When a bank accepts or collects deposits they keep some of the deposit as reserves (0.r is the reserve ratio) and advance the rest. As this money is spent it comes back into the banking system as someone else’s deposits. Some of this new deposit is kept as reserves and the rest advanced. This process continues until the new deposit becomes so small it can be ignored.
The value credit creation multiplier is an indicator of the final change in bank deposits which will stem from the initial change. We can calculate this as 1 / 0.r, where 0.r is the reserve ratio.
In the example below the credit creation multiplier equals 4 (that is, 1 / 0.25). Further we can work out the growth in the money supply (eventual increase in money supply), using the following formula: Eventual increase equals 1 / 0.r multiplied by the initial deposit in the money supply. In our example it is 4 times $100m equals $400m. The example below shows that loans given by one bank then become a deposit in another bank. Of that $75m deposited 25% must be kept in reserve ($18.75) and the remainder can be lent out ($56.25). This process continues through the banking system. We can also calculate the secondary expansion or credit created using this formula: Credit created equals (1 / 0.r multiplied by the initial deposit) minus the initial deposit.In our example it is $400m – $100m equals $300m.
The change in the money supply may not be as high as calculated because of leakages or withdrawals from the credit creation process. Banks tend to lose reserves as the public will not deposit the whole of the loans back. The public may retain some of the loan in the form of cash, or banks may be unable to find creditworthy customers to make advances to, or funds may get diverted into government securities.
Reserves may also be lost to taxation and imports (under a fixed exchange rate). The reasons for the initial increase in bank reserves could be the public banking more notes and coins than they withdraw, or public debt maturing. If a Central Bank buys back (purchases) government securities or other financial assets from the public or financial institutions, then there will be an increase in bank reserves.
The world’s three major private credit-rating agencies (CRA) Standard & Poor’s, Moody’s and Fitch are using their power to prevent low-income countries from restructuring their debts and stimulating their economies. Credit rating agencies realise that developing economies who engage with private creditors, which is part of the G20 Common Framework for Debt Treatments, run the risk that those creditors will incur losses and therefore CRA downgrade the developing country’s credit rating. The Common Framework is supposed to help debt-ridden countries and are the best chance for developing countries to reduce their liabilities but a ratings downgrading damage their prospects.
Standard & Poor’s, Moody’s and Fitch control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. Below are the ratings that each company uses.
We’ve been here before – conflict of Interest and the sub-prime crisis of 2008 Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.
Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.
But consider the following: Bear Stearns – rated A2 a month before it went bankrupt Lehman Brothers – rated A2 just days before it collapsed AIG – rated AA within days of being bailed out Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government Citigroup – A2 before receiving a bail out package from the Government Merrill Lynch – A2 before being sold to Bank of America
In the 1970’s Doc Marten boots were a symbol of youth culture, inner rebellion and an essential part of the uniform. However last week the company floated on the London Stock Exchange which sort of sums up the unequal environment that we live in as it seems that everything can be repackaged, commodified and resold – e.g. US housing market and subprime mortgages.
The story of Doc Martens is the story of the financialisation of the global economy. It is a tale of credit cycles, access to capital and a winner-takes-all form of capitalism that undermines our social fabric. The story is a microcosm of much that is problematic with late-stage, 21st-century financial engineering. Some key points about the financialisation of Doc Martens:
1945 -Klaus Märtens a doctor in the German army injured his ankle whole skiing. Designs a better boot.
1947 – now with investor partner Herbert Funck they start to make good sales
1959 – R. Griggs group Ltd (UK shoe manufacturer) bought patent rights
2013 – Griggs family sell the company to private equity company Permira for £300 million
2021 – Permira plans to float Doc Martens at a valuation of $4 billion.
The advantage to firms like Permira is that they can borrow money at virtually 0% interest and deals like this normally involve a small amount of equity, carrying a significant amount of debt.
This means that if the debt-to-equity ratio of the original deal was 90/10, the return on committed equity could be more than 100 times the original cash investment. It is not difficult to see why, at times of very low interest rates, the return to the already wealthy and financially literate goes through the roof. Financial engineering that benefits the extremely rich, converts an everyday shoe company into a gold mine. (We are talking Doc Martens here, not a life-saving Covid vaccine.) David McWilliams
Inequality statistics from the USA:
Top 10 per cent of wealthiest families in the US hold 76 per cent of total household wealth.
Bottom 50 per cent held just 1 per cent of the nation’s wealth.
Top 1 per cent of families account for 40 per cent of all wealth.
Between 1979 & 2015, households in the top 1 per cent saw their incomes grow five times as fast as the bottom 90 per cent,
Earnings of the top 0.1 per cent grew 15-times faster than the bottom 90 per cent.
In 1941, US supreme court justice Louis Brandeis noted: “We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can’t have both.”
A recent paper by Sebastian Doerr, Stefan Gissler, José-Luis Peydró and Hans-Joachim Voth investigates the role that a financial crisis in Germany played in the Nazis coming to power. They show how financial distress can lead to radical voting when accompanied by a convergence of cultural and economic factors. In less than four years, the Nazis went from capturing 2.6% to 37.3% of the popular vote. The authors identified the failure of one bank as being significant in growing the support of the nazis – Danatbank.
Danatbank and Dresdner Bank Danatbank (the second largest bank in Germany) was widely seen as responsible for causing the financial crisis, and it was headed by the well-known Jewish manager Jakob Goldschmidt, a favourite target of Nazi propaganda. Its collapse in 1931 saw a surge of support for Hitler. Dresdner Bank, Germany’s third-largest lender, failed as well. Exposure to Dresdner Bank had a similar negative effect on city incomes as exposure to Danat, but had almost no effect on support for the Nazis. By contrast, Dresdner Bank was not the key target for Nazi propaganda – even if it had numerous Jews occupying leading positions like most German banks. While the economic impact of the two bank failures was almost identical, only exposure to Danat had a significant effect on Nazi voting. By 1932 Danatbank and Dresdner Bank merged.
Note: The shaded area indicates the period of the 1931 banking crisis, from the beginning of troubles at Austrian Creditanstalt to the merger between Danatbank and Dresdner Bank. Blue vertical lines show: (A) beginning troubles at Austrian Creditanstalt (May 1931), (B) Nordwolle accounting irregularities discovered and Hoover Moratorium established (June 1931), (C) failure of Danatbank and ensuing bank holidays (July 1931), and (D) forced merger of Danatbank and Dresdner Bank.
The Depression enabled the Nazis’ rise to power, but the financial collapse of 1931 thus lent seeming plausibility to a key Nazi hate narrative, helping to bring a large part of the German middle class round to the party’s world view.
Chinese property company called Fangdd Network where its value jumped from US$800mn to US$10bn in four hours of trading. Fangdd Network made it sound like a cheap ETF (ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually) for the FAANG technology giants.
Nikola, an aspiring electric vehicle manufacturer with no revenues that launched three months ago on Nasdaq saw its value spike to almost US$30bn, up from US$300mn at its March IPO, mainly because, like Elon Musk’s electric car company, it was also named after 19th century Serbian-American inventor Nikola Tesla.
Anatole Kaletsky 5 features of market madness
While monetary easing usually starts a bubble, a reversal in monetary policy is unlikely to deflate the bubble once the speculative momentum builds.
Valuations do not matter while a bubble is inflating, but they become very important after it bursts.
Bubbles typically end with the some huge corporate collapses (Charles’s analogy of dynamite fishing), often tainted with fraud.
Bubble dynamics need not bear any relation to the strength, or weakness, of the economic cycle.
Speculation increases dramatically when prices break through major highs.
These examples show that it is not analysis of valuations, monetary policy or economic data that is driving prices up. Famous economist J.K. Galbraith once remarked that ‘economic forecasting was invented to make astrology look respectable’. He also said that we are mush reassured by the ‘conventional wisdom – i.e. strongly held beliefs that have, at best, a tenuous grounding in reality. John Maynard Keynes stated that ‘the market can stay irrational longer than you can stay solvent’.Mervyn King, former Governor of the Bank of England, argues that economic decisions always occur under conditions of, what he calls, ‘radical uncertainty’ – unaware of what might happen in the future. King says that people use ‘narratives’ to make sense of the world. He also suggest that economists in the 2008 GFC didn’t learn from history – the Great Depression before they were born.Each time they suggest that this time it is different – an expression by experts suggesting that the new situation (GFC) bears little resemblance to previous crises. Carmen Reinhart and Kenneth Rogoff in their book entitled ‘This Time is Different’ show that we haven’t learnt from what happened in the past – short memories make it all too easy for crises to recur.
Excellent video from The Economist regarding the disconnect between Wall Street and Main Street i.e. Stock Market and the Economy. The S&P 500 is up 38% since the middle of March this year when the US economy has been going through one of its worst recessions. The US Federal Reserve had a role here by providing aid packages so the increase in the S&P was seen as a Fed rally and not from normal fundamentals.
Japan is top of the table in accumulating government debt and with a record stimulus to cushion the impact of COVID-19 it is approaching debt levels of 250% of GDP. So how does Japan manage to keep its government bond yields so low (see graph below) and investor confidence high that it can avoid default?
To finance this debt, the Japanese government issues bonds known as JGBs. These are snapped up in enormous volumes by the Bank of Japan (BoJ), the country’s central bank that is officially independent but in practice closely co-ordinates economic policy with the government.
Bond Prices vs Yield
Like any investment the buyer of the bond wants to get the greatest return. Bond prices and interest rates (yield) move in opposite directions and an easy way to consider this is zero-coupon bonds. Here the interest is derived by the difference between the purchase price of the bond and the value of the bond on maturity. Bond price $920 – Maturity value $1000. The bond’s rate of return = (1000-80 ÷ 920) x 100 = 8.7% return. However a lot depends on what else is happening in the bond market. If interest were to increase and newly issued bonds were giving a return of 10% the 8.7% return is no longer attractive. To match the 10% the original bond price would have to decrease to $909. The bond’s rate of return = (1000-909 ÷ 909) x 100 = 10% return
Reasons for low rates on JGB’s
Japanese Government Bond (JGB) is a bond issued by the government of Japan. The government pays interest on the bond until the maturity date. At the maturity date, the full price of the bond is returned to the bondholder. Japanese government bonds play a key role in the financial securities market in Japan.
The BoJ has recently been buying up billions dollars of Japanese government bonds keeping interest rates around 0% in the hope of increasing the inflation rate to its 2% target. Therefore any rise in bond yields triggers a buy action from the BoJ. As of 2019, the central bank owns over 40% of Japanese government bonds. The BOJ’s government bond holdings rose 3.4% from a year ago to 486 trillion yen ($4.5 trillion) as of March 2020, roughly 90% the size of the country’s economy, according to the central bank’s earnings report for the previous fiscal year.
Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.
Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:
M x V = P x T
M = Stock of money V = Income Velocity of Circulation P = Average Price level T = Volume of Transactions or Output
Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.
Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.
Secular stagnation Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.
Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors
When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).
Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro
Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.
John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:
What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.
Bitcoin – Economic Crisis to Global Crisis – Ranking Countries – Brexit – Globalisation – Inflation vs Deflation – Hot Money – AI – BRICS – Inequality – Tax Evasion – Climate Change – China – Trade Wars and many more economic issues.
One table I found interesting was the return of US$10,000 over the last five years – see table below. Bitcoin has been incredible but stay clear of Argentinian stocks.