Milton Friedman wasn’t trying to be cagey. Quite the contrary, he was recognizing the complexity of the world we actually inhabit and then stating this in perfectly clear language. Things aren’t so simple as positive versus negative, especially when it comes to moving progress forward – or stopping in its tracks. What if progress merely slows; worse, what if it slows down for a very long period of time?
Notice below what Friedman was actually saying about “tight” money conditions. It did not, and does not today, necessarily mean outright contraction.
The simple fact of the matter is we live in a nonlinear world. Plus or minus, the sign in front of the rate isn’t actually the most important part of that rate. If the world needs the real economy to grow at, say, a sustained 8% rate and it only manages, say, 4% because the monetary system can only supply, say, 2%, given enough time stuck in this shape, it would only be a matter of time before all the things fall apart. I’m not talking strictly about labor participation rates and CPI puzzles.
Though the money supply is growing, the economy will be stuck with a tight money situation anyway, low interest rate situation anyway. And all the problems that will inevitably entail, including confused central bankers confusing the public.
These persistently low interest rates (the fallacy) that have got them perplexed are only the first clue/symptom. The lack of inflation means lack of sustainable growth meeting the economy’s potential. This doesn’t mean there will be no growth at all, like the monetary system this sucker is nonlinear, too.
But we have to recognize all the consistent evidence and signals, every one pointing in the direction of tight money. Which money, though?
We’ll pick things up where we left off yesterday, which means right here:
The banking system has created a seeming mountain of checkable deposits in the aftermath of 2008’s GFC1, perhaps partly in response to the Fed’s promise of bank reserves created when it undertakes its various QEs. That’s what you can see, and if that’s all you can see starting from a static baseline of what’s visible, it sure looks like it could be excessively inflationary.
But it hasn’t been. The rapid advance of checkable deposits, like bank reserves, has instead left the Fed with a monetary puzzle. Where’s the inflation? Where’s the recovery? Neither happened; on the contrary, a decade of undershooting which only recently left policymakers to laughably conclude while they missed their inflation target the problem must be inflation itself rather than the policies they made to spark first inflation and then recovery.
The conventional monetary programs simply do not account for the zoo. What you see is only part of the story, and, as we’ll see, a very small part.
To begin with, checkable deposits aren’t really monetary growth on the liability side just as QE is nothing more than an asset swap seen from the proper perspective of the banking system. More than anything, and this is the key part, these checkable deposits represent the other disinflationary side of the QE asset swap – a liability swap.
The end result of a shadow money arrangement had left formerly commercial banks with a ridiculously shaky proposition (owing money in repo on crap collateral, for instance). QE offered a much safer alternative where at the end of it the primary dealer created a stable deposit liability (with the federal government) offsetting the bank now holding one of the least risky assets (bank reserves).
Repo MBS vs. checkable deposit. No contest. Plus, with the latter, the bank would end up with a choice of holding UST’s or bank reserves (to QE, or not QE – depends upon repo collateral!), both liquid and bulletproof. De-risking on both sides of the balance sheet.
If I’m right about this liability swap business, then that’s just what we should see in the real data (Z1). And we do. Shadow money or not, it’s actually not the slightest bit difficult to find.
We’ll start with the depository bank system (a subset of the entire financial system) and work our way as far into the shadows as this clumsy dataset enables.
At the height of the pre-crisis eurodollar era (above), this cohort of banks (which, as noted yesterday, now includes both depositories as well as formerly commercial banks) had relied more and more on pure wholesale money for its marginal balance sheet funding – federal funds (unsecured, ST interbank) and repurchase agreements, or repo (secured by collateral of various kinds, ST interbank). At the peak, more than $1 trillion, an enormous sum already and still just the tip of the iceberg.
Since August 2007 (Q3 2007 in these figures), the banking system has been reducing its reliance on wholesale. But that contraction extends into the nonlinear; meaning, while the amount has fallen outright, the full level of this monetary shortfall is appropriately measured against its “potential”, represented by the dashed baseline (above, below).
After more than a decade, the scale of this funding gap has grown to more than $2 trillion. And this is exactly where the checkable deposits show up.
For starters, it already looks just like a liability swap; shaky, unreliable wholesale down, stable checkable deposits up. The one taking over for the other.
Congratulations three successive Federal Reserve Chairmen? Bernanke to Yellen to Powell, offsetting this vast monetary gap by getting the banking system to create checkable deposits so as to participate in QE?
Not quite. As I wrote, we’re just getting started.
The raw amount of the increase in checkable deposits does stick to the baseline for where wholesale funding “should” have been had it been left uninterrupted by that whole monetary crisis in 2007-08. Right off the bat, however, this is not a perfect substitution. Dynamic wholesale which had supplied a blending of all kinds of bank activity compared to checkable deposits with far more limited function.
Also note that, though some, most, maybe all of the checkable deposits may have been created to buy up securities at security auctions, therefore beginning in the hands of the federal government, they don’t stay there – the feds immediately spent all the money they borrowed which didn’t lead to any inflation, either.
These checkable deposits changed hands and had entered the public domain. Didn’t matter.
Again, it’s what you haven’t seen which does.
While checkable deposits barely covered the gap of wholesale liabilities within the visible depository system, what about the rest of the financials? ABS issuers had been, since around 1995, one of the largest sources of credit for the US and global economy. Astronomical amounts. While not technically banks, off-balance sheet still means sponsored by and connected to them. A fuzzy, little-appreciated extension of the banking system.
All that really means is one more step further into the shadows of the monetary zoo, and already the checkable deposit liability swap is dwarfed by the monetary destruction we find in just this one other part. A key part of the ABS function was commercial paper, another unsecured, ST interbank wholesale liability (Bill Dudley would’ve made famous if there wasn’t so much Aristotelian corruption).
Putting only these two small wholesale pieces together, ABS CP plus depository fed funds and repo, the increase in checkable deposits doesn’t even offset it, already showing us how the liability swap is really more destruction than it was ever a one-for-one swap.
It’s the perfect description of a chronic, systemic liquidity shortfall. Not only does wholesale disappear, checkable deposits do nothing so far as replacing even $1 of wholesale function. Again, what I wrote yesterday, “De-risking on both sides of the balance sheet.”
A qualitative as well as quantitative tightening.
And we’re not done yet. Let’s broaden our horizons further. Rather than focusing on individual, separate pieces of the whole financial system, the depository or ABS parts in isolation, we’ll string all of them together and come at it from the top (at least, the “whole” insofar as what the Fed is able to uncover and keep track of with Z1).
Like before, we’ll focus on just two wholesale liabilities of the entire domestic financial sector and compare them with the increase in checkable deposits. For the full visible system, again, it’s really only a partial liability swap at best; far more wholesale disappears (and never happens) than any deposits which appear as a response to that disappearance.
Qualitative tightening also means a change in systemic behavior, not just a reflexive response to QE (nor one that can be blamed on regulations; this stuff all began, as you can plainly see, years before Dodd-Frank or Basel 3).
Adding these together, the level of hidden monetary destruction even in the face of the liability swap is what jumps out – not the Fed, not QE, not really checkable deposits:
The parts that get counted in the M’s go way up, further reinforcing the inflation/money printing narrative, while the more dynamic and useful pieces that aren’t in any M’s got crushed, reinforcing disinflationary monetary reality. People see and hear constantly about the M’s, but the results (disinflation, interest rates, lack of growth) are all dictated instead by what’s going on in the shadows.
Given just the wholesale money destruction I’m showing you here – and there’s even more of it outside the US I won’t get to – it’s no wonder the major change in general liquidity conditions regardless of QE’s, bank reserves, and checkable deposits. De-risking both sides of shrinking balance sheets becomes a self-reinforcing process against which the Fed’s puppet show is laughably irrelevant.
Even giving it the most benefit of the doubt, QE or not, banks were already swapping liabilities like assets in the wrong direction.
And that extends into the bond market beyond Treasuries. You’ll often hear about a credit bubble going on there; if the banking system has been hobbled by whatever shadow problems, some continue to say bonds especially corporate credit has more than made up for it (with many people, wrongly, attributing this to “the Fed’s” low interest rates).
No. Bonds plus loans, banks plus markets, both are reacting in exactly the way you’d expect, given these tight money conditions. Liability swap on the one side, asset swap on the other greatly favoring the risk-less. Again, Friedman; credit has grown since 2008, but at a ridiculously reduced pace (above). It’s not close! Not even the federal government’s alarmingly record bond binge has made up for the smallest part of the gap.
And that binge was easily absorbed, demand never once wavered, only increased, because liquidity risks/tight money conditions remain paramount.
Excluding the federal government (below), the amount of risky credit flowing into the domestic financial system and ultimately supporting the economy is actually a fraction of what had been keeping things moving. And that, too, makes perfect sense when you recognize the starting monetary position is disinflationary and tight.
When factoring the very real perhaps likely possibility there had been too much credit before GFC1, even then you still don’t end up with a baseline down this far, with financial therefore economic growth persistently dragged so much below potential for this long.
The simple fact of the matter is we live in a nonlinear world. Reduced liquidity, reduced credit, reduced growth. The Fed doesn’t act in the system directly, and banks have shown they’d continued to de-risk on both sides of their balance sheets which further reduced liquidity, further restrained credit, and acted as even more of a tight lid on economic growth.
Inflation puzzle solved; no need to flatten AW Phillips’ reputation just to make QE appear like it could’ve worked despite its clear lack of results.
The net result is simply this: a world that won’t take much more of it. And that was before 2020. The Fed and the federal government’s collective response to 2020 has been more of the same. Same puppet show. Same bank reserves. Same liability swap. Bond market apathy to the inflation narrative therefore is and has been perfectly reasonable, never standing up to the accounts nor the accounting, a fact requiring you to take only a couple steps into the wholesale, shadow money zoo to easily establish.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.