COMMENTARY OF THE MONTH

May 9, 2005

Letter to Richard Russell

In your commentary on May 2, you state that you doubt we will see monetary deflation. While you correctly interpret the Fed’s intentions to fight deflation – Bernanke’s Helicopter will be dusted off to fight price deflation, or even unwanted disinflation, before we see monetary deflation – you perhaps overestimate the Fed’s ability to succeed in battling monetary deflation.

Monetary deflation would require credit to contract – outstanding credit is either paid off or written off in greater magnitude than new credit is created. The Fed can only expand or contract its own balance sheet which is relatively small relative to the total supply of credit. In expanding its balance sheet it creates the capacity for credit expansion but such expansion can only slightly increase the supply of credit directly. It is left up to banks and the credit markets to expand credit. To the extent that the demand for credit contracts, the Fed’s attempt to create the capacity on the supply side of the equation will do little to battle deflationary tide.

This is, in fact, what the Japanese authorities have faced over the past decade. The Japanese M2 money multiple has declined by more than 50% from its peak in 1992 to its recent trough (from over 13x to less than 6.25x). The monetary authorities steadily expanded monetary reserves with little on-lending by a severely damaged banking sector. The banks have effectively reliquified their balance sheets by writing off non-performing loans and buying JGBs in lieu of expanding credit to private borrowers. Money supply has grown much more slowly than the reserves created by the BOJ in an attempt to reflate the economy. There the banking system was crippled by non-performing loans but also the demand for credit has remain subdued even as the capacity for credit expansion has increased. While technically Japan avoided a monetary deflation (although barely - money supply went nowhere from 1991 to 1992), an outright contraction of money supply was avoided by monetization of a dramatic increase in government debt.

Based upon the Japanese experience, which you refer to insightfully as the Balance Sheet Recession, you might infer that a monetary deflation could be avoided in the U.S. through the same interventions. However, that assumes that the creation of new credit, even if represented by the monetization of government debt, will outstretch debt repayments and write offs. In the Japanese case, there was an intense aversion to writing off clearly non-performing loans which were largely concentrated in three sectors and linked to real estate collateral. Not writing off non-performing loans resulted in a prolonged recession but it also allowed Japan to escape outright monetary deflation. Had they followed the U.S. solution to the thrift crisis – aggressive liquidation of non-performing loans – they might have experienced a monetary deflation over the short run (given the scale of the problem) but they would likely have benefited from higher economic growth subsequently and a return to a credit expansion.

Nonetheless, the Japanese situation in the late 1980’s differs from the current situation in the U.S. The capital markets are much more important in the U.S. today in respect of credit intermediation than in Japan in the late 1980’s (or ever for that matter). It is hard to over emphasize the degree to which the capital markets as opposed to portfolio activities of the banking sector is responsible for the expansion of credit in the U.S. market – even (or especially) with regards to consumer debt. Especially since the mid 1990s, the expansion of financial credit has become an important component of total credit growth.

Over the past couple of years, we have seen two periods in which outstanding money supply, as measured by M-zero, has declined in the U.S. This is technically monetary deflation. During both of these periods, the Fed continued to expand the monetary base. The ratio of money supply to adjusted monetary reserves declined in both "deflationary" episodes. In the last two quarters of 2003, money supply declined modestly but the money multiple declined from a record high since the Fed was expanding its balance sheet during this period. More recently (first quarter of 2005), the Fed has not grown the monetary base and the money multiple has been contracting (albeit modestly) since its peak in the second quarter of 2004.

These episodes demonstrate, albeit in a very narrow sense, that a monetary deflation is possible. Credit has continued to expand during these episodes but it is possible, given the growing important of financial credit growth, that we could experience a contraction in credit that overwhelms the Fed’s ability to counteract the contraction through the expansion of its own balance sheet. In essence, it is possible that market participants come to doubt the efficacy of the Greenspan Put (or perhaps the Bernanke Helicopter when Greenspan retires).

The money multiple remains near historical highs. Perhaps because few focus on monetary aggregates anymore, it has been forgotten that the money multiple contracted pretty much steadily from the first quarter of 1987 through the first quarter of 1995 as the banking industry was struggling with non-performing emerging market and real estate loans (thrift crisis) and even the failure of Drexel Burham. The Fed was doing its part but the intermediation process was partly crippled and financial leverage was declining. Since then, of course, we have reached new extremes of financial leverage. Cash holdings as a percentage of personal liabilities is at an all-time low. We could see a period of debt aversion in spite of Herculean attempts of a Bernanke Fed to create inflation.

Best Regards,
JF