There are many analysts today who insist on measuring global liquidity through the total amount of outstanding credit in the economy rather than the total money supply in circulation. While it is true that it in many cases the overall direction of both credit and the money supply will tend to move in unison, it is important to note that while some forms of credit creation and contraction can certainly lead to either an increase or decrease in the money supply, it is not universally true that credit serves as a proxy for global liquidity.
When the bank lends money to a borrower it is obvious to everyone that credit is increasing, but it is also true that money is being created “out of thin air” in the sense that the bank has created a new deposit for the borrower out of nothing. The borrower is then free to spend the newly created money in the broad economy which over time raises overall prices, anoints winners and losers, and creates mal-investment through the distortion of relative prices (for a more detailed explanation of this process, see Inflation, the Disease of Money). These types of loans are unquestionably inflationary since there is now a greater amount of money bidding on the same amount of goods and services in the economy, leading to a reduction in the overall purchasing power of money and an eventual increase in the price of goods and services. Conversely, when the borrower goes to repay the bank and retire the debt, the loan is extinguished and the money is destroyed. While credit has indeed contracted, it is the decrease in the money supply which reduces liquidity and contributes to a general deflationary effect on the economy.
In this sense it may seem to the uncritical eye that the use of credit as a proxy for global liquidity is in fact correct and proper, since in the above example it was the creation and destruction of credit which served as a catalyst for the expansion and reduction of the money supply. But this is not entirely accurate, for as we will see in the following example, bank credit can in fact change independent of a corresponding increase or decrease in the money supply. Consider now that the borrower in the above example, having borrowed and spent the new money created by the bank, is somehow unable to repay the debt according to the initial terms of the agreement and defaults on the loan. In this case the loan is extinguished, but the money supply has not decreased. The funds have been spent and have already propagated through the economy even though the initial loan will never be repaid and the outstanding credit has been correspondingly reduced. The bank in this case has made a poor investment which will impair its business operations in some detrimental manner, but liquidity itself has not contracted at all. The loan default and subsequent credit reduction was not inherently deflationary.
Of course, the total or partial loss of the loan owed to the bank may impact its business operations in other ways by reducing the rate by which it is willing to extend credit to other borrowers. It is certainly the case that when experiencing large-scale defaults that often occur during recessions, lenders tend to “pull in their horns” and are less willing to take on additional risks even among credit-worthy borrowers. However, the impact that bank credit has on liquidity is better and more appropriately measured directly through the money supply. It is simply not necessary to infer economy-wide liquidity through credit when we can measure it directly by simply looking at measures of the total quantity of money in circulation. Of course, in attempting to measure the extent that liquidity is either contracting or expanding, it is important to use proper measures of money since officially reported indicators such as M1 and M2 are often grossly misleading. This is because their composition is often unduly influenced by changes in components that do not actually meet the criteria for money. For an example of a more consistent and proper money supply definition and metric, see Follow the Money (Supply).
This is not to say that an analysis of bank credit is unimportant. Since the money supply can be influenced by only two factors (bank lending and central bank QE), observing bank credit can often be useful to supplement existing analysis of the money supply and general liquidity conditions. For example, one can certainly make the observation today that money supply growth is decelerating while bank loan growth is largely unchanged. This allows us to infer that liquidity contraction is happening predominantly as a consequence of central bank-induced tightening and not consumer and business de-leveraging within the banking system. We can further confirm this theory through an examination of the Fed’s balance sheet to see that the central bank is indeed unwinding its asset purchase program and is in fact the likely source of the decelerating money supply.
And yet even after having taken into account Fed asset purchases and sales (QE), it is important that we are not fooled into thinking that credit constitutes the only other direct form of liquidity. In a recession it is entirely possible that credit within the banking system contracts while the money supply is still expanding. Defaults and write-offs cause banks to realize the consequences of their reckless behavior which threatens their solvency and impairs their loan portfolio, all the while the money supply has not declined proportionately since the borrowed funds have already been spent into the economy. Analysts who focus predominately on credit during such periods have in the past been guilty of incorrectly predicting imminent deflation when a proper analysis of the money supply would clearly show this not to be the case at all. While an increase or decrease in bank credit can certainly spawn a corresponding expansion or reduction in the money supply, it is merely one possible factor impacting economy-wide liquidity and should not be mistaken as liquidity in and of itself. Defining liquidity as money only as opposed to money and credit allows us to capture those changes in credit that do in fact impact liquidity while ignoring those factors that clearly do not.