How We Are Racing Towards The Economic Cliff | | 12.2.12

Forget about the fiscal cliff. Are we headed to the economic cliff? A successful software entrepreneur and school friend sent me this chilling email last week:

Yesterday I was speaking to a banker in central California who related how he is being prevented from doing his job due to the compliance people (read government pressures) and could not  convince the powers-to-be to make a loan despite his long history of good  decisons.  I hear stories daily regarding how people have seen orders evaporate as a result of the election. Multply this across the nation to understand the impact.

But how could loans be scarce when the Fed has been printing money at an unprecedented rate?

Here is Cato Institute and Johns Hopkins economist Steve Hanke’s explanation, from a recent EconTalk podcast:

[S]tart with Lehman’s collapse in September 2008. That’s a convenient date. Since that point in time, the Federal Reserve’s balance sheet has increased roughly by three and a half times. So that means they are buying a lot of these [U.S. government] bonds….

Now that means that high-powered money, or what I call state money–the amount of money produced by the state–has more or less tripled. It’s exploded…. [S]tate money has increased from about 6.5% of the total money supply, when you measure the money supply properly with a broad measure, like M3–so we went from state money being at about 6.5% at the time Lehman collapsed, until now it’s about 15% ….

[In other words] state money is peanuts. What really is important is bank money–and bank money is created by the commercial banking system and shadow banking system, and that’s what really counts.

So, in a way we have had the following scenario develop after Lehman: We’ve had ultra-loose monetary policy with regard to state money and the Federal Reserve.But with the financial regulation that was legislated with Dodd-Frank, and also with what is called the Basel capital requirements, and specifically Basel III, which is being imposed on banks–to increase the capital-asset ratios of the banks.These two things–financial regulation and Basel–have in effect imposed ultra-tight monetary policy on the banking system and bank money.

So, as a result of the two, we’ve had the total amount of the money supply actually being very anemic, not growing very much at all. And in fact, if you look at a trend line since 2009 and look at the endpoint today of the trend line as you are going left to right, that point is about 7.5% higher than the actual level of the money supply that we have.

So, you could argue that relative to trend we’ve got a deficiency of about 7.5% in broad money. And the reason why is that the dominating feature has been the reregulation of banks and the tight monetary policy imposed on bank money. Which accounts for 85% of the total amount of money in the economy.

Basel III is an international banking agreement — one of a series dating to the late 1980s — that is imposing increased reserve requirements on major money center banks globally, and is being applied in the U.S., it turns out, on regional banks, too. Thanks to it and Dodd-Frank, regulators are forcing U.S. banks to shift their portfolios toward U.S. government debt and other assets that qualify as reserves. This is, of course, very convenient at a time of World War II-scale federal borrowing needs made bigger by the president and his Congressional allies insisting on more entitlement and other domestic spending, meaning more debt, not less.

Who comes out on the short end?

My friend pretty much nailed it — the small and mid-sized companies seeking operating capital and longer term loans for expansion. Add in the hammering down of their equity capital that will come from election-insured (unless the House GOP can stop them) higher tax rates, arbitrary regulations and, yes, further ratcheting up of spending, and, sure, you can imagine that those companies are canceling orders. Hiring decisions, too.

And so we race lemming-like toward the economic cliff.

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