“Seven key lessons from the money sector in 2021”

What have the “messages from the money sector” taught us?

Visual summary of the CMMP framework linking all economic sectors together (Source: CMMP)

The key message

Over the past twelve months, the “messages from the money sectors” have taught us more about:

  1. The true value in analysing global banks
  2. How to improve our understanding of global debt dynamics
  3. What does (and does not) constitute a pragmatic and responsible fiscal outcome
  4. Why official forecasts for UK government spending remain flawed
  5. How QE fuelled the “wrong type of lending” and what the ECB thinks should be done about it
  6. How to avoid misinterpreting trends in monetary aggregates
  7. How the behaviour of UK and euro area households reached an important inflexion point at the start of 4Q21

Unfortunately, there is a risk that the renewed rise in COVID-19 cases and emergence of the omicron variant may have masked the final lesson over the Christmas period.

Nonetheless, a final positive message from 2021 is that firmer economic foundations (and higher levels of vaccinations) suggest that both the UK and euro area regions are in a stronger position to face renewed COVID-related challenges now than they were at the start of the year.

Seven key lessons from 2021

Lesson #1: where is the true value in analysing banks?

The true value in analysing global banks comes from understanding the implications of the relationship between the money sector and the wider economy for macro policy, corporate strategy, investment decisions and asset allocations.

Based on this core foundation, CMMP analysis incorporates:

  • A quantifiable and objective framework linking all domestic economic sectors with each other and the rest of the world (see key chart above)
  • A deep understanding of global debt dynamics (see lesson #2 below)
  • Unique insights into the impact of global money, credit and business cycles on corporate strategy and asset allocation

Lesson #2: how can we improve our understanding of global debt dynamics?

Household and government debt as a share (% total) of global debt (Source: BIS; CMMP)

Our understanding of global debt dynamics is improved significantly, at the macro level, by extending analysis beyond the level of debt to include its structure, growth and affordability and, at the micro level, by distinguishing between productive (COCO-based) and non-productive sources of debt (FIRE-based), at the micro level (see lesson #5 below).

A great deal of attention focused on the fact that global debt levels hit new highs during 2021. Much less attention focused on the key structural changes that have taken place in the structure of global debt since the GFC:

  1. There has been an important shift away from household (HH) debt towards government debt at the aggregate, global level (see chart above)
  2. Advanced economy dynamics have driven this structural shift, especially in the US and UK
  3. In contrast, the structure of EM debt remains broadly unchanged, with a bias towards private sector debt

I will explore the implications of these (and other structural changes) in my first post in 2022.

Lesson #3: what constitutes a pragmatic and responsible fiscal outcome?

UK financial sector balances (4Q rolling averages, £bn) (Source: ONS; CMMP)

“Pragmatic” and “responsible” fiscal outcomes are those that deliver a balanced economy not a balanced budget.

The three key sectors in any modern economy – the domestic private sector, the domestic government and the RoW – each generate income and savings flows over a given period. If a sector spends less than it earns it creates a surplus. Conversely, if it spends more than it earns it creates a deficit.

Extending fundamental accounting principles, we know that any deficit run by one or more economic sectors must equal surpluses run by other sector(s). This leads to the key identity pioneered by the late Wynne Godley:

Domestic private balance + domestic government balance + foreign balance (must) = zero

UK private and public sector net savings/borrowings as %age of GDP (Source: OBR; CMMP)

Contrary to popular political rhetoric, budget outcomes are inappropriate goals in themselves. Worse still, fiscal surpluses reduce the wealth and financial savings of the non-government sectors.

The good news during the pandemic was that the unprecedented shifts in net savings of the private sector were matched by equally unprecedented shifts in the net deficits of the public sector (see chart above for the UK experience). In other words, policy responses were both timely and appropriate. The risk looking forward is that policy makers ignore these lessons and repeat the mistakes of the post-GFC period (see also lesson #4).

Lesson #4: where are the flaws in offical UK forecasts

Historic and forecast UK sectoral net lending – % GDP, rolling annual average (Source: OBR; CMMP)

Forecast improvements in UK government finances from the OBR rely on dynamic adjustments by other economic sectors and unusual patterns of behaviour beyond that. The assumed end-result is one where sustained, twin domestic deficits are counterbalanced by significant and persistent current account deficits (see chart above).

The OBR described this as a “return to more normal levels.” CMMP analysis suggest it is anything but. Viewed from a sector balances perspective, the risks appear tilted to the downside ie, government finances may not recover as quickly as forecast.

Lesson #5: has QE fuelled the wrong type of lending?

Contribution (ppt) of COCO-based and FIRE-based lending to growth (% YoY) in total lending in the euro area (Source: ECB; CMMP)

Unorthodox monetary policy has fuelled growth in the wrong type of lending. There has been a shift away from productive COCO-based lending towards less-productive FIRE-based lending. The stock of productive lending in the euro area, for example, only returned to its previous January 2009 peak last month (November 2021).

Outstanding stock (EUR bn) of productive COCO-based lending in the euro area (Source: ECB; CMMP)

In other words, the aggregate growth in lending since then has come exclusively from non-productive FIRE-based lending. According to the latest ECB data, for example, FIRE-based lending accounted for 2.7ppt of the total 3.7% YoY growth in private sector lending in November 2021 (see chart below).

What’s driving private sector lending in the euro area? (Source: ECB; CMMP)

In its latest, “Financial Stability Review” (November 2021), the ECB calls for a policy shift away from short-term measures towards “mitigating risks from higher medium-term financial stability vulnerabilities, in particular emerging cyclical and real estate risks”.

This is a welcome development given the negative implications that the rise in FIRE-based lending has for future growth, leverage, financial stability and income inequality. Within the EA, Germany stands out given current house price and lending dynamics, the extent of RRE overvaluation and the absence of targeted macroprudential measures.

Lesson #6: how can we avoid misinterpreting monetary aggregates?

Growth in euro area M3 (% YoY) and contribution (ppt) from M1 and private sector lending (Source: ECB; CMMP)

Trends in monetary aggregates provide important insights into the interaction between the money sector and the wider economy but headline YoY growth figures can be easily misinterpreted, leading to false narratives regarding their implications.

The message from rapid broad money growth in the pre-GFC period, for example, was one of (over-) confidence and excess credit demand. In contrast, the message from rapid broad money growth during the COVID-19 pandemic was one of elevated uncertainty and subdued credit demand (see chart above). Very different drivers with very different implications…

CMMP analysis has focused on three key signals throughout 2021 to help to interpret recent trends more effectively: monthly household deposit flows (behaviour); trends in consumer credit demand (growth outlook) and the synchronisation of money and credit cycles (policy context).

Lesson #7: has HH behaviour in the UK and EA reached an inflexion point?

Monthly HH money flows as a multiple of pre-pandemic levels (Source: BoE; ECB; CMMP)

The behaviour of UK and euro area households reached a potentially important inflexion point at the start of 4Q21. Monthly money flows moderated sharply (see chart above) while monthly consumer credit flows hit new YTD highs ie, positive developments in two of the three key signals.

The recent rise in COVID-19 cases, the emergence of the omicron variant and renewed restrictions imposed by governments may result in these points being missed or, worse, still, reversed.

That said, and to finish on a positive note, firmer economic foundations (and higher levels of vaccinations) suggest that both the UK and euro area regions are in a stronger position to face renewed COVID challenges than they were at the start of the year.

Thank you for reading and very best wishes for a very happy and healthy new year.

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.

“Missing the point?”

Household behaviour at an inflection point

The key chart

Monthly HH money flows as a multiple of pre-pandemic levels (Source: BoE; ECB; CMMP)

The key message

The behaviour of UK and euro area households reached a potentially important inflexion point at the start of 4Q21. Household (HH) money flows moderated sharply in October 2021 while monthly flows of consumer credit hit new YTD highs.

Recall that HHs increased their money holdings significantly during the pandemic and built up (estimated) excess savings of £162bn in the UK and €285bn in the EA – a combination of forced and precautionary savings. This meant that the rise in broad money during the pandemic was a reflection of the deflationary forces of increased savings and delayed consumption.

The accumulation of money holdings peaked during 2Q20 and again in 4Q20 and the low point in terms of YoY declines in consumer credit demand was passed in February 2021. Monthly flows of consumer credit have been positive for the past six months and hit YTD highs in October 2021 in both regions. At the same time, the accumulation of money holdings has fallen back to 1.2x and 0.6x pre-pandemic levels in the UK and EA respectively.

Unfortunately, the recent rise in COVID-19 cases, the emergence of the omicron variant and renewed restrictions imposed by the UK and EA governments may result in these points being missed, or, worse still, the positive trends being reversed. That said, firmer economic foundations in both the UK and EA (and higher levels of vaccinations) suggest that both regions are in a stronger position to face renewed COVID challenges than they were a year ago.

Missing the point – the charts that matter

HH money flows

Monthly HH money flows in the UK (£bn) and multiple (x) of 2019 average flow (Source: BoE; CMMP)

HHs in the UK and EA increased their money holdings significantly during the COVID-19 pandemic. Monthly flows peaked at 6x pre-pandemic levels in the UK in May 2020 (see chart above) and 2.4x pre-pandemic levels in the EA a month earlier (see chart below). At the start of 4Q21, they had moderated to 1.2x and 0.6x pre-pandemic levels in the UK and EA respectively. A key building block for a sustained economic recovery.

Monthly HH deposit flows in the EA (EUR bn) and multiple (x) of 2019 average flow (Source: ECB; CMMP)

Excess HH savings

Estimated build up of excess HH savings in the UK (£bn) (Source: CMMP estimates)

In aggregate, and as a result, HHs have built up excess savings in the form of bank deposits of £162bn in the UK (see chart above) and €285bn in the EA (see chart below) since February 2020. These reflect a combination of forced savings (that may be released relatively quickly to support economic activity) and precautionary savings (that are unlikely to move straight into investment of consumption).

Estimated build up of excess HH savings in the EA (EUR bn) (Source: CMMP estimates)

As noted back in May (see “More bullish on UK consumption”) and confirmed by the ECB in August 2021 (see “Economic Bulletin, Issue 5”). The majority of these accumulated savings have accrued to HHs that already have sizeable savings, have higher incomes, and are older. Such HHs typically spend less from any extra savings they accumulate i.e. they have relatively low marginal propensities to consume. The release of these excess savings is likely to be only partial and gradual, therefore.

Impact on monetary aggregates

M1 as a percentage of M3 in the UK and EA (Source: BoE; ECB; CMMP)

HH behaviour had a marked impact on money supply dynamics during the pandemic with narrow money (M1) representing an ever-larger share of broad money (M3) in both the UK and EA (see chart above). As an example, overnight deposits contributed 6.8ppt to the total EA broad money growth of 7.6% in October 2021 alone (see chart below).

Contribution of M1 (ppt) to growth rate in EA M3 (% YoY) (Source: ECB; CMMP)

This matters because the expansion of broad money during the pandemic reflected the deflationary force of HHs increasing their savings and delaying consumption. Money sitting in overnight deposits contributes to neither growth nor inflation.

HH demand for consumer credit

Growth rates in consumer credit in the UK and EA (% YoY) (Source: BoE; ECB; CMMP)

Annual growth rates in consumer credit reached a low point in February 2021 in both the UK (-10% YoY) and the EA (-3% YoY). The rate of decline has narrowed subsequently to -1.0% in the UK in October. In the EA, annual growth rates turned positive two months later in April 2020 (see chart above).

Monthly consumer credit flows in the UK (£ bn) and EA (EUR bn) (Source: BoE; ECB; CMMP)

More importantly, monthly flows of consumer credit have been positive for the past six months and reached their highest levels YTD in both the UK (£0.7bn) and EA (€2.7bn) respectively (see chart above).

Conclusion

A moderation in monthly HH money flows and a recovery in demand for consumer credit represent important foundations for a sustained recovery in the UK and the EA. The rise in COVID-related risks comes at a very delicate and unfortunate time, therefore, for the recovery in both regions. It remains too early to say whether recent events will reverse these dynamics in a meaningful manner. The positive news is that firmer economic foundations in both the UK and EA suggest that both regions are in a stronger position to face these challenges than they were a year ago.

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.