The headline of the article Joe Calhoun sent me this morning doesn’t quite square with the content that follows. It screams that, “BIS Debunks Claims of Collateral Shortage”. As is often the case, the editor responsible for the headline may have been engaging in intentional hyperbole that would not necessarily be agreeable to the BIS authors highlighted within the piece, or even the author of the article itself. Since we don’t know that such a divergence exists, we can only go by what content has been shared.

Fortunately, the two BIS economists largely contradict the headline right in the second paragraph of the WSJ writeup,

“In an article in the BIS’s quarterly report, economists Ingo Fender and Ulf Lewrick argue that there is plenty to go around, although they do admit that it is unevenly distributed…” [emphasis added]

In other words, they agree with pretty much every credible collateral critique that has been offered in the QE era. There is an error of logic in that melodramatic headline that does not extend into any reasonable interpretation of what the BIS actually found. If a segment of the banking system can easily find and use collateral, but another segment cannot, would that not be construed as at least a shortage in the afflicted region?

We are back again at modern monetary policy 101, namely the difference between stock and flow. Mainstream economists still cling to the idea that money stock measures are the prerequisite as an economic elixir. If the central bank simply increases the stock of money available to the banking system, it releases the credit expansion impulse to stage an economic turnaround. It is standard monetary textbook stuff.

It was the same kind of policy prescriptions that were followed in 2008, but as we saw then the crisis deepened despite these “best” money stock efforts. If we follow the logic contained in the WSJ headline here, there was no crisis five years ago. There was an ample stock of liquidity in 2008, or by their vernacular, there was no dollar shortage. According to this reasoning, the fact that the fed funds rate was well-below target for much of the “panic” period demonstrates that conclusively. The money stock existed; therefore there can be no problem.

Fragmentation fed funds eurodollar

Of course, that is complete and unabashed nonsense. The case, from the outbreak of the crisis in August 2007, was (and still is) always about fragmentation in the markets, and thus flow. Money stock has largely been irrelevant for anything other than psychology. As the chart above shows, there clearly was a dollar shortage in 2008, it was just “unevenly distributed”, to say the least.

Fragmentation is alluded to by the WSJ author, though that is never exploited by a fuller explanation of why this might be important (of primary importance, really),

“But with the U.S. Federal Reserve taking tens of billions of dollars of high-quality bonds out of the system every month with its quantitative easing program, and with a host of new regulations forcing banks to hoard more and more ‘high-quality liquid assets,’ good collateral has been increasingly difficult to get hold of–at least for some.”

If those “some” banks that are increasingly able to access collateral silos, diminishing the flow of collateral to those that are not, is that not a problem for the entire system regardless of how much “high quality collateral” exists on an aggregate basis? Given what happened in 2008 and 2011, with memories still fresh, collateral problems even for these lower tier banks would ignite a liquidity run (of some scale) despite the overwhelming presence of collateral stock in various forms and located in numerous “silos” (central bank balance sheets and even insurance company portfolios).

The collateral problem in 2008 was very much similar to that. It began narrowly in only certain institutions but grew as the primary dealer network began to “hoard” collateral for fear of losing it as a consequence of rehypothecation in bankruptcy. So again, it was not a money or collateral stock issue as it was about collateral dispersal and flow.

There is nothing here that even suggests the flow issue has been addressed. In fact, the authors of the BIS paper get to the very heart of the problem; collateral is just a symptom,

“A common problem, especially in the euro zone, where fears of unexploded bombs on bank balance sheets are still widespread, is that banks and funds with surplus cash (in countries such as Germany) are only willing to lend so much of it against paper issued by countries such as Italy or Spain, or by their banks, which have such high exposure to their respective sovereigns. It’s for that reason that the banking systems of Spain and Italy still have nearly 500 billion euros ($665.1 billion) in loans from the European Central Bank, an institution that is supposed to be the lender of last resort.”

The primary goal of monetary policy in the US and Europe since 2009 has been some version of “extend and pretend”. The operative theory, based almost exclusively on psychology, has been to “fool” markets into bidding up the price of every asset class, and thus ending the solvency/price problem of mortgage bonds and mortgages, or PIIGS sovereigns, on balance sheets (and off). It was certainly true that illiquid market pricing difficulties were driving some of the accounting losses at banks, that fed into the “hoarding” and fragmentation issues, but not all of the banking system’s difficulties were tied to pricing problems.

Regardless of money stock, there are still too many banks insolvent by any realistic measure, and other banks know it (there has never been a CMBS shakeout, for example). The institutions closest to the marketplace refuse to lend into it because they know who their counterparties are and what risks they still contain. If solvency were no longer a systemic issue, unsecured lending would be supporting all these marginal liquidity flow needs and collateral would be an unimportant and arcane detail for banking system models. That should be the highlight of the BIS paper.

Fragmentation has always been the primary problem, leading to shortages in parts of the dollar and euro system. At points along the way, the fragmentation shortages have been very acute and nearly fatal. And at those times, money stock and even the aggregate stock of collateral have not been badly behaved, but all the stock in the world will be less than useless if it cannot penetrate illiquid segments. It has always been about flow and availability beyond the center (the largest banks connected directly to the central banks).

So the incongruity of the WSJ headline stands out in relation to what is actually presented in the article. Fragmentation is and remains the system’s biggest problem. The fact the WSJ chose the headline it did speaks to an agenda to discredit critics of the mainstream in favor of entrenched monetary ideology. It would still be another logical fallacy even if it were true (critics of the Fed are wrong about everything since they are wrong about the collateral shortage), but even their article fails to defend that position in the slightest. In fact, if anything, the BIS paper offers even more evidence to the collateral problem as it really exists.

 

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