New Monetarism22 January, 2008, 6:12. Posted by Zarathustra
Tags: Economy, Monetarism
How hard is subprime hitting US and global economy? I write this article to introduce the view by David Roche, which I watched from Bloomberg TV some weeks ago. Maybe his theory would help us to understand how subprime can hit so hard on US and global economy.
In the past, commercial banks receive deposits from you and I, paying small interest to us, and lend to others at higher interest rate, earning the spread between lending and saving. Remember our introductory Economics textbook in college, that because the borrower of money would end up deposit the money back into the banking system, the banking system now have more deposit, and thus, they can lend out more. For example, if I am a CEO of a company, planning to acquire some plants and equipment, I would ask bank for money to pay the bill of acquisition. When I pay to the owners of those plants and equipment, those people would likely to put this money back into the bank as deposit. In banking regulations, the central bank would normally set a reserve requirement, which is the percentage of money of the deposit which can be lend out. For a 10% reserve requirement, the bank essentially create 10 times of the original amount of money in the system. This is known as the money multiplier.
At the heart of the subprime crisis is the financial innovation of securitization, which means that the loans which the bank lend out can be sold to others, so that when you pay the principles and interests to the bank, the bank would pass this money to the bond holders. Essentially, when a bank lend out some money, this loan will be booked as an asset on the balance sheet. However, if the bank can securitize this loans and sold it as a bond, they can keep this away from the balance sheet, and make more loans again without having accept new deposit (deposit is a liability to a bank in its balance sheet), and as if they are now having no risk of default on these loans. In this way, the bank can make more loans without lowering its reserve ratio. So according to David Roche, while in the past, banks create perhaps 10 times of money in the system, thanks to the financial innovation, the banks were creating perhaps 100 times of money, or in fact, they can now create infinite money supply in this process.
However, this kind of prosperity would soon be turning into a tragedy. In the first place, for the bank to be able to sell these securities, the market of these securities must be very good, with inflation of these asset prices. However, when the default rates go up, the prices of these securities would go down dramatically, in which some of them are now practically worthless. If the banks have to guarantee the loan, as they bring these loans back on the balance sheet and write-off them significantly, it will heart the capital adequacies of banks. According to David Roche, in the past, if the bank lost one dollar of Tier One Capital, the whole system lose perhaps 10 dollars. However, if the bank lost one dollar of Tier One Capital now because of write-off, the whole system probably lost 100 dollars! Thanks to the multiplier, when things go reverse, we are drying up liquidity.
Implications to the economy
If his theory is right, now we are really facing the hard time. The money supply in the past is probably very much inflated because of the ultra-money-multiplier effect. So when things go wrong, the liquidity dried up as much and as fast as how money was created. Years of prosperity was possible because of this mechanics of money creation, so what are we facing now? If the central banks want to inject liquidity into the system, how much would they need to inject?
Although some questions could not be answered properly in his theory (e.g., why inflation could be kept at so low level in the past years despite the inflated money supply?), David Roche’s theory does represent the reality of the current situation. Yes, we probably will have a bearish outlook on economy and stock markets, particularly in US and Europe.