Equity markets and credit contraction

There is one class of money that is constantly being created and destroyed, and that is bank credit.

Bank credit is created when a bank lends money to a customer; it becomes money because the customer draws down this credit to deposit in other bank accounts and to pay creditors. It is not money that is created by a central bank; it is money that is created out of thin air by commercial banks to lend. Its contraction comes about when it is repaid, or if a customer defaults.

The recent sharp fall in equity markets is leading to two levels of contraction of bank credit. Brokers’ loans to speculating investors are being unwound from record levels, notably in China and also in the US where in July they hit an all-time record of $487bn. Then there is the secondary effect, likely to kick in if there are further falls in equity prices, when equities held as loan collateral are liquidated. This is when falling stock prices can be so destructive of bank credit, and as the US economist Irving Fisher warned in 1933, a wider cycle of collateral liquidation can ensue leading to economic depression.

Fear of an escalating debt liquidation cycle is always a major concern for central bankers, so ensuring the secondary effect described above does not occur is their ultimate priority. Macroeconomic policy is centred on ensuring that bank credit grows continually, so since the Lehman crisis any tendency for bank credit to contract has been offset by central banks creating money. The bald fact that equity markets have now lost upside momentum and appear to be at risk of a self-feeding collapse will be viewed by central bankers with increasing alarm.

For this reason many investors believe that a bear market will never be permitted, and the combined weight of central banks, exchange stabilisation funds and sovereign wealth funds will be investing to support the markets. There is some evidence that this is the direction of travel for state intervention anyway, so state-sponsored buying into equity markets is a logical next step.

The risk to this line of reasoning is if the authorities are not yet prepared to intervene in this way. When the S&P 500 Index halved in the aftermath of the last financial crisis, the subsequent recovery appeared to occur without significant US government buying of equities. Instead the US government might continue to rely on more conventional monetary remedies: more quantitative easing, reversing current attempts to raise interest rates, and perhaps attempting to enforce negative interest rates as well. If, in the future, state jawboning accompanying these measures does not stop the bear market from running its course, the next round of quantitative easing will have to be far larger than anything seen so far.

Alternatively, if states by buying equities attempt to kill the bear, it will have to be through massive market intervention, aiming helicopter-distributed money at investors as well as rigging the alternatives to make them relatively less attractive. Either way, the shake-out in equities we have seen so far is a wake-up call for mainstream economists and commentators who believe in the comfort of government statistics, which seem designed to convince us all that economic growth is perpetually on its way.

Since the Lehman crisis, investors have bought into this bullish argument to the exclusion of any likely risk that a bear market will happen. Consequently, considerable amounts of speculative money are committed to the concept of a perpetual state-guaranteed bull market; so if the destructive forces of reality do intervene, the potential for a severe fall in equity prices will be much greater than before.

Meanwhile global bank credit looks like it is already contracting in key markets, such as China, in which case global fundamentals are definitely deteriorating. This being the case, it will take increasing amounts of newly-issued money from the central banks to perpetuate the illusion that markets are rising, and that the economy is still growing, with or without state-directed buying of equities.