Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
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Established 1995
Oops!...I Did it Again - Contracting Broad Money, The Longest
Apology in History & The Memphis Blues Again (04/05/2023)
Let me end my talk by abusing slightly my status as an official representative of the Federal
Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're
right, we did it. We're very sorry. But thanks to you, we won't do it again.
Ben Bernanke Speaking At Milton Friedman’s Ninetieth Birthday Party 2002
In their seminal work A Monetary History of The United States 1867-1960 Milton Friedman
& Anna Jacobson Schwartz put the blame for the Great Depression firmly at the door
of the US Federal Reserve:
The contraction is in fact a tragic testimonial to the importance of monetary forces. True, as
events unfolded, the decline in the stock of money and the near-collapse of the banking system
can be regarded as a consequence of nonmonetary forces in the United States, and monetary and
nonmonetary forces in the rest of the world. Everything depends on how much is taken as given.
For it is true also, as we shall see, that different and feasible actions by the monetary authorities
could have prevented the decline in the stock of money – indeed, could have produced almost any
desired increase in the money stock. The same actions would also have eased the banking
difficulties appreciably. Prevention or moderation of the decline in the stock of money, let alone
the substitution of monetary expansion, would have reduced the contraction’s severity and almost
certainly its duration.
Ben Bernanke accepted the criticism and with QEI, QEII and QEIII he acted to ensure
that the money stock did not contract as US commercial banks either contracted their
balance sheets or materially slowed the growth rate in their balance sheets. Bernanke
acted to create money when commercial banks acted to destroy money. So why is the
Fed now watching the contraction in broad money? The Solid Ground believes that it is
because we are all now better informed in relation to the bifurcation of money, in terms
of the impacts of the different forms of money and their impact on economic activity.
The Fed sees expanding bank credit as creating the form of money that impacts demand
for goods and services and thus inflation. As long as that form of money continues to
expand at the right rate the Fed will keep monetary policy tight. Should, however, there
be any chance that the banking system is creating too little money or destroying it they
will have no option but to move, as Bernanke did three times when faced with the same
facts, to QE. If this analysis is correct then it is one of the reasons why equity prices are
rising and why they should continue to rise.
The monetary prescription to prevent a contraction in the money stock and a depression
was well explained by Irving Fisher as early as 1933 (The Debt Deflation Theory Of Great
Depressions), accepted by Bernanke in 2002 and applied by him in 2009, 2011 and 2013.
Arguably it was also used in 2020 when policymakers feared a contraction in bank credit
in the pandemic. So if the understanding of the imperative to prevent a contraction in
the money stock is so dominant, why is Jay Powell permitting a contraction in the money
stock? Does he ever think, ‘What would Ben do?’
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Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
Established 1995
When QE was launched its impact on asset prices and the real economy was poorly
understood. At the end of 2007 there was USD890bn of Federal Reserve money in the
system and by January 2015 there was USD4,516bn of Federal Reserve money in the
system. We have never seen anything like this before, at least in a developed world
economy in peacetime. What would the impact be from a substitution of money created
by commercial banks with a money created by central banks? Many expected such an
injection of money to create high levels of inflation - it didn’t. It turned out that this
particular form of money had a much bigger impact upon asset prices than it had upon
the prices of goods and services. In crediting newly created money to the sellers of
fixed interest securities the Fed forced those institutions, given the institutional
imperative to invest that drives all fiduciaries receiving fees for their services, to buy
other assets. The direct impact from the Fed’s creation of this form of money was to
see it ricochet around the financial market ghetto. However, there was also supposed
to be an indirect effect that would see money escape the financial market ghetto and
impact the demand for goods and services. The creating of Fed money, commercial
bank reserves, was supposed to lead the banks to lend more and create money.
The form of money created by the Fed appears in the system as a reserve of the
commercial banking system - the most liquid of all assets held by banks. Commercial
banks in pursuit of a profit, flush with high levels of low yielding liquidity, were
supposed to respond by expanding their balance sheets and, in the process, creating
the deposits that are exactly the form of money that impact upon demand for goods
and services. For many reasons this secondary impact did not happen from 2009 to
2019. Commercial bank balance sheet growth was sluggish in the US and non-existent
in the Eurozone. As a result the growth in broad money was anaemic and the
inflationary consequences from the explosion in the Fed’s balance sheet did not
materialise.
Your analyst turned bullish on equities in early 2009 and initially expected inflation to
rise - as it did. However by early 2012 it was obvious that commercial bankers could
not respond to the liquidity infusion as expected, they would not expand their balance
sheets aggressively creating lots of money and hence it was back to the risks of
deflation. There were to be two more skirts with deflation, in 2015 and 2020, despite
the massive creation of money by the Fed. The Fed’s money had a direct impact on
asset prices but failed to have the indirect impact. Because of the failure of banks to
respond to greater liquidity we have come to recognise that there are two types of
money.
We learned something from 2009 to 2019: within the money stock not all money can
be treated equally in assessing its impacts upon the demand for goods and services. The
Solid Ground believes that only this realisation can account for the apparent relaxed
attitude that the current Fed has to the contraction in the money stock. So, if this
acceptance of the bifurcation of money is the new normal, what might it mean for
monetary policy and the course of asset prices?
Is Jay Powell relaxed about the contraction in the money stock because bank credit
continues to expand creating the form of money that ultimately counts for those trying
to assess the outlook for inflation? To your analyst this seems the most likely cause of
Fed inaction, given that the headline money supply data is warning that a debt deflation
is now imminent. It seems unlikely that there is no institutional memory within the Fed
from the Bernanke era nor that Powell has not consulted Bernanke on the
consequences on the contraction of the money stock. Indeed, if Ben Bernanke were
concerned on this issue it would not be unknown for a retired Fed chair to make,
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Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
Established 1995
perhaps veiled, public pronouncements on the issue. So far, as far as The Solid Ground
can assess, no such announcement explicit or implicit are forthcoming.
As long as the banking system continues to create credit, and the form of money that
impacts demand for goods and services, the contraction in broad money will be ignored
by the Fed. Having spent two weeks visiting investment managers in NYC, Boston,
Toronto and London it is clear that the market currently fears that bankers are now
expected to curtail their lending and destroy money. This is not what The Solid Ground
expects but, if it occurs, look on the bright side for QE will surely follow. If it doesn’t,
then the Fed is proclaiming that actually Bernanke was wrong, Friedman was wrong,
Fisher was wrong and a contraction in the money stock does not bring with it a debt
deflation. If this revolution in thought has occurred within the Fed then your analyst
will be surprised, alarmed and very wrong.
What is happening with commercial bank money creation and what does this mean for
Fed policy? In the last newsletter we looked at the very early data as to how US bank
credit growth was responding to the various bank runs in the US. There was a major
decline in bank credit from mid-March as key banks were removed from the aggregate
bank balance sheet data as they became wards of the FDIC. That reclassification of
bank assets and liabilities does not impact the amount of money in the system as long
as depositors have access to their deposits throughout this process - and they do, which
is in great contrast to what happened during the Great Depression. Following the
removal of those banks from the data bank credit declined to a low of USD17,292bn
on March 29th. Since then the data has been erratic but as of April 19th bank credit had
expanded to USD17,335bn. If The Solid Ground has a reputation for anything it is
perhaps in not being overly concerned about the short term, so it is with some
trepidation that we now look at weekly data. What it shows is that since March 29th
bank credit has grown at an annualised rate of about 4%. It is far too early to take
anything for granted here, but at least it’s an expansion and not a contraction in bank
credit and thus indicates, at this early stage, that bankers continue to be in the business
of money creation.
Bank credit expansion drives money creation but bank credit has two key component
parts: bank lending and bank ownership of securities. If bank credit expansion indicates
that banks are still making money, what does bank loan growth indicate about their
willingness to fund the private sector and also the private sectors demand for credit?
In the same period that bank credit has been growing, loans and leases, the dominant
part of bank credit, have been growing at an annualised rate of 5.6% - slightly faster
than bank credit growth in aggregate. If we look at a key subset of loans and leases,
commercial and industrial loans, they have been growing at an annualised rate of 6.3%.
This is good news but comes with a caveat.
It is not unusual for bank credit growth to rise heading into a recession. As Chairman
of a listed company myself I am conscious that credit lines are there to be drawn and
operating companies in particular, perhaps expecting a forthcoming decline in cash
flow, often draw down credit lines and build up cash balances in preparation for worse
times to come. Thus it is possible that the expansion in bank credit, focused as it is on
commercial and industrial loans, is driven more by this move by corporations to build
up precautionary cash balances than by demand by the private sector to spend and
invest. It is just too early to tell.
However it is worth reminding ourselves that there are some companies with huge
incentives to borrow beyond the need to build up cash balances. These companies are
recipients of state largesse under the terms of the Inflation Reduction Act (IRA). This
piece of legislation transforms the credit quality of many smaller companies in the US
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Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
Established 1995
and makes them more attractive to banks as potential customers. There can be more
such legislation to follow and it remains the opinion of The Solid Ground that there will
be direct government intervention to prevent any faltering in bank credit growth. The
lesson governments learned in 2020 is that commercial banks are key conduits for the
expression of state policy. That is not a lesson they are likely to forget so soon. As
regular readers will know, this does of course raise serious questions as to whether the
central bank or the government is now the monetary authority. The Solid Ground believes
that the state, through de facto bank credit control, is evolving into the monetary
authority but this remains to most people a crank’s view.
In the past The Solid Ground has focused upon the use of government bank credit
guarantees to encourage bank credit growth but the IRA can achieve a similar goal by
improving the credit characteristics of banks’ corporate customers. There is more than
one way to skin this particular cat of ensuring commercial bank credit growth. While it
is too early to proclaim that the banking system will sail through the current
perturbations, while expanding credit, there are reasons why it can do so. If it needs a
little encouragement from the state to do so then it will get that encouragement. State
interventions to resolve liquidity/solvency issues in the commercial banking system
only increase the prospects for such encouragements.
It seems that recent resolutions of bank failures mean that all the deposit liabilities of
US banks are guaranteed, if implicitly and not explicitly. The price of funding for some
banks may have moved higher, as depositors differentiate more in relation to bank
solvency, but for those who benefit from deposit flight the cost of funding is declining.
Deposits held as part of a savings portfolio are probably shifting in search of higher
yields, but banks also fund themselves from the mass of deposits held for transactional
purposes which rarely, at least in the hands of the household sector if not the corporate
sector, are yield seeking. The bigger banks are attracting such lower yielding deposits
which is good for them if bad for the smaller banks. The system as a whole retains a
large phalanx of low-yielding deposits which make some banks particularly competitive
as lenders. While there is some evidence of credit quality deterioration for banks, it
seems that most of the problems associated with that deterioration will fall upon the
non-bank credit system
What if we are now about to live through a major re-intermediation of credit as the
banking system becomes so much more competitive, boosted by its government
guaranteed liabilities in an era when bad credit is impacting the non-bank credit system?
That would result in much higher levels of broad money growth without aggregate
credit growth being as high. This is a very large subject and subscribers to the quarterly
product will find this subject covered in significantly more detail in the 2Q report
Dimon v Fink The Rumble In The Credit Jungle due out late June. Spoiler alert - it’s
Dimon in round one. The consequences from that victory are profound.
The Solid Ground is very clear that greater and greater government intervention will stop
the contraction in bank credit and this changes, as previously discussed, the nature of
the business cycle to the benefit of equities. Let us say, however, that the various
subsidies already in place to spur bank credit growth and state intervention to come fail
to have the desired effect. What happens then? Well, if Powell follows the Bernanke
playbook he will have to expand the Fed’s balance sheet as Bernanke did when banks
stopped creating money in 2009, 2011 and 2013. The decline in the money stock, then
spreading to the form of money that directly impacts the demand for goods and
services, is exactly the form of contraction that Bernanke promised to ‘never let it
happen again’. Such a return to QE would, history suggests, be positive for the price
of equities.
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Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
Established 1995
As The Solid Ground has written twice now since last September (see The Fix Is In Parts
I and II) there is evidence that global central bankers are already spreading the foam
on the runway to assure that commercial banks do not find themselves contracting
their balance sheets. If we have learned nothing else about them since 2009 it is surely
that there is no limit to the monetary foam that central bankers will spread to prevent
a repeat of the events of The Global Financial Crisis. Bernanke’s 2002 address may
have been the longest apology in history but everyone in the room knew why it is was
so long - because of the consequences from the mistakes. While cause and effect in the
course of human history will always be subject to doubt, there is a general belief that it
was the Great Depression that brought fascism and war to Europe and then to the
world. If central bankers and governments believe that such are the consequences of
permitting a debt deflation, at a time of heightened geo-political risk, will they go big
and go early to prevent such an outcome? They already are. If going big and early does
not prevent the contraction in bank credit then expect plenty of QE. In such an
environment equities are a better place to be than bonds.
Investors should now expect the following course of events: continued intervention by
central bankers and governments to ensure that bank credit growth continues; that the
creation of the form of money that spurs demand for goods and services continues and
that policymakers have to accept the consequences for inflation of such an expansion.
If bank credit growth falters, as it now seems to be doing in the Eurozone, we should
expect governments to bring forth more plans to redress this problem and Europe is
still to launch its own form of the Inflation Reduction Act. If neither of these outcomes
comes to pass we should expect central bankers to return to QE to prevent the
contraction in the money stock that is recognised by the Fed as the greatest monetary
mistake in its history.
Central bankers are aware of the scale of geo-political change under way in the world
and, according to Christine Lagarde, are prepared to adapt to those changes:
In this sense, insofar as geopolitics leads to a fragmentation of the global economy into competing
blocs, this calls for greater policy cohesion. Not compromising independence, but
recognising interdependence between policies, and how each can best achieve their objective if
aligned behind a strategic goal.
Speech by Christine Lagarde, President of the ECB, at the Council on Foreign
Relations’ C. Peter McColough Series on International Economics, April 17th 2023
These are not the words of a central banker prepared to force a contraction in broad
money, a debt deflation and perhaps a depression upon the world. These are words
from this particular overmighty citizen that recognise that there is a need to fuse central
bank and government policy. This is exactly the compromise that Arthur Burns
explained as the causes of his own failure to control inflation in the 1970s in his
remarkable speech in Sarajevo in September 1979. At this moment in history, of a great
geopolitical bifurcation, central bankers are even less likely to make the error of not
supporting growth and expansion to meet the challenges of the emergencies ahead in
the new Cold War.
The Solid Ground expects the socialisation of risk through state intervention in the
commercial banking system to condition the shape of this recession and thus ensure
that it is mild and with sticky inflation. It’s a socialisation that makes us look more like
China, for such is the fate of any free market system entering conflict with a command
economy system: that it has to become more like its enemy in the pursuit of victory. If
such a form of economic contraction is engineered, through a further mass socialisation
of risk, it is very unlikely to come with the scale of collapse in corporate earnings that
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Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
Established 1995
would push equity prices lower given their price declines from late 2021. However, if
this is wrong and banks do begin to contract their balance sheets and destroy money,
we should expect the purchase of securities by the central banks that, heretofore, has
been positive for the price of equities.
Market participants are struggling to understand why the price of equities is rising as
we approach a recession, but the answer is that central bankers and governments,
having learned lessons from the Global Financial Crisis, are already acting aggressively
to ensure that we have a very different form of recession this time. They acted similarly
in 2020 and the S&P500 exceeded its February high by September of that year. The
socialisation of risk does exactly what it says on the tin: it sucks risk off private sector
balance sheets and adds them to public sector balance sheets. This risk reallocation is
good for private sector assets and ultimately, at a date that is extremely difficult to
forecast, it undermines public sector credit. Whether this risk reassignment is carried
out by the central bank or the government, or both, it changes the nature of risk, the
business cycle and the outlook for equities.
The alternative forecast is that we repeat the 1930s and that one day a central banker has to stand
up in public, hopefully without a soundtrack, and state that Oops!...I did it again. So it
won’t be full Britney Spears but thankfully more Bob Dylan because ultimately the
overmighty citizens that are our central bankers know that, at this stage in the monetary
cycle and the geopolitical breakdown, they must provide us with what we need which
is very much what we want.
When Ruthie says come see her
In her honky-tonk lagoon
Where I can watch her waltz for free
’Neath her Panamanian moon
An’ I say, “Aw come on now
You must know about my debutante”
An’ she says, “Your debutante just knows what you need
But I know what you want”
Oh, Mama, can this really be the end
To be stuck inside of Mobile
With the Memphis blues again
Bob Dylan, Stuck Inside of Mobile With The Memphis Blues Again, Blonde on Blonde, 1966
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Newsletter 4 th May 2023
RUSSELL NAPIER
russell@orlockadvisors.co.uk
Established 1995
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