Decreased Lending Shrinks Money Supply

Deficit Reduction Will Shrink It Further

The size of our continuing deficits and bloated debt have politicians concerned and citizens scared. The fiscal path we are on has been repeatedly characterized as "unsustainable" by economists, members of Congress, and the Federal Reserve.

The IMF warns that US gross public debt will reach 97% of GDP next year, and 110% by 2015.

Willingly, or unwillingly, change is on the horizon. The federal budget will be cut.

If the US were to cut its projected 2010 deficit in half by 2013 — as agreed to at the G-20 summit — that would be a cut of $780 billion. There is no easy way out of this. It will cause a lot of pain to a lot of people.

As the government begins paying down its debt, standards of living will decline.

With a national debt exceeding $13 trillion and other debts and obligations — such as Social Security, Medicare/Medicaid and veterans payments — reaching $99 trillion (according to the Dallas Federal Reserve), the only hope the US has to repay these debts is by inflating its currency to the point that it loses value. Fixed debts can then be paid back with devalued money.

However, events seem to have gone beyond the reach of the government and the Federal Reserve. Despite their best efforts to stimulate the economy and create at least a little inflation, the threat of deflation now seems more likely.

An unintended consequence of shrinking government spending will be shrinking the money supply, since virtually all “money” today originates as loans or debt.

However, the money supply has already been shrinking at an alarming rate.

In a May 26 article in The Financial Times titled “US Money Supply Plunges at 1930s Pace as Obama Eyes Fresh Stimulus,” Ambrose Evans-Pritchard writes:

“The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of institutional money market funds fell at a 37pc rate, the sharpest drop ever."

As Professor Tim Congdon from International Monetary Research notes, "It’s frightening. The plunge in M3 [money supply] has no precedent since the Great Depression."

This is not good for the banking system since the vast majority of the money supply is created by banks as loans (or credit). And since bank loans are now virtually the only source of new money in the economy, the interest can only come from additional debt.

Just this week, the earnings results of the three biggest US banks were announced, and they weren't encouraging.

Bank of America, the largest U.S. bank by assets, said Friday that second-quarter net interest income was $13.2 billion, down 10% from $14.7 billion in the same period last year.

J.P. Morgan Chase, the second-largest U.S. bank by assets, said net interest income was $12.8 billion in the period, down 13% from a year earlier, largely driven by lower loan balances.

And Citigroup, the No. 3 U.S. bank, reported a 13% drop in quarterly revenue. Average loans in the company's Regional Consumer Banking business fell 2% to $218 billion, partly driven by declining balances in North America.

Consumers and businesses simply aren't taking out new loans. Instead, they're still focused on reducing the massive debts they racked up during the boom of the previous decade.

In this environment, bank revenues will likely remain flat or continue to shrink. When you combine decreased borrowing in both the private and public sectors, the money supply will continue to shrink.

Unfortunately, the economy will continue to shrink along with it.

The pace of events is outstripping the efforts of the Treasury and the Federal Reserve. It seems that neither is able to control the shrinking money supply and, therefore, they cannot control the outcome.