  are the size of the bank, and its geographic coverage. The smaller the bank in terms of the number of its depositors and loan recipients, and the more locally based its depositor base, the more vulnerable it is to external events. For example, a bank that takes all its depositors money and makes five large  loans with it, is much more exposed if one of them defaults, than one that makes one hundred.

As a side note, this also means that the stability of a fractional reserve based banking system itself, depends in part on the distribution of monetary tokens within the community. A society where all the monetary tokens are controlled by a small number of people, is potentially far more vulnerable to banking crises than one where ownership of monetary tokens is more evenly distributed.

The pattern of a large number of small, locally based banks, was especially the case in the 18th and 19th centuries, when there a much higher incidence of bank runs than even today. Customer demand for money that exceeded the available reserves could just happen  randomly, because at the end of the quarter money had to be transferred from depositors to lenders at different banks. Ludwig von Mises also mentions this problem occurring in the Austrian Banking system in The Theory of Money and Credit.  It could happen because some event acted to co-ordinate borrower’s demand for funds – say a local crop failure requiring food to be purchased with savings, which might also put pressure on the bank from both directions, if the crop failures also caused local  farmers to default on their bank loans. It could even happen because the owners of the town’s other bank started a rumour, in order to get customers to switch their deposits.

From the perspective of the people running the banks though, this is regarded more as an annoyance than a real issue with the system itself. After all the depositor’s money is out there somewhere  in the form of a loan which will eventually be paid back. If the depositors would only wait, then they could receive their funds. Silly people for not understanding modern banking concepts and panicking. This is what comes of letting the common people have bank accounts. Etc.

The solution that was found in Great Britain in the 19th century was to introduce the concept of a central bank, in their case the Bank of England, as the lender of last resort. If a bank didn’t have enough funds to satisfy instantaneous demand, the Bank of England would provide funds to do so, and the Bank could then repay the Bank of England when its loans came due. Problem solved.

From 1866 onwards there were no financial crises in Britain at least for the rest of the 19th century. The banking system in the United States of America on the other hand, which at that time consisted of a large numbers  of very small banks,  saw repeated local bank panics, and occasionally some non-local ones with their associated major financial crises. It wasn’t until the early 20th century, that the United States copied the British system and setup the Federal Reserve Banks to act in a similar role as lenders of last resort in 1913. Following the wide spread bank failures during the Great Depression there,  a further support in the form of deposit insurance was introduced to the American system (and subsequently copied in Europe), and since then, there have been remarkably few bank failures, at least until the Savings and Loan crisis in the 1980’s.

From a distributed systems perspective, these are both good and valid solutions to the problem created by excessive demand for instantaneous funds.  Essentially what both these changes did was to distribute the problem represented by instantaneous demand for funds that exceeded the available local reserves of a small bank across the entire banking system.  While the available funds/loan balance of  single  bank could be badly de-stabilised by a single customer with a large deposit moving their account to another bank say, within the context of the entire banking system, this is a non-event.

Unfortunately, either lulled into a sense of complacency by the absence of bank panics, or perhaps because it was something that was never explicitly acknowledged,  the Central Banks appear to have forgotten the other purpose the individual bank’s reserve requirement played in the monetary system.

Providing a limit on the total quantity of loans made available by all the commercial banks.

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What is the limit on the amount the Commercial Banks are allowed to lend?

The story of credit crises is usually told from the demand side. The irrational exuberance of speculators down the ages drives inflated prices for over priced assets.  Inevitably the bubble bursts. Inevitably everybody pays the price. But the supply side of this formula always seems to get overlooked.  Why are the commercial banks able to supply a seemingly  limitless quantity of  loans to fuel the credit bubble? Why does a speculative bubble in Beanie Baby’s merely cause general embarrassment, while one in real estate cause massive economic dislocation?

This is a deceptively simple question, in the context of the larger fractional reserve banking system, since it is not just the quantity of the  loans that is potentially problematic. Through the fractional reserve process, commercial bank lending also has potential money supply implications. If there is no limit on the total quantity of commercial bank loans, then there is effectively no limit on the commercial banks’ ability to create money through the fractional reserve re-deposit process.

It is also notable that discussion of the problem of credit supply last year, concentrated on the supposed fear that the banks have of the risk in lending to each other in the inter-bank markets, rather than the possibility that they might simply not have had any money to lend.

Hypothetically then, the question can be framed in at least three ways. Either there is a limit on bank lending, in which case it might be reasonable to suppose that it is that limit that is preventing inter-bank lending, and not a sudden outbreak of pathological loan aversion in bankers; or there isn’t, in which case the money supply is being controlled by the commercial bank’s individual lending policies  rather than the central banks, which would be contrary to every foundational Economics textbook.  The third possibility  is that there is supposed to be a limit on lending, but some elements of the financial industry have found a way around it. However, given the entanglement that fractional reserve lending creates between the money and loan supplies, how exactly could this even be detected?

Going back to the previous post, a side effect of the fractional reserve banking system is that it creates two different kinds of debt within the economy. One is straightforward transfers in exchange for IOU’s of various kinds, either between individuals, businesses primarily in the form of bonds, and the government (treasuries). The other are the loans from the commercial banks, which represent a deposit somewhere in the banking system. For want of any better ideas, I’m going to channel physic’s particle/anti-particle structure and call them anti-deposits.  Commercial bank originated loans for long. Debt that results from a direct transfer of monetary tokens will be referred to as transfer debt.

If there is something going wrong uniquely within the fractional reserve banking system, then one expected outcome might be a change in the proportion of anti-deposits  to transfer loans within the general economy. If the amount of outstanding commercial bank loans is increasing faster than the quantity of transfer loans for example. Conversely, if the actual cause of the systemic problems that we’re currently living through is in fact government transfer debt, or increases in “fiat money” as I was confidently told by an Austrian economist back a few months, then we would also see a change, but it would be an increase in the amount of government originated transfer debt relative to commercial bank originated anti-deposits.

The quantity of outstanding debt within the United States economy is reported on a sector basis in the Z1 Flow of Funds report, Table D.3 The chart below shows the per sector information on Debt Outstanding.

From the explanatory notes in the current report. Foreign debt represents amounts borrowed by foreign financial and non-financial entitities in U.S markets only. Domestic financial sectors consist of government-sponsored enterprises, agency and GSE backed mortgage pools and private financial institutions.

The sectors aren’t totally clean with respect to being able to divide into transfer versus anti-deposit (bank originated debt). The domestic financial sector debt is for the most part being derived from bank loans in the forms of mortgages, since it includes Fannie Mae and Freddie Mac, who buy mortgages from U.S. banks and repackage them as bonds. Presumably also student loans, under the guise of Ginnie Mae.

Even so, it’s noticeable  from the chart above that bank originated debt is growing faster than other sources. Comparing proportionately the amounts owed by each sector in 1975 versus 2008, shows this quite clearly:

Proportionally, the last 30 years have seen a shift away from government debt towards commercial bank debt, primarily in the form of mortgages, since that is the main component of the Domestic Financial Sectors sector. They have also seen an extraordinary rise in the total amount of debt, as was shown in the original flow of funds chart, and it also appears that this new debt has predominantly originated from the commercial banks, chiefly in the form of mortgages.

In theory, the fractional reserve mechanisms don’t allow banks to issue arbitrary amounts of debt.  Originally they were  limited to a fraction of their deposits, now they are limited to a multiple of their equity capital. So what exactly has gone wrong that is allowing the commercial banks both to create so many loans, and to increase the money supply?

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