A Note on Credit Market Debt

Credit market debt is a measure of the debt in the economy. This post examines total credit market debt in relation to the money supply and advances some thoughts on inflation.

To start with, the Federal Reserve Z.1  publication, “Flow of Funds Accounts of the United States“, defines credit market debt as:

Credit market debt consists of debt securities, mortgages, bank loans, commercial paper, consumer credit, U.S. government loans, and other loans and advances; it excludes trade debt, loans for the purpose of carrying securities, and funds raised from equity sources.

In short, it is all the outstanding debt carried by all sectors of the economy. The St. Louis Fed’s graphical data tool, FRED, gives us a look at the total credit market debt, Figure 1 (TCMDO):

In our discussions on money, we have shown that all that we consider to be money is also a form of debt. At the base of all money, currency is still a debt instrument. As we discussed in “Understanding Money: Part 2” the fractional reserve banking system takes currency deposited (lent) to banks and multiplies it in the form of new debt. In fact, institutions throughout the financial system, have multiplied our base money in the form of a pyramid of debt.

Every time new debt is created based on some existing level of money supply, the debt is said to be leveraged. So total credit market debt represents the total amount of money that has been created by various multiplication schemes or chains. And the root of all money chains is the monetary base, Figure 2  (AMBNS):

Now if all loans were collapsed, then what is left is the monetary base, currency plus bank reserves on deposit with the Fed. The factor by which the total credit market debt exceeds the monetary base, TCMDO/AMBNS, is the leverage in the system. And we can see what that looks like! Using FRED, Figure 3:

Comments on the Graph

First consider the blue line which represents the ratio TCMDO/AMBNS or the leverage in the system. From about 13x in the early 1950s it peaked at just over 60x in the recent recession. Since then it has fallen to about 20x.

You might ask how this came about. The Federal Reserve, through QE1 and QE2 pumped about two trillion into the system via the major banks known as primary dealers. This is seen by the size of the Fed’s balance sheet, Figure 4 (WALCL):

Most of this money remains on deposit with the Fed as what are called excess reserves. We have shown these excess reserves on an inverted scale as the red line in Figure 3. The result is that the Fed’s actions have deleveraged the system dramatically.

The Fed’s Dilemma

In 2007, the system locked up because most of the money created as debt was locked up for the maturity period of the various debt instruments. There was little spare cash or liquidity in the system and the system was in danger of freezing before imploding. The Fed, through a variety of programs acted quickly and aggressively to take longer term debt instruments off the books of the banks in return for instant liquidity in the form of account reserves.

One of the primary mandates of the Fed is to control the money supply and it does this by creating and destroying money in the monetary base. When it creates money it may be in the form of Federal Reserve Notes (paper currency) or in the form of account credits in the accounts of the primary dealers. But in return for this new money, it demands collateral. Before 2007, they would accept little more than Treasury instruments. Now they accept other stuff. But for every dollar they “create” they have in their possession a dollar of Treasury or some other kind of debt.

The Fed has always maintained it can unwind what it has wrought. The mechanism is to reverse its recent operations by selling the assets on its balance sheet. Assuming it still has about 2 trillion in assets from its buying spree in the late 2000s, it can sell them back to the primary dealers and destroy the money it receives in payment. But that instantly levers up the system towards its crisis levels.

Unless the system continues to deleverage the Fed cannot shrink its balance sheet. And further deleveraging is a deflationary process which the Fed has sworn to fight. So the Fed’s balance sheet is stuck at these levels – the new normal.

The Power of New Money

 

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