Bank Credit and the Bull Market

Bank credit is the single most important element behind the economic stability—or instability—of nearly every country in the world under the control of a central bank. This truism is more true here in America than in any other country. A well-oiled credit machine, as maintained by the Federal Reserve and its member banks, is crucial for stimulating the economy on the local, regional, and national levels. In short, bank credit is the very engine behind the modern day business cycle.

Economists from nearly every major school of economic thought have long recognized the central role played by bank credit in galvanizing a given country's stock market, and by extension, its economy. A liberal, expansionist credit policy undertaken by central banks typically results in excessive investment and mal-investment. Investors and consumers, spurred on by low interest rates and easily available credit, tend to be less risk-averse in pursuit of monetary rewards. Equities markets tend to experience extraordinary gains as care-free investors heedlessly pump liquidity into a market, resulting in a runaway bull. An era of "good feelings" will ensue as investors are emboldened by the abundant credit and speculate ever more recklessly in a market suddenly propelled by nothing more substantial than promissory payments (i.e., debt). Is it any wonder then when this artificially inflated market implodes in a spectacular collapse when investors' debts exceed their ability to pay? This phenomenon is the hallmark of every stock market bubble driven by credit expansion.

One of the basic premises of technical analysis is that humans are destined to repeat the mistakes of the past; further, those mistakes can be charted and have prognosticative value. It therefore comes as no surprise that the present bull market in stocks on Wall Street is also destined for collapse, as it is being almost exclusively powered by an expansionist credit policy. It is of paramount importance that we understand the nature of this credit expansion and what it portends for the U.S. stock market. For, as a recent cover of Newsweek magazine expressed it, we are inextricably wedded to the stock market, and our collective fortunes are almost exclusively dependent on the market's performance. As the Dow's fortunes are dependent upon the continued availability of credit, it would do us well to examine a highly important and misunderstood banking concept.

A primary component of bank credit is the money supply (as measured by M1, M2, and M3). For our purposes, we will focus on M1—that part of the money supply that includes currency, checks, and other demand deposits. It is this component of the money supply that determines the availability of credit for the average investor/consumer. From 1959 to 1963, M1 remained relatively constant with only minimal increases in supply. But beginning in 1964, the Federal Reserve undertook an inflationary monetary policy and greatly expanded the money supply. M1 grew at an exponential rate during the late '60s and through the early '90s. But in 1989, M1 growth began to slow and experienced a decline, the first such supply decrease in nearly three decades. This contributed in large measure to the recession of 1990-91. Soon thereafter, the Fed opened wide the monetary spigots and the money supply began to inflate once again.

Through the 1970s and '80s, inflation made its presence known in the retail and consumer goods segments of our economy, manifesting itself through higher retail and consumer prices. Thus, inflation became very difficult to hide when reflected by commodities and consumer prices. But beginning in the middle part of the '90s, an interesting phenomenon occurred. For the first time in decades, inflation in the retail and commodities sectors began rapidly to abate and price declines were in evidence. This phenomenon, which has rapidly expanded over the past one year, has convinced many that a new era of low inflation is underway. But the fear of inflation that has characterized the past three decades is still very much in evidence and has become the subject of intense scrutiny among today's investors, as well as monetary authorities. Observers have been actively scouting the horizon waiting for inflation to rear its ugly head, never once realizing that inflation is right under their very noses. But unlike past years, inflation is now mainly confined within the realm of equities. The powerful seven-year bull market in stocks has been propelled almost entirely by a runaway credit expansion, and the inflation that in past years was evidenced in commodities and consumer markets is now discreetly embedded in the stock market.

Because any new money that is created by the Federal Reserve is now immediately funneled into the stock market, inflation becomes harder to detect while, simultaneously, stocks soar to previously uncharted heights and the speculative bubble grows at an ever-expanding rate. But like all inflationary bubbles, the current stock market must eventually deflate, and the signs of this inevitable deflation are already present.

A quick glance at the chart showing M1 money supply growth shows a rather steeply pronounced drop in the M1 supply over the past one year. Quite simply, the money supply is contracting, however subtly, and liquidity is slowly beginning to diminish. Bank credit, while still plentifully available to the great masses of investors, is also beginning to contract. According to recently-released statistics, consumers are beginning to amortize debt and to rely less and less on debt leveraging to purchase goods and services. And while millions of consumers/investors are leveraged to the hilt, preliminary evidence indicates that credit use is slowing while payments on debt are increasing—a negative sign for the bull market as the present stock market bubble can only continue to inflate inasmuch as debt continues to expand. "A credit contraction is the kiss of death to any bull market," as renowned market analyst Bob Prechter said recently. When the credit bubble in America bursts, so too will the bubble in stocks.

An inflationary monetary policy is the signature of central bankers everywhere, including the bankers who constitute the Federal Reserve. Austrian economist Ludwig von Mises pointed this out many years ago in his seminal works on monetary policy and the business cycle. In his book, The Theory of Money and Credit, Mises argued that business and investment cycles were caused by credit expansion, and that the only cure for a boom in business was a bust that would permit correct relative prices to reassert themselves (Vaughn, Austrian Economics in America, pg. 48). Mises further stressed that when economic expansion is financed by bank credit that is not backed up by voluntary savings, interest rates will fall below the "natural rate" and entrepreneurs will think that consumers are demanding more long-term investment projects and fewer short-term consumer goods (Vaughn, pg. 49). This goes a long way in explaining the current phenomenon of high equities prices and low prices for consumer goods. As producers misinterpret the signals being sent by investors, unprofitable capital investments abound and eventually, a recession or depression (depending on the level of over-investment) will result. Such crises occur because producers are fooled by relative scarcities from incorrect factor prices, and their expectations about future profits are misled by inappropriate credit availability (Vaughn, pg. 49). The end result of this credit-induced error is investments that result in costly errors that have deleterious consequences for the future shape of the free market.

Already, the negative effects from America's current credit expansion are observable. Economists recently noted that America's manufacturing segment is faced with a huge inventory glut as well as weak overseas demand attributable to the Asian currency crisis. The Commerce Department on May 28 issued first quarter GDP results, showing that America's trade deficit expanded to its largest ever under a flood of imports from Asia, and economists said domestic demand has been insufficient to soak up many of these goods, the first sign of an economic slowdown in the U.S. This overproduction on the part of U.S. manufacturers is a direct result of the credit expansion, as producers misinterpreted and misgauged consumer demand, resulting in a misallocation of resources. Truly, America is only just beginning to suffer the consequences of this monetary mistake.

Banks, too, are beginning to suffer for their indiscretion in extending credit to the non-credit worthy. Numerous banks are having to write off the bad debts and loans to delinquent debtors. Consequently, bankruptcy filings are at an all-time high.

The low interest rates that presently characterize the U.S. economic landscape, while lauded by investors, are only contributing to what will certainly be their demise. Here the Federal Reserve finds itself backed into a corner and faced with an imposing dilemma. If the Fed elects to raise rates, it risks incurring the wrath of investors as well as putting a sudden halt to the bull market in equities. If, however, it elects to leave rates unchanged at their current low numbers, it will only perpetuate the continued expansion of the credit and stock market bubbles, thereby ensuring a profound crash when the bubble eventually burst. Low interest rates encourage consumers/investors to go into debt and leverage their investments/purchases. This folly will shortly be exposed and at the expense of both the borrowers and the lenders.

One further sign that the credit/monetary expansion may already be in the process of ending is found in recent monetary base figures released in early May by the Federal Reserve Bank of New York. The estimated data for the two-week period ended May 6 showed that total bank reserves were down from the previous reporting period. The monetary base, which includes reserves held by depository institutions at their district Fed banks, plus Fed currency and U.S. currency and coins outstanding, was also down from the previous reporting period.

Other Fed data showed that all three monetary supply measures—M1, M2, and M3—decreased by several billion dollars during the latest reporting period.

The time is nigh approaching when America's great credit-fueled stock market will come to a sudden and inglorious halt. When it does, economists will no doubt hasten to point their fingers at a great number of undeserving suspects while the real culprit—excessive credit—will remain hidden from the eyes of the public as the real cause of America's second Great Depression.