01/21/2000 A Theory on Money and Credit Creation *

Unfortunately, we will have to admit that our earlier view that some rationality was going to return to the marketplace has proven little more than wishful thinking. We certainly saw little in the way of rationality this week, at least in regards to the most speculative sectors of the market. For the week, the AMEX Biotechnology index surged 15%, increasing its January gain to 25%. The NASDAQ Telecommunications index jumped 7%, and The Street.com Internet index 5%. The small cap Russell 2000, clearly led by the more speculative issues within this index, surged 5% also. For the week, the NASDAQ 100 gained 4% and the Morgan Stanley High Tech index increased 2%. Semiconductors came under a bit of selling pressure, declining 1%. This sector, however, still holds a 14% gain for the month. For the bluechips, however, it was a rough week. The Dow sunk 4%, although the S&P500 declined less than 2%. The economically sensitive issues underperformed with the Transports down 5% and the Morgan Stanley Cyclical index dropping 6%. The Morgan Stanley Consumer index declined 2%, while the Utilities rose 1%. The financials were once again under heavy selling pressure as 10-year Treasury yields jumped another 9 basis points. For the week, the S&P Bank index dropped 7% and the Bloomberg Wall Street index fell 5%. In sum, speculation ran absolutely rampant while ominous storm clouds gathered on the horizon. With expiration now behind us, next week could be interesting.

We live in extraordinary times, so we will take extraordinary measures. Beginning today, and continuing on Fridays, Doug Noland will present market commentary and analysis under the title “The Credit Bubble Bubble.” The goal is to focus attention clearly on the issues and ramifications of unprecedented money and credit creation. It is our view that this subject matter is not being adequately addressed today, and that conventional analysis completely fails to explain the current environment. It is our hope to raise some points and encourage thinking; it is our goal to provide insightful and valuable analysis. We don’t, and Doug doesn’t claim to have all the answers, but we do have plenty of determination. Importantly, there have been many great economic thinkers that have addressed money and credit issues throughout history, and Doug will work to learn from and share this wisdom. We expect that a truly amazing story will continue to unfold, and we plan on telling it.

Of course, it is our strongly held view that we are in the midst of a momentous financial and economic bubble fueled by unprecedented money and credit excess. It is also our belief that, unappreciated by the vast majority of analysts, non-banks have developed into the leading propagators of the credit bubble. In this vein, this week Freddie Mac reported that it expanded its balance sheet by $22 billion during the fourth quarter, a 25% annualized rate. Freddie Mac and Fannie Mae combined to increase assets by $46 billion during the fourth quarter, and $155 billion for the year. After moderating growth during the first half of the year, Fannie and Freddie came on strong to increase assets by $94 billion during the second half. For the year, Fannie and Freddie increased assets by 19%. Interestingly, money market fund assets also increased by about 19% during 1999, expanding almost $260 billion. Also noteworthy, money market fund asset growth slowed during the first half but also came on very strong during the second half of 1999. Mere coincidence? We don’t think so. After all, it is Fannie and Freddie along with the aggressive non-bank lenders such as GE Capital, GMAC, and the Wall Street firms, that borrow from the money market and finance the bubble excesses. As goes their borrowing and lending, goes the fuel for the bubble. This was particularly the case during the second half of 1998, and again during the latter months of 1999.

Actually, we almost have the sense that “the wheels are moving,” that a few “independent thinkers” within the economic and financial world are coming to a clearer understanding as to what has exactly transpired. A couple of analysts have recently focused on the powerful role that Fannie Mae and Freddie Mac have played in fueling the US bubble, although the vast majority hold firm with this strange notion that these institutions are only “intermediaries” and do not provide credit. Interestingly, in yesterday’s market commentary, the always insightful Don Hays discussed MZM, the St. Louis Fed’s index of “Money at Zero Maturity.” This index is basically M2, which includes retail money market funds, plus institutional money market mutual funds, but excludes bank time deposits. Quoting from his report, “If you look at the chart of MZM, you will see that every time it has moved above a 10% year-over-year growth rate, it in effect cocks the hammer on the bullish gun. It causes extreme, excessive speculation…” Our response, “Precisely!!! The fuel for the bubble is within MZM.”

There is, however, nothing magical or mysterious about MZM. In fact, to simplify the analysis we suggest that one focus instead directly on money market fund assets. This is the key, the “fountainhead” for the US bubble. In fact, during 1999, about 70% of the increase in MZM is explained by the growth of money market mutual fund assets. And, after expanding about $60 billion during the first half, money market fund assets surged almost $200 billion during the second half. Is there a relationship here between money market fund assets and stock market speculation? Well, we see that during the first half of 1999 the NASDAQ Composite gained 493 points. During the second half, the Comp rose 1,383. Again, is this mere coincidence? We see that margin debt increased $36 billion during the first half and $52 billion during the second. Is there a relationship between margin debt and money market fund assets? Does heightened money and credit growth fuel rising stock prices that exacerbates speculation leading to additional stock market leverage and further money and credit creation? When brokerages borrow in the money markets to provide customers funding for stock purchases, does this create money? When derivative players borrow in the markets to purchase securities, say if they have written call options and the market is rising and these options are moving into the money, does this create money and credit? If not, why not?

Before deregulation, the money and credit creation process was dominated by the banks. “Money” was basically currency and bank liabilities/deposits, and money expansion was restricted by prudent bank lending and reserve requirements. Economists studied bank reserve data to judge the banks’ potential for expanding lending. Bank lending completely overshadowed credit creation in the capital markets. But times have changed, and the structure of the financial system has gone through a momentous transformation. Today investment bankers, brokerage firms and the money markets are kings of credit creation and the banks just follow along. Security issuance and financial sector borrowing governs the credit creation process. The business of lending has opened up to virtually any company that wants to try to earn a buck making a loan or providing financing. All one need do is lend the money and get a securities firm to bundle it, securitize it, and sell it. If you are big enough, or have a government guarantee, you can borrow cheap money in the money markets and balloon your balance sheet with loans and leases. Obviously, many major US corporations have recognized it is much easier to meet Wall Street earnings growth targets through “financial services” than it is by manufacturing products. And if Wall Street likes your “growth prospects,” it will go out of its way to help you become a “player” in the lending game. Lending to risky credits has for some time been a growth story.

As such, bank credit has become a very poor indicator of credit growth in a world with a proliferation of non-bank lending, and, besides, even the banks now securitize and sell a big chunk of their new loans. At the same time, bank deposits have become a woefully inadequate measure of what functions as money in the real economy and, importantly, in the financial sector. In the age of brokerage accounts, credit cards, home equity loans, lines of credit and mutual funds, bank deposits are virtually useless as an indicator of available buying power.

For an example, let’s say one cashes in on some company stock options and now has $100,000. We hear this is not an uncommon situation. Well, this money could be placed in a bank account at Chase Manhattan. At Chase, one might choose a money market fund or a savings account, although they make it much more attractive to choose the money market fund. Or, more likely, this $100,000 is placed in a money market fund at a new online trading account opened at Charles Schwab. Either way, it doesn’t really matter much as these accounts serve virtually the same “monetary” function for the financial system. But, surprisingly, much of the world views that money creation only occurs with the deposit into a bank account at Chase. Yet, today the vast majority of what functions as money are simply entries on a vast electronic ledger system. Money is electronic and created simply by additional electronic entries. Importantly, the Fed is certainly not the only institution that can create money by making electronic entries and the banks certainly don’t have a monopoly on the process. To be a player in this electronic financial landscape, one just has to borrow and lend money in the markets – create a balance sheet of entries on the vast electronic ledger of debits and credits. It doesn’t take much to get in the game, as is being proven with the proliferation of companies providing financial services on the Internet.

All the same, most analysts take as an article of faith that only banks create credit and that the Fed is the master of money creation. We see this is an intellectual trap that is not only erroneous, but severely hampers sound real world analysis. Today, any sensible analysis would certainly expand the definition of what functions as money to include other liquid financial assets, such as holdings in money market funds. The Fed understands this, and therefore includes retail money market funds in M2 and institutional money funds in M3. So, if we accept that money market fund assets are money, then who creates it? Is it the Fed? Is it the banking system? No. The creators of this money are those institutions that create the financial liabilities that are the assets of these money market funds. The creators of this money are predominantly those institutions that borrow in the money market, create additional liabilities, and then use these funds to either lend or purchase financial assets, such as mortgages. Let’s say Fannie Mae borrows $100,000 from a money market fund to provide financing for a home equity loan. Fannie simply creates an electronic IOU, and exchanges this IOU with the money market fund as “money” is electronically transferred to the borrowing homeowner. Here, money market fund assets indeed remain the same, as “cash” is credited, IOU from Fannie is debited. However, the difference is that the homeowner now has $100,000 to deposit into a Charles Schwab money market account to play the market, as well as $100,000 more debt. There need not be a bank anywhere involved in the transaction. And as far as the original money in the money market fund that began the process, it could come from myriad of sources, including the sale of company stock or options. The key point is that electronic money is multiplied instantaneously and, we will add, without any restriction of reserve requirements.

Think of it this way. Bank credit is created not by depositors, but by the lenders. It is the act of bank lending that creates additional deposits, or new money. A similar process works to create credit outside of the banking system. In fact, this borrowing and lending process works with the same “multiplier effect” that is taught in Econ 101. There are differences, however. In the economic textbook example, a bank takes a deposit and makes a loan, hence increasing deposits and multiplying money within the system. The problem with this teaching, however, is that it fails to take into consideration the transformation of our financial system. Today, the non-banks borrow in the money and capital markets and make loans, hence increasing total credit within the system. And while the belief is that only the Federal Reserve and its member banks can “multiply,” this is not true. In fact, the idea of “multiplying” has been discussed at least as far back as 1690. Today, money and credit are created by Fannie Mae and Freddie Mac when they borrow and balloon their balance sheets and lend “money.” Money and credit are also created by General Motors Acceptance Corp., GE Credit and other captive finance companies when they borrow in the money markets and lend for credit card purchases, auto loans or new mortgages. Money and credit are also created when Charles Schwab or Merrill Lynch borrows in the money markets to fund margin debt when their customers borrow money to buy stocks. Indeed, money and credit are created by a long list of lenders within and without the banking system. Moreover, we see this mechanism of borrowing in the money markets and financing the purchase of financial assets working much as “high powered money,” creating money and credit unrestrained by reserve requirements – we see it as an “infinite multiplier effect.”

Today, it should be considered the financial sector that creates money and credit, not the Fed and banks exclusively. We know this analysis is going to drive conventional thinkers crazy, but we will stick with it nonetheless. Conventional analysis will try to stick with a narrow definition of “money,” arguing that only banks create bank deposits. Well, it is hard to disagree with such a statement but such analysis completely misses the point. We think in today’s world the functional definition of money is becoming ever broader, almost to the point that there is increasingly less differentiation between money and credit. In a world of fiat money and a growing mountain of marketable securities, credit is virtually money, and certainly money is little more than credit. But to those who insist that only banks create money and credit, we ask why and how can this be the case?

Recently, a leading American economist stated to us that Fannie Mae and Freddie Mac are only “intermediaries,” just like insurance companies. Well, we very much disagree and see a very critical difference. Insurance liabilities do not function as money, like much of Fannie and Freddie’s liabilities. If an insurance company aggressively expands its liabilities, this does not immediately increase purchasing power throughout the financial system and economy. Insurance liabilities do not provide additional financial market liquidity, fueling higher stock and real estate prices as well as a bubble economy. Others say that these non-banks are simply intermediaries, taking money from one person and giving it to another. Well, as far as we are concerned, this is precisely the essence of lending and credit creation. And others see the non-banks as champions of free markets, effectively allocating savings and in no way being factors in inflationary credit. We disagree and, beside, what savings? Let the debate begin!

While keeping in mind the preceding discussion and the fact that household sector savings has deteriorated to insignificance, think about the following statement - and the financial and economic ramifications - from Charles Schwab’s recently released fourth quarter earnings report:

“Our customers brought a record $33 billion in net new assets to the firm during the fourth quarter, which pushed net new assets for the year to $107 billion, up 35% from last year. Net new assets per new account equaled $40,000 during the fourth quarter of 1999, up 18% from the same period last year. Customers opened a total of 1.5 million new accounts during the year, and we had 6.6 million active accounts by the end of 1999. We crossed the $700 billion milestone in customer assets during December, and ended the year with $725 billion in customer assets, an increase of $234 billion over year-end 1998.”

Wow, there is obviously something very extraordinary going on here. Clearly, all this “money” did not come from savings. And, since this is just from one brokerage firm, this is but the “tip of the iceburg” in what was another bout of runaway money and credit creation last year. Over the past two years, M3 has grown more than $1 trillion, with $600 billion being an increase in money market fund assets. Over this same period, the three largest GSEs, Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System have increased their assets by almost $600 billion. Stock market speculation has exploded, margin debt has exploded and derivative trading has exploded. Corporate debt issuance has exploded and household mortgage debt has exploded. Our financial system has run completely out of control and it is about time that this is recognized and addressed. We don’t claim to have all the answers but there is absolutely no doubt that there is a big problem here. We strongly urge the US economic community and the Federal Reserve to “get with the program” before it is absolutely too late.