The Rhyme of History

by Sean Corrigan

We have quoted before from the writings of Benjamin Anderson, Chief Economist at Chase Manhattan from 1920-37, spanning the period from the sharp post-WWI depression via the New Era madness and on through the Great Depression itself. Much of what he wrote in his masterful u2018Economics and the Public Welfare' rings eerily true today.

A firm believer in what is now regarded as the Austrian school view that true capital can only be formed by abstinence from consumption and that bank credit is nothing but a temporary substitute for this, his contemporary writings in the prestigious Chase Economic Bulletin constantly warned against the seductive poison of easy money and railed against the Fed for enabling its provision to take place on what was then an unprecedented scale.

Writing of the 1924 credit expansion, he excoriated the Fed's open market purchases of that year, saying:

u2018..this additional bank credit was not needed by commerce and it went predominantly into securities: in part into direct bond purchase and in part into stock and bond collateral loans. It also went into real estate mortgages…'

u2018This enormous expansion of bank credit, added to the ordinary sources of capital, created the illusion of unlimited capital and made it easy for our markets to absorb gigantic quantities of foreign securities as well as a greatly increased volume of American security isuues.'

In the five years to the end of 1999, even as the combined total of C&I loans and consumer credit (C&I+CC) on US commercial bank balance sheets rose $400 billion, security holdings and security loans increased $407 billion and real estate loans went up by $460 billion. Exposure to real estate was also heightened by the fact that, of the increase in securities, $210 billion was in the form of liabilities of Government-sponsored agencies, MBS, CMO or otherwise.

Anderson then writes, is only when the Federal reserve banks take the initiative, through their purchases of government securities, in creating that surplus reserves of the member banks are created thereby and that multiple expansion..takes place.'

Fed holdings of government securities today are up 51% or $100 billion since June 1996 alone.

Anderson then highlights the divergence between the behaviour of demand deposits and time deposits, arguing that the more rapid expansion, greater volatility and concentration in the money centres of the latter was proof positive that more money was being created than could be put to productive uses.

Institutional arrangements are naturally very different today, so we cannot pursue this blindly, but note that transaction deposits have actually fallen by $170 billion in the last five years to stand no higher than in 1991 (helping reduce reserve requirements sharply), while non-transaction deposits have risen $1.16 trillion in the same period, so that whereas banks typically had $2.20 of the latter for every $1 of the former in the 20 years preceding the Bubble, they now have $4.74.

Furthermore, the spillover into mutual funds has been terrific. There were $611 billion in assets in short-term mutual funds – taxable and non-taxable – at the end of 1994, a sum which represented 56% of banks' contemporary C&I+CC loans. Five years on, mutual fund assets have risen 137% or $836 billion and now equate to 96% of banks' C&I+CC advances.

Declining liquidity and the deterioration of credit quality were other factors referred to frequently by Anderson as banks overexpanded and simultaneously had to compete for funds with the booming stock market. Chasing down the credit spectrum and skewing the loan portfolio away from u2018quick' or readily realizable assets into u2018slow' ones was one of his recurring themes. Several times he paraphrased Adam Smith to the effect that a banker should know the difference between a bill of exchange and a mortgage.

Consider the following extract from the FDIC Regional Review for Q4'99:-

u2018In order to maintain and grow profits…institutions are expanding into activities such as subprime consumer lending, high loan-to-value mortgage lending, and lending with minimal or no documentation requirements. Rapid growth in syndicated lending to leveraged companies also indicates that large commercial lenders have increased their tolerance for risk.'

u2018Competition has made funding with deposits more difficult. As a result, some institutions are relying increasingly on securitizations and more expensive, market-based sources of funds, which can alter an institution's liquidity position, interest rate risk profile, and operational needs. Institutions have also responded to competitive pressures by cutting costs or merging in an attempt to achieve greater efficiencies. In some cases, deep reductions in operating costs support profits at the expense of less effective operational controls.'

u2018The current economic expansion is closely tied to the ready availability of market-based financing for households and businesses and to wealth generated with the help of rising stock prices and falling interest rates. For this reason, the currently strong economic outlook may be subject to sudden deterioration in the event of market shocks that sharply raise interest rates or lower stock prices.'

Finally, let us conclude with a last, extended quotation from our sage:-

u2018..our position was thus an unwholesome and precarious one. We were busy and active, we were making money, there was little unemployment. But we were going ahead despite a fundamental disequilibrium..'

u2018The continuance of the bank expansion…was, moreover, bringing about ominously unhealthy conditions..our bank assets were growing illiquid. Speculation in real estate and securities was growing rapidly and a very considerable part of the supposed income of the people which was sustaining our retail and other markets was coming, not from wages and salaries, rents and royalties, interest and dividends, but from capital gains on stocks, bonds and real estate, which men were treating as ordinary income and spending in increasing degree in luxurious consumption…u2018

u2018..the time for us to pull up was overdue…the dangers of the course we had been pursuing…were increasingly grave. We could prolong it for a time by further bank expansion and by further cheap money policies, but only at the cost of creating a desperately difficult sutiation later.'

Plus ca change.

Sean Corrigan writes from London on the financial markets, and edits the daily Capital Letter and the Website Capital Insight.