Month: May 2023

“If you wanted to create panic about EA banks….”

…you might focus exclusively on narrow money.

The key chart

Recent trends in monthly flows (EUR bn) and YoY growth rates in EA monetary aggregates (Source: ECB; CMMP)

The key message

If you wanted to “create panic” about euro area (EA) banks you could focus exclusively on negative YoY growth rates and monthly outflows in narrow money (M1), and then develop a narrative about money destruction and an impending credit crisis. After all, the EA is experiencing the fastest contraction in M1 since the creation of the Economic and Monetary Union in 1999, and banks have experienced eight consecutive months of negative flows in narrow money too.

Unfortunately, there are a number of problems associated with this “panic narrative”. It ignores simple concepts such as opportunity cost and portfolio rebalancing and mispresents the causal links in money creation.

  • The opportunity cost problem: unprecedented tightening by the ECB has led to a rapid increase in the opportunity cost of holding ON deposits, in contrast to most of the past decade. It has triggered a partial reallocation of ON deposits to other ST deposits. M2-M1 (other ST deposits) increased 21% YoY in April 2023 – also the fastest rate since the creation of the EMU.
  • The portfolio rebalancing problem: The phasing out of net asset purchases and TLTROs has incentivised the issuance of bank bonds (up €170bn) since September 2022. This has led to portfolio rebalancing away from deposits (down €200bn over the same period) to longer term liabilities that do not form part of monetary aggregates (by definition).
  • The causal link problem: the principal way in which bank deposits are created is through commercial banks making loans. Banks are not simply intermediaries that take in deposits and then lend them out (“loanable funds theory”). Instead, banks create money. Growth in private sector credit peaked in September 2022 (7.0% YoY) and has slowed to 3.3% in April 2023, however. This reflects the relatively rapid pass through from higher policy rates to the cost of borrowing, weaker loan demand and tighter credit standards. Slower credit growth implies slower deposit growth (ceteris paribus).

In short, recent EA monetary dynamics are unprecedented in some respects. They are not a cause for panic over EA banks, however. They reflect instead a combination of an increase in the opportunity cost of holding money, portfolio rebalancing, weaker credit demand and tighter credit standards.

This is not to suggest that the message from EA banks is a positive one. On the contrary, it remains one of weaker economic activity and a challenging policy context in which the ECB is expected to continue tightening as economic stresses mount.

An important message, but a very different one to the “bank panic narratives” seen elsewhere…

If you wanted to create panic about EA banks

Focus on narrow money

Growth rates (% YoY) in EA narrow money since 1999 (Source: ECB; CMMP)

Narrow money (M1) in the EA is contracting at the fastest rate since the creation of the Economic and Monetary Union (EMU) in 1999 (see chart above). The annual growth rate in M1 turned negative in January 2023 (-0.8%) and has decelerated each month since then: -2.7% YoY in February 2023; -4.2% YoY in March 2023 and -5.2% YoY in April 2023.

Monthly flows (EUR bn) in narrow money since June 2022 (Source: ECB; CMMP)

EA banks have also experienced eight consecutive monthly outflows of narrow money since September 2022, largely due to the outflow of overnight deposits. The outflow in April 2023 was €-75bn, compared with €-135bn in March 2023, and €-140bn in February 2023 (see chart above).

From here, it is tempting to create a “panic narrative” for EA banks. Tempting, but wrong…

Problems with the panic narrative – “opportunity cost”

Growth rate in M3 (% YoY) and contribution from ON deposits and other components (ppt) (Source: ECB; CMMP)

The first problem with the panic narrative is that it ignores the fundamental economic concept of opportunity cost.

Note that for most of the past decade, narrow money has been the main driver of EA broad money growth. The chart above illustrates the growth rate in broad money (M3) and the contributions to growth made by ON deposits (the light blue columns) and all other M3 components (the maroon columns).

The exceptionally large contribution and accumulation of ON deposits in the EA (and elsewhere) over the period reflects (1) the extended period of low interest rates and, more recently, (2) the COVID-19 pandemic. Unorthodox monetary policy reduced the opportunity cost of holding ON deposits dramatically and the pandemic resulted in a sharp rise in both forced and precautionary savings.

Policy tightening by the ECB since June 2022 has been notable for both its scale and pace. The pass through from higher policy rates to the cost of overnight deposits has been very slow/limited and has lagged the pass through to the cost of other forms of ST deposits, however.

In short, the opportunity cost of holding ON deposits has risen rapidly since the start of policy tightening.

Spread between rates on other HH ST deposits and HH ON deposits (ppt) (Source: ECB; CMMP)

The chart above illustrates the spread (or opportunity cost) between HH deposits redeemable at notice of up to three months and deposits with an agreed maturity of up to two years – the components of M2-M1 – versus HH ON deposits over the past 20 years.

The opportunity costs of holding notice deposits, and terms deposits with maturities of up to one year and between one and two years hit lows of 32bp, 13bp and 18bp in December 2021, June 2021 and March 2021 respectively. Since then they have risen to 106bp, 194bp and 194bp respectively, levels not seen since early 2013.

Spread between rates on other NFC ST deposits and NFC ON deposits (ppt) (Source: ECB; CMMP)

The chart above illustrates the spread (opportunity cost) between NFC time deposits – again M2-M1- and NFC ON deposits over the past twenty years. In this case the opportunity costs of holding term deposits hit lows of -33bp in November 2021 for maturities up to one year and 4bp for maturities between one and two years. Since, then they have risen to 215bp and 243bp respectively, levels last seen during the GFC.

Growth rates (% YoY) in M1 and M2-M1 since 1999 (Source: ECB; CMMP)

ECB policy has triggered a reallocation of funds from overnight deposits to other ST deposits. The growth rate in M2-M1 rose to 21% YoY in April. This is, in turn, the fastest rate of growth since the creation of the EMU.

Monthly flows (EUR bn) on EA monetary aggregates (Source: ECB; CMMP)

Inflows into other ST liabilities, M2-M1 and, to a lesser extent, M3-M2 have been important but still insufficient to compensate fully for the outflows in overnight deposits (see chart above). Hence, monthly flows of M3 have been negative in six of the past seven months.

Problems with the panic narrative – “portfolio rebalancing”

The second problem with the panic narrative is that it ignores portfolio rebalancing to other financial instruments. Note that money supply is derived from the banks’ ST liabilities and does not include longer-term liabilities since they are not close substitutes for money.

According to the ECB, bank bond issuance has increased by almost €170bn since September 2022. The terms and conditions of TLRTO II were recalibrated at this point resulting in sizeable repayments of funds borrowed under the programme and an increase in (more expensive) bond issuance. Bond issuance was close to total c€200bn decrease in the bank deposits over the period.

In short, M1 dynamics reflect both a substitution of ON deposits with time deposits (opportunity cost) and shifts to bank bonds (portfolio rebalancing) and, to a lesser extent money market fund shares. Funding costs may be rising but there is no evidence of liquidity-driven panic.

Problems with the panic narrative – “causal links in money creation”

The final problem with the panic narrative is that it misrepresents the causal links in money creation. Contrary to what is often taught (“loanable funds theory”), banks are not intermediaries that take in deposits first and then lend them out. Instead banks create money.

“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money”

(Bank of England, 2014).

Growth rates in (adjusted) private sector credit (% YoY) since 2003 (Source: ECB; CMMP)

The principal way in which bank deposits are created is through commercial banks making loans. Growth in private sector lending peaked in September 2022 at 7% YoY, however (see graph above). In April 2023, growth has slowed to 3.3% YoY from 3.9% YoY in March 2023 and 4.3% YoY in February 2023. The moderation in bank lending reflects the relatively rapid pass through from policy rates to the cost of borrowing, weaker demand and tighter credit standards.

Growth rates in M3, M1 and private sector credit (% YoY) (Source: ECB; CMMP)

Conclusion – focus on the wider message not the panic narrative

In short, recent EA monetary dynamics are unprecedented in some areas. They are not a cause for panic over EA banks, however. They reflect instead a combination of an increase in the opportunity cost of holding money, portfolio rebalancing, weaker credit demand and tighter credit standards.

This is not to suggest that the message from EA banks is a positive one. On the contrary, it remains one of weaker economic activity and a challenging policy context in which the ECB is expected to continue tightening as economic stresses mount. An important message, but a very different one to the “bank panic narratives” seen elsewhere…

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

“If you wanted to create panic over US public debt – II”

Be careful how you present your data and what you include.

The key chart

Long term trends in US GDP, public debt and private debt plotted on log scales (Source: FED; CMMP)

The key message

Further thoughts for those “seeking to create panic” over US public debt – (1) do not use log scales when presenting data graphically, and (2) do not include private sector debt in your analysis.

In my previous post, I illustrated how using linear scales (absolute levels) was better for creating panic than using log scales (rate of change). Recall that long time-series data that has low initial values and a constant growth rate (eg US public debt) lends itself very well to creating so-called “panic charts” (see chart below).

“Panic charts” in action (Source: CMMP)

The reason not to use log scales is simple. They emphasise instead, how the rate of growth has (1) been relatively constant over time, and (2) slower now than in early parts of the period.

Excluding private debt is a second key tactic. Since current macro thinking typically ignores private debt altogether while seeing public debt as a problem, this is relatively straightforward and uncontroversial.

What are the risks of ignoring this advice?

First, readers may compare its rate of growth (the green line in the key chart above) with the rates of growth in public debt (blue line) and nominal GDP (maroon line). They may note the extended period (1948-2007) when the rate of growth in private debt far outstripped the rate of growth in both GDP and public debt (the private debt ratio rose from 48% GDP to 165% of GDP).

Second, and from this, readers may explore the relationship between public and private debt growth rates (buying Amazon’s last copy of Wynne Godley’s, “Monetary Economics” in the process). They may note that during phase 1 (4Q1940 – 4Q1981) the public debt ratio fell from 86% GDP to 32% GDP. In other words, the net wealth of the non-government sector parked in a savings account marked “treasuries” grew at a much slower rate than GDP. They may realise that in response, the private sector borrowed more. A lot more. The private debt ratio increased from 48% GDP to 99% GDP.

From here, attention may shift naturally to the two periods of relatively high rates of growth in public debt – Phase 2 (3Q81 – Reaganomics – 3Q93) and the post–GFC Phase 4 (2Q07 – 1Q13). In phase 2, the public debt ratio rose from 32% GDP to 70% GDP. Private debt continued to grow but at a much slower place (to 118% GDP). In phase 4, the expansion of public debt reflected the government’s response to the GFC and the subsequent deleveraging of the private sector (the private debt ratio fell from 165% GDP to 149% GDP).

There are two risks here. First, attention may be drawn to the minority-held view (so far) that private debt typically causes crises while public debt typically limits their impact. Second, it may also be drawn to the fact that the US led the advanced world in the structural shift away from relatively high risk private debt to lower risk public debt in the post-GFC period.

To repeat and extent the message from the previous post – it is always worth considering how different parties chose to present their data to support their arguments and also to consider what they chose to include, or more importantly, exclude….

“If you wanted to create panic over US public debt – I”

How would you present your data?

The key chart

50 years of US public sector debt dynamics – plotted differently! (Source: FED;CMMP)

The key message

If you wanted to create panic over US public sector debt there are a number of tactics that you could use:

  • ignore the fact that US debt is a liability for one economic sector and an asset for another;
  • make no comparison with GDP;
  • ignore inflation etc.

Alternatively, you could simply present your data using linear scales – an easier and almost guaranteed method to instil panic!

1 unit of XZY growing at 10% p.a. over 100 years plotted on a linear scale (Source: CMMP)

Why is this a smart tactic for creating panic?

In the case of any long time series data that has low initial values and a constant growth, the use of a linear scale will always create a chart that is flat for a long period at the start, then becomes steeper and steeper before becoming virtually vertical (see chart above). Readers’ eyes will naturally focus on the steepening of the graph, thereby leading to the conclusion that some form of critical limit has been reached

BINGO – “PANIC ALERT!”

In contrast, the wrong tactic for creating panic would be to present data using a log scale (the maroon line in the key chart). Rather than illustrating the absolute level of US debt (the blue area) this would show its rate of change.

As can be seen, this is (1) fairly constant over time (US debt roughly doubles every ten years in nominal terms) and (2) is slower now than in early parts of the period shown. Presented this way (see chart below), the same underlying data is much less likely to create panic…

1 unit of XZY growing at 10% p.a. over 100 years plotted on a log scale (Source: CMMP)

For the rest of us, it is worth considering how different parties chose to present the same data to support their respective arguments, especially as concerns (false or otherwise) over the US debt ceiling intensify.

Remember, a chart of US public debt using a linear scale is highly likely to create panic, even if the rate of change of debt is constant.

“Why can’t the US be more like Denmark?”

A tempting question to ask, but also the wrong one!

The key chart

Twenty-year trends in debt ratios (% GDP) broken down by type (Source: BIS; CMMP)

The key message

Denmark and the US are the only two, advanced economies that maintain absolute limits on the level of government debt. Interestingly, their public debt ratios (as opposed to debt levels) were essentially the same twenty years ago (54-55% GDP). Today, however, Denmark has the third lowest public debt ratio in the world (30% GDP), while the US has the seventh highest (103% GDP).

Unsurprisingly perhaps, while we hear little “political noise” about the Danish debt ceiling (or debt ratio), we are subjected to an overdose from the US. This leads some to ask, “Why can’t the US be more like Denmark”.

A tempting question to ask, but also the wrong one…

To understand why, we need to adopt a systemic view of the Danish and US financial systems that incorporates both public and private sector debt and reflects the reality of modern money creation.

Put simply, money creation relies on actions that add to bank deposits. Bank lending and government DEFICITS (despite what is taught in many textbooks) qualify, but in different ways. The repayment of bank loans and government SURPLUSES have the opposite effect – they destroy money.

In this context, a better question to ask is, “How do the processes of money creation in Denmark and the US differ and why does this matter?”

Total debt ratios have increased in both economies over the past two decades (see key chart above). In Denmark from 223% GDP to 246% GDP. In the US from 198% GDP to 256% GDP. The processes have been very different, however.

Denmark has effectively substituted government deficits and public debt (an asset of the non-government sector) with more private debt (a liability of the non-government sector) over the past two decades. In contrast, the US has substituted private debt – mainly household debt – with more public debt. In the process, the ratio of the stock of private debt (largely ignored by policy makers and economists) to public debt has risen from 3.2x to 7.2x in Denmark over the period. In the US, it has fallen from 2.6x to 1.5x.

The key point here it that private sector money creation faces unique supply (capital and regulation) and demand (ability of currency users to service debt) constraints. Despite more than a decade of HH sector deleveraging, for example, Denmark’s HH and NFC debt ratios remain above the levels where debt is considered a constraint on future growth. The result? Further private sector deleveraging, led by the HH sector.

Private sector models are also inherently less flexible, less stable and, in advanced economies, more prone to periods of crisis that require greater to levels of public debt to resolve/address.

While lending to the private sector is also the main source of money creation in the US, the government plays a much greater role than in Denmark. As a currency issuer, the US government does not face the same constraints as the private sector (although it does face other constraints). The US is also one of only three advanced economies where both HH and NFC debt ratios are below their respective threshold limits. In short, the structure of the US model provides more flexibility and more stability, as the response to the COVID-pandemic illustrated, and reduces the risk of crisis.

The US generates significantly more political noise about the management of government debt than Denmark, the only other country to maintain an absolute debt ceiling. This noise differential in not an accurate reflection of the relative strengths of the money creation processes in each economy. It is instead, a reflection of flawed macro thinking. Thinking that views public sector debt as a problem but largely ignores private debt and falsely equates the financial constraints of currency users and currency issuers.

The irony here is that a more accurate, systemic view of Danish and US money creations leads to a different question altogether – “Shouldn’t Denmark be more like the US?”

Why can’t the US be more like Denmark?

Twenty-year trends in public sector debt ratios (% GDP) (Source: BIS; CMMP)

Denmark and the US are the only two, advanced economies that maintain absolute limits on the level of government debt. Their public debt ratios (as opposed to debt levels) were essentially the same twenty years ago (54% and 55% GDP respectively, see graph above). Today, however, Denmark has the third lowest public debt ratio in the world (30% GDP, see graph below), while the US has the seventh highest (103% GDP).

BIS reporting nations ranked by 3Q22 public debt ratios (% GDP) (Source: BIS; CMMP)

Unsurprisingly, while we hear little political noise about the Danish debt ceiling (or debt ratio), we are subjected to an overdose of “political noise” from the US. This leads some to ask, “Why can’t the US be more like Denmark”. A tempting question to ask, but also the wrong one…

Money creation in Denmark and the US – a systemic view

To understand why, we need to adopt a systemic view of the Danish and US financial systems that incorporates both public and private sector debt and reflects the reality of modern money creation.

Money creation relies on actions that add to bank deposits, the main form of money today. Bank lending and government deficits (despite what is taught in many textbooks) qualify, but in different ways. The repayment of bank loans and government surpluses have the opposite effect – they destroy money.

In this context, a better question to ask is, “How do the processes of money creation in Denmark and the US differ and why does this matter?”

The changing nature of money creation – total debt broken down by type (% total debt) (Source: BIS; CMMP)

The graph above illustrates how Denmark has effectively substituted public debt (an asset of the non-government sector) with more private debt (a liability of the non-government sector) over the past two decades. In contrast, the US has substituted private debt – mainly household debt – with more public debt.

Twenty-year trends in private debt/public debt ratios (x) (Source: BIS; CMMP)

Note the relative scale of the stock of private sector debt (largely ignored by policy makers and economist) in relation to the stock of public sector debt over the period (see graph above). In Denmark, the ratio rose from 3.3x to almost 10x before the GFC, fell back and then rose again to 7.2x today. Again, in contrast, the US ratio has fallen from 2.6x to 1.5x over the period.

Twenty-year trends in Danish money creation (debt as % GDP) (Source: BIS; CMMP)

In other words, lending to the private sector is a far more important source of money creation in Denmark (see graph above) than in the US (see below). As an aside, the Danish government ran a budget surplus in 2022, destroying money in the process.

The key point here it that private sector money creation faces unique supply (capital and regulation) and demand (ability of currency users to service debt) constraints. Despite more than a decade of HH sector deleveraging, for example, Denmark’s HH and NFC debt ratios remain above the level where debt is considered a constraint on future growth (see graph below). For reference, the BIS considers that HH and NFC debt ratio of 85% GDP and 90% GDP represent threshold limits above which debt becomes a constraint on future growth.

HH debt ratios plotted against NFC debt ratios for selected BIS reporting nations – red lines represent BIS threshold limits (Source: BIS; CMMP)

The result? Further private sector deleveraging, led by the HH sector (see chart below). Note also that private sector models are also inherently less flexible, less stable and, in advanced economies, more prone to periods of crisis that require greater to levels of public debt to resolve/address.

Twenty-year trends in US and Danish HH and NFC debt ratios (% GDP) (Source: BIS; CMMP)

While lending to the private sector is also the main source of money creation in the US, the government plays a much greater role than in Denmark (see chart below). As a currency issuer, the US government does not face the same constraints as the private sector (although it does face other constraints). The US is also one of only three advanced economies where both HH and NFC debt ratios are below their respective threshold limits.

In short, the structure of the US model provides more flexibility and more stability, as the response to the COVID-pandemic illustrated, and reduces the risk of crisis.

Twenty-year trends in US money creation (debt as % GDP) (Source: BIS; CMMP)

Conclusion – shouldn’t Denmark be more like the US?

The US generates significantly more political noise about the management of government debt than Denmark, the only other country to maintain an absolute debt ceiling. This noise differential in not an accurate reflection of the relative strengths of the money creation processes in each economy. It is instead, a reflection of flawed macro thinking. Thinking that views public sector debt as a problem but largely ignores private debt and falsely equates the financial constraints of currency users and currency issuers.

The irony here is that a more accurate, systemic view of Danish and US money creation leads to a different question altogether – “Shouldn’t Denmark be more like the US?”

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

“Does President Lagarde have an easier job…”

…than Chair Powell or Governor Bailey?

The key chart

Quarterly consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: ECB; FRED; BoE)

The key message

Does President Lagarde have an easier job than Chair Powell or Governor Bailey? In one important respect, yes.

Demand for consumer credit remains very subdued in the euro area (EA) in absolute terms and in contrast to trends observed in the US and the UK.

The European Central Bank (ECB), Federal Reserve and Bank of England each face delicate balancing acts between reducing inflation (their core mandates) and weaker growth. On the one hand, higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. On the other hand, increased borrowing is one way that households can offset the pressures of falling real incomes.

“Higher interest rates provide incentives to households to save more now and postpone consumption from the present to the future”

Philip Lane, October 2022

In terms of reducing inflation, the fact that demand for consumer credit remains very subdued in absolute terms and in contrast to trends observed in the US and the UK makes President Lagarde’s task easier (if not easy!).

The EA has experienced eight consecutive quarters of positive consumer credit flows since 2Q21 (see key chart). These flows have yet to recover to their pre-pandemic levels, however. In 1Q23, the quarterly flow totalled €4.1bn, down from €5.2bn and €4.9bn in 4Q22 and 3Q22 respectively. Perhaps more importantly, the 1Q23 flow was only 0.4x the pre-pandemic average quarterly flow of €10.2bn.

Investors positioned for growth in the EA might take some comfort from the recovery in consumer demand in March 2023. The monthly flow rose to €2.6bn from €1.6bn in February 2023, but was still only 0.76x the pre-pandemic average flow of €3.4bn.

That said, the relatively subdued nature of EA consumer credit demand suggests that the risks to the ECB’s balancing act lie more towards weaker growth/recession. A different balance of risks to those faced by Chair Powell and Governor Bailey.

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

“Have US and UK consumers read the (recession) script?”

1Q23 consumer credit flows still above pre-COVID levels

The key chart

Quarterly US and UK consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: FRED; BoE)

The key message

Have US and UK consumers read the (recession) script?

Despite rising borrowing costs, quarterly consumer credit flows in 1Q23 remained well above pre-pandemic levels, helped by a recovery in monthly flows in March 2023. The message from the US and UK money sectors in 1Q23 was more positive for consumer demand and growth, but more problematic for Chair Powell and Governor Bailey…

US consumer credit totalled $65bn in 1Q23, down from $87bn and $84bn in 4Q22 and 3Q22 respectively but still 1.5x the pre-pandemic average quarterly flow of $45bn (see key chart above). The monthly flow in March 2023 rose to $27bn, from $15bn in February 2023, and was 1.8x the pre-pandemic average flow of $15bn or 1.5x on a 3m MVA basis (see chart below).

UK consumer credit totalled £4.7bn in 1Q23, up from £3.2bn and £3.3bn in $Q22 and 3Q22 respectively, and 1.3x the pre-pandemic average quarterly flow of £3.6bn (see key chart above). The monthly flow in March 2023 rose to £1.6bn, from £1.5bn in February 2023, and was 1.6x the pre-pandemic average of £1.2bn or 1.3x on a 3m MVA basis (see chart below).

Monthly consumer credit flows (3m MVA) expressed as a multiple of pre-pandemic average flows (Source: FRED; BoE)

The Federal Reserve and the Bank of England continue to face delicate balancing acts between reducing inflation (their core mandate) and weaker growth. Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. At the same, increased borrowing is one way that households can offset the pressures of falling real incomes.

In this context, the message from the US and UK money sectors in 1Q23 was more positive for consumer demand and growth, but more problematic for Chair Powell and Governor Bailey…

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