There is one class of money that is constantly being created and
destroyed, and that is bank credit.
Bank credit is created when a bank lends money to a customer; it becomes
money because the customer draws down this credit to deposit in other bank
accounts and to pay creditors. It is not money that is created by a central
bank; it is money that is created out of thin air by commercial banks to
lend. Its contraction comes about when it is repaid, or if a customer
defaults.
The recent sharp fall in equity markets is leading to two levels of
contraction of bank credit. Brokers' loans to speculating investors are being
unwound from record levels, notably in China and also in the US where in July
they hit an all-time record of $487bn. Then there is the secondary effect,
likely to kick in if there are further falls in equity prices, when equities
held as loan collateral are liquidated. This is when falling stock prices can
be so destructive of bank credit, and as the US economist Irving Fisher
warned in 1933, a wider cycle of collateral liquidation can ensue leading to
economic depression.
Fear of an escalating debt liquidation cycle is always a major concern for
central bankers, so ensuring the secondary effect described above does not
occur is their ultimate priority. Macroeconomic policy is centred on ensuring
that bank credit grows continually, so since the Lehman crisis any tendency
for bank credit to contract has been offset by central banks creating money.
The bald fact that equity markets have now lost upside momentum and appear to
be at risk of a self-feeding collapse will be viewed by central bankers with
increasing alarm.
For this reason many investors believe that a bear market will never be
permitted, and the combined weight of central banks, exchange stabilisation
funds and sovereign wealth funds will be investing to support the markets.
There is some evidence that this is the direction of travel for state
intervention anyway, so state-sponsored buying into equity markets is a
logical next step.
The risk to this line of reasoning is if the authorities are not yet
prepared to intervene in this way. When the S&P 500 Index halved in the
aftermath of the last financial crisis, the subsequent recovery appeared to
occur without significant US government buying of equities. Instead the US
government might continue to rely on more conventional monetary remedies:
more quantitative easing, reversing current attempts to raise interest rates,
and perhaps attempting to enforce negative interest rates as well. If, in the
future, state jawboning accompanying these measures does not stop the bear
market from running its course, the next round of quantitative easing will
have to be far larger than anything seen so far.
Alternatively, if states by buying equities attempt to kill the bear, it
will have to be through massive market intervention, aiming
helicopter-distributed money at investors as well as rigging the alternatives
to make them relatively less attractive. Either way, the shake-out in
equities we have seen so far is a wake-up call for mainstream economists and
commentators who believe in the comfort of government statistics, which seem
designed to convince us all that economic growth is perpetually on its way.
Since the Lehman crisis, investors have bought into this bullish argument
to the exclusion of any likely risk that a bear market will happen.
Consequently, considerable amounts of speculative money are committed to the
concept of a perpetual state-guaranteed bull market; so if the destructive
forces of reality do intervene, the potential for a severe fall in equity
prices will be much greater than before.
Meanwhile global bank credit looks like it is already contracting in key
markets, such as China, in which case global fundamentals are definitely
deteriorating. This being the case, it will take increasing amounts of
newly-issued money from the central banks to perpetuate the illusion that
markets are rising, and that the economy is still growing, with or without
state-directed buying of equities.
This article is due to be released one week before the Fed's September
interest rate decision, which might result in a small interest rate rise, but
it is time to put the Fed's interest rate dilemma aside and instead think
beyond it about the wider economic consequences of the monetary inflation
necessary to ensure a perpetual bull market.
The views and opinions expressed in the article are those of the author
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