Will Banks Help Kill the Recovery?
10/02/2009 9:49 am EST
Despite the Fed's efforts to flood the economy with cash, the broadest measure of the money supply is declining because most of the new money is just sitting in vaults.
We've got a little problem in the economy. Tiny really. Nothing to worry about.
The government and the Federal Reserve are pumping money into the economy as fast as they can, yet the supply of money in the economy has started to fall—and that, in turn, could endanger the entire economic recovery.
The Fed is buying mortgage-backed securities ($1.25 trillion) and debt from Fannie Mae and Freddie Mac ($200 billion), expanding its lending to banks by keeping interest rates close to zero, and buying up US Treasurys.
All that, according to the textbooks, should be flooding the economy with money.
And that's exactly what you're supposed to do to get the economy running again and to avoid turning the Great Recession into a rerun of the Great Depression. (And if you need a reminder about a recovery going into reverse, try my soothing story on the recession of 1937.)
That's a lot of Money Running Around
During the early stages of the financial crisis, those policy actions did exactly what they do in the textbooks. M2, the broadest measure of the money supply that the Fed still tracks, climbed from $7.36 trillion in October 2007 to $7.88 trillion a year later, and to $8.39 trillion last June 22, according to the St. Louis Federal Reserve Bank.
That's an additional $1 trillion to fund loans and credit card bills and plant expansions and state borrowing and…well, just about anything the economy needs.
And because each dollar of that extra trillion gets used over and over by the economy, the effect is even larger than that huge sum itself. What economists call the M2 multiplier has ranged between 8 and 12 for most of the period from 1959 to 2009. So that $1 trillion has the effect of an extra $8 trillion to $12 trillion in money racing around the economy.
Even in the huge $14 trillion-plus US economy, that should be enough to jump start economic activity and raise justifiable fears of runaway inflation.
In normal times, anyway. But the numbers coming out of the Federal Reserve say these aren't normal times.
Multiplier Takes a Nose Dive
Despite everything the Federal Reserve has done to pump money into the economy (and don't forget the $787 billion stimulus package passed by Congress), money supply as measured by M2 actually declined in the four weeks ending September 14.
And that's because what's called the velocity of money, the speed with which a dollar moves through the economy, has fallen.
That's not unexpected. During the Great Depression, the velocity of money fell 22%. In tough times, people from consumers to bankers sit on more money longer.
But this isn't good, folks. It's a problem big enough to jeopardize the recovery that the economy seems to be building.
Look at what's happened to M2 since it hit $8.39 trillion on June 22:
- By July 20, M2 had dropped to $8.34 trillion, down $50 billion
- By August 24, it was down to $8.28 trillion, down $110 billion
- By September 14, the latest data point from the St. Louis Fed, M2 recovered slightly to $8.30 trillion, still down $90 billion from June 22
Economists who study this data use a four-week moving average to eliminate some of the week-to-week noise. At the worst point in the decline, the four weeks ending August 24, M2 was dropping at an annualized rate of 12%. That's the kind of contraction you get in a financial panic. Not the kind of growth you want to see as you're trying to guide an economy to recovery.
And if you factor in the drop in the velocity of money and in the M2 multiplier, the situation is even worse. Remember, I told you that the normal multiplier from 1959 to 2009 was in the range of 8 to 12. But in the financial crisis, the M2 multiplier, according to the Federal Reserve, dropped close to 4. And it hasn't bounced back.|pagebreak|
So in the past few weeks, money supply has dropped at a rate fast enough to derail the recovery, and the velocity of money has remained stuck at the slow speed of a financial crisis.
The good news is that it's pretty clear what the problem is. The bad news is that it's not at all clear how to fix it.
The problem is that the banks still aren't lending. They're sitting on a huge proportion of all the money that the Fed is pumping into the economy, and because the money they're sitting on isn't moving, that's putting the brakes on the velocity of money.
Look at what M2 actually measures. It's the sum of all the currency in circulation, plus all the money in demand deposits (checking accounts and other funds that can be withdrawn without notice), plus savings accounts, plus time deposits (CDs and the like) under $100,000, plus money market funds, plus overnight repurchase agreements and euro dollars at banks. (Those are all the big components, anyway.)
It doesn't include the reserves that banks keep in their own vaults or at the Fed.
Not Much Good in the Vaults
In other words, if the banks don't lend it out, the money that the Federal Reserve has pumped into the banking system won't reach the money supply that drives the economy. If a bank makes a loan to buy a house or to build a factory, that loan turns into paychecks, orders from and payments to suppliers, and profits for builders.
Some of that money gets spent again and again, producing the multiplier effect of any increase in the money supply.
All of the money banks lend, perhaps only fleetingly, winds up in checking accounts, savings accounts, business accounts, and other instruments that are measured as part of M2.
If the money sits in a vault, it doesn't count.
How do we know that's what's happening? By looking at another data series from the St. Louis Fed that tracks how much money commercial banks have lent. (If you want to check any of this data yourself, start here with the St. Louis Fed's series on M2.)
As you'd expect, banks cut back lending in the financial crisis and then ever so gradually increased lending when it became clear the sky wasn't falling. Total lending at commercial banks climbed from $8.7 trillion in the week of October 17, 2008, to $9.3 trillion in the week of December 24, 2008. That's a very healthy $600 billion increase in just about two months.
Lending Beset by Inertia
But then things stopped getting better. They didn't get worse, except for the weeks around the March 9 stock market low, when bank credit fell below $9.3 trillion. But bank credit stayed stuck at that level.
Until July. That's when it started to slide back. In July, bank credit dropped below the $9.3 trillion level. In the week ending August 19, it dropped below $9.2 trillion. And it stayed there for the first half of September. In the week ending September 16, total bank credit came to $9.12 trillion.
That's not a huge decline from $9.3 trillion, but it is definitely a move in the wrong direction at a time when the economy needs to see bank lending growing, not shrinking or standing still.
Why are banks cutting back on their lending? (I don't mean to pick on banks here. I think other types of financial institutions are doing much the same thing. It's just that the data on banks are so much better than in other parts of the financial industry.)
Part of it is that they don't trust the recovery. With unemployment still rising and consumers still not spending as before, being cautious about extending new credit doesn't seem particularly outrageous.|pagebreak|
Cleaning up Their Books
But that's not the major part of the problem. Banks aren't lending because they still haven't cleaned up their balance sheets. Many of them are still in the process of writing down credit card debt or mortgages or commercial loans—not to mention the complex derivatives they've still got in their portfolios. They know that regulators have suddenly turned strict about capital ratios. There are only two ways to raise your capital-to-asset ratio (and remember that, for a bank, a loan is an asset): You can either go out into the still very hostile public financial markets and pay the pound of flesh that investors want before they buy into an equity offering. Or you can improve the ratio by working on the denominator. Cut the amount you've got out in loans, and your capital ratio goes up without the need to raise more capital.
Banks know, too, that tougher capital requirements are coming not too far down the road. At the recent Group of 20 economic meeting in Pittsburgh, it was agreed that the various national regulators would go back home and increase the amount of capital that the banks must have. For 2010 and 2011, banks face a steady ratcheting up of capital-to-asset ratios. They don't want to make the challenge of meeting those new rules any tougher by expanding their loan books now.
None of this really comes as a surprise to the Federal Reserve and the world's other central banks. They knew that they potentially faced exactly this problem. But they hoped that by unleashing a campaign of financial shock and awe that involved heavy fire from all monetary and fiscal weapons, they'd be able to convince banks that it was only sensible to lend more rather than to sit on their money.
It's not clear that this policy has failed. The worrying trends really include just four weeks or so of data. But the short-term trend is worth worrying about because, having fired all their guns, the world's central banks really don't have much left in their arsenals to roll out in a new assault.
Watch the data. We're not out of the woods yet.
At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.