Out of control: credit

By: Casper de Vries, Erasmus University Rotterdam

 

In a short series of briefs we analyze how monetary policies and misguided risk management created today’s financial markets’ mess and what to do about it. My first brief on inflation argued that any simple minded, explicit and specific monetary policy targeting procedure gives a false sense of security bound to fail at some point, since these are always too restrictive for the complexity of the macro economy. This brief argues that if more attention had been given to traditional indicators like money creation and credit expansion, then the global imbalances and the financial mess might have been circumvented.

 

Ostrich Monetary Policy

 

The point of this brief is that the credit explosion was missed, partly deliberately, since central banks looked away from traditional indicators that provide advance warning, such as house prices and broad monetary expansion.

 

Take the broad money statistic M3. Apart from bills, coins and checking accounts, this statistic comprises shorter term money market instruments, savings accounts, certificates of deposit and repos. It is a clear indicator of credit expansion in the economy, since its counterparts reflect lending to the private sector, other financial institutions than banks and the government. New derivatives allow credit expansion and overinvestment to be temporarily parked without directly spilling over into the goods markets, so that it does not immediately affect consumer inflation. But many of these instruments leave a trace in M3 as they require an expansion of the short term money market instruments such as repos and margin deposits.

 

The ECB has chosen the M3 statistic as its main indicator of monetary and credit expansion. One of Greenspan’s adages was that central banks should not try to burst bubbles. I tend to agree, but neither should central banks stimulate the froth. At least they should watch the omens rather than look away. As credit expansion comes before it spills over into consumer inflation, the ECB was therefore wise not only to focus on high powered money, such as M1, but to include shorter term credit statistics in its monetary pillar as well. Based on projections of velocity and normal growth of the real economy, it defined a 4.5% rate of expansion as commensurable with its target of a 2% inflation rate. Since the inception of the euro, the rate of growth has been 7% on average, which is way above its targeted value, see the Figure below. With just 4.5% growth the M3 in August 2007 would have stood at just 6500 billion euros. Perhaps partly due to this signal the ECB has been more cautious in tampering with low interest rates than the FED. The stability and growth pact that emphasizes fiscal prudence has been another helpful restraining device. But as the overshooting of M3 growth became too obvious, the last three monthly reports have quietly stopped the print of this reference value in the main graph indicating its monetary pillar. This seems very odd, as the relevance of the reference value has never been so high before. Is the ECB about to fall in the same trap as the FED?

 

 

 

In a dramatic move, the FED has discontinued collecting data and publishing the M3 figure altogether as of March 2006. The FED motivated its decision by stating that “M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years.” This occurred as credit expansion was reaching its zenith. The same rapid expansion can be seen in the M3 figures for the USA, at a 8% yearly pace, as in the EMU until the FED stopped collecting the data. Per contrast M2 just had a 6.2% growth rate. Moreover in contrast to the EMU area the breakdown of the monetary aggregates shows that M1 in the US changed very little with a rate of growth of just over 3%. In our opinion, the M1 statistic by itself reveals very little, while relative to the M3 aggregate it is very informative. In the Euro area M1 grew more rapidly (at 9% per year) than M3, while in the US relative to the M1 statistic M3 grew at more than double pace. This shows that the credit multiplier was much larger in the US. The FED may come to regret juggling the last indicator of its own prodigality. It no longer has an indicator nor an excuse to take unpopular decisions before it is too late.

 

 

 

 

In summary

 

Our assessment is that the current patient’s illness is the central bankers’ production of over confidence in a flawed single target and an ostrich attitude towards main indicators of liquidity creation that precede inevitable inflation. Our next brief will deal with the undesired separation of tasks between central banks and supervisors.

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