It may come as a surprise to some that the total level of commercial bank loans outstanding as of the most recent week, May 22, was “only” $7.303 trillion. We say only because this number is $20 billion less than the total commercial loans outstanding as of the weeks following the Lehman failure, just before the most epic deleveraging episode in recent US history began. It is also just $600 billion higher than the cyclical lows of $6.7 trillion (net of the February 2010 readjustment of the commercial loan terminology). (Read more…) Why do we bring this up? Because as is well-known, loans are the primary commercial bank system asset, and in a normally functioning financial system, loan creation leads to deposit growth (and vice versa: there is a certain element of reflexivity when it comes to money creation).
So does this mean that deposits in the US financial system have been unchanged in the past nearly 5 years? Not at all. As the chart below shows, while commercial loans have flatlined, deposits, which previously used to track loans on a dollar for dollar basis, took off, and are now at $9.4 trillion (as per the latest H.8), or $2.2 trillion more than the $7.2 trillion when commercial banks loan hits a record in October 2008, just after Lehman filed. What’s more notable, is that as of the latest week, the excess of deposits over loans just hit an all time record of $2.079 trillion (we exclude the one week outlier from March 27 as this was a seasonal adjustment aberration).
So what gives? Quite literally, the Fed.
Recall that in a fiat system, money is created either by commercial banks (mostly: but only when there is demand for money), or by the Federal Reserve, which creates money out of thin air (in the form of fungible reserves – a Fed liability), while purchasing “high-quality collateral” such as TSY or MBS as the corresponding asset. Indeed, the chart below shows the very close correlation between the deposit over loan excess since the Great Financial Crisis, and the total amount of reserves created, in this case represented by assets purchased by Bernanke.
The problem with the latter is that Fed money creation is a “supply-push” form of liquidity creation, unlike commercial loans which are “demand-pull” which means the Fed “shotgun” injects liquidity and hopes and prays it finds its way to a consumer who, however, has no monetary preference. Hence “trickle down” and why the bulk of the $2.5 trillion in money created by the Fed has ended up in the stock market (and quite levered at that).
It also means that banks, stuck with massive excess deposits on their books (recall “The “Big Three” Banks Are Gambling With $860 Billion In Deposits“) have no choice but to use this capital and gamble with risk assets. JPM publicly disclosed as much in the aftermath of the London Whale fiasco.
All of the above is important because there still is confusion about this process four years after QE began.
Only this past week, Steve Keen, an economist whose views we respect, wrote: “So the ‘printing money’ moniker that critics give to QE is misguided: it actually creates no additional money at all (outside of the gain banks will make on the repo deal). For money to really be created, QE would have to go directly to the Deposits of the public in the private banks, and that’s not what QE does.” Actually, that’s exactly what the evidence above shows QE has done.
The only difference is that in the absence of IRR>0 opportunities for entrepreneurs, and for capital allocators in the broader economy, not to mention a still pervasive distrust of the TBTF banking system, deposit holders (without prejudice for just who it is these deposits belong to) opt to keep their money in the banks in the form of increasingly more unsecured (see Cyprus) zero interest bearing deposits, instead of allocating it to various capital intensive projects. One need to only look at the collapse in CapEx (and the surge in the balance sheet gimmick of stock buybacks) to understand why this is happening from a corporate standpoint.
The irony is that the longer the Fed remains in the market, the greater the differential between loans and deposits will become, as lack of confidence in the system remains. It was none other than Seth Klarman who explained the simplicity of the reflexive popular thinking as follows:
Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions.
They regard with skepticism those who don’t accept that we have a debt problem, or insist that inflation will remain under control. (Indeed, they know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station.)
When an economist tells them that growing the nation’s debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute. They know the trajectory we are on.
And when you tell the populace that we can all enjoy a free lunch of extremely low interest rates, massive Fed purchases of mounting treasury issuance, trillions of dollars of expansion in the Fed’s balance sheet, and huge deficits far into the future, they are highly skeptical not because they know precisely what will happen but because they are sure that no one else–even, or perhaps especially, the policymakers—does either.
Indeed, the greater fool is long dead. And as long as the Fed remains actively involved, so will excess deposits – created indirectly by the Fed but parked at commercial banks – stay at these same banks, who see no need to create loans as they are already flooded with trillions of excess deposits which in a post-Volcker and post-London Whale world, they have increasingly fewer options to allocate.
It is only after the Fed exits, that these excess deposits have a chance of entering the economy and resulting in the much needed gradual inflation. Ironically, the longer the Fed remains, the greater the capital allocation preference will be by commercial banks to inject the fungible capital created from excess deposits into stocks.
Speaking of, has anyone seen the “inflation” in the S&P500 in the past several years?