Introduction

US interest rates are just barely off 40-year lows, and despite the Fed raising short-term rates, long-term rates are still very low. Even Chairman Greenspan calls the situation a “conundrum”. Rates have been remarkably low in the face of forces that, in the past, would have driven them higher. I’ve discussed some of these forces in past commentaries.

The most important is the Federal budget deficit which requires borrowing huge amounts that would normally drive rates up. In addition, the Federal Reserve will have added 2.25% to its short-term overnight Fed Funds rate, by this June. Usually long-term and short-term rates move together.

In the following, I explain that the credit market responds to the supply of loanable funds compared to the demand for those funds, with the interest rate as the resulting price. The source that is overwhelming the credit market is the creation of new credit by the banks and the parallel financial institutions that act like banks – such as Fannie and Freddie. Credit expansion is a short-term fix for the economy that drives rates down, but it plants seeds of longer-term inflation that will be hard to control.

The interest rates for 10-year Treasury notes and the Federal Funds overnight rate below shows how low rates are in long term perspective:

Simplified View of our Credit Market

Borrowers demand credit from the credit market and lenders supply credit. If there is an excess of supply from people who want to lend, (which is to say to invest by buying paper like Treasuries), then the interest rate that they will be forced to accept will be much lower than if the reverse is true. The diagram below shows that the lenders have to match the borrowers. If there are too few lenders, then rates will rise to attract more credit, and so the interest rate is the result of the competition between these forces. Supply and demand define the price of traded items, as in any traditional economic model.

The most important supply of credit comes from the financial institutions that create most money. The Federal Reserve is the base money creator for the banking system as they are responsible for printing the paper dollars in our wallet. The creation of money is free to the central bank, and the effect is large. Based on the Fed stimulus, many US banks create far more money than the Fed. Below I discuss how this credit creation system works because it is not widely understood where all this new money (credit) comes from.

The following diagram shows more details of the participants in the credit markets:

The participants along the top supply money, and those on the bottom borrow. On the top left I indicate that the Fed can print money. The much bigger supply comes from the banking system because it can lend out far more new money. There is a whole group of institutions that act like banks lending money which are technically not banks.

The most famous of these are Fannie Mae and Freddie Mac. One little-understood link is that the trade deficit of the US gives foreigners dollars that they reinvest in the US so that the trade deficit becomes a source of money to the credit market. Traditionally, household saving is a supply of credit, but it has become small. Economists, who link savings to investment, where corporations borrow to expand their production, discuss the small savings rate incorrectly saying that if we had more savings we would have more investment. The failure of this link should be obvious in the diagram above, because there are many suppliers of credit to the market, not just savers.

There is plenty of credit for business from other sources. Business credit demand is down, as capital investment is not being made in the US where labor rates are uncompetitive. On the demand side, both Federal and State governments are borrowing, and consumers are buying houses with mortgages. I expand on the components of the credit market in the rest of the paper.

Supply of credit is growing

First, let’s look at the big picture of America’s expanding debt. The chart below shows the amount of all debt outstanding. The biggest contributor to the credit supply is the expanding creation of credit in the banks and non-banks that provide loans of all kinds, most importantly mortgages.

It is the expanding credit used to buy things that is the source of growth in money. A way to think of credit as money is to review how houses are bought: with a small down payment and a big mortgage. It is the mortgage that buys the house.

The debt has grown much faster than the economy as shown in the ratio of the above debt to GDP. Debt to GDP has doubled.

This growth in debt has fueled the supply of credit that keeps money available for lending, keeping interest rates low.

The Federal Reserve is the first source of money but the rest is credit

The Federal Reserve prints our dollar bills, and can create demand deposits out of thin air to buy Treasuries. Its balance sheet shows Federal Reserve notes (dollars) as the liability, and the Treasuries as the asset that backs them up. None of the other items on the balance sheet are big enough to matter and so can be simplified out of the analysis.

Our paper money is backed by the paper debt of the Federal government. The paper dollars are only redeemable for other paper assets. If the Fed decides it want to lower interest rates, it buys Treasuries driving the price higher, and the interest rate lower. It does this by “printing” money. More precisely, it invents an account on its books with the amount of dollars used to buy the Treasuries.

There is no restraint on how much the Fed can buy. It does so with no cost. It just makes an entry on its books to credit the Treasury seller with the money. You and I can’t do that, as it would be counterfeiting. But it is perfectly legal for the Fed.

While there is no legal limit on the Fed, there is a public perception consideration, because if the Fed printed too much money, holders of dollars would become nervous that the dollar might decrease in purchasing power. So the Fed has to act like it is “vigilant about inflation” or some such catch words for public consumption to keep that fear managed.

In point of fact, the money creation at this “Monetary Base” level is relatively contained. Our currency is around $750B with only 4% annual growth. However, in our current system, we use paper dollars less than ever for our transactions. We use plastic. With electronic debits, we can see that the transactions don’t really need to have paper dollars. So we have a system that requires fewer paper dollars and still expands transactions rapidly.

There were constraints on the Fed’s ability to print money in its early years. There was a requirement to have 45% of dollars issued backed up with gold then at the price of 22$. The depression and subsequent revisions lowered the requirement so that today there is no limit on the Fed’s balance sheet. There are 262 M oz of gold held as certificates valued at $11B at 42.22$ per oz. The low price comes from the last official level on the Fed’s books, but that small amount is not considered important. Even valued at $420 per oz it is only $110 B.

The net is that paper money is just that, with no promise to pay anybody anything. Most hard money advocates use this understanding to advocate some conversion guarantee to stabilize the currency value. But what is less well understood is that the creation of credit by our banking system is where most of the money we use comes from. It is not created by the Fed but by the financial institutions of the US and abroad. Some of the institutions are under the auspices of the Fed’s regulation and oversight, but many are completely separate. The Fed regulates banks, so it can place some restrictions on the credit they create.

Bank loans are the source of our money. The loans are used to buy things (like houses and cars), so credit is money. Banks are allowed to loan out almost all their deposits for new loans, keeping just a small “required reserve” of nominally 10% of their deposits, ready to back up any short-term demand for withdrawal of deposits.

Once the loan is used to buy something, the seller puts the money back in a bank, and that can be the basis of another loan of 90% of the deposit which was 90% of the original amount or another 81% of the original loan. This is then cycled though the banking system creating new purchasing power to the extent of one over the reserve requirement.

If all banks loaned up to the reserve requirement, the final situation would be that 9 times the original new money could be loaned out on a 10% reserve requirement. That added to the original is 10 times as much money (credit) as originally created. For a 20% reserve requirement the leverage would be only 5 times.

The traditional textbooks for courses on money and banking say that the reserve requirement is one of the tools of monetary policy that can be used to manage the creation of money and control the value of the dollar. This textbook version misses the reality: When is that last time you heard CNBC saying they are awaiting the Fed’s announcement on reserve requirements? On interest rate we all gather round the news with bated breath, but never on the reserve requirement.

The first explanation is that the Fed is not making changes so it isn’t news. A more detailed look reveals just how much the Fed has relaxed this requirement. The Fed is extremely expansive by cutting this requirement so much that I is irrelevant, and that is why we haven’t even heard about it in the real world of investing where we focus on events that move markets.

The reserves that the banks are required to keep are supposed to be on deposit at the Federal Reserve Bank earning no interest. One would think they would be sizable to be the supposed safety net for our whole banking system. Would they be $500B or maybe $1,000B? You should be surprised that they are only $12B. This tiny sum is used to back a money system measured at the M3 level as $9,650B.

How is that possible? One small answer is the regulations on reserves have been diluted for special circumstances like small banks and for certain kinds of rural deposits. Another bigger reason is that the Fed has allowed the banks to use their vault cash to meet the reserve requirement.

Vault cash is the money that banks keep in their vaults in case a depositor asks for cash. It is also the money in the ATM machine to dispense cash after normal banking hours. The chart below shows that actual money on deposit at the Fed as a reserve is a very small $12 B after the vault cash is applied against the reserve requirement. Also the total requirement for reserves has dropped since a peak in 1989 even as our economy has grown. It is a lax Fed policy.

The point is that there are few restrictions on banks in creating credit. Most of our money is created by the banks, not the Fed directly. The Fed has printed only $750B of Federal Reserve Notes, which are our dollars. The low reserve requirement has allowed our banks to create credit at will. The measure of that credit creation is Reserve Bank Credit shown below as growing about $500B per year to over $7,500 billion, which is ten times what the Fed produced directly.

Non-banking sources provide as much credit as the banks
Non-banking sources of new credit include the Government Sponsored Enterprises of Fannie Mae, Freddie Mac, Ginnie Mae, Sallie Mae. They operate like banks but are not under the control of the Fed and have no reserve requirement. Since they operate with some image of government support, they obtain loans at attractive rates, adding much additional credit.

They issue credit instruments called Agency debt that are close to government Treasuries in price and rate. The chart below shows that the government sponsored mortgage pools, Asset Backed Securities, and GSEs credit created is big at $5 trillion. Total mortgage lending is $10 trillion, about $8 trillion of which is for homes. This huge supply of credit is bigger than even the foreign investment that now totals closer to a net $4 trillion. The combination provides the source for the great supply of credit that keeps rates low.

The Trade Deficit of the US provides a source of credit

The chart below shows the trade deficit history since 1959:

The US is importing $700B more in goods and services than it sells abroad. If the price of oil goes up, and the usage stays about the same the trade deficit expands. If the Chinese adjust their currency higher, the same Chinese goods will cost us more. They are so competitive that other suppliers in the US are not likely to emerge, so the trajectory for the trade deficit is to get worse.

The following chart shows that after consumers purchase foreign goods, foreigners then recycle the dollars they collect from this trade into US government debt by buying Treasuries. The diagram uses Japan as a specific example to describe the process of what all foreign countries do. The Federal government spends $400B more than it collects in taxes, giving the consumer money to spend. The consumer spends $700B on net imports. The foreign factory receives the dollars, and exchanges them at the bank for the home currency shown here as yen to pay its workers. The foreign central bank then has dollars to “invest” by buying US Treasuries. This drives the price of Treasuries higher which keeps US interest rates lower. So our trade deficit becomes a ready source of credit and is helpful in keeping rates low.

There was a time in 2004 when the Bank of Japan (BOJ) was further intervening and buying even more dollars in the exchange market than provided by the trade surplus. They printed new yen to drive the US dollar higher. The stated goal was to keep its exports affordable to the US and to China (which pegs its currency to the dollar). This policy failed, partly because the lower interest rates made investing in dollars less attractive to others, so the dollar didn’t rise much. The intervention has not occurred after the beginning of Japan’s new fiscal year starting April 2005. The point is that foreign banks have helped keep US rates low.

Foreigners have funded our housing boom and provided enough credit that the growing federal deficits have not driven interest rates up. The US credit market matches the amount borrowed and lent. The accumulated foreign contribution of $4 trillion of lending (investment) has provided the credit for the borrowing by the US government, whose debt held by the public is now similar in size to the accumulated foreign loans to the US. The chart below shows the size of Federal government debt and the foreign accumulated current account debt to point out that foreigners are funding credit at comparable level of the government debt. The result is that the US government deficit has not crowded out the credit market and driven rates up.

If foreigners were to look for other investments, such as gold, or to cash in their current investments by buying assets like stocks or real estate, there would be a big increase in the amount of dollars within US borders, and a big increase in US prices. The implication of impending inflation is that investors would see the risk, and require higher interest rates to cover their potential loss to inflation.

Foreign central banks have also bought Agency debt of Government Sponsored Enterprises like Fannie Mae, which then provide money for housing. That credit to the housing market keeps mortgage rates low.

A combination of forces drives interest rates and the chart below shows the two big forces of the twin deficits:

The arrow away from the interest rate block is intended to show that the influence of the trade deficit is to decrease pressure on inflation and hence on interest rates. Consumers spend a portion purchasing foreign goods. The foreigners then recycle the dollars they collect from this trade into the US government debt by buying Treasuries and Agency debt of Government Sponsored Enterprises like Fannie Mae, which then provide money for housing.

As housing is supported, consumers feel wealthier, extract equity from their houses, spend, and keep the economy moving. A healthy economy keeps profits growing, so stocks stay high, also supporting the wealth of the consumer. A strong economy supports wages and consequently consumer spending.

The result of a strong economy is higher tax revenue, which can help keep government deficits lower. A problem shown on the right side is that war costs can expand the budget deficit and higher oil prices can limit consumer spending on other items. Much is simplified out of the above explanation, but the value is that we can see the biggest and most important money flows.

The problem with these related items is that if the spiral were to reverse, where the consumer is not able to spend, then the self-destructive events could feed back to make things even worse. The slowing economy could cut tax revenues, increasing the budget deficit, raising credit demand, and thus interest rates. The consumer would slow spending, which would cut foreign recycling of trade deficit, which might slow the flow of money for housing and covering the budget deficit.

That would raise rates, slow the economy more, and lead to serious recession. The problem of the big debts and the way they are supported by outside lending, and continuing expansion of credit, is that when the current Virtuous Cycle of our credit growth reverses, it could turn into a self-destructive Vicious Cycle.

The demand for credit will grow more in the future

The US government deficit will grow to unsustainable levels. The US government now borrows $400B per year. The Social Security Trust funds are now in surplus and provide $200/ year. So the deficit is closer to $600 B on an ongoing basis without this funding.

The future obligations of retiring baby boomers are calculated at the astounding present value of $40T, a huge requirement for the government going forward. The chart below shows an analysis done by Alice Rivlin and Isabel Sawhill showing how big the requirements for retirees could be:
www.brookings.edu.

While the demands for federal deficit spending are now large, they are being handled by expanding all credit, and by foreign investment. The long-term worry is that the demand will grow faster than the supply, eventually leading to much higher rates. The Austrian School of economics emphasizes money creation as the source of inflation; the quantity of money compared to supply of products dictates inflation and interest rates.

Both views – supply/demand of credit and the money creation perspective – are relevant to the setting of interest rates. In the longer term the Austrian view will prevail, but for now the expansion of credit is dominating.

My conclusion

The US Credit Market enjoys the benefit of expanding dollar supplies of credit from the panoply of sources of financial institutions built on the base of expanding credit from loans on everything from houses and cars to credit cards and exotic derivatives. The participants are as big outside the banking community as in it. They combine to fund the expansion of all credit at about 8% per year so that total credit as a % of GDP has doubled from 150% of GDP in 1972 to 300% in 2005.

This great supply of funds for loans means that the competition for places to park money keep rates low. The special benefits of the trade deficits are that foreigners have few alternatives but to reinvest their dollars, mostly in our government securities, thus keeping rates low and the dollar supported. But the long-term result of the expansion of credit is to plant the seeds of inflation, as prices of everything will rise with more money chasing goods and services.

The US avoided a serious recession in 2001 by letting the consumer expand his spending by borrowing. We now have more debt than ever, not only internationally from the trade deficit, but also for government and for mortgages. If foreigners were to consider other options for holding these dollars, there could be a glut of dollars in the world that would drive the exchange rate downward and prices in the US upward.

If inflation rises, US interest rates would rise, and many parts of the economy could turn down, such as housing and cars, as consumers cut back spending because loans become more expensive. Because of the size of the amounts involved, and the speed of today’s currency and interest rate markets, the shift could move very fast in a downward spiral of higher rates and slowing economic growth, something dubbed stagflation in the 1970s.

The long-term effects of the expansion of credit mean that there will be too many dollars chasing world goods at increasing prices. The most prominent example is in the world’s largest commodity market: oil. The US trade deficit will lead to a weaker dollar, which means alternatives to US-dollar-denominated assets must be an important part of a portfolio.

Copyright Bud Conrad and Macronalysis June 2005