The Bernanke Bust
[An earlier version of this article appeared on Forbes.com, April 27, 2012.]
To Austrians, all economic "booms" founded on monetary largesse always end in economic busts, roughly equal in size and intensity to the preceding booms. By distorting interest-rate and price signals and, as a consequence, creating malinvestments that must eventually be liquidated, monetary booms necessitate economic busts. This is true regardless of whatever short-term benefits the economy or financial markets appear to enjoy from this largesse. And whether that largesse originates via the creation of central-bank base money (through central-bank asset-purchase or loan programs) or via bank-issued on-demand deposit liabilities in excess of bank reserves or what Austrians call uncovered money substitutes (when said banks are making loans or purchasing assets), in the end the result is always economic busts.
Our broad and preferred money supply metric — TMS2 (True "Austrian" Money Supply) — posted another double-digit year-over-year rate increase in March, this one coming in at 14.5 percent. That makes 40 consecutive months of double-digit year-over-year rate increases. To state the obvious, we are in the midst of a monetary explosion.
To Austrians, this not only means we are looking at another economic bust but, given the size of this building monetary boom, a bust with a real possibility of surpassing anything we have seen in the recent past. Yes, even the housing boom turned bust turned Great Recession.
Building on an essay we wrote in March, here's the why, how, and when on what we are dubbing the "Bernanke boom–bust-to-be," named after the man most responsible for its genesis.
The Bernanke Boom–Bust-to-Be in the Context of History
Let's begin this discussion by sizing the current installment of monetary largesse; namely, the Bernanke monetary boom, against the monetary largesse that produced the tech boom-bust at the turn of the millennium and of course the housing boom-bust turned Great Recession of 2008–09.
First, have a look at the following two charts, which compare the monetary inflation rates of the three boom-bust cycles as measured by TMS2. The first chart plots the year-over-year rate of change in TMS2, cycle trough to trough. The second chart plots the cumulative change.
Now take a look at this table, summarizing the key cumulative metrics:
These graphics speak volumes. Now in its 44th month, the Bernanke monetary boom as measured by our TMS2 metric is up a cumulative 58 percent and tracking the now-infamous housing boom-bust monetary surge almost to a tee. Heck, at $3.1 trillion the Bernanke monetary boom is already 1.6 times the size of the monetary surge that produced the housing boom-bust and a whopping 4.5 times the size of the surge that gave us the tech boom-bust. What's even more interesting is that the Bernanke monetary boom is still going strong. As noted above, the latest TMS2 reading shows it was sporting a 14.5 percent year-over-year rate of increase versus the 9 percent and decelerating year-over-year rate seen in the 44th month of the housing boom-bust cycle.
We think this kind of monetary largesse guarantees an economic bust. In fact, given the size of the monetary surge so far, it's quite possible that the bust will rival the size and intensity of housing boom-bust turned Great Recession. Worse still, we could be looking at something even bigger than that.
The Bernanke Boom — Bust-to-Be, Bigger than the Housing Boom-Bust?
Yes, there is a real chance that the coming Bernanke bust could pack an even bigger punch than the housing boom-bust. One simple reason: a lot more monetary largesse could be in the offing.
We sight three primary inflationary forces:
- Eurodollar deposit flows from European to US banks
- Cashed-up US banks more willing to create uncovered money substitutes
- The Bernanke backstop
Eurodollar Deposit Flows from European to US Banks
It's no secret that the sovereign-debt crisis that is Europe is wreaking havoc with the European banking system. Up to their ears in European sovereign debt and related derivatives undoubtedly marked at prices not likely to be found anywhere in the market, all too many European banks are frankly insolvent. As a result, many safe-haven-seeking European Eurodollar depositors have been taking their dollars out of European banks and redepositing them in the perceived relative safety of US banks. The result has been a nice push for the US money supply. More importantly, it's a push that may still have a lot more oomph.
Let us explain.
First, have a look at the recent trend in Eurodollar deposit balances in the European banking system, as sourced from the Bank for International Settlements (BIS) database:
According to the latest BIS statistics, European banks were seeing some fairly chunky Eurodollar-deposit contraction during the fourth quarter of 2011. All told, deposits were off $380 billion or 5.5 percent from September's $6.9 trillion balance, bringing that balance to the lowest level since December 2010. No doubt, some of this deposit contraction was actual deposit destruction (the result of outright Eurodollar asset sales or loan repayments). But in our estimation the bulk of that contraction had more to do with European depositors liquidating their Eurodollar deposits and redepositing the dollar proceeds stateside in on-demand deposits, the proceeds of that liquidation in no small part "funded" by the latest US and European central-bank currency-swap pact (where the central banks of the United States and Europe exchange newly created dollars for newly created euros, sterling, and francs). In other words, what we have here is US monetary inflation via safe-haven-seeking European Eurodollar depositors, with a big assist from the central banks of the United States and Europe. As anecdotal evidence suggests, this was a trend that likely made its way into the first quarter of 2012, meaning European Eurodollar deposit flows had a material impact on that 14.5 percent year-over-year rate of increase in TMS2.
The question then becomes, What next?
To us, as long as European sovereign-debt woes continue to mount (something many experts think is pretty much guaranteed) and as long as the central banks of the United States and Europe continue to lend a hand to the Eurodollar market in times of market stress via inflationary currency swap or lender-of-last-resort programs (something they do as a matter of policy), US-bound Eurodollar deposit flow should remain inflight. Indeed, if European sovereign-debt problems reached levels worrisome enough to cause European Eurodollar depositors to cut and run en masse, the sheer size of the European Eurodollar market vis-à-vis the US money supply ($6.5 trillion against $8.5 trillion) would suggest a virtual explosion in the US money supply.
Having said this, we are certainly not projecting an imminent 75 percent increase in the US money supply via the European Eurodollar market. In fact, if the central banks of the United States and Europe backed away from their support of the Eurodollar market, we think we would have a whole new ballgame — outright and pervasive Eurodollar-deposit destruction outweighing whatever Eurodollar-deposit flow was able to make its way to US banks and, because of transatlantic contagion, the real possibility of US bank-deposit destruction too. But until central-bank policies change — that is, until the central banks of the United States and Europe stop responding to each and every successive wave of sovereign-debt-induced market stress with lender-of-last-resort programs — it's the same old ballgame. Each successive wave of sovereign-debt-induced market stress means more and more worried European Eurodollar depositors looking for safe-haven US banks. And with central-bank help, that means more and more US monetary inflation. Yes outright deposit destruction along the way too, but a real chance that the US money supply could very well be poised to receive a goodly portion of that $6.5 trillion Eurodollar deposit stash.
One final but important thought. Note that the Eurodollar deposit space is almost entirely composed of time deposits. Now, under the Austrian formulation of the money supply, time deposits are not money but rather credit claims to money at a specified date in the future, claims that must first be liquidated into on-demand deposits or standard notes before they can serve as money. This means that European Eurodollar deposit flows into US bank on-demand deposits not only means the US money supply is benefiting from European deposit flows but world money supply too.
Cashed-Up US Banks More Willing to Create Uncovered Money Substitutes
As we discussed in March's essay, with excess reserves of some $1.5 trillion (owing to three plus years of Federal Reserve asset purchase and loan programs) yield-starved banks — buttressed by improved liquidity and capital ratios, a Federal Reserve and US government still cleansing bank balance sheets of mortgage and mortgage related debt and near zero rate funding costs maybe as far out as 2014 — seem more and more willing to pyramid up those reserves into money and credit; i.e., to create uncovered money substitutes by making loans and buying assets. Have a look at the recent rate of change metrics in uncovered money substitutes and a proxy for its obverse, commercial bank credit as compiled by the Federal Reserve (the later which represents roughly four-fifths of total bank credit). Both have been marching steadily higher and are currently touching two and a half year highs.
As we noted in that same essay, assuming a conservative reserve ratio of 10 percent on bank deposit liabilities — the highest reserve requirement ratio on the books — banks could theoretically triple the money supply, and do it simply by buying government securities.
Now, we are not saying that banks are poised to triple the money supply, full stop. For one, banks have to be continually willing to forsake the 25 bps they receive on their excess reserves, as well as the instant liquidity those reserves provide, for higher yielding, riskier assets. Not a huge obstacle for yield starved banks that are back-stopped by the Federal Reserve, especially if the trade-off is US Treasuries or some other government-backed investment, but an obstacle that could give banks pause at some point along the way. Similarly, bank capital ratios will almost assuredly act as a constraint on bank credit expansion short of a triple — voluntarily or through regulatory edict — particularly if banks are stretching the credit curve. Then, of course, given our debt-laden economy, there is always the real possibility of a major credit event, carrying with it the ability to derail even the most yield-hungry banking system. And last but not least, if the money supply took this kind of explosive path we think it wouldn't be long before the US dollar was trashed, making price inflation a national issue and thus forcing the Federal Reserve to halt its easy-money policies. Having said all this, such constraints on bank money creation appear to be of secondary importance for now, meaning there could be ample room for some serious money creation via the banks before any of those constraints kick in.
The Bernanke Backstop
Last but not least, if European deposit flows or banks can't muster enough monetary largesse to temporarily juice the US economy and payrolls at a level sufficient to suit a deflation-wary Federal Reserve headed by a chairman scared to death of a 1937-style double dip (which he attributes to the Federal Reserve's move away from an accommodating monetary policy), rest assured there is always QE3 or some other creative monetary tool lying in the wings ready to spike the money supply on the false belief that this will spur long-term economic growth.
The net of all this monetary largesse — what's already been created and what's likely still to come — is that the Bernanke monetary boom could very well be on its way to one of the great monetary inflations in US history and, as a consequence, one of the great economic busts in US history too.
The Trigger for the Bernanke Bust
Don't tell me what; tell me when, right? Enter the trigger that will turn the Bernanke boom to bust: a cessation, even a marked deceleration in the rate of money creation.
You see, once the economy is deprived of its monetary steroids, the malinvestments created on the back of all this monetary largesse, indeed sustained by it, will be revealed as wasteful, misplaced capital and labor. The Bernanke bust will ensue as those malinvestments are liquidated, the debt supporting them purged and the capital and labor they absorbed released. A look at the housing boom-bust timeline is instructive and offers a glimpse into what's in store:
Note the deceleration in the money supply beginning in the back half of 2003 and its precipitous decline thereafter, knifing through the 10 percent mark in the second quarter of 2004 on its way to a trough low of 1 percent in the third quarter of 2006. Shortly thereafter, the subprime crisis was upon us. Roughly 18 months after that, the Great Recession.
The events that might bring on a cessation or marked deceleration in the rate of monetary inflation are many. We alluded to some of them above, such as a major credit event or a return of price inflation as a national issue, forcing the Federal Reserve to reverse its easy-money policies. But at the risk of sounding too simplistic, we think such events, while important, should be of secondary focus. Given the predictive nature of the ebb and flow of the money supply, all eyes should be on the money supply.
Just Keep Printing Money: Problem Solved
You might ask, What if the money supply continues to boom ad infinitum, even if that simply means Chairman Bernanke is the last man standing at the printing press? Could the Bernanke bust then be avoided? Delayed yes, avoided no. The endgame in this case would be a bust too; only this one would be the result of an inflationary collapse of the US dollar. Indeed, the surest way to create massive economic misery is via a concerted effort by a central bank to forever expand the supply of money and credit.
Quoting the great Austrian economist, Ludwig von Mises,
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
In other words, the Bernanke bust is coming, sooner or later, one way or another.