“Seven key lessons from the money sector in 2021”

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?

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?

“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:

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

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?

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).

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).

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?

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?

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.

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