Financial News, September 2007
The crisis afflicting credit markets has generally been perceived to be the result of specific problems, such as the weakness of the US housing market or the opacity of certain credit derivatives. This focus on specific issues makes the credit crisis seem amenable to solution and has encouraged stock market investors to remain complacent. Indeed, some argue that credit market problems are bullish on the grounds that, as in 1998, they will encourage the Fed to ease and provide liquidity for another stock market surge.
This conventional wisdom is, at best, highly misleading. The credit crisis is really a macroeconomic phenomenon – the culmination of a cycle that was initially prolonged artificially by easy money, and in which ultimately moral hazard encouraged credit expansion to extend even beyond the norms given by monetary developments.
Between June 2004 and June 2006 the US Federal Reserve raised interest rates seventeen times, the biggest tightening cycle since the beginning of the 1980s. The spread between 10 year Treasury yields and the Fed funds rate went negative in July 2006 and then inverted by 50-70 basis points. The investment share in US GDP (total, including housing) peaked in the first quarter of 2006 and the annual growth rate of total real investment fell negative later that year.
In all previous cycles since the 1960s, these developments have been associated with recession and a substantial stock market decline. But in this cycle credit continued to expand at a rapid clip. Total US domestic credit market debt grew at an annualized rate of 9.0% over the three years ended March 2007, greater than the growth of M2 money supply, at 5.1%. The monetary base (the key liabilities of the central bank) grew at a still lower 3.5%. Adjusted for inflation the monetary base is now lower than it was three years ago, the first time this has been true since the 1981-2 recession.
The sense is of a pyramid of credit built higher and higher on a limited base of money. The factors that encouraged this included the legacy of excessively loose monetary policies up until 2004, the belief that central banks were ‘underwriting’ markets, and the enormous Japanese foreign exchange interventions that stimulated the yen carry trade, providing ultra-cheap yen financing.
Now this credit pyramid is unwinding in a process that will be difficult for the authorities to halt. Contrary to popular opinion, the central bank injections of ‘liquidity’ do not represent the creation of new liquidity, at least as far as markets are concerned.
Imagine the following sequence of transactions, of a type that occurred during the credit bubble; I held a bank deposit but decided that I would do better to transfer the money to a money market fund. The money market fund bought commercial paper issued by a conduit that in turn invested in mortgage-backed securities.
After these transactions my original deposit was still in the banking system – possibly in the hands of a developer of condos in Florida. But also I now held a money market fund, which I considered to be the equivalent of money.
My transactions would therefore have contributed to lowering the price of risk and also expanding the supply of ‘liquidity’. Reversing them now leaves the conduit having to draw on its bank credit line, forcing an expansion of banks’ balance sheets, consequently tightening the demand for funds in the inter-bank market and causing the Fed to inject liquidity. But overall market ‘liquidity’ is not made higher by this – the monetary base is merely being expanded to support the existing levels of asset prices, which would otherwise collapse.
It is unclear whether banks’ balance sheets can expand enough in this way even to support the existing credit pyramid. But even if they can, the key is that the demand for credit will now decline, and probably quickly. Liquidity will tighten sharply, finally bringing this extended speculatively-driven cycle to an abrupt end.
Tim Lee is the founder of economic consultancy pi Economics