Banks Feed Off Inflation

Firstly let’s define inflation. Today’s common usage refers to inflation as rising prices either caused by an increase in aggregate demand with aggregate supply remaining static (demand pull inflation) or a decrease in aggregate supply while aggregate demand remains constant (cost push inflation).

So if there are tax cuts and there is more demand for all goods, is this considered inflationary? Yes by modern definition there will be an increase in aggregate demand causing demand pull inflation.

But my own view of inflation/deflation is the same as the classical definition of inflation which is an expansion of the money supply. The symptom of inflation is rising prices, which is why over time the factoid equating inflation to rising prices exists.

When the central bank adjusts interest rates, this affects the money held in bank reserve accounts and in turn affects a bank’s ability to make loans and increase the money supply.

When banks originate loans the money supply expands since a 10% reserve requirement will lead to banks using a $100 deposit to create a $1000 loan. This means when borrowers repay loans, the money supply contracts and similarly if a borrow defaults, the money supply really contracts. However, banks will use buffers to protect themselves against a default by first making sure the borrower is credit worthy, then requiring a deposit to banks are not taking the full risk, finally collateral will be linked to the loan (e.g. the property will be collateral for the mortgage loan).

As the money supply expands (inflation), asset prices rise since there is now more money chasing the same amount of goods. This in turn increases the demand for loans since people see asset prices rising and believe the economy is growing and additionally collateral value increases allowing potential borrowers to increase the leverage on their loan. Loan serviceability is another important factor when banks assess a potential borrower. Since all prices are increasing, including wages, pretty much all the factors a bank will look at to originate a loan improve in favour of the borrower.

This is the inflationary cycle that causes borrowing to lead to higher asset prices and then more borrowing. The central bank then tries to control this by increasing interest rates which should decrease the demand for new loans. However, there is a time delay in the effect and because the bulk of loans are long-term in nature (longer than a year) the economy doesn’t feel the full effect of a string of interest rate rises until a few years into the future. Eventually the economy begins to contract after a string of interest rate rises result in a fall in borrowing and then it is up to the central bank to re-start the game by slashing interest rates to begin a new cycle of borrowing and rising asset prices. This is how the business cycle works and is why under the current system any deflation is considered bad because if the central banks leaves the economy to contract and allow deflation to take hold, it will continue unabated until prices are so low that demand for loans increases. This could lead to a substantial contraction in the money supply and prices falling more than 10% in a single year.

The problem with this system is that banks depend on inflation the resulting loan origination to increase and maintain their current profits. If there is deflation, people demand less loans and repay their loans faster to reduce debt burdens. This causes a huge contraction in bank profits and when the economy really contracts, collateral values plunge as a vicious cycle of loan defaults and collateral devaluation takes place. One only has to look at what happens when a country has a bubble economy to see this scenario play out. Japan in the early 1990s, the US in 2008 and soon Australia will have its day of debt deflation.

Australia has hitched its wagon to the Chinese growth engine and Asia in general, which is where I fear the economic shock is likely to manifest itself. In many financial and economic crises we see banks come under severe stress and in many cases collapse as their reserves vanish via asset impairment, exposing their leveraged business model. Governments then become involved via bailouts and hence taxpayers are now proud owners of zombie banks.

This is exactly why substantial deflation (>2% deflation) will never be allowed to occur and why eventually rates will go to zero. Banks will not survive unless they dramatically increase their reserves, which I do not foresee happening during extreme economic uncertainty. The government will nationalise banks claiming that the economy will implode if nothing is done.

These are dire predictions and I am sure the majority will disagree with this forecast but is there really another outcome when the current solution to any downturn is to spur spending and borrowing via lower interest rates?