How We Are Racing Toward the Economic Cliff

Forget about the fiscal cliff. Are we headed to the economic cliff? A successful software entrepreneur and school friend sent me this chilling email last week:

Yesterday I was speaking to a banker in central California who related how he is being prevented from doing his job due to the compliance people (read government pressures) and could not  convince the powers-to-be to make a loan despite his long history of good  decisons.  I hear stories daily regarding how people have seen orders evaporate as a result of the election. Multply this across the nation to understand the impact.  

But how could loans be scarce when the Fed has been printing money at an unprecedented rate?  

Here is Cato Institute and Johns Hopkins economist Steve Hanke’s explanation, from a recent EconTalk podcast:

[S]tart with Lehman’s collapse in September 2008. That’s a convenient date. Since that point in time, the Federal Reserve’s balance sheet has increased roughly by three and a half times. So that means they are buying a lot of these [U.S. government] bonds….  

Now that means that high-powered money, or what I call state money–the amount of money produced by the state–has more or less tripled. It’s exploded…. [S]tate money has increased from about 6.5% of the total money supply, when you measure the money supply properly with a broad measure, like M3–so we went from state money being at about 6.5% at the time Lehman collapsed, until now it’s about 15% …. 

[In other words] state money is peanuts. What really is important is bank money–and bank money is created by the commercial banking system and shadow banking system, and that’s what really counts.  

So, in a way we have had the following scenario develop after Lehman: We’ve had ultra-loose monetary policy with regard to state money and the Federal Reserve.But with the financial regulation that was legislated with Dodd-Frank, and also with what is called the Basel capital requirements, and specifically Basel III, which is being imposed on banks–to increase the capital-asset ratios of the banks.These two things–financial regulation and Basel–have in effect imposed ultra-tight monetary policy on the banking system and bank money.

So, as a result of the two, we’ve had the total amount of the money supply actually being very anemic, not growing very much at all. And in fact, if you look at a trend line since 2009 and look at the endpoint today of the trend line as you are going left to right, that point is about 7.5% higher than the actual level of the money supply that we have.

So, you could argue that relative to trend we’ve got a deficiency of about 7.5% in broad money. And the reason why is that the dominating feature has been the reregulation of banks and the tight monetary policy imposed on bank money. Which accounts for 85% of the total amount of money in the economy.

Basel III is an international banking agreement — one of a series dating to the late 1980s — that is imposing increased reserve requirements on major money center banks globally, and is being applied in the U.S., it turns out, on regional banks, too. Thanks to it and Dodd-Frank, regulators are forcing U.S. banks to shift their portfolios toward U.S. government debt and other assets that qualify as reserves. This is, of course, very convenient at a time of World War II-scale federal borrowing needs made bigger by the president and his Congressional allies insisting on more entitlement and other domestic spending, meaning more debt, not less.

Who comes out on the short end?  

My friend pretty much nailed it — the small and mid-sized companies seeking operating capital and longer term loans for expansion. Add in the hammering down of their equity capital that will come from election-insured (unless the House GOP can stop them) higher tax rates, arbitrary regulations and, yes, further ratcheting up of spending, and, sure, you can imagine that those companies are canceling orders. Hiring decisions, too.

And so we race lemming-like toward the economic cliff. 

  1. Charles Mark

    How that works in Ireland is that a Bank looks at the Borrower’s net income, discounts it by 70%, then from the remaining 30% deducts the Borrower’s existing fixed commitments (mortgage, other loans, spousal or child maintenance- if it arises-and sundry others) before reaching the figure from which repayments of the proposed loan, as well as other living expenses, must be repaid. And Hey Presto! No loans nearly all of the time, moribund property market and consumer spending, emigration on the rise.

  2. liberal jim

    The internet bubble, the housing bubble and now the government debt bubble all of them courtesy of the Fed’s  cheap money low interest policies.  Explain to me again why gold would be so much worse!

  3. Mothership_Greg

    Wull, famous conservative Josh Barro sez:

    They are often delusionally convinced that the country faces imminent economic collapse.

    So presumably we don’t need to worry about any of this.  Say, anyone seen the price of arugula lately?

  4. WI Con

    My father-in-law has worked for over two decades in business bankruptcy restructuring as a court ordered 3rd party entity to help guide companies back to solvency or to wrap things up for creditors.

    He’s been telling me since the banking crisis started that situations where banks would typically obtain operating loans & lines of credit have all but stopped. The banks no longer ‘work with’ these businesses and are opting to call in the loans and close up shop.

    As an aside, while I agree with the call for increased reserve ratios for banks, does any one here know if these big banks & institutions are still fooling around with these derivatives? Are the composition of these mortgage backed securities any healthier now than before all this started?

  5. Richard Fulmer

    The Basel accords allow zero bank reserves for government loans; such loans are considered to be riskless.  If companies want money, they’ll have to get it from government since they cannot get it from banks.  Crony capitalism now and forever.

  6. Garrett Petersen

    Yes, it’s a great time to be an economist.  It’s like being an undertaker during a plague.  Huzzah!

  7. Rodin

    It sounds like the government has eliminated private borrowing and jobs as competition for government largesse. It may also explain why perceived inflation is relatively low: Before government becomes your only source of income and commodities, elastic demand drops with the economic slowdown. Only inelastic demand, e.g. energy and food, sees a rise. Because the inflation measure is not just inelastic demand, the rate is lower. But when shrinkage of value of money eventually is fully realized, full blown inflation takes over as even “elastic” demand reaches “inelastic” levels, and economic wreckage causes shortages where government does not step in the manage the means of production.

  8. Devereaux

    “Youse, youse, and youse – da bod a youse,” sit back while your behinds are enlarged yet again by a government that is “only doing it for your own good”.

    There are classically 6 phases to pretty much any project:

    - Elation

    - Depression

    - Apathy

    - Search for the guilty

    - Punishment of the innocent

    - Praise and honours for the uninvolved.

    The dems have been busy doing the last three for a LONG time.

  9. jetstream
    Keith Preston: …

    We have no power anymore, and the public is hypnotized by a demogogue…what stops it? · 8 minutes ago

    The end result of the current savage macroeconomic environment will be chronic GDP contraction (recession/depression), mass unemployment and deflation.

  10. Keith Preston
    jetstream

    Keith Preston: …

    We have no power anymore, and the public is hypnotized by a demogogue…what stops it? · 8 minutes ago

    The end result of the current savage macroeconomic environment will be chronic GDP contraction (recession/depression), mass unemployment and deflation. · 1 minute ago

    Which raises the key question again…does Obama know this?  Is he in denial, or does he somehow believe this plays to his master plan?

  11. Devereaux

    No. I don’t believe Obama knows this. Or at least doesn’t believe it. He believes his own ideology, and any data to the contrary is simply wrong, and so not to be considered.

    ?Remember his comment about raising taxes on the rich, EVEN if it means less revenue. He said yes, because of “fairness”. He has no clue. He is simply an ideologue. 

  12. ConservativeWanderer
    Keith Preston

    jetstream

    Keith Preston: …

    We have no power anymore, and the public is hypnotized by a demogogue…what stops it? · 8 minutes ago

    The end result of the current savage macroeconomic environment will be chronic GDP contraction (recession/depression), mass unemployment and deflation. · 1 minute ago

    Which raises the key question again…does Obama know this?  Is he in denial, or does he somehow believe this plays to his master plan? · 16 minutes ago

    If you believe he’s following the Cloward-Piven plan, then yes, it fits.

    Even if you think Obama is economically ignorant — and I do — his followers/handlers/czars/puppetmasters could be following Cloward-Piven.

  13. Innocent Smith

    I look forward to sitting in my car and commuting to work every day because I have Russ Roberts to keep me company.  I’d love to hear him again on the flagship podcast!

  14. KingsKnight1

    Clark Judge’s piece just convinces me more that Thomas Sowell is correct, “We’re lost. ”

  15. DocJay

    Banking side note. At 46 I have no debt other than a house I’m underwater on. The loan is a Jumbo, although not by much with a first and a credit line held by a non Freddie, Fannie. With a stable income, perfect credit, a good disability policy, and life insurance I represent a near zero risk to not pay back anything. I am unable to refinance my 5.25% loan unless I pay down the original loan considerably but have no money currently for that and by the time I will in a couple years there’s college expenses and the likelihood that interest rates will be back up again. I was told I could walk away from my house and qualify for a huge loan on a different house anytime though of a higher value than my current loan. Insanity rules it seems.

  16. Indaba

    We were looking at a fruit and veggie distribution company. They make the majority of their revenue from lending to their suppliers, the farmers around the world. There is more of this going on. The banks do not want to lend. Up here in Canada, there is a sudden dearth of finance deals. M&A are down.

  17. Indaba

    American money is all over Canada, looking to buy businesses and do private equity. They tell us the US is over shopped.

  18. Kay Ludlow

    Surprisingly, yes. Mortgage backed securities have actually been reasonably profitable since 2008. Hedge funds investing in these and stressed/distressed credit have done quite well in the last few years. (Probably thanks to the taxpayer absorbing the loss on all the really toxic assets — thanks Fannie!!).

    WI Con: My father-in-law has worked for over two decades in business bankruptcy restructuring as a court ordered 3rd party entity to help guide companies back to solvency or to wrap things up for creditors.

    He’s been telling me since the banking crisis started that situations where banks would typically obtain operating loans & lines of credit have all but stopped. The banks no longer ‘work with’ these businesses and are opting to call in the loans and close up shop.

    As an aside, while I agree with the call for increased reserve ratios for banks, does any one here know if these big banks & institutions are still fooling around with these derivatives? Are the composition of these mortgage backed securities any healthier now than before all this started? · 5 hours ago

  19. Devereaux

    I’m hardly a great historian, but doesn’t this mirror just what FDR did in the 30′s. I seem to recollect that there was actually deflation as the useful money supply dried up. People started making up money, such as chits from the bank in Utah.

    This is exactly what happens when the government goes to largess and clamps down on the economy at the same time. Throw in some government dabbling in what by rights ought to be private industry (TVA then, GM, “green energy” now) and you have a strong parallel.

  20. ConservativeWanderer
    Devereaux: I’m hardly a great historian, but doesn’t this mirror just what FDR did in the 30′s. I seem to recollect that there was actuallydeflation as the useful money supply dried up. People started making up money, such as chits from the bank in Utah.

    This is exactly what happens when the government goes to largess and clamps down on the economy at the same time. Throw in some government dabbling in what by rights ought to be private industry (TVA then, GM, “green energy” now) and you have a strong parallel. · 2 minutes ago

    I think you’re on to something there.

    In fact, I think you should expand this into a full post… or if you’d prefer, I could work on it.

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