The monetary base, which represents the quantity of money in public circulation created by the Fed, is now growing at the fastest pace on record. But since January, a new problem arose: the disruption to production supply chains from the virtual shutdown of Chinese production due to the coronavirus.
The manufacture of anything requires multiple inputs, commonly referred to as supply chains. The concept of a supply chain suggests they are one dimensional: a series of production steps that go towards a single product. This is not the case. Supply chains are multidimensional and involve supplies from many sources in many jurisdictions at every production stage. The sequential shutdown of China, South Korea and much of South East Asia was followed by Europe, Britain and America. During these shutdowns almost all production and sales of non-food goods and non-essentials ceased.
While the assembly of a product progresses in one direction, payments flow backwards down the chain as each production step is delivered. The sum of the payments involved is far greater than the value of the final product. The global payment disruption is therefore significantly greater than the GDP number, which only consists of the sum total of final products bought by consumers. In the case of the US, an approximation of domestic payment disruption is contained in the gross output statistic, which is $38 trillion compared with a GDP of $21 trillion.
The US economy is significantly services-driven, with shorter supply chains on average than an equivalent manufacturing-based economy, such as China or Germany. If you add together supply chain payments abroad that feed into final goods sold in America, total payments for intermediate production stages in dollar-driven production probably add up to more than $50 trillion, the majority of which are now frozen.
To understand the impact of this new factor on bank credit, we must divide business customers into two classes; those with cash and those that depend on bank loans for working capital.
Both categories have establishment and other costs that continue despite the collapse in production. Those with cash liquidity draw it down to make payments, reducing bank deposits, which are recycled into other deposits which may or may not be with the same bank. When those deposits reduce existing overdrafts, bank credit contracts reflecting a loan repayment. When they amount to a simple transfer of deposit ownership, they do not.
The greater problem is with businesses that need loan cover for missed payments. There are so many of them with payment failures, bankers are being overwhelmed. Whether they realise it or not, they cannot afford to say no to demands for credit because Irving Fisher’s debt deflation problem is so urgent that to deny loan requests would likely end up wiping out the banks’ own shareholders’ capital and then some.
Supply chain payment failures are becoming a banking problem many times larger than the banking cohort shareholders’ capital. The ratio of US gross output to total equity capital for commercial banks in the US is nineteen times. In other words, unless the Fed can increase base money by at least that and somewhat more to compensate for a degree of bank credit contraction, the economy and the banking system will almost certainly crash.
In Germany, where the two major private banks shown in Figure 3 have balance sheet to equity ratios of 15.1 and 22.6, supply chain disruptions seem certain to lumber them with a fatal combination of dramatically widening commercial bond spreads and payment failures from the mittelstand.
Everywhere else, the problem is the same. The Fed has responded by reducing the cost of drawing down established central bank liquidity swaps lines, but they were only available to the ECB, the Bank of Japan, The Bank of England, Bank of Canada and the Swiss National Bank. Recognising the wider problem, on 19 March the Fed extended swap lines temporarily to the central banks of Korea, Australia, Brazil, Denmark, Mexico, New Zealand, Norway, Singapore and Sweden for six months. A notable absentee from the list is China, which one would have thought is the most important user of dollar liquidity based on trade. Politics trumps the delivery of monetary policy in defiance of the scale and urgency of the crisis.
The problems facing the whole banking system have never been greater. Individually, commercial banks are bound to take every opportunity to reduce their risk exposure before the market values of collateral, particularly equities, corporate debt and both residential and commercial property categories fall further in value. Banks will attempt to reduce their interbank exposure, particularly to European banks. Eurozone banks are likely to be the first to fail, needing state bail outs. Counterparty risk in over-the-counter derivatives becomes a major concern for all. And central banks are on a wing and a prayer if they think commercial banks will simply ensure liquidity gets to the right places in time to prevent a financial crisis.
- Source, James Turks Goldmoney
