A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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An addendum to “Sword of Damocles”

Money supply and monetary transmission are important entities and functions within our system.    Usually, even broad money supply is well defined, but I was getting to thinking about shadow banking assets and the identities they may have in the minds of those who supply the funds.   Shadow banks are not deposit takers so they do not actually hold “money”, but they do hold assets that their investors may consider to be money like, i.e high yielding cash substitutes, within their portfolios.

Now if perceived money supply is actually higher and we have an asset price shock, we also have a monetary shock by default.  Now this is just a quick “throw the thought out in the air”, but if the shadow banking system is also messing with identities and virtual money supply, things may well be more complex than we think they are as things start to unravel.

Just 30 second blog….

With monetary transmission impaired we may be in a perpetual “Sword of Damocles” moment

It may be that the monetary transmission mechanism is impaired through the structural imbalances that have developed within global economies over the last 20 years (+/-). If the transmission mechanism is impaired then we are in a perpetual “Sword of Damocles moment.”

The recent IMF blog, “The New Global Imbalance: Too Much Financial Risk-Taking, Not Enough Economic-Risk Taking” introduces a well known pre existing dynamic as “a new global imbalance”:

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges

We have been in a declining capital and human investment scenario for some time (discussed in many a recent blog), in many key developed economies, and we have been in a paradigm of increased financial leverage/asset focussed money supply growth.  This is not new and is the primary reason why we are pinned to the economic floor with the proverbial boot pressed to our throats.  I discussed this also in a recent blog…  

The IMF rightly points to the risks posed by the shadow banking financial system:

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Shadow Banking:The Money View.. An Office of Financial Research paper

Shadow Banking:The Money View.. An Office of Financial Research paper..

A must read for anyone concerned with systemic risk issues to factors impacting asset class return and anyone interested in a comprehensive primer on the operation of today’s money markets.   As the following two quotes surmise, the shadow banking sector has developed to the extent it has by virtue of certain structural economic imbalances and financial system checks and balances are not set up to manage the risks of this new plumbing.

one way to interpret shadow banking is as the financial economy reflection of real economy imbalances caused by excess global savings, slowing potential growth, and the rising share of corporate profits relative to wages in national income.

From a policy perspective, the fundamental problem at hand is a financial ecosystem that has outgrown the safety net that was put around it many years ago. Today we have a different class of savers (cash PMs versus retail depositors), a different class of borrowers (risk PMs to enhance investment returns via financial leverage versus ultimate borrowers to enhance their ability to spend via loans) and a different class of intermediaries (dealers who do securities financing versus banks that finance the economy directly via loans) to whom discount window access and deposit insurance do not apply.

The document also discussed the need to have better measures of “money supply” than the narrow money measures of insured deposits.  

I for one am concerned over the large shadow banking cash pools and the financing mechanisms of today’s repo markets.   At the top of my mind is a large question mark over the interplay between QE and today’s money/collateral/derivatives markets and the impact monetary tightening will have on the shadow banking system.

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