The Banker's Dilemma

Talk of impending inflation has been everywhere - CNBC, in the print media, on the internet and on Seeking Alpha. But in the past months, there has also been discussion of deflation. Do we know what is going on? Is there no clear direction for the economy?

Each of the above questions has the same answer: Yes, we are getting an understanding of what is going on, but, also yes, we don’t have a road map for where we are going. I call the nexus of this conundrum, “The Banker’s Dilemma”.

The Fed and the U.S. Treasury have increased the money supply dramatically, printing money and infusing capital into financial institutions. The Fed has announced the intention of utilizing “quantitative easing” which involves buying debt, both private and treasury, in as great a quantity as is necessary to provide adequate bank reserves against future degradation of debt assets, plus provide money that can be lent out by the banks to ease the credit squeeze. The big unknown so far is: How much is necessary?

The counterparties to the Fed trades in “quantitative easing” are the banks. When the Fed buys debt from banks, the price of the debt is driven higher (higher demand), lowering the interest paid. This diminishes the return the banks can receive if they acquire more similar debt with the money received from the Fed and, therefore, should encourage the banks to make new loans to obtain higher interest income. The low rates on treasuries could reduce the profit margin of banks to near zero (or below).

The Dilemma

So the banker’s dilemma is a choice between two paths:

1. Hang on to treasuries held in reserve against future failures in the remaining tangled web of debt from the past several years; OR
2. Increase lending to improve margins and retain (or regain) profitability.

The risk with choice one is negative profitability, but retained solvency. Of course, negative profitability can eventually produce insolvency. However, banks can lose money for many quarters and remain solvent if they have sufficient reserves.

The risk with choice two is insolvency. Of course, the bank may achieve operating profitability, but if reserves become insufficient it will be closed by regulators.

The banker may not have been prudent in acquiring the mountain of debt that now weighs down his balance sheet. But now, with new-found wisdom, he recognizes a lack of appetite for risk and a desire for survival.

The banker, chasten by his previous frivolity, is now taking the steps necessary to ensure solvency. There will be plenty of time later to pursue higher profitability again. In the event of deflation, the banker is secure because his reserves will increase in value. In a subsequent article (The Banker’s Choice), I will discuss how the banks appear to be using their reserves.

The Velocity of Money

An important factor that the banker is affecting when increasing reserves rather than making loans is the velocity of money.

Deflation as a monetary phenomenon can be considered a decrease in the nominal value of all transactions. In other words, if all transactions in one period of time have a nominal value of $100 and the same transactions in a later period of time have a value of $80, there has been a 20% deflation between the two time periods.

Milton Friedman made popular (created?) the following equation:

nT = V M

where nT represents the nominal value of aggregate transaction, V is the velocity of money and M is the quantity of money in circulation. In the simplest view, velocity can be considered a multiplier representing the number of times a dollar is exchanged between parties (each exchange is a transaction) in a specified time period.

Going back to our simple 20% inflation example, that can occur with no change in the amount of money in circulation if V increases by 20%. Or that can occur with a 20% increase in the money in circulation if the velocity of money is not changed. In practice, both V and M change and the new product of V times M is 20% higher to produce 20% inflation.

What has happened in the past couple of decades, and accelerated in the last few years? There has been a steady increase in M, but the big change was in V. The velocity of money involved in creating a humongous pile of financial paper became very large, allowing the inflation of a huge bubble of credit. Why didn't this show up as inflation? Only because we do not measure inflation by following the prices of such things as stocks, highly leveraged debt obligations, credit default swaps, etc.

True, the cost of houses also increased in price and that is included in inflation measurements, but that was only a small factor in the list of measured factors. So we saw only moderate inflation (as measured and reported) over the past decade. The real inflation was in an area of commerce (finance) not measured and reported.

So now we come to 2008. The value of V has collapsed dramatically, and the nominal value of aggregate transactions has fallen in step. There has been massive deflation in financial assets because V has become so small. If you print enough money to double M (the currency in circulation) and V falls by 75%, the value of aggregate transactions falls by 50%, or the economy suffers a 50% deflation.

The Race is On

Now the race is on. Can we print money faster than velocity slows? If we can, deflation can be slowed, then stopped and, finally, reinflation started. If we don't print money fast enough deflation is not stopped. Persistent deflation is self-feeding and can become entrenched in the economy. Everyone holds tight to every dollar because it will buy more tomorrow than today. Consumption dries up. Investment in new facilities dries up. Deflation freezes out growth and economic contraction spirals downward.

In the preceding paragraph, I discussed what happens if we lose the money printing race. What happens if we win? All of a sudden a point comes when the product of V times M starts to increase. If we could identify that point and stop printing money in a timely manner, the growth in aggregate transactions (V times M) might continue to grow in a moderate way and inflation coming out of the deflationary period could then be controlled without drastic actions such as very high interest rates. The problem is, it is unlikely that the proper point in time to slow down or stop the printing of new money will be recognized. The most likely result is the deflationary period is followed by a period of above normal inflation.

The choice of policy makers is to risk a deflationary spiral into another Great Depression or risk the over production of money and accompanying inflation down the road. Our policy makers have chosen to risk the future inflation rather than the economic death spiral.

To conclude, the government can print vast amounts of money and we can remain in deflation if the money is kept in a warehouse (bank balance sheets) and not on the street (used in exchange for goods and services). Eventually, though, one of two things must happen:

1. Deflation persists until all economic activity grinds to a halt and people live at a subsistence level (think hunter-gatherer). OR
2. Money starts coming out of the warehouse, deflation stops and the risk of inflation returns.

As of right now, individuals and corporations are cutting back on spending and investment. This contributes to a lower velocity. If most of the money created by the TARP and Fed actions remains in bank reserves, there is little increase in the VM product. If this continues for some time, we will move further toward outcome 1, above.

Comments

[Moon Kil Woong:]

I think many institutional banks, not more prudent regional or local banks, have a bigger worry. They have on book and off book accounting. The off balance sheet Base I accounting makes them insolvent. This holds their CDS and derivatives bets and may vastly exceed the liability of their on book numbers. In order to clear it without going bankrupt they recognize it slowly (maybe 10-20 years). Thus they have little left over for anything else and keep it parked at the Fed in case some decision comes down forcing them to book their off balance sheet gambles (I can't rightly call them investments) which are largely negative.

How do we know they are negative? Because for the most part if they were positive they would have moved them to the normal balance sheet (except when they have so many gains that they want to recognize them over time to offset losses or make a steady stream of profit no matter what happens to their business). The bracketed case is what Fannie Mae did to hide their sinking economic frofile and pay off their executives that are still sitting pretty in their "public company".

Anyway, the Fed has helped them out giving them interest on their Fed deposits. This allows the Fed to backstop everything and gives them more power which they apparently like even if they never use it to actually help anyone. So now everyone is happy except for the fact this arrangement sucks $ out of the economy and leaves it stuck in limboland (the fed). The Fed would normally view this as a way to sterilize the effects of too much money and prevent inflation. This makes you wonder why they are doing it if they are trying to stop deflation and de-leveraging.

Either it's because there is something very nasty going on with the money supply and future inflation because of too much money and not enough goods and services, or because they want to cause dfelation. Now it is our turn to figure out which one it is. The bank's hands are tied. They were tried the second they started hiding assets when Base I accounting took effect after the dot com bubble. It was essentialy like them taking voluntary poison. It worked great for those CEOs who wanted to book profit for bonuses for years and years as they knew they were killing their own company (obviously greed triumphs over corporate survival for them).

Thus the banker's dellema above takes on a whole new shape making it, Guess what's the Fed's strange game. Of course maybe the Fed is just stupid. Nah... even Bernake can't be that dim witted can he?

2008 Dec 28 09:13 AM

[Jason Rines...:]

1) My article conclusion is banks are hoarding cash and will do so for at least a few quarters until they see fiscal stimulus. The loans will be for infrastructure/upward mobility programs that also have a government guarantee.When the banks begin loans, they will be getting there toe wet.

2) Construct - All those derivatives are tied into mortgages which are loans, correct? Wouldn't it be possibe to say the Fed is defending investments owned by the global Central Banks first? I think that is our answer.

2008 Dec 28 10:43 AM

[{5U}:]

The Central Bank is long a bunch of crap. Yes, I think the government is going to try to inflate their investments in an effort to inflate our way out of our problems.

In the long run it seems like another Fannie/Freddie in the making to encourage bad lending by levering up. But apparently that is the Democrat's Mantra.

2008 Dec 28 11:25 AM

[Kevin Walmsley:]

There are other dilemmas.

Banks are now being micromanaged by the Treasury department, who are pushing them to make more loans, but will act punitively when these new loans go bad now that it's the taxpayer, and not the common shareholder, who will be suffering losses. So you can't blame banks for hoarding cash, when the penalty for bad lending might be a Congressional investigation and prison term.

Also, every banker I've ever met loves to make good loans. But in a bad and worsening economy, good luck figuring out in advance which loans will be repaid.

The banking system is broken. And now that the government is now a preferred stockholder in all the big banks, it's screwed completely.

2008 Dec 28 12:31 PM

[Ricard:]

If anyone wanted to read an article that summarizes the current environment, this would be the one. It's been rehashed ad nauseum, but this one succinctly binds all the important pieces. I guess the only question I would have is...how to take advantage of this knowledge?

What I like more about this article is the absence of a gold solution. I'll probably get heckled for saying so, but I think the era of physical money is at an end. The only way gold would return is if we devolved 100 years and lost not only the access to, but the ability to build and use advanced electronic equipment. So much of our monetary system is fired around in bits and bytes that we would never be able to return to the point where lugging around ounces of gold, which would have to be weighed and analysed for content at every exchange of value, would make any sense.

Sure things are bad, indeed, very bad...but is it bad enough that someone will fire a nuke and cause an EMP??

2008 Dec 28 01:26 PM

[dcb:]

Just as the talk about high oil prices signaled the end of the commodity bubble, all the talk about deflation now running around likely signals the near end of our deflationary cycle. We aren't going to have Japan style deflation because our assets weren't as over valued to begin with. Remember the talk about how the tokyo palace was worth more than california. speculators push events to the breaking point and things turn just as quickly!!!

2008 Dec 28 02:25 PM

[Trading to Win:]

Worth a read:

www.theglobeandmail.co...

'A second myth is that Japan suffered more than the United States and other countries will today because its bubble was so much bigger. In reality, the credit and asset bubble that built up in the United States was the biggest in history. At the peak of Japan's bubble, it needed three yen of credit to make one yen of national income. The United States needed eight dollars of credit for every dollar of income. In Japan, the bubble grew for only about five years in the high-flying late 1980s. In the United States, the credit binge has been going on for a couple of decades.'

2008 Dec 28 02:55 PM

[thatguy57z:]

this will give you some in site how it is going to start working. and how they've all ready have it moving foreword go to.
youtub.com/new world order. copy and paste to your web browser

2008 Dec 28 03:08 PM

[thatguy57z:]

this will give you some in site how it is going to start working. and how they've all ready have it moving foreword go to.
www.youtube.com/watch?.... copy and paste to your web browser

2008 Dec 28 03:11 PM

[fatcat:]

The powers intend to inflate for awhile,because thats the only way to erase this massive debt.If its done worldwide,there will be little pain for the masses.The savers and retirees will get screwed,but we always do....

2008 Dec 28 04:45 PM

[jepittman:]

Banks' excess reserves have expanded recently because deposits have increased, new loans have slowed due to the financial panic last fall, while loan payments of principal and interest have continued. Add to that injections of capital by the government and banks have ample liquidity to make loans. Meanwhile the Federal Reserve has lowered short term interest rates to nearly zero.

Every dollar on a bank's balance sheet has a cost. These costs have been and will continue to fall, primarily but not limited to, deposit rates falling. Under normal circumstances these deposits can be invested in short term government obligations or loaned to other banks at the prevailing 'fed funds' rate. Recently however there are no returns in these securities that exceed banks' cost of funds. Therefore banks are facing the dillema of (1) Do not lend and face the relentless erosion of an already depleated equity base OR (2) lend in a bad environment at above cost of funds rates and hope conditions improve over time.

In my opinion most banks will choose option #2. Bankers know their markets. As the October panic subsides bankers will be contacting their customers with loan offerings at rates cheaper than they have been in years. Businesses will have opportunities to make longer term investments that will look less expensive in light of lower materials and energy prices and cheaper financing. Home buyers will find ample mortgage money available at rates approaching historic lows for homes at prices likely significantly discounted from recent levels.

These incentives will take time to play out so a quick return to GDP growth is not likely. However IMO the stage is set for a gradual recovery to build as we move through 2009. The deep recessions of the mid 1970s and early 1980s led to 'V' type recoveries. Recoveries from shallower recessions tended to be more 'L' shaped. Since the current recession is generally considered to be severe, we may be in for a sharper recovery than normal when it arrives.

The stock market is IMO currently a hostage to the creditmarket turmoil. The recent improvements in the credit markets need to continue into 2009 if we are to put in a believable bottom in the equity markets. I am watching for credit spreads to narrow considerably as well as mortgage rates continuing to fall as evidence that this trend is continuing.

Finally, conservative investors have lost their yield securities. We are now living in a 2% and under world that looks to be with us for at least several quarters. Many people will never venture out the risk spectrum but for those who need income there is now no alternative. High grade corporate debt yields have declined significantly already (see LQD chart). Next will be BBB rated debt followed by high dividend paying stocks and lower rated corporate debt. As these yields gradually fall, the S&P 500 should continue to stabilize and gradually rise. There could be a fairly significant bear market rally in January and early February. More substntial gains will need to wait for more evidence that GDP has bottomed.

Thanks to Mr Loundsbury for his fine article. Looking forward to many others.




On Dec 28 10:43 AM iThinkBig wrote:

> 1) My article conclusion is banks are hoarding cash and will do so
> for at least a few quarters until they see fiscal stimulus. The loans
> will be for infrastructure/upward mobility programs that also have
> a government guarantee.When the banks begin loans, they will be getting
> there toe wet.
>
> 2) Construct - All those derivatives are tied into mortgages which
> are loans, correct? Wouldn't it be possibe to say the Fed is defending
> investments owned by the global Central Banks first? I think that
> is our answer.

2008 Dec 28 04:59 PM

[John Lounsbury:]

Thanks to all the commentors. I think there are some good thoughts. I'm glad no one asked for investment ideas related to this subject. I think most investment ideas in banking and finances right now could by placed by rolling dice. In my opinion we are still in the discovery stage of this trial. There are not many answers yet, we just keep turning up more questions.

An excellent article by Dr. Bill Conerly (www.seekingalpha.com.a... community-bank-lending... relates his personal experiences with small banks and regulatory pressures at the current time. This was published after I submitted my article so it was not cited previously.

Ricardo - I have some definite opinions about gold, but I (as you) do not think gold is central to the banking dilemma. I am working on an article on gold, but it will look at the subject from a much different angle than what I have been reading in the past several months. For that reason, it is taking quite a bit of time to collect the data, because I can not find relevant published articles to reference.

Thanks to all who have taken the time to wade through the article.

2008 Dec 28 07:53 PM

[John Lounsbury:]

There is something wrong with the Conerly link. I'll try again:

Mixed Regulatory Messages Slowing Community Bank Lending

Sorry. Hope this works.

2008 Dec 28 07:58 PM

[John Lounsbury:]

I'll try again:

seekingalpha.com/artic...

2008 Dec 28 08:02 PM

[Steven Hansen:]

John, good work.

at such low interest rates, banks cannot lend unless they are assured they are going to get their money back.

if inflation occurs, the value of a loan at a low interest rate falls. can banks loan when they have no reasonable outlook of future economic conditions?

if banks have toxic assets, they need the reserves to cover future losses.

banks must lend or they will die. but if they lend to the wrong person they will die anyway. banks will walk a tightrope, and will lend quickly for mortgages as they can resale the paper to uncle sam. business and commercial loans will require gov't guarantees. would you lend money to a business which relied on consumer consumption today?

"The choice of policy makers is to risk a deflationary spiral into another Great Depression or risk the over production of money and accompanying inflation down the road. Our policy makers have chosen to risk the future inflation rather than the economic death spiral."

absolutely correct. the followup question is whether anything the policy makers do can prevent the economic death spiral.

2008 Dec 28 08:36 PM

[Ricard:]

John,

Thanks for the replay - I look forward to your article on gold.

I also saw the WSJ article that Conerly posted a couple of days ago. I'm certainly not an insider, but my guess would be that the bureaucrats want the banks to lend more with their new capital, but also simultaneously solve problems related to insolvency by strengthening the capital base. Like all bureaucrats, they have no idea how the business works, and are adding up 2+2 and getting 5. Add up Congress's push to save the homewoner, and 2+2 really equals several trillion dollars.

I think the message would be clearer if one were to assume that the government on this issue is not talking with one unified voice - we have Bernanke, Paulson, Bair, Congress, Bush (??), and the new transition team all with different opinions, and all representing our government. I've been able to rationalize Paulson's motives based on his public announcements, although they do differ from other parts of the government.

2008 Dec 28 09:54 PM

[John Lounsbury:]

The Hand - - -

You have added some additional perspectives that I left out and previous commenters have not stated in the same way you have. If this article attracts a good audience we may learn some more from comments yet to come.

You said: "the followup question is whether anything the policy makers do can prevent the economic death spiral." That is the $64 trillion question. As I mentioned in the comment I made above, we are still discovering the questions in this crisis. But your question trumps them all.

I have a follow-up article to this, "The Banker's Choice" which has been submitted but not published, raising some additional factors that will affect the eventual answer to your death spiral question. After you read the next article, you might want to ask the question: Can our policy makers win the battle (save the banks) but lose the war (quick return to a healthy economy)?

2008 Dec 28 10:37 PM

[Anthony Alfidi:]

Terrific article! Bankers are certainly more afraid of insolvency than anything else, because a forced sale to another institution means no bonuses, decimated deferred compensation, and little severace pay. Bankers' agency problems make them averse to lending in a low-yield market. Maybe they're waiting to see which companies get the federal stimulus infrastructure contracts before they make lending decisions.

2008 Dec 28 10:58 PM

[Nostradewmus:]

Very intriguing article. As to the Milton Friedman formula of V and M and it's relative guide toward the stability of indexing pricing pressures measured by our society through inflationary benchmarks such as CPI/PPI and nationalization of our internal value of wealth and productivity on the likes of GDP and money flow, it is abhorent to see that liberal governments attempted to socialize and "libertize" home ownership for all under the guise of CRA and have wrecklessly enforced/politicized false truths and valuations of liberty and freedom against the previous 70 years of prudent financial lending produced in our free/open capitalist markets. When 6%-8% asset growth was a good year indeed in keeping pace with 3% year-over-year inflation rates, these cautionary rewards of a true capitalist society took a backseat to sugarplum 250% increases in housing prices, and they all flocked. No inflation, easy money, 20-25% yearly asset growth, with the real estate bubble gaggle of lemmings grinding the wheel of greed toward new found liberties shorn upon the cliffs of Dover.

Had pre-CRA financial participants done so without concerns to weighting risk/value of assets/contracts against the credit-worthiness of the contracted participants, while at the same time not having treaded upon on individual freedoms? But with the inception of CRA and the application of political wizadry, this surely would obviously in turn, lead us to a more morally just end-game for all!

Instead, a bubble, a long-slick cliff, and the introduction of the game changer, the domino multiplier the introduction of "mark to market" and the elimination of the long standing uptick rule) while the Pied Piper (Christopher Cox) piped the song of screaching sorrows to all who had followed it's deadly course.

Decisions long made by bankers out of self-preservation and profitability (and shareholder value) have been held hostage to Walden philosophies and led us into a social/financial vaccuum, questioning the very heart of Adam Smith and the stability of capitalist markets worldwide. Liberal policies and SEC vigilanteeism have now corrupted the capitalist free-market caldroun with a foul witches brew. Two ends of government working against each other, culminating in a gross violation of everyone's freedoms, except those betting against the system and our viability as an emanation of life, liberty and the pursuit of happiness.

2008 Dec 28 11:48 PM

[NOWHEREMAN:]

There has been some talk of a two Tiered USD, never allowing the two to meet.

Internal and strong to allow consumers to buy. External and weak to allow the Internationals to compete.

I don't really see how it can be implemented, myself but the concept was intriguing.

2008 Dec 29 09:48 AM

[Smarty_Pants:]

If I may put on the devil's advocate hat for a moment:

The original article stated:

"because we do not measure inflation by following the prices of such things as stocks, highly leveraged debt obligations, credit default swaps, etc."


End result was that we did not have "inflation" during the real estate / derivative bubble that formed over the last 7 years. Yet once the bubble has popped and these very same assets are collapsing back to 'reasonable' prices it is suddenly labelled "deflation".

Either we had massive inflation for 5 years followed by a massive deflation, OR we had neither.

It would seem to me that those who insist on claiming we never had inflation but are now suffering through deflation wish to have their cake and eat it too.

I believe that an objective review of the costs of one's necessities would indicate that it is at least as expensive to live today as it was this time last year, probably more expensive.

Other than gasoline, pretty much every necessity I buy costs more today than it did last year. I might be saving $1000 a year in gasoline purchases, but that is more than offset by increasing costs of food, utilities, medical insurance, auto insurance, home insurance, local and state taxes, etc.

The annual CPI (all items) shown on the BLS website has remained over 1% the entire year of 2008 (and I would add that the number is highly suspect in understating true inflationary pressures via use of substitutions, etc.) :

data.bls.gov/PDQ/servl...

So the summary of the devil's advocate position is to ask for a consistent use of terminology. If you want to claim we are suffering deflation then be consistent enough to acknowledge that we had massive inflation starting in 2001 (where was the FED? - oh, generating the inflation - never mind).

What we are actually experiencing is a deflation in financial paper and the bubbles it drove. What we are not seeing is a deflation in the costs of living. Eventually all the TARP-like printing and Congressional spending will work its way into the CPI or some other asset bubble. (Devil's advocate hat OFF.)

Aside from that contention, a good article in general and several good comments.

2008 Dec 29 03:25 PM

[JKC1967:]

This is one of the best articles I have read on SA for quite some time, it really summarizes the macroeconomic situation well. What I like is the emphasis on the Velocity of money in analyzing deflation. As I understand it, John is saying that it does not matter how much money is created by the FED, if it just sits in the "warehouses" due to fear/deleveraging, deflation persists. It makes me think about how some ofthis is psychological in a sense, and that fear can be a self-reinforcing cycle that is difficult to break. Great work John!

2008 Dec 29 04:14 PM

[thatguy57z:]

this will give you some in site how it is going to start working. and how they've all ready have it moving foreword go to.
www.youtube.com/watch?.... copy and paste to your web browser , or click on my website

2008 Dec 29 09:16 PM

[John Lounsbury:]

Smarty_Pants - - -

Your analysis is exactly right, in my opinion. One of the short-comings of my article is that I did not bring the inflation points you discuss to the table as clearly as you did.

We did not measure the inflation that occurred in real estate and financial instruments (including stocks - which had a nice deflation spell from 2001-02) over the last decade because they are not measured (except for housing in a limited way) by the thing people watch, CPI. So now we don't have significant deflation (just slower inflation) when you look at the CPI, as you point out.

Summary: Inflation was high and "off the books" for the past decade, and now we have started deflation of the same "off the books" assets. CPI just doesn't measure things that are causing the trouble.

2008 Dec 29 11:43 PM

[insideoil:]

Looking to the possible consequences of this thinking, to increase velocity we will see commodities trend slowly higher to ensure deflation is kept at bay, and slowly - so as not to further damage overall demand.
The two kinds of USD need to remain boxed where they are until the "main" street system can afford to meet the "wall " street USD. The first kind of USD is trapped off balance sheet in toxic assets/liabilities and the second kind are those USD used for daily trade. At this time the overall system cannot afford to let them meet, hence the freeze up of the system. The trick - as we see as being played out now - is how governments can push enough money into the main street, without it being siphoned off to pay off the wall street problem.
My bet is on the slow but steady recovery of those commodities that have seen the worst of the recent price drops, while those that have seemed less affected will remain at remain flat at least.
As for anything financial - be it bonds, banks or whatever - its going to be toast for a long time to come as governments are forced to keep the financial service industry in the fridge to keep those two kinds of USD apart till they can afford - through controlled inflation and hopefully resurrected main street growth - to let them get together again.
Lets hope the patient work out approach will work, as the other approach of starting wars - either of the physical or the trade variety - to fight over the scraps of what remains, will certainly lead to a great deal more suffering by the world at large.

2008 Dec 30 12:46 AM