Real and Illusory Credit

By: Fred Sheehan | Wed, May 8, 2013
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"When Ro-Ro goes No-No" expounded upon the ultimate futility of conjuring illusory wealth. Bernard Connolly's analysis, "Rethinking the Rogoff-Reinhoff Thesis," made the case. Connolly wrote This Time is Different: Eight Centuries of Financial Folly, "is largely an exercise in measurement rather than theory (while many of the data in the book are new, little or none of the theory is), it can give rise - and has given rise - to dangerously misleading popular interpretations of the data which its authors had so painstakingly assembled." Connolly then offered the theory; what follows is complementary data.

A cheat sheet: The annual increases in U.S. non-financial credit - 1995: $654 billion; 1997: $793 billion; 1998: $999 billion; 1999 $1.012 trillion; 2002: $1.429 trillion; 2004: $2.096 trillion; 2006: $2.388 trillion: 2007: $2.552 trillion. Between 1995 and 2007, non-financial credit in the U.S. inflated from $13.141 TN to $32.621 trillion, or 148%. (From the Prudent Bear "Credit Bubble Bulletin," May 3, 2013.

This is what Federal Reserve Chairman Ben S. Bernanke calls "The Great Moderation." He and his comrades have attempted to erase what we have learned since the dawn of time. We await their proclamation that the months have been changed to Vendemaire, Brumaire, and Frimaire. In the end, they cannot pin nature under their tommyrot research, that will decay to dry rot.

The 1920s bubble is instructive. From David Stockman's The Great Deformation: The Corruption of Capitalism in America: "[T]he financial bubble was not just domestic. It began way back in 1914 when the 'guns of August' suddenly transformed the United States into the arsenal and granary of the world and an instant, giant global creditor."

America had been a debtor nation for 300 years. American citizens owed Europeans $3 billion 1914; Europeans owed Americans $3 billion in 1919. The U.S. bustled with commercial activity before the War; Europe was in ruins after the peace. In the words of historian William E. Leuchtenburg: "These figures represent one of those great shifts in power that happens but rarely in the history of nations."

Stockman continues: "A crucial element of the postwar stabilization process, especially in central Europe and commodity-producing nations of Latin America, was the $10 billion of foreign loans underwritten by Wall Street. That was the equivalent of $1.5 trillion in today's economy, and went to borrowers ranging from the Kingdom of Denmark and German industrialists to municipalities from Hamburg to Rio de Janeiro."

Wall Street bond houses played a role not much different from the People's Bank of China in recent years (or Cisco and Intel during the Internet years). This was vendor financing: lending currency so that others would have the funds to buy the lenders' products. Foreigners, for the most part struggling or devastated by the Great War, received Wall Street funding to buy U.S. crops, cars, and radios. On the home front, booming foreign sales spurred capital investment, consumer spending, an unsustainable real-estate escapade, and, of course, the Crash That Made the Decade Famous, in stocks.

Credit flowed. The credit system had been nationalized during World War I, through the fortuitous creation of the Federal Reserve System. In outline, the Fed boosted credit through two initiatives.

First, it greatly reduced reserve requirements of the banks. The average reserve requirements of all banks prior to the Federal Reserve Act were estimated at 21.09%. By the 1920s, the Fed, having distinguished between demand and time deposits, had reduced the reserve ratio against demand deposits (to 7% - 13%) and against time deposits (to 3%).

Banks lent as one might expect. Demand deposits did not grow in the 1920s. Between 1921 and 1929, commercial loans - those loans for commerce and industry that fulfill the traditional function of banks - fell, from $12,844,000 to $12,814,000. Time-deposit lending, with lower reserve requirements, boomed. Real-estate speculation and securities lending were part-and-parcel to degenerate gambling propensities encouraged by Prohibition. Between 1921 and 1929, loans on securities rose from 19% to 28% of bank assets; loans on real estate rose from 3% to 8%. (Commercial loans fell from a 53% composition of all Federal Reserve member banks' balance sheets to 36%.)

Mortgage debt rose through the decade, from $8 billion in 1919 to $27 billion in 1929. The fastest acceleration in new mortgage debt was between 1924 and 1927 (even though construction peaked in 1926) when mortgage debt rose from $15.5 billion to $24.2 billion - a 57.4% rise, or, a 16.3% annual rise. (Not all of this was bank lending.) Are you paying attention Canada? (See "Time to Go Short: Here Come Those Experts Again." Yep, any minute now.

A second Fed initiative was open-market operations. Today, the Fed enters the market every day, fixing interest rates while electronically transferring dollars it has created. These are open-market operations. Benjamin Strong grew addicted to more and bigger open-market operations through the decade. (Don't they all?). He had initially opposed such personal intervention most vehemently: "What I can't understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal."

Such shenanigans were not contemplated when the Federal Reserve System was rushed into law. Only "real bills" were accepted for rediscount. Government bonds need not apply. By 1927, Benjamin Strong was freelancing as America's super-government. Federal Reserve governor Adolph Miller testified to Strong's mad-scientist scheme in 1932: "[T]he Federal Reserve [put] money into the markets, not because member banks asked for it by offering paper for rediscount, but in pursuance of a policy of our own which in effect said, 'We shall not wait to be asked to provide increased money through rediscounts; we will operate upon our own responsibility....'"

Returning to Bernard Connolly's interpretation of This Time is Different, today's fantasy credit will crumble. It is backed by fanciful dreams, but not by money. James P. Warburg, a financial adviser to President Franklin Roosevelt who then became a fierce opponent of FDR's whimsical schemes, wrote in The Money Muddle (1934): "Credit cannot create money for capital investment. The credit machinery can only direct the flow of capital into productive investment, but the capital must be there - it must have been created, or be in the process of creation, by the savings out of incomes. Credit can, and frequently does, anticipate the creation of capital, but when it does, the capital it creates 'out of thin air' will again vanish into the air, if the anticipated savings do not materialize."

Rediscounted commercial bills are backed by trade or inventory. It's the real thing. Strong and Bernanke's bilge is backed by faith or absent-mindedness.

The populace at large was party to the imbalances. Between 1923 and 1929, worker's wages rose 11%, which did not keep pace with corporate profits (up 62%) and dividends (up 65%). Radio sales rose from $60 million to $852 million. Along with cars, vacuum cleaners, refrigerators, silk stockings and movie tickets (by 1918, the movie business was already one of the ten largest industries in America) there was a lot more money spent than earned.

How was all this purchased? "Installment" debt financed 75% of all radio purchases and 60% of all automobiles and furniture. [Margaret Mitchell wrote of 1926: "Everyone I knew had a car, a radio, an electric ice box and a baby that they were buying on time (everybody except me!)."] Over 40% of department store sales were purchased on credit by 1926. Margin loans blossomed in the second half of the decade. At $16 billion in October 1929, this source of instability equaled about 18% of stock market capitalization. Rising demand for credit raised borrowing rates.

Bank customers, both individuals and corporations, instructed banks to lend their deposits in the call-loan market. It has been estimated that corporations (including U.S. Steel, General Motors, AT&T, and Standard Oil of New Jersey) had lent $5 billion to New York Stock Exchange purchases by September 1929. They were drawn to the call-loan market as rates rose to 10%. In consequence, total securities loans increased from $12.4 billion on October 3, 1928 to $16.9 billion a year later. Foreign banks also lent in New York, while neglecting the local tool-and-die manufacturer in Linz or Pinsk or Omsk.

This has a modern ring to it. The Internet years. The mortgage scramble. And now, the central bankers' Disney dust. Assets far and near are bubbling. What will happen to inventory chains and their suppliers when those buying on time falter?

Reading the weekly list of international issuers in Doug Noland's Credit Bubble Bulletin could be interpreted as a shift of wealth from the west to the east or bubbleitus spread to countries with oddly distributed consonants.

A comparison:

Week of April 10, 2009:

"International debt issues this week included Korea $3.0bn, KFW $3,0bn, Suncorp $2.5bn, and Hutchinson Whampoa $1.5bn."

Week of April 26 2013:

"International issuers included African Development Bank $2.17bn, Boligkreditt $1.0bn, Costa Rica $1.0bn, Neder Waterschapsbank $900 million, Toronto Dominion Bank $2.25bn, Transport de Gas Peru $850 million, Schaeffler Finance $850 million, Panama $750 million, Turkiye Bankasi $750 million, Uralkali $650 million, Sinochem $600 million, Promsvyazbank $600 million, Saci Falabella $600 million, Andrade Gutier $500 million, Korea Resources $500 million, Credit Bank of Moscow $500 million, Far Eastern Shipping $500 million, Banco Sudameris $300 million and International Bank of Reconstruction & Development $250 million."

After 1929, the phony credit evaporated. Stockman writes: "[T]he trouble was that this prosperity was neither organic nor sustainable. In addition to the debt-financed demand for American exports, stock market winnings and the explosion of consumer debt generated exuberant but unsustainable purchases of big-ticket durables at home. So, when the stock market finally broke, this financially fueled chain of economic explosion snapped and violently unwound.

"The first victim was the foreign bond market, which was the subprime canary in the coal mine of its day. Within a few months of the crash, new issuance had dropped 95 percent from its peak 1928 levels, causing foreign demand for U.S. exports to collapse. Worse still the price of the nearly $10 billion of foreign bonds outstanding also soon plunged to less than ten cents on the dollar, meaning the collapse was of the same magnitude as the subprime mortgage collapse of 2008."

The interlinking relationships of the economy were now collapsing in unison rather than inflating. Stockman continues: "Needless to say, [the] 75 percent shrinkage of auto sales cascaded through the auto supply chain, including metal working, steel, glass, rubber, and machine tools.... The collapse of these 'growth' industries also caused a withering cutback in business investment. Plant and equipment spending tumbled by nearly 80 percent between 1929 and 1933, while nearly half of all the production inventories extant in 1929 were liquidated over the next three years. The unprecedented liquidation of working inventories - from $38 billion to $22 billion - amounted to nearly a 20 percent hit to GDP before the cycle reached bottom.

"Overall, nominal GDP had been $103 billion in 1929 but by 1933 had shrunk to only $56 billion. Yet the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and equipment, and consumer durables. [Bernanke and Yellen claim open-market money printing in 1931 would have sparked an economic recovery. This is their foundation for quantitative easing. - FJS] These components declined by $33 billion during the four years after 1929 and accounted for fully 70 percent of the decline in nominal GDP."

In this spirit, it is worth looking further into Bernard Connolly's critique of Rogoff-Reinhart's non-theory: "The underlying problem is dynamic inefficiency, which reduces future consumption possibilities; and this, in turn, means that much of the recent and current capital formation, notably in the United States, has been based on excessively optimistic expectations of future demand. To prevent a hole from emerging as today becomes tomorrow, more and more incentives to keep on bringing spending forward from the future have to be given, whether in the form of reduced 'risk-free' bond yields, or attempts to ease credit conditions, or fiscal 'stimulus." Such attempts "to bring spending forward and to avoid a near-term collapse simply reduce the (realistically) anticipated rate of return on capital still further, in a vicious downward spiral."

In June 2013, the Federal Reserve released its Survey of Consumer Finances. It showed the wealth of American family was $77,000 in 1992, rose to $126,000 in 2007, and fell back to $77,000 in 2010. The Fed is responsible for this Ferris wheel. Quoting page 2 of Panderer to Power: "From the time Greenspan was named Federal Reserve chairman until he left office, the nation's debt rose from $10.8 trillion to $41.0 trillion. He usually referred to the "debt" as "wealth." This image matched what he was selling - first stocks, then houses. He expanded money and credit; he oozed praise for derivatives. The larger volume of credit shrunk the consequences of immediate losses. It was easy to overlook areas of the economy that had shriveled and the instability of finance that compounded over the past half-century. In early 2007, this massive inflation of paper claims, many of which were claims on abstractions rather than on material assets, tottered then collapsed: the first to go was the subprime mortgage market."

On April 24, 2013, the Republic of Rwanda issued a $400 million, 10-year Eurobond with a yield of 6.875%. The issue attracted more than $3 billion, "allowing bankers to tighten the yield to just 6.875 per cent, comfortably below the 7 per cent to 7.5 per cent that had initially been expected." (Financial Times) Some potential buyers of this single-B issue were deterred because of its small size. Bonds below a $500 million limit are excluded from "influential" bond indices. Half of the foreign currency flowing into Rwanda last year came from foreign remittances. (Rwandans working abroad.) Ten percent of GDP is foreign aid.

Except for the (suspect) higher coupon, the symmetrical return to Earth of the Rwandan bond issue will not differ much from 10-year U.S. Treasuries.


Frederick Sheehan writes a blog at



Fred Sheehan

Author: Fred Sheehan

Frederick J. Sheehan Jr.

Frederick J. Sheehan

Frederick J. Sheehan Jr. is an investor, investment advisor, writer, and public speaker. He is currently working on a book about Ben Bernanke.

He is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and co-author, with William A. Fleckenstein, of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve (McGraw-Hill, 2008). He writes regularly for Marc Faber's "The Gloom, Boom & Doom Report."

Sheehan serves as an advisor to investment firms and endowments. He is the former Director of Asset Allocation Services at John Hancock Financial Services where he set investment policy and asset allocation for institutional pension plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S. Naval Academy. He is a Chartered Financial Analyst.

Copyright © 2007-2014 Frederick J. Sheehan Jr.


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