A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Wednesday, May 20, 2009

Why the Fed is in the dark: The shadow money stock

The shadow money stock: (from the podcast)

It can be argued that the Fed and Ben Bernanke have been engaged in a massive effort to inflate a way out of the current economic contraction. So far, no inflation. Demand Side has not been shy about pointing out the impotence of the Fed's policy. But what are the nuts and bolts?

Two economists from Credit Suisse, James Sweeney and Carl Lantz went on Bloomberg and presented the concept of the shadow money stock. There's a more academic treatment out just this last weekend on the Zero Hedge blog, link on the web site.


It's a concept which after one hears it seems almost too obvious.

During times of strong demand and liquid asset markets, those assets are held in lieu of money and serve the purpose of money. For example, during the housing boom, housing was extremely liquid as a financial asset. Not only could you sell it almost by accident if you answered the door wrong, you could also tap its market value easily and immediately via a home equity loan.

Let me start again with a straightforward rendition of the premise.

The shadow money stock is money the market itself creates in order to finance a boom. Money in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral will be used as near money or shadow money.

Many assets can be converted into cash easily in a boom. Take the example of the house we led off with. Homeowners held less cash in checking accounts and other forms because they knew that virtually overnight they could get low interest money out of their homes.

Similarly, government bonds can be taken to the Repo desk and for a one percent haircut converted to cash. During the boom, private bonds and asset-backed securities of less than perfect ratings could easily be converted to cash, with say a five percent haircut.

People used their cash to buy things and these other assets as the rainy day fund. When the downturn came, the value of the assets went down, yes, but also the terms for borrowing against them, including the haircut became more onerous.

For example, a bank once willing to loan on 90 percent of the value of your house became willing to loan only on 70 percent. The value of trillions of dollars of securities became useless as collateral as their markets became illiquid.

Friedrich Hayek, quoted on Zero Hedge, put it this way. (abbreviated)

"There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognized to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.


it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economize money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required.


The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided."

Lantz and Sweeney calculated that at the peak of the boom there was six trillion dollars in the traditionally defined money stock. The private shadow stock accounted for $9.5 trillion, and government-based shadow money a whopping $11 trillion. Thus the shadow money stock dwarfed the traditionally defined M2.

Remember the shadow money stock is a boom time phenomenon, and creates a lower demand for real money than one would expect. It contributes to the experience of stable or even falling interest rates during times of expansion. Not what one would expect.

Lantz reading of recent statistics indicates that today every one dollar increase in the base money increases M2 by one dollar. In more normal times each dollar of base money will increase M2 by 8.5.

The size of the shadow money stock was estimated by multiplying the haircut percentage against the asset base. For example, the value ofthe housing stock times the level of potential borrowing against it. Say during the boom, a homeowner could borrow against 90 percent LTV -- loan to value -- and now it is 80 percent. Plus -- or minus in this case -- the reduction in actual value. Lantz and Sweeney estimate that the total drop was $3.5 trillion.

They also suggest this was offset completely by an increase in the government shadow money stock, following the huge new borrowing needed to finance the deficit as well as the aggressive liquidity measures of the Fed, and presumably including the expansion of the Fed's balance sheet in the conversion of dodgy private securities into full faith and credit. This huge increase in liquidity has been the source of muchhand wringing about potential inflation. Bernanke issued notice that the Fed is "focused like a laser on the exit strategy."

In fact, according to Lantz and Sweeney, this explosion of liquidity was necessary simply to accommodate the demand for cash occasioned by the crisis. Absent this money growth, the collapse of the private shadow money stock would have led to severe, or more severe deflation.

Lantz suggests concern over inflation is ridiculously premature, and predicts much of the unwind of the liquidity measures from the government will occur naturally, as government programs get paid back and rescuemeasures for the banks wind down.

Our observation at Demand Side is that monetarists who can so clearly describe the monsters hiding under the bed will become ever more hysterical as things begin to turn around. We suspect that the adults will choose to calm them, rather than follow the more effective policy measures. The efforts to calm them will be counter-productive to the real economy.

At the risk of dislocating an elbow, we'd like to make the note that we've made a couple of comments that look good from this new perspective. Deleveraging we have said is a process of money contraction. This was an insight that arose from instinct, not instruction. Here is the instruction.

Another self administered pat on the back follows from our observation in early 2008 that credit cards as near money enabled spending from the stimulus to be smoothed, in a downward slope, to reflect the restrictions on this form of money.

In fact, the actions of banks and credit card companies demonstrate clearly the error of the Fed-Treasury plan to allow zombie banks to continue among the living. These insolvent institutions have no choice but to maximize revenues from the spread. That is, they may borrow cheaply, but this will not be passed on to their credit card clients, who will get only the maximum rate laws allow.

This note from the New York Times

From the NY Times: Overhaul Likely for Credit Cards

Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.

“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”

The larger point is that money is a much broader phenomenon than we have been used to thinking. At the same time, the Fed's control of money is much narrower. In a boom, with confidence in asset values, the effective money supply will expand as collateral becomes near-money. In a bust the effective money supply will convulsively contract, as assets become less liquid, banks lend less and keep more in reserve, and all parties hold traditional, not shadow cash against a rainy day.

The threat of inflation is much lower than widely assumed, since as things pick up, the government shadow money stock will tend to be reduced. Programs end. Loans are paid back. Et cetera.

Another blow to the quantity theory of money.