The bad news could not continue for ever. For the first time in over five years, the prospect in a major economy is for an upturn in money growth and a strong, broadly-based economic recovery. In the last five months clear signs have emerged of an upturn in the rate of growth of US M3 (and even more of US M2, although I pay less attention to that). This upturn is not due to artificial support from officialdom, such as that provided by ‘quantitative easing’ operations. I am of course not criticising QE2, which was necessary in the circumstances of late 2010. The revival in US money growth is instead the result of banks’ preparedness to expand their balance sheets and their customers’ desire to take on more debt. If oil and commodity prices dip further, the upturn in nominal money growth will be associated with definitely positive growth in real money in the next few quarters. Balance-sheet improvement should become general.
Despite the wretched Basle III rules (and the whole Basle regulatory paraphernalia), US banks apparently feel adequately capitalized. Charge-off rates on loan portfolios are now falling and, with low interest rates helping borrowers, they should continue to decline. Write-backs of provisions should further strengthen capital in 2012. Another healthy sign is that in the American public debate top bankers (notably Jamie Dimon) are starting to answer back against the media onslaught their industry has received in the last few years. More criticism is being directed towards the Fed and the regulators who are indeed just as culpable as the bankers for the disasters of the 2007 – 10 period. Investment banking faces a few more years of reappraisal and redefinition, but 2012 should be a good year for US commercial banks.
US broad money growth turning upwards
US money growth – on the broadly-defined measures which are of most macroeconomic importance – appears to have turned upwards. The message is clear-cut. Money growth accelerated sharply – much too sharply – in the first two years of the Bernanke Fed chairmanship, reaching a peak (on a six-month annualised basis) in the high teens in early 2008. From there the plunge was precipitous, initially because of Fed action to control inflation, but in 2009 and 2010 mostly because of banks’ response to demands for higher capital ratios from officialdom. In early 2010 M3 was between 3% and 5% down on a year earlier, the weakest number since the 1930s, with the deflationary impact fortunately offset by very low interest rates. However, M3 stopped falling in July/August 2010 and from November 2010 was boosted by large-scale Fed purchases of government securities in the controversial QE2 programme. Banks raised more capital and held back the growth of their risk assets, in line with (in my opinion misguided) regulatory demands. However, the Fed’s operations ensured that the quantity of money did grow in early 2011. Roughly speaking, the banks added $600b. of cash to their assets as their depositors credited the proceeds of government bond sales (to the Fed) to their bank accounts. I had worried that, once QE2 stopped, banks’ reluctance to expand their risk assets would be followed by a return to money stagnation. The happy news is that since the end of June banks have in fact been expanding their risk assets. Loans for ‘industrial and commercial’ purposes have been particularly buoyant and that, plus purchases of securities, has meant that banks are – once again and at long last – growing their balance sheets for healthy profit-making reasons rather than as a by-product of open market operations by the official sector (i.e., the government and/or the central bank). Are the last few weeks a flash in the pan? So will the resumption of normal profit-seeking asset acquisition by the banks fizzle out in the new few months?
Recent burst of M2 growth
The revival in money growth is more obvious with the M2 measure than with M3. In the year to 12th September M2 rose by 8.8%, more or less in line with the very long run average over the last 50 years, while in the 13 weeks to 12th September it went up at the stonking rate of 18.2%. Some commentators have started to leap up and down about an imminent inflation problem. However, it is important to realize that nowadays M2 is only two-third the size of M3, and excludes most deposits held by large companies and financial institutions. The surge in M2 is largely due to switches – within the larger M3 aggregate – between balances inside and outside the M2 definition. These switches are not irrelevant. They are worth noting because they suggest that money-holders may be considering more active deployment of their liquid balances. But by themselves money-into-money transactions do not add to demand for goods and services. M3 is the vital aggregate for macroeconomic diagnosis.
One illustration of the weakness of M2 is that it does not include money market funds held by the major savings institutions. The weekly data for such balances are compiled by the Investment Company Institute and published by the Federal Reserve as part of its money supply release. The importance of these numbers is that these are the money holdings that institutions are balancing against their holdings of equities, bonds and real estate in their portfolios, and so play a critical role in asset price determination. While M3 was falling 2010, ‘institutional money market funds’ were collapsing. As the chart below shows, they have continued to go down in recent weeks, even as M2 has been soaring. The explanation may be partly that financial institutions have been taking up new security issues by companies on such a large scale that money has been transferred from them to the corporate sector, and partly that – within their overall money holdings – financial institutions have decided to keep more in sight deposits with the banks and less with the money market funds.
(A proper analysis requires a lot of detailed institutional work which I don’t have time or inclination to do on this side of the Atlantic. I would nevertheless insist that M3, not M2, should be the focus of macroeconomic analysis and commentary. Ever since the Fed stopped publishing M3 numbers in March 2006, a debate has been simmering – and sometimes threatening to boil - about the wisdom of that decision. Last year Gary Gorton of the Yale School of Management argued in a new book on Slapped by the Invisible Hand: The Panic of 2007 that the balances created by repo transactions are definitely ‘money’, since they could be re-invested until the expiry of the repo contract. The book includes a letter, written in 2107 [this is not a misprint], asking how the Fed’s weird discontinuance of M3 could have happened. Gorton believes – like me, incidentally – that the Fed will eventually restore publication of M3 data and save analysts the bother of comparing private sector guesstimates. Subscribers will already be aware that in my next book, Money in a Free Society, I am very critical of the Fed in general, and Bernanke in particular, for ending the preparation of the M3 figures.)
Is the upturn in money a flash in the pan?
Given the notorious volatility of money growth, cynics may question the reliability of claims that US money growth is rising. However, two recent accompanying developments support an optimistic assessment of the monetary outlook. The first is that US banks are now operating on high capital/asset ratios by the standards of the last 30 years, as noted in my e-mail of 11th August on ‘US banks are now better capitalized than for over 30 years’. I am not sure that they are fully compliant with the Basle III rules, as this is a complex and rather technical question. However, we do know that the American banking industry is fed up with the demands for extra capital. A majority of US banks, by number, did not abide by the Basle II rules and life went on.
The second point is that charge-off rates on US banks’ loan portfolios have been declining for several quarters and seem likely to continue to do so. In line with the media stereotype, charge-off rates in the latest cycle have been much higher for the US banking system as a whole than in the previous worst episode since the 1930s, which was in the late 1980s. (The banks then had bad debts on Third World loans, and on loans to farms, Rust Belt companies and some real estate developers.) But the recent bad debt experience for many banks has in fact not been worse than in the 1980s. Banks concentrating on corporate lending in, say, the Mid-West – where farms have been prospering (unlike the 1980s) – have had less trouble than 25 years ago and do not understand why there is such a regulatory onslaught to force them to hold more capital, liquidity and so on.
As the two previous periods of credit anxiety show, once credit-worthiness starts to improve, it tends to keep on improving for several quarters. From the peak charge-off rate of 1.69% in Q3 1991, the rate dropped for three years; from the peak charge-off rate in the next cycle, of 1.12% in Q3 2002, it declined for four years. Since US banks are now very profitable in operating terms, further falls in charge-off rates will enable them to rebuild capital and move closer to the Basle III objectives (insofar as they are objectives), perhaps with little difficulty
Higher US money growth and relatively strong US banking system: what are the wider implications?
In the long run the rates of growth of real money and real output are similar, even if they are not identical. In the short run the rate of growth of real demand tends to be correlated with the rate of growth of real money, although the relationship is often rather untidy. At present oil and commodity prices are weakening, with fears of a global recession – attributable to the Eurozone’s various agonies – discouraging the build-up of inventory. So a 5% annualized growth rate of broad money and a moderation of inflation pressures in early 2012 imply a favourable background for the American economy. Past cyclical patterns argue for widespread improvements in balance sheets and rising asset prices, which should reinforce the virtuous circle of recuperation in the banking system. Domestic demand could well grow at an above-trend rate, quarter by quarter, in 2012.
Several caveats need to be entered. As the USA continues to run a current account deficit on its external payments, it would be something of a puzzle for US domestic demand to be buoyant relative to other industrial economies in 2012. Of course the Eurozone remains crippled by the assorted dysfunctional characteristics of the single currency experiment, with banks all over the Eurozone – and not just in the Club Med countries – reported to be having difficulty in funding their assets. One investment conclusion is that the dollar ought to gain ground relative to the euro in 2012, despite the persisting current account deficit. It has indeed historically been a common pattern for the dollar to strengthen in the upswing phase of US cycles.
Furthermore, the better American banking situation and monetary trends argue against too much bearishness about the world economy in 2012. The Eurozone is a nightmare, with the roles of its leading institutions – particularly the European Central Bank – now being exposed as incompletely defined in the treaties that established them. But the Eurozone is less than 20% of world output, while the GDP of Greece is less than that of many US states. Above-trend growth in the USA in 2012 ought to be consistent with at least trend growth in the world as a whole. The main concern remains that policy-makers will again indulge in the follies of autumn 2008, with bank recapitalization seen as the solution to the world’s woes. In fact, bank recapitalization exercises – if sudden, unexpected and on a large scale – are highly deflationary.
Tim Congdon is the founder of International Monetary Research Ltd.