Shadow lenders have left...deflation to continue

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DrKrbyLuv
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Shadow lenders have left...deflation to continue

Ellen Brown has provided a great article about shadow lending and it's impact on our economy (Complete Article Link):

The problem today is that bank lending has fallen off dramatically. The Fed has been creating money as fast as it can find federal and bank borrowers to take the money off its hands, yet it can’t keep up with the rampant deflation in the real economy. Bank lending has dropped by 17 percent since October 2008, when the credit crisis was already in full swing. “There has been nothing like this in the USA since the 1930s,” says Professor Tim Congdon of International Monetary Research. “The rapid destruction of money balances is madness.”

The reason the level of bank lending is so important is that virtually all of our money today originates as loans created by private banks. Most people think money is issued by the government, but the only money the government creates are coins, which compose less than one ten-thousandth of the money supply – about $1 billion out of $13.8 trillion (M3). Coins and dollar bills together make up only about 7% of the money supply. All of the rest is simply written into accounts on computer screens by bankers when they make loans.

And this is the real source of the exponential inflation in the money supply in the last half-century.

As Robert Hemphill observed in the 1930s, if we had no banks we would have no money, other than pennies, nickels, dimes and quarters. When old loans are paid off and new ones aren’t taken out to replace them, the money supply shrinks; and lately, new loans have fallen off dramatically.

Why? Banks insist that they are lending as much as they are prudently allowed to. The problem is that they have reached the lending limits imposed by the capital requirements set by the Bank for International Settlements. In the years of the credit boom, banks were able to leverage their capital into far more loans than are being created now. This was because loans were taken off the banks’ books by investors, allowing the same capital to be used many times over to generate new loans. These investors, called “shadow lenders,” have now exited the market, and they are not expected to return any time soon. They left after it became clear that the credit default swaps allegedly protecting their investments were only as good as the solvency of the counterparties (typically AIG or hedge funds), which had a bad habit of going bankrupt rather than paying up. An estimated $10 trillion disappeared from the money supply along with the shadow lenders, and the Fed has managed to get only a few trillion back into the market as replacement money.

“Shadow Money”: Another Blow to the Quantity Theory of Money

Along with the disappearance of the “shadow lenders,” there has been a dramatic decline in something called “shadow money.” The concept of shadow money was presented by two economists from Credit Suisse, James Sweeney and Carl Lantz, in a Bloomberg interview in May. As explained on DemandSideBlog, shadow money is money the market itself creates in order to finance a boom -- “money” in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral is used as near money or shadow money. Shadow money can include government bonds, private bonds, asset-backed securities, credit card debt (which can be incurred and paid off without drawing on the M1 money stock), and even real estate (when it is highly liquid and easily tradeable).

In a fuller explanation on Zero Hedge, Tyler Durden (a pen name) quotes from Friedrich Hayek’s Prices and Production (1935). Hayek said:

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognized to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

“. . . [I]t is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.”

Lantz and Sweeney calculate that at the peak of the boom there were six trillion dollars in the traditionally-defined money stock (or money supply). The private shadow stock accounted for $9.5 trillion, and government-based shadow money accounted for another $11 trillion. Thus the shadow money stock dwarfed the traditionally-defined money stock. This can be seen in the chart below provided by Tyler Durden. The blue strips at the bottom, called “outside money,” are dollars printed by the Federal Reserve. The red sections, called “inside money,” are money created as loans by the banks themselves. The green sections, called “public shadow money,” are money created by the government and the Fed as debt (or loans). The purple sections, called “private shadow money,” are the money created as private debt securities by the shadow lenders.

Lantz and Sweeney estimate the total drop in private shadow money (the purple blocks) during the current credit crisis at $3.6 trillion. This has been offset by an increase in public shadow money, both from the massive borrowing needed to finance the federal deficit and from the aggressive liquidity measures taken by the Fed in converting private securities into loans.  Those measures helped prevent an even worse drop in the commercial money supply than actually occurred, but they were not sufficient to eliminate the credit squeeze from lowered commercial lending, which continues to act as a tourniquet on the productive economy.

Moreover, the lending situation is slated to get worse. At the G20 meeting in Pittsburgh in September, deadlines were set for increasing the amount of capital that financial institutions must set aside to cover their loans. That means that credit could get even tighter, further shrinking the global money supply and precipitating an even deeper depression.

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