The "New" Liquidity

This is the age of the “New” liquidity.  This new liquidity is driven by two things: first, information technology; and second, by the free flow of capital throughout the world. 

Finance is nothing more than information.  A dollar bill can be exchanged for another dollar bill.  A demand deposit can be exchanged for dollars and is nothing more than 0s and 1s on some bank’s computer.  A bond provides you with a series of cash flows, which are nothing more than electronic blips, 0s and 1s.  Mortgage-backed securities are nothing more than different cash flows cut into streams that suit the needs of whoever buys them…0s and 1s.

Information can be “sliced and diced” any way that you want it and can be stored and transmitted instantaneously almost anywhere in the world.   This latter point is where the free flow of capital throughout the world enters the picture.

This free flow of capital throughout the world is where the “new” liquidity comes in.  Financial assets, in today’s world, are extremely liquid.

 That is, these assets are liquid…until they aren’t liquid!  They remain liquid until something changes, like the price of the real estate behind certain assets ceases to rise continuously. 

And, this is the new world that the Federal Reserve has to operate within. 

The financial innovation of the last fifty years has been truly exceptional.  Information technology has aided this advance.  There are derivative instruments everywhere.  International capital markets have meant that financial assets can be placed all over the world.  The finance industry has become a huge part of the global economy, both in terms of wealth produced and in terms of employment.  Even manufacturing firms like General Motors and General Electric have gotten into the game and in recent years their finance wings have produced a majority of their profits.

The volume of financial assets that have been produced in this environment has relied on the liquidity of international capital markets to facilitate and expand the flow of these assets into every corner of the world.  The ease of the flow has been truly remarkable.

But, it is the very ease of the flow that has created problems here and there.  The problems I am alluding to are called “bubbles.”  Because capital can flow so freely from market to market and this flow can take place almost immediately, capital can move rapidly from various segments of the capital markets into other segments as sentiment or information changes.  And, as long as the markets remain “liquid” the movements can continue until the situation is played out.

This is a different environment from the one that the current model of monetary policy is based upon.  That model, originally created through the Bretton Woods agreement in the 1940s, assumed that there would not be a free flow of capital internationally.  Thus, with a gold standard and fixed exchange rates, the economic policy of a government could be focused on maintaining high levels of employment, low levels of unemployment. 

Of course, the credit inflation of the 1960s destroyed the underlying assumptions of this international monetary agreement and this was institutionalized on August 15, 1971 as President Richard Nixon took the United States off the gold standard and floated the value of the dollar.

The subsequent period of credit inflation and the consequent explosion of financial innovation has taken us into another realm.  And, it is this new environment we are dealing with now.

Money can now flow almost anywhere at extremely rapid speeds.  Money can flow almost instantenously into different sectors of the financial market.  Thus a change in investor sentiment or the introduction of new information or a change in the stance of monetary policy can create “bubbles” in different sectors of the economy. 

We saw a growing occurrence of bubbles over the past 20 years.  We saw the dot,com bubble in the 1990s followed by its collapse in the early 2000s.  We saw the housing bubble in the early 2000s, followed by the collapse in the housing market in the latter part of the decade.  We seemed to have had stock market bubbles in both decades. 

Recently we seem to have had a bubble in international commodity markets due to the quantitative easing of the Federal Reserve system along with bubbles in certain emerging nation stock markets.  One can also make the argument that the recent behavior of the Treasury bond market represents a bubble.  How else can you explain the fact that the yield on Treasury Inflation Protected Securities (TIPS) has been negative.  Participants in the financial markets were not interested in TIPS for their yield but as a price play connected with the “rush to quality” in international financial markets.  (See Jeremy Siegal and Jeremy Schwartz, “The Bond Bubble and the Case for Stocks,” http://professional.wsj.com/article/SB10001424053111903639404576516862106441044.html?KEYWORDS=jeremy+siegel&mg=reno-wsj.)

Former Fed Chairman Alan Greenspan continues to claim that a bubble cannot be perceived before-the-fact, that is, before the bubble has burst.  Hence, the Federal Reserve could not fight off bubbles in financial (or commodity) markets because they could not be identified.  This seems to be the reigning philosophy of the current leadership at the Fed.   It is the old model of monetary policy.

Yet, the liquidity of international financial markets is a reality and the existence of bubbles is a fact of life.  I believe that these facts are being accepted by the people running our governments and central banks.   Yet, their thinking still has a ways to go and their model of how central banking should be conducted has not been completely formed. 

For one, these “leaders” seem to think that every problem they are facing is a liquidity problem.  I have addressed this earlier. (See http://seekingalpha.com/article/288610-the-debt-crisis-it-ain-t-over-until-it-s-over.) Thus, their solutions are systematically based on the maintenance of liquidity in international capital markets.

The fact that the market for an asset may be illiquid because it is related to cash flow problems, say as in real estate investment, and that no amount of liquidity will bring the value of the asset back to previous levels seems to escape these “leaders.”  That is, an asset is liquid, until it is no longer liquid.

Second, the model being used by these “leaders”, a model that places high economic growth to achieve low levels of unemployment, leads these “leaders” to adopt policies, like QE2, that are totally inappropriate for the current economic situation.  Providing liquidity in these cases may create further bubbles, as presented above, but may have little or no effect on economic growth or employment.

Fed Chairman Ben Bernanke is a very creative person.  He has been improvising monetary policy for the last three years.  The old model does not seem to fit any more.  Yet, a new model has not been created.  But, any new monetary policy must be based on the reality of today, a reality dominated by instantaneous flows of money to almost any where in the world.   

Keynes knew that you could not focus a nation’s economic policy on its own employment situation when capital flowed freely throughout the world.  That is why he created his macroeconomic model.  His followers, especially the fundamentalists Keynesians, don’t seem to understand this reality.   It is time to move on.  It is time to accept the reality of the “New” liquidity.

European Choices Continue to Narrow

On May 24, my post stated that debt ultimately leaves you with no good options. (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options)

Martin Wolf in the Financial Times reduces the choices now available to the European Union to two: “The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support.  The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged.” (See “Intolerable choices for the eurozone,” http://www.ft.com/intl/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ.)

The “original” design of the union, Wolf contends, is for all purposes, dead.  That could only be achieved by removing some of the countries now in the union.

To achieve the second of the two choices he mentions above is going to require a contortionist.  First, Wolf argues, European banks cannot remain national.  Whoa!  Second, he argues that the current system of European System of Central Banks (ESCB) must be eclipsed by a “sufficiently large public fund” that manage “cross-border” financial crisis.  Double Whoa!  And, third, the finance of the “weak countries” must be taken out of the market for years, “even a decade.”  Whoa! Whoa! Whoa!  What would result would be something Wolf calls a “support union.”

This certainly is “deeper financial integration and greater fiscal support than was originally envisaged” by the creators of the European Union. 

The question is, “could this ‘support union’ ever be achieved short of all countries in the eurozone coming under a common government. 

But, even so, I do not see that this “solution” reflects any change in the underlying economic philosophy of the current leaders of Europe concerning the propagation of the credit inflation that the leaders of Europe have perpetrated for the last fifty years or so.  With no basic change in philosophy, I cannot see how this second choice achieves anything except the postponement of the “day of reckoning” in which the range of options available to the European Union drops to one. 

Does this mean that the European Union will eventually be providing investors with a “sure-fire”, riskless investment similar to the one given George Soros by the British government in 1992?

It seems to me to be a real possibility.

John Plender, who also writes for the Financial Times, argues that the European Union can “Muddle along for now; but a Greek default is inevitable.” (http://www.ft.com/intl/cms/s/0/21922f88-8ba4-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ)

Plender writes that the burden of the policies imposed upon the Greek government by the IMF will only produce “great demands on the population” which is already enduring a deep recession.  Greek workers will have to ‘endure wage deflation” so as to restore the competitiveness of the Greek economy and the privatization program being discussed will put the transfer of Greek assets in the hands of an external agent. 

However, the other option, debt restructuring, is not currently acceptable to Plender, either.

He sees it as the only real choice for the time being: “If a package is agreed in June, which seems probable, the challenge will be to bring Greece to a primary budget surplus...” and “at that point, it would be sensible for Greece to bow out of the monetary union and take advantage of currency devaluation.” 

He goes on, “For that to work, though, European banks would need in the interim to have bolstered their capital.  And the execution risks are phenomenal.  This is policymaking on a wing and a prayer.”

The leaders of the United States need to absorb this lesson.  No matter that the United States is richer and deeper in resources than Europe.  No matter that the United States is bigger.  No matter that the United States has the reserve currency of the world.  The debt burden catches up with you.  As, as the debt burden is catching up with you…your options become fewer in number and they become less and less desirable.

The United States is not exempt from this outcome…unless it changes course before all the options go away. 

In all financial crises, the initial response of the central bank and the government must be to provide sufficient liquidity to keep the banks open and to avoid cumulative downturns in companies and the economy.  Bailouts and quantitative easing may be appropriate…for the short run.

But, there is a difference I have written about many times, between a “liquidity” crisis and a “solvency” crisis.  A liquidity crisis is a short-run phenomenon, which gets an economy over the short-run shock of a financial event. 

The longer-run problem is the solvency problem.  And, solvency is tied up with debt…debt loads that must be worked off.  And, working off debt loads takes time…lots of time.  And, working off debt loads cannot really be achieved by flooding the financial markets with more credit and more liquidity.  This is a “postponing” strategy.

To solve the “debt” problem and to prevent it occurring again in the future, leaders must change their basic economic philosophy about the creation of debt.  Credit inflation always leads to debt problems, and further credit inflation aimed at solving debt problems only leads to diminishing options and eventual collapse.  Insolvency cannot be solved by more debt. 

It should be obvious that more debt is not the solution to a problem if the options one has decline in number and the desirability of the options also declines.  To continue to pile on more and more debt is like the person in the hole, digging the hole deeper and deeper in an effort to get out of the hole. 

Europe is finding this out.  It, apparently, must be the case that the United States will have to learn this lesson as well.

If anything is going to give the emerging countries of the world the chance to close the gap on the developed countries it is a continuance of the credit inflation policies of Europe and America.  The ironic thing is that the shoe used to be on the other foot…the developed countries had control over their credit inflation whereas the emerging nations were reliant on excessive amounts of credit inflation.  This relative performance was given as an important reason why the developing countries could not hope to catch up with the developed world. 

China is catching up with the west faster than most analysts believed it would.  So with India…and Brazil….  If the European Union…and the United States…continue to push the edge of debt creation and continue to shrink their options, the tipping point  to this emerging world might occur sooner than most of us imagine.     

Making the Same Mistakes All Over Again

Policy makers continue to base their economic and monetary policies on the contention that the problems “out there” are liquidity problems…not solvency problems.  This focus is highlighted in three articles in the morning newspapers. 

The most direct treatment of this is that of Desmond Lachman of the American Enterprise Institute, “The IMF is making the same mistake all over again”: http://www.ft.com/intl/cms/s/0/b2f38dd2-8195-11e0-8a54-00144feabdc0.html#axzz1Mnj4kmN5.

Mr. Lachman makes the argument that the policies followed by Dominique Strauss-Kahn and the IMF with respect to the sovereign debt crisis in Europe is that they have treated “the crisis as a matter of liquidity rather than solvency…” The consequence of this approach is that this philosophy has “led the IMF to eschew any notion of debt restructuring or exiting from the euro, as a solution to the periphery’s public sector and external imbalance problems.”

In another article, Scott Minerd, chief investment office at Guggenheim Partners, argues that “There will Be More Monetary Elixir After the End of QE2”: http://www.ft.com/intl/cms/s/0/96ec2b02-8146-11e0-9360-00144feabdc0.html#axzz1Mnj4kmN5. 

The motivation for QE3? “The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover…Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program will present real headwinds to growth.  Layer on top of that the fact that 2012-13 would probably be the end of the expansionary portion of the business cycle, and what is left is a recipe for a serious economic slowdown or possibly even another recession.”

And, finally, there is Alan Blinder’s opinion piece “The Debt Ceiling Fiasco,” http://professional.wsj.com/article/SB10001424052748703421204576329374000372118.html?mod=ITP_opinion_0&mg=reno-wsj.  To stay within the debt ceiling, Mr. Blinder argues, the government must immediately drop it expenditures by 40%. “Suppose the federal government actually does reduce its expenditures by 40% overnight…That’s an enormous fiscal contraction for any economy to withstand, never mind one in a sluggish recovery with 9% unemployment.” 

“Second, markets now assign essentially zero probability to the U. S. losing its fiscal mind.”  That is, the credit risk built into U. S. government securities is zero and the inflationary expectations that are now built into long-term interest rates are also roughly zero. 

And, what has allowed the United States to get into this position?  Well, “The full faith and credit of the United States has been as good as gold—no one has better credit.”  The federal government has been allowed to increase its debt at an annual compound rate of growth of about 8%, year-after-year for the last fifty years.  “Should the view take hold that threats to default are now a permissible weapon of political combat in the world’s greatest democracy, U. S. government debt will lose its exalted status as the safest asset money can buy—with unpleasant consequences for the dollar and interest rates.” 

That is, the United States government will lose its unlimited privilege to flood the world with debt and liquidity at little or no consequence to itself.

  

All three of these articles are concerned with the view that the basic problems of the economy have to do with liquidity…and not solvency.

I have argued for several years now in this blog that this has been a major problem in the analysis of the economy and the current financial difficulties we are now going through.   Right from the start of the current unpleasantness, the problem has been diagnosed as a liquidity problem and not a solvency problem.  The TARP program was designed to give liquidity to certain “troubled” assets on the balance sheets of various financial institutions.  QE1 was designed to provide liquidity to banking and financial markets.  So was QE2.  So were the bailout programs, both in the United States and Europe. 

But, liquidity problems have historically been considered to be “short-term” problems.  They have to do with whether or not an asset can be sold into the current market in real time without having to take a discount from market on the price at which it is sold.  In the past, a liquidity crisis should be over, given the appropriate monetary policy, in a matter of weeks, six- to eight-weeks at most. 

Liquidity problems did not and do not exist for three or four years!

Yet, this is what our policymakers are claiming.  They are claiming we are still in the midst of a liquidity crisis and so we must tailor our monetary and fiscal policies to deal with the lack of liquidity in financial markets.

The reason for this approach?  The models that these policymakers and their advisors are using only include debt in a cursory fashion.  The structure of conventional macroeconomic models over the past fifty years has not included debt in any meaningful way and so the existence of large amounts of debt has not really been relevant for analysis.  And, consequentially, the solvency issue does not surface.  

The focus then is placed on the “liquidity” issue, the desire of economic units to want to hold onto cash assets.  If banks and other economic units desire to hold onto cash rather than lend the funds to others or to spend the funds themselves then the economic will falter and economic growth will be tepid at best leading to high rates of unemployment.  This is a “liquidity trap.”

The solution to this problem is to flood the banking and financial markets with so much liquidity that people just can’t hold on to any more liquidity and so either begin to lend the funds or begin to go out and spend the funds themselves.  This seems to be the current thrust of economic policy, at the Federal Reserve…and throughout the world. 

But, what if a large number of economic units are insolvent.  In such cases, even with large amounts of liquidity on their balance sheets, they will not lend, or will not borrow any more, or will not go out and spend this excess liquidity because of their balance sheet problems.  What about homeowners who find that they cannot pay their loans or find that the value of their home is less than what they have borrowed?   What about banks who hold large amounts of delinquent residential mortgages or commercial real estate loans on their balance sheets?  What about businesses that owe way too much debt and have little or no current cash flows to cover the debt?  What about State and Local governments that have obligations far in excess of their current revenues?  And, what about sovereign nations who face similar problems?

If the problems are ones of solvency, liquidity is going to do very little for those who have a negative net worth other than postpone the day of reckoning. 

This is the problem of debt.  America (and Europe) has done a very good job over the past fifty years of inflating people, organizations, and governments, out of their increasing debt burdens.  The inflation of housing prices was a wonderful “piggy bank” for the middle class during this time period.  Maybe, the United States government went a little overboard in trying to push down this “piggy bank” to more and more people who even with the inflation could not support the debt.  The credit inflation did wonders for building up the salaries and pension funds of state and local governments.  Unfortunately, history shows over and over again that there are limits to the amount of debt people can carry.  But this is a solvency problem not a liquidity problem.

Finally, a country whose “faith and credit “ is as “good as gold” can abuse that privilege.  This, too, is a solvency problem and not a credit problem.  And, as we are finding out…once again…solvency problems cannot be postponed forever.      

Why Debt Is Going To Continue To Be A Problem In The United States

Officials at the Federal Reserve and in many other leadership positions around the world believe that liquidity is the solution to our current woes. And, if the amount of liquidity that is in the anking and financial markets is not enough to resolve our problems then more liquidity is certainly the answer.

This is behind QE2, and this is behind most of the effort to resolve the sovereign debt crisis in Europe.

What does liquidity allow you to do? It allows you to sell assets into the marketplace.

However, selling assets into the marketplace does not solve your problems if the price at which you sell the assets is substantially below the accounting value of the assets on your balance sheet. In such cases, having liquid markets in which to sell assets may allow you to more than wipe out your equity and leave you unable to pay off your debts.

There are two ways to counter this problem. The first is to inflate prices so that the real value of the debt declines which reduces the amount of leverage you have on your books. The second is to create income and wealth so that equity increases relative to the debt outstanding thereby reducing leverage.

The people advocating the injection of more liquidity into the financial system hope to spur bank lending and thereby stimulate economic growth. Those that are concerned with the creation of more and more liquidity argue that this first group of people really just want to create inflation and reduce the real value of the debt.

The problem I see unfolding is that the economy is expanding and will continue to expand in 2011, but it will not expand in such a way as to stimulate sufficient income growth and wealth creation so as to lower the debt loan many people are bearing. As a consequence, the further liquefying of the banking and financial markets will just benefit those who are not too highly leveraged…generally the financially better off in society…and continue to depress those who are highly leveraged.

In terms of economic growth, the economy is expanding. However, by historical standards, the year-over-year rate of growth of real Gross Domestic Product is substantially below the general recovery pattern. In the year-over-year rates of growth in 2010 were 2.4%, 3.0%, and 3.4% in the first, second and third quarters, respectively. Historically, at this stage of the recovery, the growth rates are usually much greater.

The problems come when we observe some very basic facts with respect to economic performance. First, although Industrial Production has recovered from the lows reached during the recession it has not come close to reaching the peak it attained before the recession set in. Second, the capacity utilization of our manufacturing has recovered, yet it still lies well below its previous peak (which is the lowest peak achieved since the statistical series was begun in the 1960s). Finally, even though unemployment dropped last month, under-employment continues to be extremely high as I estimate that one out of every four or one out of every five individuals of employment age are either unemployed, working part time but would like to work full time, or have dropped out of the work force. This phenomena is captured in the data on the Civilian Participation rate. Note, that this rate is substantially below the level it was before the Great Recession began in December 2007 and is also even further below the level reached before the 2001 recession. Under-employment in the United States has been growing, almost steadily, since the latter part of the 1960s.

Even though corporate profits are rising dramatically, even though many large corporations are acquiring other corporations at a very rapid pace, even though commodity prices are going through the ceiling, even though the big banks are doing very well, thank you, there seems to be a real structural problem in the United States. Liquidity is helping a lot of people but it is not the people we are talking about in this

Bailouts or Defaults?

This question is the defining question in finance and economics today.

Yet, the predominant approach used in macroeconomic policymaking does not include debt and the possibility of defaults in its model. So, the policy answer is obvious. The policy makers must “bailout” individuals, banks and businesses, and governments.

Well, forget individuals, let them default!

But, we need to save banks and businesses…and governments. Provide them with cash grants. Provide them with excessive amounts of liquidity. Defaults of banks and businesses and governments are not a part of our theoretical picture of the world.

Look through the book “”Ben Bernanke’s Fed” written by Ethan Harris, a former research officer at the Federal Reserve Bank of New York and published by Harvard Business in 2008. Chapter 2 is called “How the World Works: a Brief Course in Macroeconomics.” Here we get a picture of the basic model the Federal Reserve uses in its analysis of the state of the world.

“Getting into the head of the Fed requires a basic primer on how the economy and monetary policy works, Harris writes, “Nonetheless, a relatively simple framework underlies much of the discussion at central banks today.”

The foundation of the Fed’s analysis, according to Harris is something called “the Phillips Curve” which supposedly captures the tradeoff between inflation and unemployment. This, of course, incorporates the two government policy objectives written into law in 1978 and affectionately referred to as the Humphrey-Hawkins Full Employment Act.

Harris continues that “Bernanke is a proponent of the ‘financial accelerator model,’” which brings the credit market into the picture. “The idea that strong financial and credit conditions and a strong economy can reinforce each other to create economic booms (and that weak conditions can interact to create busts). During booms, both firms and households have stronger incomes and their assets are worth more, encouraging relaxed lending rules. Easy lending makes the economy even stronger and that, in turn encourages even easier lending standards.”

In other words, Bernanke, and people within the Fed, believe that pumping credit into the economy produces “stronger incomes” and “assets are worth more.” Thus there is a wealth effect. But, as long as inflation is “in check” there will be no problems on the “real” side of the economy and unemployment will be reduced. BINGO!

However, within this view of the world, there are no problems with debt loads, foreclosures, and bankruptcies. Piece of cake…just throw more spaghetti against the wall! (See “Bernanke’s Next Round of Spaghetti Tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.)

Remember, Keynes won and Irving Fisher lost the battle for the hearts and minds of the economics profession. To resolve economic downturns just create more and more debt. Forget about the fact that debt has to be paid off. Just toss more liquidity into the markets.

Defaults are not considered in the model because the assumption is that the problem is one of liquidity, not solvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

Therefore, individuals, banks and businesses, and governments can issue all the debt they want and the Federal Reserve, the European Central Bank, the United States government, or the European Union can step in and solve any discomforting situations that arise through bailouts and loose monetary policy.

However, debt does matter! And, defaults should not just fall on individuals and families. Foreclosures and bankruptcies are very common into the world today.

Yet, governments continue to try and sweep solvency issues “under-the-rug” when it comes to banks and businesses…and to governments.

The only time we really hear about problems of this sort within these institutions is the weekly list of bank closings overseen by the FDIC. But, this information tends to end up on the fifth or sixth page of the business section of the newspaper and rarely, if ever, gets into the radio or television news. Maybe this news, week-after-week, is too boring. However, the FDIC is closing three to four banks a week and they have been doing this for more than a year. Still there are nearly 900 banks on the FDICs list of problem banks, and this does not include a thousand or more banks that are sliding into this problem bank list but have not reached the “statistical” test of being on the list.

This has to be the case within the sector of non-financial businesses. How many small- to medium-sized firms are still on the brink of insolvency? My guess is…a lot. It seems like every week there are more and more empty spaces in the strip malls and other business buildings.

And, then there are the state and local governments. The municipal bond market is in a mess!

In the banking week ending November 19, 2010, the Federal Reserve reports that the average yield on State and Local bonds was 4.72 percent. In the same week 30-year U. S. Treasury bonds yielded 4.30 percent. And, State and Local bonds are not taxed.

WHEN HAVE YOU SEEN AN INTEREST RATE RELATIONSHIP LIKE THIS BEFORE?

Now we get into sovereign debt. Let me just start listing the problems: Greece, Ireland, Portugal, Spain, Italy, France…

Need I say more?

And, what about the United States? On September 30, 2009, the Gross Federal debt outstanding was almost $12 trillion; the Federal debt held by the public was about $8 trillion on that date. And, what if the Gross Federal debt more than doubles over the next ten years as I have been predicting? How acceptable will the debt of the United States government be in the world?

DEBT MATTERS!

Why isn’t debt included in the models the policy makers use? We can’t continue to operate under the assumption that debt doesn’t matter and that all we need to do, policy wise, is throw more spaghetti against the wall.

People, other than individuals, families, small businesses, and small banks, must come to realize that there is a penalty for taking on too much debt. That penalty is default followed by bringing one’s books under control. People must learn that the solution to issuing debt is not issuing more debt!

Economy Still Seeks Liquidity, but Move Slows Down

Over the past sixteen months or so, since September 2008, people and businesses have moved a great deal of their wealth into very short-term assets. This continued into January 2010, but the pace has tapered off.

In September 2009, currency in the hands of the public was more than 10% higher than it was one year earlier. Demand deposits at domestically chartered commercial banks were almost 20% larger than in the same month in 2008, and other checkable deposits at commercial banks and thrift institutions were about 16% higher. Movements into these accounts represented the flight to liquidity in the United States economy that accompanied the financial crisis.

Funds also flowed into savings accounts as well: these accounts rose by 14.5%. However, small-denomination time deposits dropped by about 5% during this time and retail money funds fell by almost 16%.

There was also a shift in funds from all thrift institutions except credit unions into commercial banks over this time period.

The move into more liquid accounts continued into January 2010, but at a slower pace than was seen early last fall. For example, NOW accounts and ATS balances at both commercial banks and thrift institutions rose by 20% in the year ending this January.

Also, savings deposits at commercial banks and thrift institutions continued to rise: they rose by more than 15% from January 2009 to January 2010. (Note that currency in circulation increased over this time period at a more normal 4% annual rate and demand deposits at commercial banks rose only by 1.6%.)

However, the withdrawal of funds from small-denomination time deposits and from retail money funds accelerated. The former deposits dropped at a 21% rate over the twelve months ending in January while the latter fell by almost 27%.

Again, the evidence pointed to a shift in deposits from thrift institutions to commercial banks. Overall, at thrift institutions all checkable deposits and time and savings accounts rose by only 1.7% in the year ending January 2010. Taking credit unions out of this total and you get an actual decline at all other thrift institutions. At commercial banks, the total of these accounts rose in excess of 9%.

This shift in funds has had a very dramatic impact on the two narrow measures of the money stock. In January 2010, the year-over-year rate of growth of the narrow, M1, measure of the money stock rose by 6.5%: the year-over-year rate of growth of the broader, M2, measure of the money stock increased by just 1.9%.

These rates of growth are substantially less than they were in the middle of 2009, when the growth rate of the M1 measure was in excess of 17% and in the M2 measure was around 9%. These numbers were, of course, not generated by the actions of the Federal Reserve but by the movement of assets in the economy as the economy de-leveraged and moved into more liquid assets.

The fact that these rates of increase were not driven by the Federal Reserve can be shown in the January figures. The rates of increase in the M1 money stock (6.5%) and in the M2 money stock (1.9%), bear no relation to the injection of reserves into the banking system that has taken place since September 2008.

If we look at the year-over-year rates of growth for January 2010, we observe that total reserves in the banking system rose by over 29% and that the monetary base increased by almost 17%. Obviously, the reserves that have been forced into the banking system have not found their way into loans and thereby into deposits. This, of course, is why the excess reserves of the banking system remain so high, reaching a new average high of $1.119 trillion in the two banking weeks ending February 10, 2010.

The behavior of the banks is confirmed in the numbers produced by the Federal Reserve on the commercial banks. The banking industry continues to shrink in terms of asset size and the amount of bank loans, every kind of bank loan, is dropping. The commercial banking industry, on net, is just not lending. See http://seekingalpha.com/article/188566-the-banking-system-continues-to-shrink and http://seekingalpha.com/article/188074-problem-loans-still-weighing-on-small-and-medium-sized-banks.

Historically, a 2% growth rate for the M2 measure of the money stock is incapable of producing economic growth. In fact, to sustain this number would imply a deflationary economy.

However, there are two contradictory things going on here. First, as mentioned above, the growth rate in BOTH measures of the money stock over the past year or so has been generated by people and businesses de-leveraging, becoming more liquid, and moving existing assets around. This is the deflationary scenario.

The growth rates in BOTH measures of the money stock have not been achieved through Federal Reserve actions. The reason is, of course, that the banks aren’t lending! If the banks continue to stay on the sidelines, money stock growth will continue to be anemic…at best!

Second, the inflationary scenario, the Fed has injected over $1.1 trillion of excess reserves into the banking system. A major concern is whether or not the Fed can unwind this injection without having repercussions on bank lending, money stock growth, and inflation. We can only hope that the Fed is successful in its “undoing.” See http://seekingalpha.com/article/187292-tightening-at-the-fed-get-ready-for-the-undoing.

We need to keep an eye on these figures because it is going to be important to observe how people are allocating their assets and how they are spending their money. Couple this with information on lending in the banking system and we should get some idea of the health of small- and medium-sized business, the hoped-for foundation of an economic recovery.