How money & credit can shrink (i.e. deflation)?

November 19th, 2007

Share |

Recently, Goldman Sach warned that (see $2 trillion lending crunch seen)

… mortgage wipeout could result in a $2 trillion cutback in lending and have dramatic implications for the U.S. economy.

When that happens, the supply of money and credit will contract in the economy. This is, according to the definition of the Austrian School of economic thought, called a deflation (see Cause of inflation: Shanghai bubble case study for understanding the true meaning of inflation). The symptoms of deflation include falling asset (e.g. property, bonds, stocks) prices. In severe cases, even prices of consumer goods can fall as well (see The mechanics of deflation- increase in demand for holding cash).

Now, how does Goldman Sach comes up with the figure of $2 trillion? As the above-mentioned article said,

A bank that aims to maintain a capital ratio of 10 percent would need to shrink its balance sheet by $10 for every $1 in credit losses.

Therefore, given that Goldman Sach’s estimate that half of $400 billion of loans in the US financial system will go bad, then banks will have to shrink their balance sheet b $2 trillion.

How does this work?

Recall that in our earlier article, 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, we said,

Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let?s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The original $100 in cold physical cash forms part of the monetary base (or M0). Technically, these physical cash and banks’ deposit on the central bank (yes, banks have accounts in the central bank for them to ‘store’ their money too) forms part of the monetary base. Thus, given a 10% reserve ratio, every $100 of monetary base will result in up to $900 of loans (i.e. credit). That is, the original monetary base is being multiplied up to $1000 worth of money and credit.

Now, what happens if $50 worth of loans has gone bad (i.e. the borrower defaults on the loan)? This time, the multiplication works in reverse. When that happens, you can see that in order to maintain a 10% reserve ratio, $500 worth of money and credit has to be withdrawn from the financial system, by hook or crook. When that happens, banks have to stop lending or recall back their existing loans. If this happens en masse in the financial system, you can imagine what a disaster it will be!

Now, look at how vulnerable Australia is. In September 2007, money and credit (M3) is Australia is worth $910.6 billion. The monetary base is $38.9 billion. Therefore, the overall reserve ratio is only 4.27%. That is, every $1 of physical cash deposit, on average, resulted in $23.40 worth of money and credit added into the financial system. Therefore, every dollar that has gone bad can potentially result in the withdrawal of around $23.40 worth of money and credit from the financial system.

The seriousness of this situation will depend on the quality of debt. If you look at the amount of private debt relative to GDP in Australia (see Steve Keen’s DebtWatch report), you will appreciate the high level of debt risk that Australia is facing right now. Any unfavourable economic shock can easily unravel Australia’s debt bubble, resulting in a serious case of deflation. Right now, we are hearing disturbing news report of mortgage stress and business debt stress (see Debt stress for Australian businesses) in Australia. With the likelihood of sustained interest rates rise, the problem is going to get worse.

Be warned.