Last week the Dow Jones industrial average fell 4.2%, the steepest drop since March 2003. Financial shares took a beating on growing evidence that problems in the sub-prime mortgage market are spreading, making financing the corporate buy-outs that drove the market's rally more difficult.
Many financial market participants are of the view that there is a definite deterioration in credit conditions, which means less liquidity for private equity, stock buy-backs, and business expansion. Fed officials, however, have downplayed this claim.
In an interview with the Wall Street Journal on July 24 the president of the Philadelphia Federal Reserve Bank, Charles Plosser, said that the present slump in the housing market is not going to trigger a liquidity crunch and a consequent general economic recession. The reason for this is that banks are unlikely to curtail lending since their balance sheets are in good shape. Plosser attributes this to financial innovations (financial engineering) in the last 10 to 20 years that have enabled banks to distribute much of the risk.
Plosser adds:
Does that say nothing bad can happen? Of course not. But it means I'm a little more sanguine that that whole view of a credit crunch is probably not as applicable now as it might have been 10 or 20 years ago…. Banks in this district are pretty healthy …. Their biggest complaint is not housing mortgage defaults and credit crunch, it's the yield curve. They've got money to lend.1
(Banks as a rule lend at long-term rates and raise funds at short-term rates. Hence they prefer an upward sloping yield curve — when long-term rates are higher than short-term rates. At present the yield curve is relatively flat, which undermines profits from lending.)
Fed officials including Plosser present the current housing slump as the outcome of irresponsible lending by mortgage brokers and various other mysterious forces. On this logic it is the role of the Fed to monitor the situation in the housing market and, if required, to interfere in order to prevent the housing slump from spilling over to the rest of the economy.
We suggest that what we are currently observing in the housing market is the deflation of the housing bubble, which could be a precursor to a widely spread liquidity crunch. The deflation of the bubble is the result of the Fed's boom-bust monetary policies. Here is why.
We define a bubble as activity that has emerged on the back of the loose monetary policy of the central bank. In the absence of monetary pumping this type of activity would not have emerged. Since bubble activities are not self-funded, their emergence must come at the expense of various self-funded or productive activities. This means that less real funding is left for true wealth generators, which in turn undermines real wealth formation.
When new money is created, its effect is not felt instantaneously across all markets. The effect moves from one individual to another and thus from one market to another. In short, monetary pumping generates bubble activities across all markets as time goes by.
It is quite likely that the loose monetary policy of the Fed between January 2001 and June 2004 has laid the foundation for the emergence of various non-productive activities. (The federal funds rate target was lowered from 6.5% to 1%.)
An easy monetary stance coupled with fractional-reserve bank lending has given rise to an abundance of money out of "thin air." Between Q3 2001 to Q4 2004 the average yearly rate of growth of our monetary measure AMS stood at 7.5%. This should be contrasted with the rate of growth of 2% in Q2 2001 and 0.9% in Q4 2000. The illusory prosperity that the bubble activities have generated in fact amounted to the consumption of real savings and to a weakening of the pool of real funding — the heart of real economic growth.
Since June 2004 the Fed has reversed its monetary stance. The fed funds rate target was raised from 1% to 5.25% currently. In response to this the growth momentum of our monetary measure AMS has been in visible downtrend since Q4 2004. The yearly rate of growth fell from 7.1% in Q4 2004 to 1.4% in Q2 2007.
Once the Fed tightened its stance this started to undermine various activities that emerged on the back of the previous loose monetary stance. In short, these activities have come under pressure.
We have seen that the effect of changes in money supply (i.e., creating and supporting various non-productive activities) on various markets operates with a variable time lag. As a result of this, the effect from past changes in money supply can continue to assert its dominance notwithstanding more recent changes in the money supply. (Past loose monetary policies can still provide support to various bubble activities despite more recent tight monetary stance.)
We suspect that the tighter stance since June 2004 is only now starting to gain momentum with the housing market being hit first. This means that sooner or later the various other parts of the economy are likely to exhibit difficulties.
In short, the fall in the growth momentum of money is going to put pressure on activities that sprang up on the back of previous loose monetary policy. (Remember that bubbles are supported by means of loose monetary policy that diverts real funding from wealth generating activities. Once the money rate of growth slows down, this slows the diversion of real wealth, i.e., slows down the support for these activities.)
When various non-productive activities start to deflate, this tends to exert a direct and indirect effect on the quality of bank assets notwithstanding financial innovations. Obviously once this happens banks tend to curb their lending growth.
Does this imply that the United States is heading for a serious liquidity crunch and severe economic slump? We suggest that this will be dictated by the state of the pool of real funding.
If the pool of real funding is still growing then commercial banks are unlikely to curtail their lending — at the worst, they might reduce the rate of lending expansion. This means that instead of being liquidated, various false activities might be forced to slow down their pace of expansion.
Obviously, if commercial banks were to significantly curtail their lending then this could be indicative that the pool of real funding at the disposal of Americans is in trouble. Should commercial banks trim their lending it is likely to lead to a fall in money supply and to a liquidity crunch, all other things being equal.
For the time being, overall commercial bank lending is still expanding although at a slower pace. After climbing to 11% in November last year the yearly rate of growth fell to 8.3% so far in July. (In the week ending July 18, bank loans increased by $23.3 billion.)
Another possible source for a liquidity crunch is the Fed's policy of targeting the federal funds rate. In the week ending July 25, the Fed's balance sheet (also called Fed Credit) fell by $3.669 billion. The yearly rate of growth fell to 2.7% from 3.1% in June and 4.2% in March.
The decline in the pace of monetary injections by the Fed could be indicative that the current fed funds rate target of 5.25% is too high relative to economic activity. In short, a weakening in economic activity puts downward pressure on interest rates. To protect the target of 5.25% the Fed is forced to slow down its monetary pumping.
It follows that liquidity could come under severe pressure if the Fed decides to cling to the current fed funds rate target whilst the economy is weakening.
We can thus conclude that as the effect of the tighter monetary stance of the Fed since June 2004 gains strength the chances for a widely spread liquidity crunch are rising. The entire issue could further exacerbate should the Fed cling to the current fed funds rate target whilst the economy is weakening.
- 1"Fed Official Sees No Signs Of Subprime Woes Spreading," The Wall Street Journal, July 24, 2007.
