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.

cc Out of Real Time