The charts below come via Mish’s post today on why it doesn’t matter that Bernanke wants to eliminate bank reserve requirements. The quick answer: Greenspan already did that in 1994 when he allowed overnight sweeps on checking accounts to free them from reserve requirements just like savings accounts. In this era, banks lend first and look for reserves later.
Anyway, way back in 2007 I first became convinced that this would be a deflationary depression because of this simple equation: there was $52 trillion in outstanding debt in the US, and only (at the time) $850 billion in base money (all the “cash” that the Fed had created since it was founded in 1913). As defaults and write-downs started to reduce the amount of debt, the Fed was likely to create new money to bail out banks and monetize deficits. It was plain to see that the difference in scale betwean the two pools, debt and cash, would tip the scales in favor of deflation, along with a shift in attitude towards frugality and a new respect for the value of a dollar.
Well, here we are in 2010, and the Fed has indeed created a fresh $1.2 trillion, but the debt pile has stopped growing over the last year, even taking into account the massive issuance of treasury debt. This chart comes from Karl Denninger:
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I suspect that if properly marked to market, the private debt figures (household, business credit and financial instruments) would be considerably lower. There is a lot of pretending going on at banks, since they do not want to take write-downs. How much of that household credit card and mortgage debt will really be paid off?How much of those financial instruments are junk (and even investment-rated) bonds that will be defaulted on in the next few years? How many business loans are in arrears or just barely being made?
On the other side of the equation, here is the base money supply since 1999:
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If reserve ratios mattered, wouldn’t debt have at least doubled (or more if you believe in the multiplier effect)? The fact is, nobody who can handle a loan wants one, and nobody who wants one can handle it.
Credit conditions and risk appetite are what drive lending, not reserves. Banks simply don’t hold reserves anymore, which is why bubbles get so out of hand and why they are always a few bad loans away from bankrupcy. If bankers’ asses and depositors’ funds were on the line like in the 1800s, you better believe banks would hold reserves. Depositors would sniff out those that tried to scimp, and take their funds elsewhere, nipping any trouble in the bud. Busts were frequent and localized, and freed up capital for productive hands. That’s why that era produced the greatest improvement in living standards and real GDP growth of 3-4% while prices were steady to falling for decades.
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Here’s another chart that shows our state of debt saturation from Nathan’s Economic Edge. GDP no longer grows with debt — this is the point of no-return where interest can no longer be serviced with production, so the whole thing starts to collapse.
Sovereign Speculator 