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Key to economic recovery lies in rules for private banks

Just the hint that the U.S. Federal Reserve might slow its money printing sent a fright through financial markets last week, pounding commodities and bond prices.


Just the hint that the Federal Reserve might slow its money printing sent a fright through financial markets last week, pounding commodities and bond prices. The December minutes from the U.S. central bank showed policy makers divided on how long they should keep up quantitative easing – shorthand for new money creation – which is now running at the stupendous annual clip of about $1-trillion (U.S.), based on the current monthly rate of security purchases.

Market players are clearly worried that the Fed might turn down the monetary spigots sooner than expected. But a more useful market insight might be gained by trying to figure out why the Fed's incredible money creation binge, and similar ones at the Bank of England and the European Central Bank, have produced such paltry results.

Sure, money printing has helped levitate stock and bond values, but it hasn't produced the turbocharged economic recovery you'd expect from so much central bank largesse. Growth is anemic just about everywhere, outside of emerging markets.

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So what gives?

One of the more convincing explanations comes from Steve Hanke, an economics professor at Johns Hopkins University and chairman emeritus of Friedberg Mercantile Group, the savvy Toronto-based currency and commodity trading firm.

Mr. Hanke's take is that central bank's efforts to stimulate the economy are being derailed in the commercial banking sector. He has an automotive analogy that describes the situation: "The central banks have basically put the accelerator to the floor board and just kept it there," he says, while commercial banks "had the brakes put on as hard as they possible can."

Mr. Hanke's view, outlined more fully in the current issue of Globe Asia and reproduced at the Cato Institute's website, explains both why growth hasn't been better and why central bank money printing hasn't stoked inflation. The Fed, after all, has more than tripled the size of its balance sheet since the financial crisis, yet inflation has remained moribund, mocking the gold bugs and many financial pundits who figured Weimar-style hyperinflation was just around the corner.

The heart of the problem, according to Mr. Hanke, is that while the central banks have been busy creating money, private sector banks have been forced to destroy money or create less of it because of tough new capital rules. The rules go by the shorthand label of Basel III, named after the Swiss city where the global financial overseer, the Bank for International Settlements, is headquartered.

For those not initiated in the arcane art of money creation in a modern capitalist economy, it's worth delving into the process to better understand Mr. Hanke's argument. Central banks are able to create money literally out of thin air when they purchase bonds, placing this newly minted cash into the financial system. Commercial banks, meanwhile, use this new money to make loans, which in normal times leads to a virtuous cycle of deposit and loan creation, limited only by the amount of capital that banks must hold for prudential reason. Most of the money supply in the economy arises in the private banking sector through this cycle of loan and deposit growth, and not via central banks.

Under the new Basel rules, commercial banks will have to have to hold capital equal to at least 7 per cent of their risk-weighted assets, up from 4 per cent. Banks can increase their capital ratios in two ways: by raising more equity, which is not an attractive option given that their shares often trade below book value, or by reducing lending.

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Banks have been opting to meet the new regulations mainly through shrinking their loan books or by growing their loans more slowly. That is why money supply growth has been so anemic in recent years, and the five-year recovery from the financial crisis so weak. As a take-home message, Mr. Hanke figures economic growth will remain subpar until private banks attain the capital ratios required by the Basel rules.

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About the Author
Investment Reporter

Martin Mittelstaedt has had a varied reporting career at the Globe and Mail, covering politics, the environment and business. He opened up the Globe's New York bureau for the Report on Business, and has also been on the banking and capital markets beats. He's written extensively on investing themes. More


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