06/28/2001 The Liquidity Showdown *

It was another volatile week in global financial markets. Here at home, the Dow ended the week with a decline of about 1%, and the S&P500 was left largely unchanged. The Transports jumped 5%, and the Utilities were slightly positive. The Morgan Stanley Cyclical index added 1%, while the Morgan Stanley Consumer index declined 2%. The broader market ended the quarter with a sharp rally, as the small cap Russell 2000 jumped 5% and the S&P400 Mid-Cap index ended up 3% for the week. Technology stocks rallied sharply, with the NASDAQ100 increasing 6%, the Morgan Stanley High Tech index 8%, and the Semiconductors 6%. The Street.com Internet index surged 11%, and the NASDAQ Telecommunications index gained 6%. The Biotech index added 2%. Financial stocks were mixed, with the Securities Broker/Dealer index increasing 1%, and the S&P Bank index declining 1%. With gold declining about $2 for the week, the HUI Gold index dropped 2%.

The U.S. credit market took it on the chin this week. Two-year Treasury yields surged 36 basis points to 4.26%, the highest yields in a month. Five-year yields increased 34 basis points to 4.95%, with the key 10-year yield rising 28 basis points to 5.40%. Long-bond yields rose 28 basis points to 5.75%. Damage was inflicted across the board, with mortgage-back yields jumping 29 basis points and agency yields surging 32 basis points. The benchmark 10-year dollar swap spread added 3 to 89, the highest since April 16th. Bonds were pummeled globally, with UK bond yields rising to the highest level in eight months. Bonds were hit from Canada, to Brazil, to Europe, to New Zealand. According to Bloomberg, "international bond sales climbed to a record $908 billion during the first half of the year," up about 13% from last year. A record $557 billion of U.S. corporate bonds were sold during the first half, with Salomon Smith Barney leading the ranks with sales of $100 billion.

Broad money supply jumped $32.8 billion last week. The money supply (M3) has now increased $666 billion since the end of October (33 weeks), an annualized rate of 15%. Over this period, institutional money market fund assets have surged $270 billion, or at an annualized rate of 57%. Retail money funds have increased $79 billion, or at a 14% rate. Institutional money fund assets have now surpassed $1 trillion, doubling since October 1998. I could only chuckle at today’s Bloomberg headline: "ECB Money Supply Rises for Third Month, Signalling Inflation Still Untamed." Euro-zone broad money supply expanded at an annual rate of 5.4% during May.

Increasingly, the U.S. economy is like a tug-of-war with the struggling technology (bubble burst) and manufacturing sectors pulling one way, while the booming real estate sector (bubble still inflating) pulls with considerable gusto in the opposite direction. For the short-term, it’s difficult to bet against the powerful Team Real Estate. At the same time, the future consequences of a faltering real estate sector loom larger by the month. But for now, it is worth noting that consumer confidence jumped in May to the highest level this year. The government also revised first-quarter consumer spending to up 3.4% from 2.7%. Today’s report from the Chicago Purchasing Managers was the highest this year, with notable sharp increases in both new orders and backlogs. We also see that new homes sales are on pace to eclipse the previous record set in 1998. The average (mean) price for a new home sold during May jumped to a record $211,000, up almost 6% from last year. Year-to-date, 423,000 new homes have been sold, a 9% increase from last year. The inventory of new homes remains low at 3.8 months, and builders report strong backlogs. Ultra-easy credit conditions continue to fuel this bubble. While stocks are now recognized as risky, real estate has become the "can’t lose investment."

This week the National Association of Realtors reported that May existing home sales came in at a stronger than expected rate of 5.37 million units, the third strongest monthly performance on record. The average selling price has jumped $10,000 during the past three months to $185,400, and is up over 5% from last year. Inventory of existing homes dropped to 3.4 months from April’s 3.7 months. Out in the Golden State, the California Association of Realtors reported median (no report on mean average prices) sales prices for the month of May at $257,060, up almost 7% over the past 12 months. Median condo prices of $206,450 were up almost 13%. Of the 20 California regions, only one has experienced year-over-year price declines, while four experienced at least 20% gains, and another five rose more than 10%. The volume of transactions, however, is now signaling caution, with sales for the state running about 13% below year ago levels. Inventories remain relatively tight, at about 3.8 months. I read recently that the average gain on a California home sale surpassed $100,000 for the first time. Now that’s one heck of a real estate bubble.

During May, the median price in Marin County dropped $79,000 to $620,000, but remains $10,000 above one year ago. And while real estate markets have cooled considerably in the greater San Francisco Bay Area, they continue to bubble in Southern California. According to the LA Times (quoting Dataquick), San Fernando Valley prices jumped to a record $260,000, up about 9% during the past year. LA Country experienced one of the "biggest growth spurts in 12 years, as the median price of houses sold jumped 13% from a year earlier." Orange County saw its median price rise to $297,000, up 11% year over year. It is, however, worth noting that sales volumes were down 16% in Orange County, the fourth straight month of declining volume.

Using nationwide existing home sales price and volume data to make a total "sales transactions dollars" calculation provides a good indication of increases in real estate lending. During May, annualized sales transactions (5.37 million units at $185,400) almost reached $1 trillion, up about 9% from last year. More illuminating, "transactions dollars" are today running about 60% above levels from just five years ago (May 1996, 4.4 million units at $141,100.) One cannot overstate the role played by this inflationary surge in mortgage credit, for the economy or the financial system. What’s more, May’s dollar volume is anything but an aberration, as can be seen when comparing the first quarter’s total annualized mortgage loan growth of $546.3 billion to 1996’s total increase of $283.5 billion (up 93%). If this boom continues through yearend, 2001 could easily challenge 1999’s record $592 billion of new mortgage debt. It is today worth noting that mortgage lending growth this year will likely be more than five times that of 1992.

Last week’s Bulletin discussed the U.S. financial system’s extraordinary capacity for unfettered money and credit creation, with an emphasis on the mechanism for financing the explosion of securities holdings through the creation of financial credit. Indeed, we are today functioning with a monetary regime unlike any in history. This is The Great Monetary Experiment, operating a system with absolutely no limit on the quantity of money or credit created, nor any mechanism for convertibility. Why would anyone not expect such a system to go to wild excess? It may be mindlessly celebrated as an "efficient" and "effective" contemporary regime, but the bottom line is it operates precariously without a monetary anchor or even a rudder. The Fed no longer manages the nation’s money supply (apparently paying no attention to credit growth), choosing instead to tinker with short-term interest rates, make lots of public statements (the Fed joins the Washington "Spin Cycle"!), and assures marketplace liquidity. Incredibly, the Fed virtually invites destabilizing speculation, with its interest rate policies, assurances and utter disregard for excess. As we have written previously, we are certainly in "uncharted waters" with the Fed now having clearly lost control of the credit system.

Furthermore, no longer is the banking system the pillar of lending or system liquidity, ceding this role to the government-sponsored enterprises and securities markets. Truly a modern marvel, the contemporary credit system today includes more than $28 trillion of outstanding credit market debt, unfathomable derivative positions, and a daisy chain of contracts, liquidity arrangements, and other financial promises. Include another $15 or so trillion for the value of the U.S. stock market, and one sees that the securities markets are a multiple of our nation’s output. Today, more than ever before, the financial markets dictate economic conditions, not vice versa. Yet, such a system does function exceedingly (seductively) well during bull markets and concomitant brisk (and self-reinforcing) credit expansion. During the boom, seemingly endless liquidity can be (and is) taken for granted.

I think much of the current misconception is related to the fact that the consensus views financial system developments over this long expansion as very much a "natural" progression, benefiting tremendously from the consequences of innovation, deregulation and "free markets." Seeing things in a similar vein to "real economy" technological improvements and advancement, the contemporary U.S. financial sector is indeed a "new and improved" model – "the latest and greatest," much like the most recent Intel Pentium processor, Dell PC, or Cisco router. And just like we would not open up the back of a computer to try to understand its components, the bullish consensus seems to have little interest in digging into the intricacies of this most complex financial system. Instead of seeing a "wildcat" system spewing uncontrolled money and credit excess wherever it can make a quick buck, there is blind faith in a sophisticated and "efficient" financial apparatus "effectively" allocating "capital." And while we nervously ponder the ramifications of faltering liquidity for a credit mechanism dominated by security issuance, derivative trading, and leveraged speculation, ideology allows others the comfort of assuming that such a wonderful unfettered "free market" financial system will by its very nature continue to operate smoothly and for the good of all society. It is not easy to have a meaningful debate with these two views operating on very different planes. Most importantly, the bullish consensus takes liquidity for granted for this New Age financial apparatus. This is precisely where they will be inevitably blindsided.

To help appreciate where we are today, it certainly doesn’t hurt to review where we’ve come from. With this week’s cut, we are now only 75 basis points away from the 3.0% Fed Funds rate established in September of 1992. Why do I feel like we have come full circle? I remember that 1992 period clearly, with a potential California real estate collapse arguably threatening the solvency of a fragile U.S. banking system. An understandably panicked Greenspan cut rates aggressively, and was at the same time more than willing to open the floodgates to nonbank credit creation (with an impaired and increasingly frantic U.S. banking system tacking unsuccessfully against "steep headwinds.") With the Fed fighting a very ferocious real estate deflation and economic downturn, Wall Street was granted free rein to use the securities markets to "reflate" the economy and financial system. And instead of acting responsibly to nip the fledgling leveraged speculating community in the bud, the Fed "sold its soul" and allowed these players to become an ever increasingly critical cog in the credit wheel. The overriding priority was clearly a banking system in desperate need of recapitalization, and the Greenspan Fed was willing to pull out all the stops. And so began an historic trip down a most slippery financial slope.

So as much as the Fed and Wall Street spinmeisters would like to promulgate technology innovations and a so-called productivity miracle as the source of the Great Roaring ‘90s boom, its not going to change the facts: today’s Credit Bubble was born in the process of desperate measures and was sustained through a series of extraordinary domestic and international financial crises. All along, financial forces have played the commanding role in this historic boom. In the end, it’s safe to say that it ran completely out of control.

In so many ways, the seeds for this historic financial bubble were sown back in the early 1990’s. I actually read something the other day that struck me as quite interesting. Apparently, the Federal Reserve entered the 1920’s with very little appreciation for the power it could wield. That all changed quickly early in the decade, as the Fed recognized – while fighting a major economic downturn in 1920/21 - that it had in its possession potent tools to effectively dictate credit conditions (injecting reserves with open market operations and generally managing market liquidity conditions). When the economy recovered quickly it was not surprising that a bullish consensus developed that the almighty Fed had gained control over the business cycle. Things did appear to go swimmingly for some time, although the Fed increasingly lost control to the securities markets as the decade progressed. Now we have witnessed something very similar during the past decade, although during this cycle the Fed enjoyed a partnership with the Government-sponsored enterprises. It is certainly my view that those at the very top of the political process understood all too well the critical importance of strong real estate markets in fueling an economic and financial boom. Further, it was recognized that the GSEs, with their unlimited access to the financial markets, afforded tremendous opportunity to dictate credit and general financial conditions throughout the economy. I am left to assume that over time things just got away from them.

Total GSE assets increased by $23 billion during 1990 and $19 billion during 1991. Then, during the dark days of 1992, GSE expansion jumped to a then unprecedented $56 billion, followed by $79 billion during 1993. When the leveraged speculating community was hammered and forced to liquidate leveraged trades during 1994, the GSEs purchased a then stunning $151 billion of financial assets. This created the liquidity necessary to avoid severe financial crisis, while also sustaining economic recovery. The GSE star began to shine powerfully in both Washington and New York. As liquidity (leveraged players) quickly returned to the credit system, GSE asset purchases nonetheless remained significant, averaging just over $100 billion annually from 1995-97. But then came the Russian and LTCM debacles, and the GSEs responded by increasing financial asset holdings by a record $304 billion during 1998. This was followed by purchases of $317 billion in 1999 and $249 billion in 2000, with history’s greatest credit expansion fueling an enormous speculative bubble throughout the technology sector. With the system again coming under significant stress during this year’s first quarter, the GSEs acquired financial assets at an annualized rate of $352 billion. There is now no way around it; the overleveraged and hopelessly fragile U.S. financial system has become addicted to GSE credit creation.

And with the Fed pegging interest rates and pandering to the markets, as the increasingly powerful GSEs stand ready and willing to assume the role of "buyer of first and last resort," it truly became a (1920’s-style) New Era of managed financial system liquidity. Such a favorable backdrop, not surprisingly, created a bastion of speculation. This then ushered in an environment of unprecedented demand for securities, while an enterprising Wall Street geared up to manufacture as many as it took to satisfy what at times appeared insatiable demand. Just recall the size of security positions acquired by just one hedge fund – LTCM! It was, importantly, this explosion of speculative activity and the resulting effect on credit availability that provided great impetus for truly profound financial system developments and newfound economic vigor. This is clearly not the foundation for a sound financial system. And don’t, as the bullish consensus is prone to do, confuse a monetary regime of "managed liquidity" and endemic credit excess with the forces of the "invisible hand" or "free markets".

There was $15.2 trillion of total credit market debt outstanding at the end of 1992. By the conclusion of this year’s first quarter, total outstanding credit market instruments had surged to $27.9 trillion, an increase of $12.7 trillion, or 84%. Total marketable mortgage debt increased $2.9 trillion, or 72%, to $7.0 trillion. Consumer credit market debt jumped 95% to $1.6 trillion. Total corporate credit market debt (financial and nonfinancial) jumped 153% to $5.2 trillion. Ending 1992 at $552 billion, total GSE assets grew to almost $2.1 trillion by the end of the first quarter.

During 1992, there was a total of $792 billion net additional credit market debt issued, comprised of $524 billion non-financial and $244 billion financial sector borrowings. During this year’s first quarter, the non-financial sector increased credit market borrowings by $966 billion and the financial sector by $894 billion, for a total of $1.8 trillion. Money market funds increased asset holdings by $5 billion during 1992, compared to a $623 billion annualized rate during the first quarter. Total mortgage debt increased by $114 billion in ‘92, compared to the first quarter’s $546 billion (annualized). Asset-backed security issuance of $62 billion is compared to the first quarter’s annualized $279 billion. Security Broker/Dealers increased financial asset holdings by $49 billion during 1992, compared to $216 billion last year. Non-financial corporate credit market borrowings of $173 billion during 1992 compare to the first quarter’s $400 billion (annualized). It is also certainly worth mentioning that there was $414 billion of personal savings during 1992, compared to a negative $64 billion (annualized) during the first quarter. This year’s current account deficit will approach 10 times the $48 billion from 1992. The household sector ended 1992 with total assets of $13.8 trillion and liabilities of $5.6 trillion. At the end of the first quarter, these assets had inflated in value to $27.7 trillion, with liabilities increasing to $9.8 trillion.

Hopefully, these numbers illuminate the impact of the incredible nine-year U.S. credit system expansion. It has been an amazing transformation, from a bank-dominated credit creation process to one commanded by Wall Street, the GSEs, and the securities markets. I would like to reiterate, "I am an analyst, not a pessimist." I just see the "transformed" U.S. financial system as highly unstable, dysfunctional, and unsustainable. I am "bearish" because I am convinced that after such unprecedented excesses and momentous financial and economic developments, there is no way around one major adjustment period and painful retrenchment. As we have witnessed, a credit system with the capacity for unlimited credit creation - and dominated by the securities markets - is destined to foster dangerous credit excess, rampant leveraged speculation, and hopelessly dysfunctional boom and bust dynamics. And it is just amazing to me that there is no recognition that a financial system that caters heavily to speculative "Hot Money" flows is an accident waiting to happen. We saw exactly these forces at work here at home in 1994, in Mexico ‘94/‘95, SE Asia ‘97/‘98, Russia ‘98, and home again for LTCM in ‘98. In each case, when speculative flows reversed markets immediately faltered in illiquidity.

Interestingly, the bullish consensus likes to focus on what they see as the great advantage of the present system: a large amount of lending risk placed in the market, apparently isolating the banking system from credit risk. There is also the false optimism that system risk has been mitigated in "the derivative market." Indeed, there is today the perception that much of the banking system remains immune to the technology bust. And with real estate markets largely trading at record prices (while consumer spending and the general economy thus far holds up relatively well), it is true that serious problems have yet to emerge for most lenders. This complacency, however, is quite unwarranted. Today, the overwhelming systemic risk lies in faltering liquidity.

We are, of course, in the midst of an unprecedented money supply expansion. I continue to argue that this historic monetary explosion is in fact the financial sector’s emergency "defense mechanism." Money supply has been growing at 15% for sometime now because it has to, as a system with the capacity to create its own liquidity has been forced to use this capability in spades. Some see this as a sign of the modern credit system’s strength and resiliency - we don’t. It should instead be recognized as a clear warning of structural weakness and the system’s approaching liquidity problems. There is just no getting around the fact that credit and asset bubbles require enormous and unrelenting additional credit creation – the new buying power necessary to keep both real and financial asset prices levitated. Prices are set "at the margin," and it is the ample liquidity provided by new buyers that is necessary to maintain market prices. The greater the amount of financial assets in the marketplace, the more onerous the task of sustaining sufficient buying power. The less an economy’s true savings, the more the credit creation process depends on financial leveraging (financial credit). And the larger the role played by highly leveraged players (financial institutions, hedge funds, etc.), the more acutely vulnerable the system becomes to even moderate declines in asset prices or waning liquidity conditions. This is precisely what we mean by "financial fragility." I do believe Mr. Greenspan appreciates this predicament, and this explains why he has moved so aggressively despite the economy not yet having experienced even one quarter of negative growth.

Importantly, our securities-based credit system is today absolutely dependent on continuous strong demand for new securities. At the same time, sustaining credit growth becomes an increasingly precarious endeavor at the late stages of bubbles. There are critical qualitative issues, with the debt created late in the boom increasingly suspect. For one, previous excesses have worked to ravage business profits and impair cash flows, making it increasingly difficult to locate attractive new credits. At this point, if companies really need the financing, you probably don’t want to lend it to them (telecom!). Additionally, the general uncertainly that comes part and parcel with a maladjusted bubble economy also becomes a critical credit issue, with the California utility debt fiasco providing a good example. There is also what should be an obvious problem: all the new debt created backed by increasingly inflated asset prices, especially with dysfunctional monetary processes directing a flood of speculative finance to the inflating asset markets.

Meanwhile, with the bursting of the technology bubble, investors (pros and individuals alike) have suffered losses and have become increasingly risk averse. Then there are the over borrowed consumers, naturally shying away from volatile financial assets. So a system dependent on enormous amounts of new risky debt to sustain liquidity and feed the bubble economy are forced to adapt to investors largely wishing to acquire only "safe" and "liquid" assets. The dilemma is that the financial sector is left to absorb tremendous amounts of risk. As discussed repeatedly, it has for some time been clear that for the Credit Bubble to be sustained, it was going to be up to the financial sector to continue lending aggressively, while taking on additional leverage and "intermediating" (absorbing interest rate, credit and liquidity risk) risky loans into "safe money." We also knew that the GSEs and the inflating real estate sector generally were, by necessity, going to be key to this process. They certainly again rose to the occasion.

But this historic mortgage-refinancing boom is now fighting old age in its six month, an aging process exacerbated by this week’s sharp jump in rates. From mortgage insurer MGIC: "Borrowers who refinanced home mortgages during the current refinancing boom raised their first mortgage loan-to-value (LTV) ratio by an average 6%, their first mortgage balance by $41,000, and their interest rate an average of 0.60%…" Wow, an average equity extraction of $41,000 for refinanced mortgages! Actually, while I expected this refi boom would see unprecedented equity extraction, I find this number stunning. Some of this has certainly supported consumer spending, some has made it to support the stock market, and a portion has been used to pay down consumer debt (buttressing credit consumer credit performance!). Considering the millions of mortgages refinanced, there is now no denying the degree of credit creation that has occurred, or the role played by this refinancing process in liquefying the system. It also begs the question as to the ramifications for the tempering of these flows. Hundreds of billions of new mortgage debt has been created, largely being "intermediated" by the GSEs, money market funds, and financial sector into "safe money." This "reliquefication" created the immediately available funds for record asset-backed security issuance, as well as a record deluge of corporate debt. It has been amazing to watch. This was the financial sector’s "trump card," and at this point this hand has largely been played.

I expect that over the coming weeks (or perhaps months) the U.S. financial system will be heading toward a critical crossroads. I see no way around an inevitable Liquidity Showdown, and this process may have commenced this week. This incredible real estate lending boom cannot run forever, and when it begins to wane another source of significant credit creation must develop. If one is not forthcoming, the serious liquidity crisis that has been knocking at the door for some time will finally make its appearance. It is just not clear to me from where a major new source of credit creation can be found. With negative news and faltering earnings from the likes of Merrill Lynch, Goldman Sachs, and some of the major U.S. money center banks, I would expect these previously aggressive institutions to manage risk cautiously going forward. It would be surprising if some on Wall Street have not recognized the nature of this mortgage credit "reliquefication," thus using this "window" to diligently get risk under control and their "houses in order." Such a mindset is not conducive to creating the additional financial credit (financial sector leveraging) necessary to sustain system liquidity. I also suspect that we have likely seen the peak in speculative positions from the expansive hedge fund community. This is a major "wild card" going forward.

Mr. Greenspan certainly made his intentions well known awhile back. And I don’t think it is hyperbole to say that the global leveraged speculating community converged on the U.S. credit system to position for these aggressive rate cuts, having in the process created history’s greatest (and most crowded!) leveraged bet on interest rate spreads and credit market prices. With this in mind, it should not be too surprising that this trade has not afforded the "free money" profits that the big crowd so anxiously anticipated. When too many players with too much money all play the same game, it makes this game much more difficult to play successfully. Perhaps I am a "worry-wart," but I do get quite concerned when I sense that the leveraged players are crowded on the same side of the boat, while getting increasingly agitated with debilitating volatility and the lack of trading profits. I would imagine they expected things to be much easier than this, and would today be increasingly questioning the risk/reward of playing in this environment. We have witnessed on several occasions how quickly things can turn sour when the crowd begins to move. I certainly see the heightened volatility in various global markets as indicative of the "boat rocking" and players looking to get off. This is especially the case now that the Fed is running thin on rate cut ammo.

It certainly looks as if we have entered what could be a very unstable period for global markets. As discussed previously, global derivative markets are an accident in the making, and if the leveraged players begin unwinding trades, this can have a destabilizing effect on various instruments, sectors, and markets. It is time to watch developments very carefully, and to be prepared for even greater volatility. At the minimum, I would expect the more seasoned players to be exiting leveraged credit market trades, in what in itself would prove a critical development for system liquidity.

Going forward, I expect the issue of liquidity to garner considerable attention. I will certainly be surprised if it does not now become an ongoing problem for a fragile U.S. financial system. When it comes to "financial fragility," the work of the great Hyman Minsky is invaluable. For the current environment, his analytical focus on borrower and lender risk, as well as the key issue of "refinancing risk", is particularly pertinent. He also had interesting things to say about liquidity. In my definition of money I use the criterion "perceived store of value." The problem is perceptions do change, and confidence and liquidity can be very fleeting things. Over the past few years we have created trillions of new financial claims, with perceptions thus far holding that many of these financial assets are both safe and liquid. But only over time will we see how well this "money" maintains its characteristics of ultimate liquidity and a secure store of value. Ponder the extraordinary contemporary monetary regime as you read through some cogent analysis written by Hyman Minsky in the early 1960’s - describing how the monetary system used to operate (excerpts from Longer Waves in Financial Relations: Financial Factors in the More Severe Depressions, from Monetary Theory by Thomas Mayer):

"An economy’s stock of ultimate liquidity consists of those assets whose nominal value is essentially fixed and which are not the liabilities of any private unit within the economy. The ultimate liquid assets carry no default risk and as they are essentially fixed in market value, they are always available to meet payment commitments. No private unit is constrained by payment commitments embodied in these assets.

In the United States the ultimate liquid assets consist of the gold stocks, various types of treasury currency, and the public debt outside government trust funds. The inclusion of the government debt implies that necessary support operations by the central bank will occur. A large part of the stock of ultimate liquidity is held by the monetary system. The extent to which the assets of the monetary system consist of ultimate liquid assets is a qualitative characteristic of the money supply. A growth of the money supply that reflects the growth of ultimately liquid assets owned by the monetary system has quite different implications for the behavior of the economy than a growth of the money supply that is due to the acquisition of private debts by the monetary system.

The ratio of the values of ultimately liquid assets and total financial assets in the economy is a measure of the extent to which financial positions are impervious to financial losses; the higher the ratio of ultimately liquid assets the more stable the financial system. In addition, the ratio of the value of ultimately liquid assets to income measures the extent to which a shortfall of income and its concomitant effect on asset prices will not result in a default of payment commitments."

"The view presented here is that the strictly defined money supply is a proxy for deeper, more significant financial variables; and that the observed relations between changes in the money supply and economic activity really reflect the impact of the evolving financial structure upon economic activity. The central role of the money supply in past deep depressions is due to the institutional accident that commercial banks were the dominant financial intermediary. Under alternative institutional arrangements, where much greater weight is attached to non-bank financial institutions, a financial panic could occur even though the money supply does not fall."

"Mild and deep depressions cycles are, to a point, the result of a common cycle generating mechanism. However, in a deep depression cycle an initial downturn of income or a random decrease in particular asset values, triggers a general decline in asset values. In a mild depression cycle no such financial reaction takes place. Which type of cycle occurs at any time depends upon the stability properties of the existing financial system."

"Of particular importance for the development of a financial panic is the ability of financial institutions to meet these commitments and to continue acquiring assets. Financial distress for both bank and nonbank financial intermediaries affects both the ability of many units to make payments and the markets for assets. Hence ‘distress’ for financial intermediaries seems to be necessary if a financial panic is to develop."