Resource Ruminations

March 2012

Shadowlands

A Diapason Research Report by Sean Corrigan

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Resource Ruminations March 2012

Shadowlands
The fallacy [that the Bank cannot overissue money] lies in not distinguishing between an advance of capital to Merchants and an additional supply of currency to the general mass of circulating medium Bullion Report, 1810 If, it is argued, the central bank has both the will and the means to control the supply of money . . . all will be well. Our view is different... Though we do not regard the supply of money as an unimportant quantity, we view it as only part of a wider structure of liquidity in the economy... It is the whole liquidity position that is relevant to spending decisions. . . . The decision to spend thus depends upon the liquidity in the broad sense, not upon immediate access to money. . . . The spending is not limited to the amount of money in circulation but it is related to the amount of money people think they can get hold of, whether by receipts f income (for instance from sales), by disposal of capital assets, or by borrowing Radcliffe Committee Report, 1959 My doubts begin with the more detailed analysis and its consequences for policy. To begin with, there is this curious repudiation of some alleged over-emphasis somewhere on the supply of money which occurs like a leitmotiv throughout the argument as though some peculiarly discreditable connection were being repudiated. I am not at all sure that I have got to the bottom of this, any more than that I always understand the precise meaning of the Committee's substitute notionthe so-called liquidity of the system as a whole. But, speaking as one who still finds the influence of money supply a useful central guiding concept, perhaps I might say [that] I do not know a single economist since the 17th century who has argued that the supply of money is the only factor determining the volume of spending and the level of employment and prices. Lord Robbins, Radcliffe Report Debate, House of Lords 1959 Four years ago, the sudden, if not entirely unforeseen, outbreak of financial crisis swept away the disastrously intertwined business models associated with Fannie & Freddie, GMAC, GE Capital, the monoline insurers, AIG, and the entire Bulge Bracket (of whom only one was not to be taken under the sheltering wing of the corporatist state, with the rest, despite their undeniable failure, surviving to exercise their often baleful influence on world affairs today). equity) liabilities of US financial business to the actual money kind shot up 45% from Sept 02s cyclical trough (itself a 53% gain from the previous local minimum in Dec93) to June 08s soaring pinnacle.

Evading the flailing attempts at half-hearted regulatory restraint imposed by populist governments all too happy to enjoy the soft budgets and favourable electoral calculus offered by their version of financial alchemy; waxing mischievously inventive in the sensory Since then there has been much understandable focus lacunae of those Wise Monkeys of central banking who on the activities of this motley crew, together with can hear, see, or say nothing if their preferred version their main partners-in-crime who together comprise of core CPI seems to be rising with due moderation; what has come to be called shadow banking. A good empowered by a Moores Law of rising leverage and deal of that attention has, in turn, been concentrated on exploding complexity in a world where a too-lax and the repo-collateral based system of credit which largely too-predictable monetary policy had coupled with connected its members. vast, currency-fixing deficits-without-tears to engender the inevitably fatal search for yield, these were Justifiably so, perhaps, given that the extraordinary the Shadows which ultimately led the charge over the growth of this particular course of the inverted pyraCliff. mid which forms our over-proportioned and highly unstable financial infrastructure was as much a salient Nonetheless, if it sometimes seemed as if This-Notfeature of the last Boom-Bust cycle as any of the arcane Different Times equivalents of the old-fashioned, of CDO-squareds and PIK LBO loans. This can be seen small depositors bank run had been professionalised in the fact that the ratio of total non-money (noninto a wholesale grab for collateral which was greatly
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Resource Ruminations March 2012

exacerbated by an often predatory demand for extra margin amid what the jaundiced might view as a global falling out of thieves, we must resist the temptation to conflate the idiosyncrasies of this particular cycle with a superficial appeal to the writings of certain authorities (past, present, and putative) into a much more profound rewriting of economic law. be somehow treated as money or that the disappearance of even trillions of dollars from the ledgers of those who traffic in them is, per se, a matter of deflation.

Yes, there are times when such claims will pass readily from one player to another with few questions asked and, during such excesses of wishfulness, much finanThe intent here is not to deny that far too much credit cial business some of it even representing transachad this time been extended outside as well as inside of tions in the real world will be conducted without the banks i.e., by the non-monetary, as well as by much in the way of actual money ever changing hands. what the Europeans usefully differentiate as monetary But such a circumstantial facility still does not transfinancial institutions. Nor was it insignificant that mute these claims into money, properly understood. much of that non-bank credit depended on the illusory To argue so is both to confuse what is meant by being safety of security collateral a fantastical bootstrap of liquid (able to be realised for cash without a large paper claims of often dubious provenance, typically concession in price and a long search for a taker) with owned by some usually unidentified other than their being current (passing from hand to hand as a means immediate profferer, which were being used to support of overcoming the restrictions of barter) and somehow the issue of a whole chain of other such insubstantial to confer upon the clearing house the abilities of the claims. mint. However, what we must insist is that this latter-day version of that abuse so deplored by the Victorians of the so-called accommodation bill a speculative piece of paper all too often resting on the ephemeral surety of the contractually unenforceable guarantee offered by a fee-taking man of straw of limited resources can The curious view that it does is hardly novel, either, being associated not just with James Tobin (he of the infamous transaction tax so beloved of the globalists), but also with the High Keynesian, Cambridge Circus worthies who delivered the notorious Radcliffe Committee Report excerpted at the head of this piece which

Total US Financial Business Non-Money/Money Liabilities: Source - FOF

35.0 Money, rescaled (lhs) Non-Money, rescaled (lhs) 30.0 Ratio (lhs) YOY% Change (rhs) 25.0 10.0 20.0 5.0 15.0 Having hit a record high on the eve of the collapse (a not entirely coincidental observation), the ratio of non-money liabilities to money proper has since fallen back sharply. The total of the two, however has, if anything, grown slightly 15.0 20.0

0.0 10.0

5.0

-5.0

0.0
Mar-57 Mar-62 Mar-72 Mar-82 Mar-92 Mar-97 Mar-07 Mar-52 Mar-67 Mar-77 Mar-87 Mar-02 Mar-12

-10.0

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Resource Ruminations March 2012

condemned Britain and, by imitation, several other afflicted nations to the gathering stagflationary horrors of the two decades of misconceived policy which succeeded its release. and overdraft facilities can sometimes act as if they were money and of how far this concept can be transferred to the routine chicanery practiced today around the tables of the global financial casino. Incidentally, savings accounts may be money to the extent they are Somewhat ironically, given the mans lifelong disdain themselves subject to cheque and/or readily breakable for both Keynes faulty economics and the cult-like na- at little cost; bills of exchange were briefly money, as ture of his disciples, modern proponents of this money they certainly played such a role in pre-deposit bankdoesnt matter view often seek to give credence to ing, 19th century England; but the last is surely nothing their advocacy by quoting some of the musings of F. A. more a confusion of cash-at-hand with potential creditHayek. These are carefully and selectively culled from worthiness or financial strength, as T. Newlyn put it various points in an intellectual lifespan which ran in in 1964. excess of a half-century, a time during which with a maddening degree of inconsistency for such an other- The Price of Everything wise impressive intellect his penchant for contriving unusual hypothetical examples which ran counter to The first point we would make is that it is one thing to the received wisdom about the impact of this or that say that activities taking place in the Land of Mordor economic approach even stretched to contradicting the (where the Shadows lie) can impact peoples decisions results of his own earlier analyses. to about how much money to hold and so can change the quantity of things which a given quantum of that Was he for a series of fixed international exchange money will buy (as Robbins pointed out in our header), rates, presided over by well-reserved central banks, or but it is quite another to say that this makes the associdid he favour a complete privatisation of the money ated instruments into money themselves. After all, if I creation function? Both. Did he feel that any rise in the can persuade you that you should empty out your value of money would ultimately elevate its real value bank account to acquire a store of canned food, or a to the point where a formerly anxious populace again cache of Canalettos, or if your life suddenly becomes sought to reduce their holdings by spending it or, deincomplete without a Tiffany bracelet or a variegated spairing of such a natural feedback process ever halttulip bulb, it will surely alter both your holdings of ing a depression, did he advocate some form of what and, by extension, the societal value placed by everywe might now cell nominal GDP targeting? Both. Was one at large on the existing stock of money, without he for a gold standard, or a quasi-index standard deany of these objects of desire ever threatening to take fined by the price of a basket of several selected comthe place of the euro or the dollar. Conversely, if you modities, or a limited token standard? All three. Did pop your grannys false teeth so you can get your this inveterate deprecator of macro-aggregates wish to hands on the latest incarnation of the iPad, that doesnt stabilize a general price level or did he bemoan the fact mean her dentures have miraculously transubstantithat any such an artificial attempt at stabilization ated into currency. would, in the hands of the central bank, prove horribly pro-cyclical whether productive efficient rose or fell? Repo collateral may certainly oil the wheels of financial Both again. speculation and the effect of such speculation on asset prices (and hence on the cost of financial capital means) Thus, when we read of him arguing that money could can equally exert an influence on decisions to save, dissometimes consist of more than currency in circulation save, invest or consume and hence bring about alteraplus demand deposits at the banks and so, by impli- tions to a whole range of critical price relations - but cation, enlist him anachronistically to the ranks of that does not mean you would ever routinely accept an those who insist that shadow bank credit dealings also owned-at-multiple-removes T-bill in lieu of your create and destroy money we need to stop and think wages, or that you can pay for your groceries or a tankabout what the exact occasion was for Hayeks reful of gasoline by whipping out someone elses thricemarks. Specifically, we need to recognise that even if loaned evidence of Sallie Maes past indebtedness and you do allow him his gentler postulates which closely lodging it with the check-out or petrol pump attendant follow the work of Chicago economist H. C. Simons in your turn. that such things as savings accounts, bills of exchange,
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Resource Ruminations March 2012

Apart from this quality of ready, near-universal acceptance in payment at par (thats par - 100% - all you happy haircut merchants in the wannabe-money crowd) which marks out money by the fundamental distinction that it serves as the medium of exchange, there is another litmus test of what separates the pecuniary sheep from the non-pecuniary goats, one to which Hayek (to mimic our opponents argumentum ad verecundiam) himself alludes in the course of a discussion about cross-border flows in his 1937 work, Monetary Nationalism and International Stability. This is namely that a transfer of ownership in money (a payment) does not create any new claim but rather, by implication, it extinguishes one i.e., the assignment of money is the final consummation of any exchange whereas the passing on of a debt claim is only a deferral of such an act of completion. Ironically, the only time the collateral underpinning one of Saurons latest borrowings can be said to do the same is when the Dark Lord either fails to redeem it on the agreed date, or he is unable to meet his next margin call when it declines in value (ever seen one of those made on money, either?) and the paper is sold out from under him - and sold, moreover, for whatever money it might fetch! There are two other, slightly more subtle characteristics inherent to the medium of exchange which we can marshal in our defence of the uniqueness of a true money i.e., notes, coin, and bank-issued demand deposits - which these other pseudo-monies do not possess. The first sounds like a quibble, but is actually of profound importance. This is that while money itself has no single price, everything else has a money price. We cannot categorically say that the price of a $1 is three apples, because it is also five tomatoes, one pineapple, 40 grams of cheese, four pints of crude oil, and 3/10 of a grain of gold, etc., etc., but we can, of course, say the converse. So, ask yourself this: is the price of the current, on-the-run, 5-year Treasury note 98 cents per $100 face value or is a dollar 1.105 T-notes? Do we price Agency MBS in dollars or dollars in Agency MBS? The answer might give us a clue as to which was the money and which the hapless pretender. The reason this is important is that if there is an excess supply of bonds, or stocks, or bell-bottomed trousers, their individual price will fall (and, in the case of the first two, their yields will rise) to the point that they attract a new cohort of buyers and the market for them again clears. Let there be an excess supply for money,

US Inside Money & pGDP v Total Money %: Source - FRB, BEA, Diapason
80.0 42.5

'Inside': US Chartered Bank Demand & NOW Depos less Balances with Fed v 'Total Money': Total chequable 60.0 depos + Currency

32.5

22.5

40.0

Autonomous banking creation of 'inside' money may have fallen proportionately, but the Fed has more than compensated with its 'outside' money provision to the point that the total is more abundant v-a-v national income than at any time in four decades, having risen faster since LEH than in any like period in the record.

Money/pGDP (rhs) 3 1/2 -yr change in ratio (rhs) Inside% (lhs)

12.5

2.5

20.0 Mar-65 Mar-70 Mar-75 Mar-85 Mar-90 Mar-95 Mar-05 Mar-10 Mar-60 Mar-80 Mar-00

-7.5

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Resource Ruminations March 2012

however, and no single price change can operate to bring about the adjustment. Instead, there is set in train a generalized but highly differentiated rise in the price of most, if not all, other goods, services, and assets over time to the point that the increased nominal supply once more becomes consistent with the real worth people wish to hold. Such a pervasive reordering which entails both varying magnitudes and sequences of response, with the implied disruption of input-output and present-future price relations in what can be a highly arbitrary and unpredictable process - is the very reason that monetary disequilibrium can be so uniquely pernicious in a way that a shortage of left-handed screwdrivers or a surfeit of Gibson Les Pauls can never be. Thus, to admit that a sudden realisation of the parlous condition of the loans one has made, or a four-in-themorning epiphany as to the unsoundness of the collateral one has been accepting will suddenly increase ones desire to sell them for money is precisely to demonstrate that they are different from money, not cognate with it. Money is distinct by virtue of one critical facet of its primary function. This is that it flows. Just think about this for an instant and you will realise that the vast bulk of the money that ever came in to your hands, or into the cash registers of a business, or the coffers of the state treasury never stuck there but was soon sent off on its merry way to its next, eager but equally temporary owner. So much is this instant transmission the key attribute of a money, in fact, that any augmentation or diminution to that mighty flow caused by more or less of it being siphoned off into the typically smallscale reservoirs which we do each tend to maintain can have a pervasive influence on the economic data. A practical demonstration of this assertion may lie just ahead of us for it is a signal fact that, since the crisis broke, US non-financial corporates have been unusually avid holders of money Thus, in devoting 85% of retained earningsor 20% of ex-dividend, after-tax cash flowto accumulating a $630 billion mountain of money (cash plus demand deposits) over the past 2 1/2 years, these most unlikely of hoarders have so far helped retard the most incendiary effects of the Feds extraordinary actions. In part this has been a result of the regime uncertainty which has arisen as the authorities have dispensed with the rulebook in trying to shore up the tottering edifice of Western finance, and as they have unveiled some radical new measure with each turn of the news-cycle in much the same counterproductive way as did that inveterate tinkerer and cynical political fixer, Franklin D Roosevelt. In part, it has been a defensive response to the salutary experience of watching the crepuscular credit engine

U S No n-F in Cor porates: Per centage of Intern al Fun ds accu mulate d as M o ne y, 6Q cum ula tive: source - FOF

20.0

15.0

10.0

5.0

0.0

-5.0

-10.0 Jun-54 Jun-94 Jun-99 Jun-04 Jun-09 Jun-59 Jun-64 Jun-69 Jun-74 Jun-79 Jun-84 Jun-89

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Resource Ruminations March 2012

seize up around them, in 2008. Given the possibility of being cut off from all sources of funds, foolish not too keep a war chest stoked with readies, even at the cost of a little balance sheet efficiency. In part, too, the move has been an artefact of policy in the sense that bank deposits have been subject to more governmental guarantees than many of the alternatives, while the Feds near-zero rate policy has erased most of the opportunity cost of staying as liquid as possible. A welcome pause in policymaking on the hoof might soon lessen the first incentive; continued recovery coupled with healthier financial balance sheets (and less shadow banking!!) might diminish the second anxiety; and the sunset provisions to remove those same Federal backstops at the end of 2012 will automatically terminate the third. money, things could quickly get very hot on the inflationary front if the transition is not managed well.

Too Much of a Good Thing

But, to return to our theoretical considerations, this property of being useful principally as a half-way house between buying and selling also means that, to reiterate a point which Leland Yeager was often at pains to remind us, the medium of exchange, money, is not subject to the ordinary law of supply and demand since an increase in the supply of money, by raising the price of the things it buys, automatically raises the transactional demand for it (certainly once we allow for any transitory effect such changes may have on the voluntary holding of cash balances) and hence, eventually neutralises the change.

Strictly speaking, money cannot be in a surplus because its greater profusion will raise prices, meaning it If so, the key issues will be whether these same corpo- will take more units to move the same number of rates will begin to spend this cash, or whether they goods than it did when it was formerly less abundant. will simply rediscover an appetite for alternative, non- The change in nominal flows may also lead us to hold money assets (and the Fed should certainly take the on to a slightly greater proportion of what comes our opportunity to trim its swollen security portfolio by way in order to maintain an effective precautionary helping satisfy this reawakened urge, should it arise) reserve. As Andrew Dickson White once remarked of and then, if they do, what those to whom they redirect the great French Assignat inflation, men never feel that the funds will do with them in their place. If the upmoney is quite so scarce as when there is too much of shot is that there is a sizeable remobilisation of this it about.

U S Re al AM S nsa v long-te rm fitted log tre nd of 2.8% pa g rowth: Source FRB, BLS, Diapas on
0. 13 QE programmes begin wi th LEH-A IG Crash 7.3

7.1 0. 06

Residuals

6.9

0. 00

6.7 R = 0.9679
2

-0. 06

NO shortage of money, thanks to the Fed

-0. 13 Jul-11 Jul-87 Jul-99 Jul-83 Jul-85 Jul-89 Jul-91 Jul-93 Jul-95 Jul-97 Jul-01 Jul-03 Jul-05 Jul-07 Jul-09

6.5

6.3

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Resource Ruminations March 2012

For as long as money is money then for as long as it has not excited such distrust in it customary users in a violent inflation that people repudiate it, or it has not become so scarce as to become an impediment to trade in a deflation that they seek to substitute for it in their everyday dealings it will bend the entire matrix of prices to its will so that its absorption is complete. No other asset possesses so much power since the take-up of these others will ultimately be rationed by changes in their price (and hence their yield). Thus, even if the commercial banks lose their will or ability to issue more demand liabilities to their customers through increasing their loans, the central bank knows no such constraint, short of a complete catastrophe. If money cannot be lent into existence, it can always be spent into circulation, so long as it is not refused in the payment of wages, doles, rents, or other forms of income, or as settlement for the purchase of non-money assets or goods. Truly, as Charles Goodhart opined long ago, for those countries with access to the printing press, deflation is a policy choice. It is certainly one that the Federal Reserve has decided against taking. Now, forgive me if Im being a trifle antediluvian in this Looking Glass world of negative real interest rates juxtaposed with yawning peacetime budget deficits, but can anyone really argue that we could say the same about, e.g., UK government paper that, no matter how much of the blessed stuff HMT was offering on the market, it would be readily taken up absent the sweetener of a sufficient, glut-induced decline in its unit price (which would, of course, serve to reduce the aggregate sterling sum needed to acquire the whole increment) or lacking a sufficient, countervailing increase in the supply of money so that people would individually seek to reduce their holdings of that money, some of them choosing to buy enough extra bonds with their new surplus so as to stabilise their price? Forget George Osborne: not even Apple can do this with its securities, though the limits might be harder to find in the latter case than the former, at present! So, while not denying that there are indirect linkages between the stock of Shadow claims or between the ever-shifting, thoroughly-subjective attractiveness attached thereto - and the primary economic relation between goods, services, and money-proper, we must resist the urge to attach too much importance to the post-Crash decline of the number of claims each hypertrophied financial entity holds on the other, or to assume that this reduction must permanently cast an immediate pall over the doings of industry and commerce in quite the manner being suggested and regardless of developments in both the supply of money and the avidity with which it is held on to.

Gilding the Lily

It is, in truth, hard to resist the though that much of this fascination with an ill-defined liquidity is merely narcissistic navel-gazing; that it is case of the very practitioners of the sin agonising over the sort of financial market incest which those ever-perceptive Victorians used to decry as pig on pork - i.e., as an unnecessary and unwholesome duplication of exposures between thinly-capitalised, lightlyreserved zerosummers which could only divert any participating bank from its real purpose of collecting savings and reallocating them to fund the most productive enterprises it could identify. And heaven forbid, too, that any of our forefathers lending was done to a finance company a prototypical, captive shadow bank which, having seen its promoters parent company exhaust its legitimate appeal to equity or bond investors, sought to disguise its true role in tying up shortterm, working capital in the long-term, fixed assets of that same parent! So, if today, the likes of JPM lends to CS which lends to HSBC which funds a Deutsche Bank SIV which finances receivables from Ford whose treasury antes up for some trade put on by Quantum allowing it to buy a share in an metals ETF which invests the float in some paper issued by Pimco which invests in Fannie whose pension fund takes a participation in KKR which, pending finalisation of a buy-out, buys in to the cash management programme of Blackrock which takes some CMBS from JPM on repo whether or not they shuffle the same tatty piece of US Treasury paper between them as a supposed added guarantee along the way - who really cares about this little La Ronde apart from the scalpers and commission jockeys salivating all along the chain? No Muppets were involved in the making of this picture, after all at least no real world ones who actually MAKE the things and provide the (non-financial) services which keep us clothed, fed, groomed, and entertained. This is a daisy chain, not an intermediation of useful credit or the creation of productive capital. If it disap8

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Resource Ruminations March 2012

peared tomorrow, there might certainly be a repricing of gambling chips and the change would not go entirely unregistered in the machine shops of Wolfsburg, or the grain elevators of Winnipeg, but neither would it stop the hard-working welder of the first from buying bread made with the wheat shipped from the second, nor would it prevent the shift supervisor at the latter from putting some of his pay packet towards the down payment he needs for that shiny, new Audi A4 hes been eyeing up in the local showroom. Up by the staircase - down by the elevator, as the old market adage has it. Or, in a passage we never tire of citing, from the pen of the great Richard Cantillon:

In 1720 the capital of public stock and of Bubbles which were snares and enterprises of private companies at London, rose to the value of 800 millions sterling, yet the purchases and sales of such pestilential stocks were carried on without difficulty through the quantity of notes of all kinds which were issued, while the same paper money was accepted in payment of interest. But as soon as the idea of great fortunes Far better then to acknowledge that swings in the acinduced many individuals to increase their expenses, to buy ceptability of non-money claims can add a wholly spu- carriages, foreign linen and silk, cash was needed for all that, rious volatility to their valuation both as means in I mean for the expenditure of the interest, and this broke up themselves and as the suspect underpinning for the all the systems. generation and transmission of other claims. This example shews that the paper and credit of public and When the skies are blue and the games participants private Banks may cause surprising results in everything are at their least critical, one may be piled upon anwhich does not concern ordinary expenditure for drink and other up to the very face of heaven without any profood, clothing, and other family requirements, but that in the portionate need for money to buttress the construction. regular course of the circulation the help of Banks and credit But, when a change of wind brings a chill to the exof this kind is much smaller and less solid than is generally posed nether regions of our most naked financial em- supposed. perors, the desire for precisely those sums of money that their pretensions had long deemed to be an enSilver alone is the true sinews of circulation - and tirely antiquated consideration will give rise to the aw- not Shadows, we might add! ful, toppling corrective to their earlier delusion.

Sean Corrigan

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Resource Ruminations March 2012

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