Did a Declining Money Supply Cause the Crash

Posted by John Slater on October 15, 2008

While most economists and the Fed discount the control of monetary growth as a tool for managing the economy, money does matter. Monetary growth in excess of growth in the economy’s productive capacity contributes to inflation. Similarly a sharp decline in the money supply would likely lead to economic contraction and ultimately to deflation, as was experienced during the 1930’s.

In my world, mergers and acquisitions and corporate finance, we witnessed a unique phenomenon during the 2005-2007 period as many new sources of financing became available to support the rapidly growing Private Equity community. Loans were syndicated at a furious pace and specialized finance entities, many supported by hedge funds, aggressively provided capital with a speed and at risk levels not seen with traditional bank lenders. Second lien and tranche B paper became the norm.

Much of this paper was ultimately securitized through issuance of collateralized loan obligations and similar instruments. Some have estimated that this resulted in an increase in credit availability of at least 25% above levels that would have been possible if the market had been restricted to traditional sources such as banks and asset based lenders. The net impact was a dramatic decrease in the cost of capital, with loan spreads contracting by several hundred basis points and a sharp relaxation of underwriting standards. Lenders routinely provided senior debt at five times cash flow to companies and deals that would have only supported two and a half to three times cash flow a few years earlier.

As a result purchase multiples increased dramatically and companies that might have been worth six times cash flow earlier in the decade were suddenly worth eight times cash flow or even more. The worm has now turned and deal loans, if available at all, are being underwritten at more traditional levels and more traditional pricing. Purchase prices are beginning to come down, though the full effect will take some time to play out as sellers remain in denial.

What we witnessed in M&A was mirrored throughout the economy, certainly in housing finance, but likely in many other areas as well. From 2003 through summer of 2007, a significant portion of the credit boom was funded through what Nouriel Roubini has described as the Shadow Banking System. By Prof. Roubinis definition the Shadow Banking System comprised approximately $10.5 Trillion in 2007, including $2.2 Trillion of commercial paper conduits, $2.5 Trillion in the repo/reverse repo market, $4 Trillion of brokerage assets and $1.8 Trillion in hedge funds.

For analytical purposes I believe it makes sense to define Shadow Credit even more broadly to include various other financial institutions, conduits and debt markets not regulated as banks. These sources of credit and liquidity include private equity groups (PEGs), finance companies such as GE and Allied Capital, mortgage backed securities (MBS), structured investment vehicles (SIVs) , collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), Fannie Mae, Freddie Mac, etc., etc. Many of these vehicles have been supported by credit default swaps (CDS), further leveraging their impact on the monetary system. While in theory these private institutions do not have the money creation ability of deposit taking banks, collectively they had the effect of creating money-like liquidity not captured in the traditional monetary aggregates. I will refer to the combination of traditional money and these new sources of liquidity as the Effective Money Supply.

The growth of these alternative credit and liquidity sources during the current decade has been so significant that they can no longer be ignored in formulating monetary policy. At a minimum, using Prof. Roubinis definition, Shadow Banking is 40% larger than M2 and more broadly defined Shadow Credit may be as much as three times M2 (i.e. well in excess of $20 Trillion). To date there is no recognized monetary aggregate that adequately measures the impact of this Shadow Credit on the Effective Money Supply and as a result policymakers have focused on the measuring tools at hand such as M2. Using its traditional tools the Fed allowed moderate growth in M2 from late August 2007 until late August 2008 at an annual rate of approximately 5.4%.

Given the inflationary pressures at the time, this appeared to be a logical response, neither too accommodative, nor too restrictive. However, from late March until early September 2008, the Fed conducted a more restrictive monetary policy with essentially no monetary growth, presumably in an attempt to soak up perceived excess liquidity created around the time of the Bear Stearns collapse.

Taking this same data and applying a new lens, we see a far different picture. Assume for the moment that M2 reflects only a small portion of the total credit and liquidity available to the economy, perhaps as little as 25-30%. Assume further that, by applying an appropriate multiplier not yet empirically defined to the non-regulated credit and liquidity that makes up the Shadow Credit System, one could determine a measure of Effective Money (i.e. the total credit availability that drives activity in the real economy). In that case a divergence between the growth rate of traditional money and that of Effective Money could cause significant distortions in the real economy. Such a divergence occurred between August 2007 and September 2008, resulting in a likely decline of Effective Money sufficient to have had a seriously negative impact on the real economy. After August 2007, with the collapse of the syndicated credit market, the creation of new Shadow Credit ground to a halt. Since that time there has likely been a meaningful decline in aggregate credit available in the Shadow Credit System. The collapse of the SIVs alone took $400 Billion of credit out of the system worldwide, forcing many of these entities’ liabilities onto the balance sheets of already strapped banks.

For purpose of example, if we assume M2 of $7.5 Trillion and Shadow Credit of $22.5 Trillion and apply a multiplier of as little as 33% for measuring the impact of Shadow Credit on the Effective Money Supply, the net impact of changes in Shadow Credit would be the same as that of changes in M2. Since there is no agreed yardstick for measuring Shadow Credit and no empirical data as to the appropriate multiplier, the actual impact could be lower or higher, but it is inconceivable that the growth and decline of Shadow Credit has not had a significant impact on Effective Money.

In the above example a decline in Shadow Credit of a little more than 5% from August 2007 to August 2008 would have been enough to fully offset the growth of M2 during the period. My suspicion is that the actual decline was greater. Bringing the analysis to the present crisis, the accelerating decline of Shadow Credit during the period following the Bear Stearns collapse, combined with the stagnation of traditional monetary aggregates, would indicate that Effective Money shrunk significantly from spring 2008 until the onset of the financial collapse in September 2008. Such an effective tightening of the money supply, when the system was already quite shaky, could easily have played a significant role in catalyzing the current crisis.

Going forward I believe that it is critical that the monetary authorities and the academic community get their arms around the impact of this non-traditional money on the Effective Money Supply and develop tools to bring the Shadow Credit System under sufficient control to prevent similar impacts in the future. If not we are almost certain to witness another rapid runup in Shadow Credit, perhaps with new structures and new players, creating the potential for another and even more disastrous inflationary bubble not too far down the road.

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