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The Chicken or the Egg

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By RodgerRafter
January 11, 2006

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Which comes first, the Federal Deficits or Credit Expansion?

I read in a book somewhere (I think it was the Creature from Jekyll Island) that all money comes from Federal Debt. If the government were to pay off its debt then all money would disappear. Based on this, it is no surprise that when the Congress finally achieved a balanced budget in 2000, the economy stalled and went into recession. It might be safe to say that historically credit expansion required a government willing to run up its national debt.

There's no question in my mind that deficit spending stimulates the economy by making consumers think they have more wealth than they really possess. However, I'm not comfortable with the view of deficit spending being primary in today's financial system. The Fed creates money when it purchases government debt, but as Bernanke and others have mentioned, they could monetize anything. Some observers think they've secretly been monetizing US stock futures to prop up the markets whenever there is a significant sell off or a reason to want to cause a rally. Personally, I think that the US Treasury is behind those mysterious 2:00 rallies, rather than the Fed, and that the Fed hasn't needed to be covert in its use of stimulation... yet.

Member banks can use treasury securities (federal debt) as collateral when they want to borrow funds through the overnight window at the Fed Funds rate, but they can also use Agency debt and other mortgage backed securities. Agency debt from Fannie Mae grows as a result of credit expansion and using Agencies or MBSs as collateral is just one way that credit expansion itself can lead to more credit expansion, eliminating the need for increasing government debt.

Reserve requirements used to be around 10% to provide a measure of stability among banks, but for many lending institutions now reserve requirements are almost meaningless. These requirements kept banks from lending out too much money, and from exposing themselves to failure in the face of a slowing economy and mounting defaults. They've decreased in size, allowing banks to increase profits by increasing their carrying costs while dramatically increasing the level of risk of failure. For many banks and lenders (in the push to lend more and keep costs low) reserves are the result of overstated profits and equity, and therefore merely a figment of accounting imagination. Additionally, loans are often "sold" or "financed" in ways that eliminate the need for reserves but still place the liability for default on the lender. I believe that the banks argue for this accounting and regulatory treatment because they want to maximize short term profits and executive bonuses and don't care if it eventually will mean total loss of equity for shareholders or a credit crisis in the greater economy.

Getting back to the core question, I now believe that credit expansion is currently necessary to fund a high rate of expansion in US government debt. Foreign investors and central banks have been the prime beneficiaries of mounting consumer and mortgage debt as consumers have taken their borrowings and used them to fuel the trade gap. However, the rate of foreign purchase has slowed and money still flows into the treasury with each new treasury auction. The accounts that make up M3 have been growing rapidly as a result of credit expansion and especially in the face of slowing purchases (and even sales) by Japan and China. Banks generate interest for many of these accounts by purchasing treasuries and agency debt. In this way credit expansion fuels both the federal deficit and continued mortgage credit expansion.

I heard countless times from countless sources over the last few years that the treasury would be in trouble if foreigners stopped buying up US debt. Now it appears to me that the bigger trouble will be if M3 stops expanding rapidly enough to channel institutional money funds and large deposits into the treasury market. Consumer credit has slowed for two consecutive months (Oct-Nov) and the mortgage market has also declined. The other big sources of credit expansion is likely loaning to hedge funds and short term financing of US corporations. Leveraged buyouts are coming back in style and are serving a duel purpose of propping up stock prices and expanding credit. Hedge funds may be slowing their growth, but the promise of more pension fund money creates the opportunity for continued, accelerated expansion through borrowing to increase their leverage. If the consumer stalls in the face of overwhelming debt burdens and falling real wages, there is still the possibility of even more aggressive action in the financial markets to make up the difference.

I think a big test will come in February when tax receipts slow and the US Treasury must begin the process of raising over $100 billion in a relatively short period of time. During that time we may see better whether increase in government debt lead to increases in credit expansion, or whether credit expansion is needed first to fund the expanding government debt. If credit expansion isn't sufficient, then we could see a sharper rise in interest rates that could draw more money out of other markets, drive down asset prices and cause actual credit contraction in some areas (like the mortgage markets).

If bank failures got out of hand, it could conceivably lead to a repeat of the Great Depression. The Fed typically monetizes in billions of dollars, but there are potentially trillions of dollars in bad debts out there. When Japan's real estate and stock market bubbles collapsed, Japanese banks had tremendous losses and technically had failed. They were allowed to remain open by essentially pretending that the bad debts weren't there. Trillions of Yen were created by the BoJ, loaned to banks and used to purchase equities off of balance sheets of banks. Zero percent interest rates also enabled banks to also slowly profit their way back toward solvency. In the end, many of the loans to banks were eventually forgiven, completing the cycle of letting the banks profit wildly during the bubble years without paying the consequences for their role in creating the bubbles through excessive risk taking. In the US, as in Japan, the central bank serves the interests of bankers first and the economy second. Negative real rates were used for a couple of years here to bail out banks for their role in creating the stock market bubble. It will be interesting to see what measures are taken if/when the resulting credit bubble begins to unwind violently.


Getting back to the question, my final opinion is that credit expansion comes first and makes government deficit spending possible. If credit expansion exceeds growth in federal deficit spending then the economy temporarily thrives on the surplus liquidity and opportunities for profit. If the government overspends faster than the credit markets can provide for, then all the risk that has been built up through credit expansion can come crashing down on itself and can cause an economic slowdown in proportion to the scope of risk taking during the expansion. Time will likely tell if this opinion is correct.


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