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Equity markets and credit contraction

September 13, 2015

Equity markets and credit contraction

There is one class of money that is constantly being created and destroyed, and that is bank credit.

Bank credit is created when a bank lends money to a customer; it becomes money because the customer draws down this credit to deposit in other bank accounts and to pay creditors. It is not money that is created by a central bank; it is money that is created out of thin air by commercial banks to lend. Its contraction comes about when it is repaid, or if a customer defaults.

The recent sharp fall in equity markets is leading to two levels of contraction of bank credit. Brokers’ loans to speculating investors are being unwound from record levels, notably in China and also in the US where in July they hit an all-time record of $487bn. Then there is the secondary effect, likely to kick in if there are further falls in equity prices, when equities held as loan collateral are liquidated. This is when falling stock prices can be so destructive of bank credit, and as the US economist Irving Fisher warned in 1933, a wider cycle of collateral liquidation can ensue leading to economic depression.

Fear of an escalating debt liquidation cycle is always a major concern for central bankers, so ensuring the secondary effect described above does not occur is their ultimate priority. Macroeconomic policy is centred on ensuring that bank credit grows continually, so since the Lehman crisis any tendency for bank credit to contract has been offset by central banks creating money. The bald fact that equity markets have now lost upside momentum and appear to be at risk of a self-feeding collapse will be viewed by central bankers with increasing alarm.

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