Banking On Failure: Money, Lending, And Inflation

WORLDWORKS by Joe Pimbley

Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt.

The previous excerpt for Chapter 10 explored the connection between Inflation and the Money Supply

Increased Lending Boosts the Money Supply

With simple examples both historical and hypothetical we argued in the last section that increasing the money supply results in inflation. This inflation, or “price inflation,” is equivalent to devaluation of the currency. Our argument was broad and intuitive rather than precise or detailed or exacting. We did not define “money supply,” for example. We also left it to the reader to infer that demonstrating that huge, Zimbabwe-like money printing produces hyper-inflation necessarily implies that moderate creation of money will yield commensurately lower, but still positive, inflation.

Banking on FailureA fascinating new thread is that bank lending boosts the money supply and non-bank lending can push prices higher as well. For explanation, we must first add some precision and define “money supply.” In the U.S., the Fed has direct control over the “monetary base:”[1] “the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve).” Two other, more widely applied, measures of money supply are “M1:”[2] “currency in the hands of the public; travelers checks; demand deposits, and other deposits against which checks can be written” and “M2:”[3] all of M1 “plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.” For our discussion purposes, we now designate M2 as the “money supply.”

[bctt tweet=”Banks “create money” when they lend.” username=”bizmastersglobal”]

[4] As brief explanation, imagine a depositor holds immediately available funds at Bank A. This account adds to the nation’s total M2 and the depositor reasonably considers this account to be her “cash.” When Bank A uses these funds and those of other depositors to make an auto loan, for example, this “loaned money” finds its way into another bank deposit account somewhere else. That is, the borrower will pay the money to an auto dealer who then retains some funds and distributes the remainder to the auto supplier and employees. The people and companies that receive the money will place their portions in their own bank accounts – where the money contributes to M2. It can seem like the process counts the “same money” twice or multiple times for M2 … and that’s true!

The assertion that banks “create money” when they lend is arguably just a self-fulfilling consequence of the definition of M2. Since M2 counts all deposits, including those created by the borrowers’ dispersal of funds, then the increase in M2 – “increase in money” – is unavoidable. To make the example simpler, assume Bank A lends to the borrower who then simply deposits the proceeds in Bank B. The Bank B deposit counts for M2. If the borrower then closes his account with Bank B and repays the loan from Bank A, M2 decreases to its previous level and “money is destroyed.”

Yet the situation is not as trivial as it may seem. Essentially all of M2 is available to the cash holders and account owners as “spending money.” Since it is clear as we discuss below that lending pushes price levels higher, we see nothing amiss with an agreed paradigm in which bank lending increases the stated money supply.[5]

Increased Lending Pushes Prices Higher

The proposal that lending itself pushes prices higher might strike one as tenuous. Let’s consider a simple example. A homeowner wishes to sell her house. She paid $100,000 when she bought the house five years ago and borrowed most of this purchase amount through a mortgage (a loan in which the borrower pledges the house itself as collateral to the lender). Clearly the owner would like to receive as high a sales price as possible, but she’ll be content if this price is at least $100,000.

Now imagine that the mortgage market is gone. Whatever the cause of the disappearance of home lending, potential buyers must pay cash. In order to sell her house for $100,000, then, the owner must find a buyer who has $100,000 of his own funds to pay. The problem for the current owner, of course, is that there are relatively few potential buyers with $100,000 at hand. Thus, at this asking price the buyer demand is much lower than it would be in a world of available mortgages. The dearth of prospective buyers will compel the owner to accept a lower price if she chooses to sell.

This loan-price dynamic persists for the “easiness” of loan terms as well. If we now hypothesize that standard mortgages exist for buyers with the requirement of a 20% down payment, then potential buyers may borrow $80,000 to buy the owner’s house for $100,000 after adding $20,000 of their own funds. In this scenario, there are many more prospective purchasers since more people will have $20,000 at hand than $100,000. With more buyer demand, the homeowner will sell her house at a higher price than she would in the absence of any home lending. Yet still, there will be a large group for whom $20,000 in available funds is still disqualifying. As the banks’ down payment requirements weaken (for example, from 20% to 5%), more buyers will bid house prices higher in all price ranges.

Summarizing, as home mortgage loans become more abundant with “easier” terms, house prices inflate. As mortgage lending develops “tighter” terms or disappears completely, house prices deflate. For clarity, other supply-and-demand factors matter as well. Increase in population or building restrictions in a local area can push prices higher while the loss of a large local employer can deflate home prices. The “monetary component” of the availability and terms of mortgage lending, though, is always present.

Prices of other “big ticket” items such as college tuition and cars function similarly. As with houses, one might argue that the costs of the college or the auto manufacturer or the homebuilder don’t depend directly on the loans to the buyers of the products of these institutions. So why should prices rise and fall with lending availability? It’s the demand for each product that lending impacts. All else equal, more (less) lending produces greater (diminished) demand to push prices higher (lower).

Even small, everyday purchases follow the pattern. Consumers use credit cards to obtain loans on a daily basis. Total credit card and student loan debt in the U.S. are comparable at roughly $1 trillion.[6] Thus, credit cards are lending instruments that increase demand for small-scale items. The principle applies as well at the other extreme of large investors’ purchases of financial assets. When hedge funds, for example, buy corporate loans or mortgage bonds in typical amounts of $5 million and higher, they always borrow as much of the purchase price as a bank lender will permit. When banks panic and shut down this lending for whatever reason, the market prices of the corporate loans and mortgage bonds fall immediately.

Boom and Bust

Of course, whether it’s credit cards or auto loans or home mortgages or college student loans, there’s a limit to the impact of lending. The limit is simply the point at which banks or other lenders judge that they are at significant risk of not being repaid. If lending standards are too “loose,” then a high proportion of borrowers will default on the loans. Ensuing losses to the banks will compel these lenders to curtail new lending and rebuild capital.

One might imagine the ideal scenario for society to be that banks impose lending guidelines that strike the right balance between “credit availability” and “ability to repay” for borrowers. That is, bank lending would find the middle ground in which loans are widely available and have low levels of borrower defaults. In reality, this middle ground is not stable. While losses are low, lenders compete by lowering interest rates and making other terms such as down payments, paperwork, credit checks, and income verification “friendlier” for the borrowers. Lenders who maintain higher rates and tighter standards generally lose the competition for business. For the borrower, after all, it matters little which lender makes the loan. The borrower has no risk to the lender. Loans are a commodity in this sense.

Good performance of existing loans, then, prods lenders in the aggregate to increase lending and to ease terms. The increased lending also pushes prices higher which feeds both the amount and risk of the loans that follow. Then it snaps! One’s intuition is that, as loan risk increases, the loan losses will rise gradually such that lenders will “read the tea leaves” (i.e., examine trends in their data carefully) and restrict lending accordingly when losses mount. But intuition often fails to describe reality as lending moves from “boom” to “bust” quickly.

As we noted earlier, the “bust” in lending begins with borrower defaults that give immediate losses to bank lenders. Since we know from chapters 3-5 that lenders are highly leveraged, there is high sensitivity to loss. Banks reduce lending immediately due both to the higher risk that is now evident and to the need to reduce leverage. The sharp fall in lending reverses the prior price appreciation. Falling prices are deflation rather than inflation. The “busts,” then, are deflationary.

Another, gentler name for “boom and bust” is “the credit cycle.” As credit becomes plentiful, lenders chase borrowers and thereby create the conditions (risky loans with no margin for error) for a burst of loan defaults. Losses subdue the lenders and push total borrowing (and prices) to the low point of “the cycle.” With borrowers now having great difficulty finding loans, the healthiest lenders cautiously come back to the market since there is much less competition. Lending revives and the cycle repeats.

The next excerpts for Chapter 10 will discuss Fractional Reserve Banking and a “Tale of Two Countries”

[1] See http://www.federalreserve.gov/faqs/money_12845.htm and http://research.stlouisfed.org/fred2/series/BASE/ .

[2] See http://www.ny.frb.org/aboutthefed/fedpoint/fed49.html .

[3] Id.

[4] One finds this surprising, counter-intuitive, confounding, yet important statement in virtually all economics textbooks. See, for example, R. Apostolik, C. Donohue, and P. Went, Foundations of Banking Risk, John Wiley & Sons, 2009. We also appreciate the colorful explanation of P. L. Bernstein, A Primer on Money, Banking, and Gold, Random House, 1968.

[5] The article M. McLeay, A. Radia, and R. Thomas, “Money creation in the modern economy,” Bank of England Quarterly Bulletin, Q1 2014, 1-14, begins by stating “… the majority of money in the modern economy is created by commercial banks making loans.”

[6] See, for example, the “Quarterly Report on Household Debt and Credit,” Federal Reserve Bank of New York, February 2014.

Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.