A lot of people are looking at bond yields as an early warning for a coming recession. What we should be looking at is the credit market, as this isn’t a correlation, it’s the cause.
If we’re worried about a recession, looking at the last one we had, the Great one, can be pretty instructive as to what is really behind these things and what we really need to worry about.
What happened in this case is that, by way of all the credit defaults we saw when the housing market crashed, we experienced a huge credit crunch. It is important that a very high percentage of credit gets paid back and doesn’t default, because if this gets out of hand, there’s less to go around for everyone.
People have generally heard about how banks “multiply” deposits by lending them out and only retaining a fraction of these deposits in reserve. Governments set the reserve ratio and they don’t set them low just to allow bankers to make a lot of money, and in fact, it is the economy itself that benefits.
Critics of the fractional reserve system don’t realize how important this is to an economy, and in fact it would be hard to overstate it. If we raised this up by a fair bit, this would actually cause the destruction of the economic system we know today. We could legislate our way into a recession that could be much worse than the Great Depression if we really wanted to, but thankfully, we are not that crazy.
Countries don’t even tend to mess around very much with raising their fractional reserve requirements, and do so with considerable care. The intention here has to be to contract the economy, and even a small change is very effective in promoting this. Central banks usually use the much less potent weapon of interest rate hikes, and we know how powerful they can be, but increasing reserve requirements is both more powerful and much more dangerous.
The economy isn’t fueled so much by money, it is fueled mostly by credit. If we got rid of credit altogether, we might think that everyone is living within their means now, but this means would be drastically reduced, as this would bring down both governments and businesses, leading to a financial apocalypse.
When we see an above average amount of credit defaults, this also serves to substantially decrease money supply, and the effect is multiplied by the fractional reserve system. So, when we see credit default losses of a certain number, that number may be a huge one, but it is very small when you look at the total loss including multiplication.
If we deposit $100,000 in a bank, banks don’t just loan out a big fraction of this money. The money is loaned out, they get this money back through deposits and loan it out again at a similar fractional rate. This cycle repeats until we exhaust the funds through a little less of it being re-deposited each time.
With a 10% reserve rate, our $100,000 deposit will see a million dollars being loaned out. This is a real million dollars because that’s how much of this was spent from the proceeds. When we lose the proceeds of a loan though, we lose not only the nominal amount but all the times this money could have been loaned out again until we dissipate the leverage.
With less money to loan out, the amounts lost multiplied by 10 essentially with a 10% requirement, this really has a big effect upon money supply and the economy. When this is going on, this can sap most of the power of central bank rate decreases, because the real problem isn’t that the rates are too high for people to borrow, it is that there is so much less out there to lend at any rate.
When the Supply of Credit Shrinks a Lot, There’s Not Much We Can Do
The central bank therefore influences demand for credit mostly, where the supply of it is very much dependent on the recirculation and re-multiplication of existing loans. If you have a big supply problem, looking to stimulate demand won’t work well because it’s already higher than supply.
This is the exact reason why the Fed couldn’t just zap us out of the Great Recession by just putting their rate down to zero. Sure, this helped our recovery, but it still took quite a while as we had to rebuild the credit market.
When the economy goes from its normal growth level, stimulated by inflation essentially, into a recession, where the numbers decrease, this is not something that happens naturally. If inflation is around 2%, as it is now, this means that, all things being equal, this will propel the economy quite nicely unless it is really interfered with.
There isn’t much standing in the way of this expansion over time, but shrinking credit markets are one of them, and the real one actually. If the credit market is healthy, as it certainly is today, all this borrowing continuing will keep us on the expansionary side, by its very nature.
We do need a demand for borrowing as well as a supply, and this demand is by no means unlimited, but in a growing economy, this alone will stimulate demand for credit generally.
Credit Shrinkage is What Really Cause the Pain of Recessions
When things go sour though, that’s a whole different story, and the contractionary nature of this can certainly bring our growth into the negative, the dreaded recession. This can also bring us into depressions, holes that can take very long periods of time to recover from, a generation or even longer.
We might wonder why something like a couple of percent reduction in growth per year might even be that big of a deal. This in itself is really not that meaningful at all, and if this were transferred into stocks, your stock just goes down 2% at the end of the year, which would not really bother anyone that much.
It is not the nominal reduction in growth that causes the pain here, it’s having that multiplied by the overall loss to money supply due to how much this shrinks credit, and like on the way up, the numbers get multiplied the same way on the way down.
When we look at what happened during the Great Recession, we saw a 0.1% reduction in GDP in 2008, peaking at –2.5% a year later. This 2.5% gets multiplied by 10 though and now we’re looking at a much bigger number, one that really hurts.
The real pain isn’t even caused by the recession itself, it is caused by the credit crunch, and we can even quantify this as 90% credit crunch and 10% recession. The fact that we are calling this a recession is entirely due to credit drying up enough to turn GDP from going up to going down.
Needless to say, the credit market plays a huge role in our economy. If we are worried about its health, we can take its temperature very well by looking at how well the engine that it runs on, credit, is performing.
Since it’s people not paying back this borrowed money that causes this whole cascade, this is what we really need to be looking at, default rates. As it turns out, default rates have worked their way down every year since the spike we saw during the housing crisis, and are now perfectly normal.
This does not mean that we are protected against another bear market, and bear markets do appear from time to time regardless and are influenced by a number of other things. However, if you want to avoid one, it’s just better to have the credit market humming like it is now, so that it can fight against economic slowdowns caused by such things as trade restrictions.
As far as a recession goes, it’s really not a big secret among those who really know how the economy really works to tell you that it’s credit crunches that cause recessions. We’re not in one, and quite far from it, so that should tell us that this should not really be much of a worry.
However, we do need to remember the role of the Fed in credit markets. When the Fed raises or lowers interest rates, it is amount of credit in the economy that they are manipulating, and that’s all this does. The dovish stance of the Fed that we enjoy today arose primarily from their realizing that their plans such as putting rates up twice in 2019 would pose too great of a strain on the credit market.
The credit markets are the good guys in this movie, fighting recessionary pressures, in the same manner that has it being too inflationary if it expands too much. It requires continued and competent monitoring by central banks such as the Federal Reserve in order for to at least not do too much harm.
There are therefore two main risks of recession, a credit crunch caused by too many defaults and a credit crunch caused by the Fed being overzealous in restraining credit. We have neither going on at the present time, so we should be breathing normally.