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Dec 30, 2015 Fed Funds Rate up 25 Basis points...so what?
Dec 15, 2015 Fed Funds on the rise? Has Yellen 'Fell-in'?
Oct 15, 2015 Labor Markets Seven years of misery
Oct 6, 2015 Sept: Horrible Month for Labor
Sept 30, 2015 The FED: Interest Rate Angst
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July 31, 2015 Trade and Foreign Exchange Rates
July 20, 2015 Economic Growth?
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Dec 23, 2011 Revisionist History Depression
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Nov 16, 2011 Taxes Part 2
Nov 8, 2011 Taxes Pt 1
Nov 1, 2011 Demographics
Oct 12, 2011 Fed-FOMC
Oct 6, 2011 Fed's Operation Twist
Sep 30, 2011 What Price Bailouts?!
Sep 9, 2011 Trade Deficit - States
Sept 3, 2011 Unemployment Ongoing Challenge
August 22, 2011 Restricting Oil Supply
August 11, 2011 Credit Rating-Taxes
August 8, 2011 QE3? What to do?
Aug 5, 2011 Employment Update
August 1, 2011 Competitive Free Mkt Capitalism
July 26, 2011 Cradle of Democracy
July 16, 2011 Capital Ratios
July 10, 2011 Unemployment Again
July 1, 2011 QE2 Over-Apres Moi, le Deluge
June 11, 2011 Unemployment
June 8, 2011 Net Worth Collapse
May 18 2011 Credit Collapse '08-'10
May 15, 2011 Fed Miracle-Mayhem
May 10, 2011 Unemployment
Mar 30, 2011 Puppet Show
Mar 18, 2011 Locked-in-Effect
Mar 10, 2011 Bummer Days
Feb 12 2011 Inflation by Decontenting
Feb 6 2011 Unemployment
Jan 14 2011 Money Supply
Jan 12 2011 Trade Deficit
Jan 6 2011 Printing Press Myth
Dec 18, 2010 College Pricing
Dec 7 2010 Debt & Deficits
Dec 2, 2010 J-Laffer Curve
Sep 24 2010 Competition
Sept 23 2010 Trade Deficit China
Introduction
About us
Links of Interest
Straw Poll
Definitions & Miscellaneous
 

Economic Newsletter for the New Millennium

May 18, 2011

Editor
Donald R. Byrne, Ph.D.
dbyrne5628@aol.com  

Associate Editor
Edward T. Derbin, MA, MBA
edtitan@aol.com  



Download current blog

GreatCreditCollapseof2008-2011.pdf


 

THE GREAT CREDIT COLLAPSE OF 2008-2011:
The Smoking Howitzer


Caveat!

The pictures accompanying the following article are very vivid and we recommend the weak of heart view this with adult supervision.


The Flow of Funds Accounts of the Federal Reserve System for the last five years goes a great distance in explaining the ongoing financial and economic malaise of the U.S. economy.  The total credit creation was trending upward and reached a peak in 2007 at $4.483 trillion.  It fell to $2.582 trillion in 2008 and dropped further, turning negative, (-$634) billion in 2009.  This means that in a net sense, no new net credit creation was occurring and outstanding credit was allowed to run off by either credit recipients paying off some of their debt or because lenders undertook bad debt write-offs.  A very slight revival occurred in 2010 with $736 billion credit being created.  This was 83.6% less credit than was created in 2007.  The Flow of Funds data for the first quarter of 2011 is not yet available.


Board of Governors of the [U.S.] Federal Reserve System

Flow of Funds Accounts of the United States

Flows and Outstandings

Fourth Quarter 2010


http://federalreserve.gov/releases/z1/Current/z1.pdf  

 

THE THEORETICAL AND HISTORICAL BACKGROUND


Just as Keynes shattered the neoclassical vision of what was to be called macroeconomics, economists, John Gurley and Edward Shaw shattered the accepted view of credit creation.  What it boils down to is that credit creation has two sources, credit can be created by creating new M-1 money as depositories such as banks and credit union do, or it can be created by non-depositories such as finance companies, insurance companies, mutual funds and pension funds, to name but a few, by offering the holders of existing M-1 money, nearly always in a checkable deposit form, a substitute such as a certificate of deposit or pension fund claim or the cash surrender value of a life insurance policy and then “lending out” or investing the just acquired M-1 money.   Gurley and Shaw viewed these substitutes as near M-1 money.  Many of these substitutes are the non-M-1 components of the more inclusive monetary aggregates such as M-2, M-3, etc.  

The monetary aggregate M-1 will support a larger GDP and thus the GDP velocity of M-1 is increased.  In other words, the financial intermediaries can also create credit by increasing the velocity of M-1 money.  While credit creation is related to M-1 money, the greater is the velocity of M-1 money, the greater the creation can be in relation to a given quantity of M-1 money.

This has been implicit in continental monetary theory and policy making.  Especially in post WWII Germany where the monetary authority mandated required legal reserves for a much broader spectrum of monetary assets than in for example, the United States.  The “spiritual father” of monetary policy on this side of the Atlantic Ocean has been the classical-neoclassical versions of the quantity theory, called monetarism in its modern form.

When the velocity of M-1 was stable or at least unstable but reliably predictable, monetarism dominated the FED’s policy making activities.  Hence defining, estimating their size, publicly reporting their size, and targeting the growth rates of five monetary aggregates, M-1 though M-5 were characteristics of monetary policy. 

With the inflation driven explosion of substitutes for M-1, moving from M-1 to the broader aggregates or from those broader aggregates back to the narrower aggregates including M-1, caused the predictability of the velocity of the monetary aggregates to become increasingly unreliable, as the basis for monetary policy decisions.  The reign of monetarism ended as did the estimating and reporting of the broader aggregates M-3, M-4, and M-5.   


=================================

Discontinuance of M3 (March 23, 2006)

http://www.federalreserve.gov/releases/h6/discm3.htm  

 

Chairman Ben S. Bernanke

At the Fourth ECB Central Banking Conference, Frankfurt, Germany

November 10, 2006

 

Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective

“M4 and M5 were dropped in a 1980 redefinition of the monetary aggregates.”

http://www.federalreserve.gov/newsevents/speech/bernanke20061110a.htm  

=================================


Even when Monetarism was gaining wider acceptability, Monetarists disagreed on just what was the monetary aggregate that was a chief cause of price level changes.  Most argued M-1 as being too narrow a measure.  Many chose a broader and more inclusive monetary aggregate such as M-2 or M-3.  The broader the aggregate, the less the impact on the velocity of these more inclusive monetary aggregates such movements between its components had.  Some chose to define the appropriate aggregate differently than did the FED.

Velocity changes can become quantity changes in the broader aggregates.  As the monetary aggregate is more broadly defined and more inclusive, it approaches the totality of credit creation.  Estimates of such a broad aggregate become more difficult to make and time lags in the availability of their estimates become increasingly problematic.  While the velocity problem is reduced, other such problems as just mentioned make the use of monetarism more difficult as the basis for money policy deliberations and policy choices.

Since the explosion of substitute financial assets, the FED has gradually returned to influence economic and financial behavior by attempting to control the cost and availability of credit.   

FED - Lender of Last Resort?


QE.jpg


===============================================

Tales of Quantitative Easing

QE 1 = 2009 
 

Release Date: March 18, 2009

http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm  

 
…In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.  The Committee [Federal Open Market Committee] will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.  To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. 

QE 2 = 2010-2011

Release Date: November 3, 2010

http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm   

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee [Federal Open Market Committee] decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.

===============================================

 
There is an old expression that warns us, “You can lead a horse to water but you can’t make him drink”.  To paraphrase it for purposes of this article:  You can supply all the legal reserves you want to the depositories but you cannot make them create M-1 money and credit.

We have pointed out in previous newsletters and blogs on this website that depositories create money (checkable deposit form of M-1 money) and credit (lending out the newly created money in the form of loans and investments) in order to increase profits.  If such credit creation is not profitable, they will not undertake money and credit creation even with significant excess reserves.  The pre- WW II literature on monetary policy referred to this reaction to monetary stimulus as the “reflux mechanism.” 



Thomas M. Humphrey – The Federal Reserve Bank of Richmond


“Tom Humphrey worked as an economist in the Research Department for 35 years. He retired from his position as senior economist and research advisor in 2005.

Humphrey published numerous journal articles and books during his career at the Richmond Fed. He continues to write on monetary policy history, most recently about the Federal Reserve's role as lender of last resort.” 

http://www.richmondfed.org/research/economists/authors/humphrey2.cfm 


Taking apart the Fed’s Balance Sheet…

http://federalreserve.gov/releases/h41/Current/h41.pdf  

Federal Reserve H.41 Release: The FED's Balance Sheet




h41.pdf


The FED upping the ante: Tripling the size of its Reserves - the ability to create credit has been expanded, but the reality is that the credit creation can't be forced


Bank Credit.jpg



In the past, the FED depended heavily on very short term repurchase agreements in its bid to regulate the creation of credit.


RP Agreement.jpg




In adding Mortgage Backed Securities (MBS) to its portfolio at face value, the FED effectively backstopped the collapsed real estate based collateralized debt obligations (CDOs) markets, etc.  The current value of the assets in the FED's portfolio is certainly much less than the face value.


MBS.jpg


An examination of the following charts is very helpful in revealing where credit creation has been weak.  The first two charts below show total credit market borrowing and then its breakdown by sector.  First note the collapse beginning in 2008 and the anemic revival in 2010

Drilling down on the Financial Sectors…[BORROWING]

The borrowing in the markets absolutely crashed and then cratered in 2009.  There was a combination of bailed out financial institutions not extending credit; anemic economic growth, leading to much less demand; and the fact that credit was virtually unattainable for those who really needed it.


Credit Borrowing.jpg



Business borrowing and Household borrowing disappeared.  Not to fear, the government ratcheted up borrowing to unheard of levels.


Borrowing by Sector.jpg



The Financial Sector was riding high and peaked in 2007.  It collapsed in 2008; went negative in 2009, and stayed negative in 2010.


Credit Borrowing.jpg



Commercial banking, and more importantly, the bank holding companies (which included broker segment) collapsed in 2009 and 2010.


Borrowing Commercial Banks.jpg






Borrrowing Credit Unions.jpg





Borrowing GSE ABS LIC.gif





Borrowing Funding Brokers.gif



Drilling Down in the Financial Sector…[LENDING]




Credit Market Lending.jpg





Lending by Sector.jpg






Lending Financial Sectors.jpg




 

Lending FED.jpg


again

QE 1 = 2009

Release Date: March 18, 2009

http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm  

…In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.  The Committee [Federal Open Market Committee] will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.  To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. 

 
 

QE 2 = 2010-2011

Release Date: November 3, 2010

http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm  

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee [Federal Open Market Committee] decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.




Lending Commercial Banks.jpg





Lending Credit Unions and Savings Institutions.jpg





Lending Pensions and LIC.jpg





Lending Investing.jpg





Lending ABS GSE.jpg




 

Lending Investing Funding Brokers.jpg



THE BASIC THEORY OF CREDIT CREATION


Recall that only depositories (commercial banks, savings banks, credit unions and savings and loan associations) can create credit by creating additional M-1 money and lending it out (in checkable deposit form: demand deposits, NOW accounts, share drafts at credit unions, and ATS accounts).  Credit creation by non-depository financial intermediaries such as insurance companies, pension funds, finance companies and mutual funds, etc., is achieved by their increasing the velocity of existing M-1 money (by issuing substitute financial assets for already existing M-1 assets).  These non-depository financial intermediaries cannot create checkable deposits and have to acquire the already existing M-1 money created by the depositories, usually in the process of creating credit.  For example, a pension fund issues pension fund claims in exchange for checkable deposits from the contributors, either individuals or the firms that employ them.  The pension fund can then lend the checkable deposits by making loans or investments, i.e. creating credit.



M-1 Components.jpg




GDP.jpg





M1.jpg





Velocity of M1.jpg


   
From the data, since all non-depository financial intermediaries as well as the depositories were reducing substantially their credit creation activities, the growth of M-1 slowed to a crawl and the velocity of M-1 fell sharply. 

This can be seen in the accompanying charts. 


 



  


Velocity of M-1.jpg

 

 

This was not the case for the U.S. Government which has been experiencing record deficits in the last (3) three years. 



Borrowing FED.jpg



Glossary of Terms – Federal Reserve Board of Governors

http://www.federalreserve.gov/newsevents/reform_glossary.htm   

 
just a few…

Asset-backed securities (ABS)

A security that is collateralized by a discrete pool of assets (such as loans, leases, or receivables) and that makes payments that are based primarily on the performance of those assets. 


Agency mortgage-backed securities (agency MBS)

Mortgage-backed securities issued or guaranteed by federal agencies and government sponsored enterprises.

 

Mortgage-backed securities (MBS) 

A security that is collateralized by a discrete pool of mortgage loans and that makes payments that are based primarily on the performance of those loans. 

 

Depository institution 

A financial institution that is legally permitted to accept deposits from individuals. Depository institutions include savings banks, commercial banks, savings and loan associations, and credit unions. 

These are often referred to as primary deposits.  This is the chief way in which the depositories acquire legal reserves and enable them to create secondary deposits in the process of credit creation.  Secondary deposits are those checkable deposits created by depositories in the process of their creating credit, i.e. making loans and investments.

The total checkable deposits, as they relate to the total legal reserve of each depository institution, are called the legal reserve ratio.

 

                                                 ----------------------------------------------