How Central Banks Buy Growth

Dorothea Lange Good Coffee May 1937
"Post office Finlay, Texas"

The best of the lot must be the Daily Telegraph's headline: Economy firing on all cylinders as growth hits 0.6%. I mean, how does one trump that? Looks like they need to install extra cylinders just to grow 1%. I must admit I also really liked the claim that the UK economy will receive a £250 million boost from the Royal Baby™. Yes, in the United Magic Kingdom solid GDP growth can apparently come from the sale of millions of cups and plates and trinkets from one Brit to another, even if most are produced in China. All you need to do is get British citizens to spend £10 for a royal mugshot and we're on our way to recovery. Why don't they all just crash into each other's cars at 100 miles an hour, that's even much better for GDP.

The wish for growth must be a continuing strong incentive for many, because all over Europe there are claims that one country or another (France, Spain) have left the recession behind them. One green shoot and people think they're lost in a rainforest. S&P does not agree:

House prices to continue decline in Europe, says S&P

House prices are set to continue falling in much of Europe this year, with some of the steepest declines coming in core eurozone countries such as the Netherlands and France, according to a Standard & Poor's report out today. [..]

Spain will be worst hit, with house prices tumbling 8% this year and another 5% in 2014 because of "a lack of solvent demand to absorb excess supply", said S&P economist Sophie Tahiri. But she warned that the fall could be even worse. [..]

The second steepest drop in house prices will come in the Netherlands, S&P said, putting it down to weak growth, falling purchasing power, higher unemployment and changes to regulations. It forecast declines there of 5.5% this year and 1% next year, with the market bottoming out in 2015.

France will experience a 4% fall this year and next year, despite the market there proving "more resilient" than the rating agency expected. "Low interest rates and supportive lending policies imply a softer landing in France over the next 18 months," the report said.

And the IMF can also still see the forests for the trees:

IMF: Euro region at a high risk of stagnation

A year after the European Central Bank doused the risk of a euro-zone breakup, bank lending continues to collapse, unemployment is still increasing, and signs of recovery remain “elusive,” the International Monetary Fund reported Thursday in a sobering new analysis of the currency union. The IMF, which has loaned massive amounts of its own money to bail out euro-zone nations and keep the monetary union intact, portrayed the group of countries as at a “high risk of stagnation,” with few short-term options for turning their economies around.

The combined debt of households, companies and governments has barely budged from recent peak levels, constraining them from borrowing to buy or invest. Banks, stung by losses on government bonds in places like Greece, have retreated behind national borders and remain hesitant to lend to one another or take risks in other nations. Political momentum for reform has slowed, with major projects like a banking union half-finished.

ECB head Mario Draghi promised last summer to do “whatever it takes” to keep the euro zone together. With the risk of a larger collapse averted, it was hoped that politicians, banks and entrepreneurs could fix some of the region’s other problems — from misaligned wages and prices to a financial market that is fragmented along national lines.

Some of that has happened, said IMF euro-zone mission chief Mahmood Pradhan. But it has moved far more slowly than expected and has left the region vulnerable if the world economy slows further. “Relative to a year ago, it looks weaker,” Pradhan said.

“This is a depression”, Carl Weinberg, chief economist at the High Frequency Economics consulting firm, wrote after data showed another monthly drop in euro-zone bank lending — the 18th monthly drop in the past 21 months. “The contraction of credit is a death sentence.”

Moreover, the Fund sees a threat to Europe from America:

IMF fears Fed tapering could 'reignite' euro debt crisis

The tapering of stimulus by the US Federal Reserve risks reigniting the eurozone debt crisis and pushing the weakest countries into a "debt-deflation spiral", the International Monetary Fund has warned. Early tapering by the Fed "could lead to additional, and unhelpful pro-cyclical increases in borrowing costs within the euro area", the IMF said.

"The macroeconomic environment continues to deteriorate," said the Fund in its annual `Article IV' health check on the eurozone. "Recovery remains elusive. Growth has weakened further and unemployment is still rising, and the risks of prolonged stagnation and inflation undershooting are high. Mounting social and political tensions pose an increasing threat to reform momentum."

The report warned that the onset of a new tightening cycle in the US had already led to major spill-over effects in the eurozone, pushing up bond yields across the board. Early tapering by the Fed "could lead to additional, and unhelpful, pro-cyclical increases in borrowing costs within the euro area. This could further complicate the conduct of monetary policy and potentially damage area-wide demand and growth. Financial market stresses could also quickly reignite," it said.

The Fund said the European Central Bank must take countervailing action to prevent "a vicious circle setting in," ideally by cutting interests, introducing a negative deposit rate, and purchasing a targeted range of private assets.

It should launch "credit-easing" policies to alleviate the deepening lending crunch in Spain, Italy, and Portugal, where borrowing costs for firms are 200 to 300 basis points higher than in Germany, with small businesses struggling to raise any money at all. The IMF said the more the Fed tightens in the US, the more the European authorities need to offset this with other forms of stimulus.

The report came as fresh data from the ECB showed that loans to the private sector contracted by €46 billion in June, after falling by €33 billion in May , and €28 billion in April. The annual rate of contraction has accelerated to 1.6%.

The M3 broad money supply is also fizzling out, with growth dropping to 2.3% year-on-year. There has been almost no growth in M3 since October 2012. The money data tends to act as an early warning indicator for the economy a year or so ahead, and therefore casts doubt on recent claims by EU leaders that the crisis is over.

And there are more ugly stats available for your reading pleasure:

Eurozone Debt Burden Hits All-Time High Even After Austerity

Europe's debt dynamics keep getting worse in spite of years of cost-cutting and tax hikes designed to return public finances to health. Official figures showed Monday that the debt burden of the 17 European Union countries that use the euro hit all-time highs at the end of the first quarter even after austerity measures were introduced to rebalance the governments' books.

Eurostat, the EU's statistics office, said government debt as a proportion of the total annual GDP of the eurozone rose to a record 92.2% in the first quarter of 2013, from 90.6% the previous quarter and 88.2% in the same period a year ago. [..]

Greece, which in 2009 became the first euro country to suffer a loss of investor confidence over the state of its public finances, has the highest debt burden in the eurozone of 160.5%. That's up from the previous quarter's 156.9% and from the previous year's equivalent 136.5%.

The second highest debt-to-GDP ratio in the eurozone is Italy's 130.3%. Though Italy has not needed a financial rescue like Greece, Ireland, Portugal, Spain and Cyprus, its government has pursued a raft of measures to make sure its investors are happy to keep on lending money so it can service its 2 trillion euros debt on its own.

Across the eurozone, total debt stood at €8.75 trillion ($11.4 trillion) at the end of the first quarter, up from €8.6 trillion the previous quarter and €8.34 trillion the year before.

It's not just the euro countries that are suffering a debt overhang. Across what was then the 27-country EU, which includes non-euro countries such as Britain and Poland, the debt burden rose to 85.9% at the end of the first quarter from 85.2% the previous quarter and 83.3% the year before. Total debt stood at €11.11 trillion, up from €11.01 trillion the previous quarter and €10.67 trillion the year before.

Enough about Europe. Let's move on to Japan. According to Ambrose Evans-Pritchard, it's a country of miracles these days. Me, I'm not so sure:

Abenomics has worked wonders but can it save Japan?

Japan refuses to go quietly into genteel decline. The revolutionary policies of premier Shinzo Abe have done exactly what they were intended to do – a triumph of political will over the defeatist inertia of Japan's establishment.

Abenomics has not caused a collapse of confidence in Japanese debt after all. The bond vigilantes are, for now, resigned, as the Bank of Japan soaks up 70% of state bond issuance each month, printing almost as much money as the Fed in an economy one third the size.

"Abenomics is working," says Klaus Baader, from Societe Generale. The economy has roared back to life with growth of 4% over the past two quarters – the best in the G7 bloc this year. The Bank of Japan's business index is the highest since 2007. Equities have jumped 70% since November, an electric wealth shock.

"Escaping 15 years of deflation is no easy matter," said Mr Abe this week, after winning control over both houses of parliament, yet it may at last be happening. Prices have been rising for three months, and for six months in Tokyo. Department store sales rose 7.2% in June from a year earlier, the strongest in 20 years.

Japanese retail sales have grown recently, albeit in a fairly volatile fashion, and reached a new peak in May. "Above all, Abenomics has shifted the yen," said Mr Baader. The 22% devaluation since October has held, rather than snapping back as usual. The psychology of yen appreciation is breaking. Exports have jumped 7.4% from a year ago.

Abenomics has not caused a collapse of confidence in Japanese debt after all. The bond vigilantes are, for now, resigned, as the Bank of Japan soaks up 70% of state bond issuance each month, printing almost as much money as the Fed in an economy one third the size.

The IMF says Japan's gross debt was 216% of GDP in 2010, 233% in 2011, 238% in 2012 and will reach 245% this year. This is already a debt-compound spiral.

Mr Abe had to confront this head-on before the cataclysm hit. He has done so by turning to the ideas of Takahashi Korekiyo, the statesman of the early 1930s, later assassinated by military officers.

Takahashi tore up the rule book and combined monetary and fiscal stimulus, each reinforcing the other, until Japan was booming again, and the debt trajectory came back under control. The BoJ became a branch of the treasury, ordered to finance spending. "What he accomplished was what can be called the most successful application of Keynesian policies," said Mr Abe in his Guildhall speech last month.

"Five years before John Maynard Keynes published his General Theory, Takahashi succeeded in extricating Japan from deep deflation ahead of the rest of the world. His example has emboldened me." Takahashi's triumph was to smash expectations. "It is impossible to get rid of ingrained deflationary psychology unless you clear it out all at once. I myself have attempted to do exactly that," said Mr Abe.

[..] There is a contradiction to the BoJ's policy. If printing money does raise inflation to a new target of 2%, bondholders will suffer, either by a capital loss if yields jump or by slow erosion if they don't. Life insurers and pension funds might at any time refuse to buy. But it is a question of picking the lesser poison. The Fed navigated such reefs in the late 1940s, mostly with financial repression to whittle away war-time debt. Japan can do the same. This will be horrible for pensioners.

I would humbly suggest that perhaps Japan got out of the 1930's depression the same way Germany and the US did; through warfare, not through (pre) Keynesiasm. What's more, I think all Abe and the Bank of Japan are doing is spending their people's money to buy something that may look like growth, but is not that at all. Because I also have an idea where the present positive numbers for Tokyo come from. And that idea, which I have already written about quite a bit recently, was further reinforced this week by reading two pieces from Tyler Durden. The first is 3 months old:

How The Fed Holds $2 Trillion (And Rising) Of US GDP Hostage

When it comes to the real measure of a nation's economic output, one can rely on "flexible", constantly changing definitions of what constitutes the creation of "goods and services" as well as transactions thereof, goalseeked to meet the propaganda of constant growth no matter what (and which it appears will now, arbitrarily, include intangibles such as iTunes), or one can go to the very core of "growth" (just ask the anti-Austerians for whom debt and growth are interchangeable) which is and has always been a reflection of the increase (or decrease) in broad and narrow liquidity or money supply, which in turn means how much money is created through loans, either via commercial banks or the central monetary authority, also known as the Federal Reserve.

This is best shown by the following chart which shows the near unity (on the same axis) between US GDP and total liabilities in the US commercial banking system (traditionally the primary source of loan creation) as reported quarterly by the Fed's Flow of Funds statement (combining statements L.110, L.111 and L.112)

 

The chart above implies one simple thing: if there is loan creation, and thus injection of liquidity in the system, there is growth. If there is no liquidity injection, there is no growth, at least growth as defined by GDP-tracking economists.

And here we run into the problem.

A quick look at just loan and lease creation in the US commercial bank system reveals something very troubling: at $7.290 trillion as of the week of April 17 (a decline of $12 billion from the week before) there has been exactly zero loan creation in the US commercial bank sector, conventionally the primary locus where money demand translates into new loans as the Fed itself defines it in Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, since the failure of Lehman brothers. Specifically, in October 200/ total loans and leases outstanding in the US were $7.323 trillion. This means that loans, historically the biggest asset on bank balance sheets by far and whose matched liability is deposits, have been responsible for negative $30 billion in GDP growth in the past five years (source).

 

And yet, as the first chart above shows, total US bank liabilities have grown by $1.6 trillion since the failure of Lehman (from $13.6 trillion at December 2008 to $15.3 trillion as of the end of 2012) which means bank assets have also grown by a comparable amount, resulting in a matched GDP growth of roughly $2 trillion. How is this possible if commercial bank loan creation has been dormant at best, and in reality – negative, and no incremental matched liabilities could have possibly been created?

Simple: Presenting "Exhibit A" – the Federal Reserve, which has created $1.8 trillion in incremental reserves since the failure of Lehman, bringing its total balance sheet to $3.3 trillion.

 

The chart above shows that far more than merely goosing the market to record levels based on nothing but hot potato chasing by Primary Dealers loaded to the gills with record liquidity, and momentum-escalating High Frequency Trading algorithms, the Fed's "out of thin air" created excess reserves (a liability for the Fed) have come home to roost on the balance sheets of banks in the US (including foreign banks operating in the US) as positive carry (at the IOER rate) assets.

It also means that the Fed's excess liquidity, at least from an accounting identity standpoint, has manifested itself purely in the form of consumer and corporate deposits held at US banks ($9.351 trillion as of April 17), which as the chart below shows, used to track loans on a one to one basis, until QE started, and have since then surpassed total loans by just about the amount that the Fed has injected into the system.

 

Of course, the sad reality of what happens to the economy when the Fed pushes not only reserves into banks, but forces "deposits" into the hands of consumers and corporations, is precisely the one we have witnessed for the past four years: no real growth apart from the propaganda, with occasional spurts of growth driven by confusing the surge in the stock market (which is more than happy to absorb the record liquidity and where JPM and other banks use the excess deposits over loans to buy stocks and other risk assets) with a push higher in the economy. In the meantime, the middle class evisceration continues, the real unemployment is 11.6% or unchanged since 2009, US households on foodstamps are at a new record high every month, core CapEx spending is imploding to a pace not seen since 2008,  corporate earnings and revenues are stagnant at best, while companies continue to get stigmatized for daring to keep excess cash on their books instead of investing it (that the rate of return on such "investments" would be negative according to the corporate executives themselves is apparently entirely lost on the propaganda media and political talking point pundits).

But at least the S&P is at record highs, and corporate and sovereign yields are at record lows.

Sadly, since there never is a free lunch, what the above data tells us is that due to the persistent refusal of banks to take over from the Fed as lender (and money creator) of main resort over four years into the "recovery", that $2 trillion of the $16 trillion in US GDP is now held hostage by the Fed. In other words, if it wasn't for the Fed's "narrow liquidity", "low power money", whatever one wants to call it, creation, US GDP would be 12% lower, or at June 2007 levels. It also means that virtually every incremental dollar of US GDP "growth" comes solely courtesy of Ben Bernanke's narrow money spigot.

And since the US has to "grow", since US GDP has to be spoonfed to the masses as increasing at a ~1.5% annualized rate every quarter, and since US banks continue to not lend (and in fact their eagerness to not lend is further cemented by the far easier returns they can generate courtesy of the Fed in chasing stocks, and not take on NPL risk in exchange for meager 4-5% annual returns, which means a feedback loop is created where more QE means less bank lending means more QE means less bank lending), can all trivial and absolutely meaningless discussion over whether the Fed will halt QE (now or ever) finally end? It absolutely never will, until everything one day comes crashing down.

And the second Durden piece, the icing on the cake of the first is from this week.

How Much US GDP Growth Is Thanks To The Fed?

By now even the most confused establishment Keynesian economists agree that when it comes to economic "growth", what is really being measured are liabilities (i.e., credit) in the financial system. This is seen most vividly when comparing the near dollar-for-dollar match between US GDP, which stood at $16 trillion as of Q1 and total liabilities in the US financial system which were just over $15.5 trillion in the same period.

What, however, few if any economists will analyze or admit, and neither will financial pundits, is the asset matching of these bank liabilities: after all since there is no loan demand (and creation) those trillions in deposits have to go somewhere – they "go" into Fed reserves (technically it is the reserves creating deposits but that is the topic of a different article). It is here that we can discern directly just what the contribution of the Fed to US GDP, or economic growth.

The chart below shows the time series of US GDP since 1960 compared to total US financial liabilities over the same time period (compiled as the total of U.S.-Chartered Depository Institutions, Excluding Credit Unions (L.110), Foreign Banking Offices in U.S. (L.111) and Banks in U.S.-Affiliated Areas (L.112) all from the quarterly Flow of Funds, Z.1., report). This is a chart we have shown previously.

What we have broken out this time in the red shaded area, however, is how much of bank liability funding is matched by reserves originating by none other than the Federal Reserve. This amounted to a record $1.75 at March 31. It also means that excluding the Fed, US banks would have some $1.75 trillion fewer in assets and thus liabilities. Finally, it also means that the broadest aggregate of "credit creation", the US economy, would be some $1.75 trillion lower at the end of the first quarter.

 

And a quick update: we await the next full Z.1 update to reflect Q2 balances due out in a month, we do know that total Fed reserves grew by $250 billion in Q2 to $2 trillion, and as of last week stood at a new record high of $2.1 trillion. This is "money" that is inextricably linked to the US GDP, and also means that absent a pick up in credit creation in the private sector, that would be US commercial banks whose total loans and leases once again declined and continue to still be below Pre-Lehman levels (!), have to step up. Sadly, in a world in which all the banks are habituated to relying on the Fed for all money creation, and instead invest excess reserves manifested at the bank level in the form of excess deposits over loans, this is not going to happen.

So perhaps the question that economists should ask is: what will be the impact of the Taper on US GDP going forward (hint: very negative). And what happens when the establishment admits that as of last quarter, some $2 trillion in US GDP was exclusively thanks to the Federal Reserve, a number which will rise to $2.3 trillion at September 30 (and continue rising).

The truth is, you can't buy growth. No free lunch. But you can indeed fool people into believing that you can. Which is a remarkably easy thing to do when they are sufficiently eager to believe. That's the game all western governments and central banks, plus China, are playing these days. Have been playing for 5 years or more now. At a huge cost to the citizens of their countries, and their children (no free lunch!), and a huge profit for the wealthy.

There is no actual GDP growth in the US. There's only the $2 trillion+ that Bernanke has pumped into the Wall Street banks' excess reserves. That's what the red area in that last graph tells you. There's no growth in Europe or Japan either. While Chinese numbers get uglier and more questionable by the day. Central bankers cannot continue to "buy growth" in this fashion forever. And when they stop, there will be contraction, and deflation. There is no real source of growth. It's one big costly fake. Just look at the graphs.

We have told you for years to get out before that steamroller comes. Many of you today are thinking and saying: but it looks so good! Now you know, if you didn't already, and from yet another angle, what makes it look good.