When the Credit Transmission Mechanism Breaks…

We have an economy built around what Monetary Realism calls “inside money” or bank money.  That is, most of the money in our economy is deposits that exist as a result of bank loans (loans create deposits).  So it makes sense that the price of this money can have an enormous influence on the economy.  Outside of natural market forces and the demand for credit (which helps banks set the price of loans) the government can influence the cost of this money via monetary policy.  This is why the Fed’s operations are often seen as being so important.  When the Fed changes interest rates they are essentially changing the spread or the price at which banks can make their loans.  The Fed does this using “outside money” (money created outside the private sector) by changing the amount of reserves in the banking system or via alternative policies like QE.

I was rummaging through this morning’s data and noticed the depressed state of new home sales.  Now, I know there’s a supposed “housing recovery” going on at present, but the fact of the matter is that the data doesn’t actually support this view at all.  If anything, housing is still deeply depressed although it is coming off these very depressed lows.

But the more interesting thing to note is the broken credit transmission mechanism.  If you look at the 30 year mortgage rate closely you’ll notice a relatively steady inverse correlation between rates and new home sales.  That is, all the way up until about 2007.  Then, rates remain low and new home sales stay depressed.  The low rate transmission mechanism breaks.

Why does it matter?  This is exactly what we’d expect to see given the state of the balance sheet recession.  You see, demand for credit is very low because households are still recovering from the implosion in their balance sheets.  Instead of taking on more debt, households are paring back debt.  This is clear from yesterday’s NY Fed report on household credit trends.  And this is why monetary policy has been so broken in recent years.  The Fed can’t gain traction because their primary transmission mechanism is busted.  And the economy won’t feel quite right until this part of the monetary system starts working normally again….


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Very Serious Sam

    A question about ‘most of the money in our economy is deposits that exist as a result of bank loans (loans create deposits)': the ‘most’ stipulates that there are other components. There ae persons and businesses who create deposits w/o having loaned the mone from elsewhere, since they own more than they owe. Is this per (actual) saldo quantifiable? I don’t get the simplyfing zero sum theory (one man’s debit is another one’s credit). Because this doesn’t take into account for instance term transformations and entitlements, no?

    Sorry if this is a stupid question – I am just a layman trying to get a bit better understanding about economics. And your pragcap project helped me in this already a lot, thank you for that.

  • http://coppolacomment.blogspot.co.uk Frances Coppola

    Cullen, I agree with you about the broken credit transmission. And there is no doubt that households are cutting back spending and reluctant to take on debt. But isn’t there a another constraint too – namely the (understandable) reluctance of mortgage lenders to lend to higher risks? I don’t know about the US, but here in the UK we are seeing banks demanding large deposits and refusing to lend to anyone who hasn’t got a squeaky-clean credit score. The result is that although mortgage rates are low it is difficult to get a mortgage and therefore the housing market is depressed, house prices are falling – but rental prices are at an all-time high.

  • http://www.primeeconomics.org Ann Pettifor

    Cullen thank you for this. Demand from households may be low because of deleveraging, but what about firms? Here in the UK there is an unmet need for credit – because the credit on offer by commercial banks is too costly; rates across the spectrum – safe, risky, real, short & long – are very high, even while policy rates are low. So if there is a break in the transmission system it has been there for some time. Central banks long ago lost control over the full spectrum of rates, and just have (almost irrelevant) control over only one rate – the policy rate.

    But you are so right. It matters a lot that the transmission system is broken.

  • jt26

    The only reason why the transmission mechanism broke is because median price gains broke below MORTG in 2006. Current Case-Shiller price increases was reported to be ~3% which is close to MORTG so I think the mechanism will likely work again. BTW the government has no choice. Inflating the housing bubble is the only simple policy response: it increase “wealth”, results in an effective salary cut (for those who hate sticky wages), creates low productivity employment (and is much easier to create jobs than digging gold out of the ground!), and doesn’t require austerity.

  • http://www.orcamgroup.com Cullen Roche

    When I say “other” forms of money I am primarily referring to outside money. That includes notes, coins and bank reserves. These forms of money are all provided by the govt. The private sector can create “money like” instruments in addition to inside money, but that gets much more complex and isn’t really relevant to this discussion. Mike has covered this at the MR site in some detail.

  • http://www.orcamgroup.com Cullen Roche

    Hi Frances,

    Yes, that’s definitely an issue as well. Credit is obviously a two sided coin. The banks want to issue loans to creditworthy customers and those are increasingly difficult to find these days. Especially as credit standards have tightened.

  • http://www.orcamgroup.com Cullen Roche

    Hi Ann,

    Corporations are actually rather healthy. That’s been a big part of why the USA is not exactly Japan. In Japan it was corporations that were wrecked. In the USA & UK it’s the households. That’s one reason why we see stock prices rising throughout this crisis. Corporate balance sheets are actually okay. I am not sure about the UK, but here in the USA the primary borrowers are households so that’s the primary cause of the broken mechanism here.

  • http://www.financialgraphart.com JP Koning

    In mainstream econ, there are at least three channels through which Fed policy can operate – the portfolio balance channel, the expectations channel (specifically about the promised path of the interest rate after recovery has occurred), and the credit channel (which is the one you’re talking about). If the credit channel has gone dead, surely the others haven’t.

  • http://www.orcamgroup.com Cullen Roche

    I agree, but those other two channels are substantially less powerful than many presume. At least in my opinion. I think we’re seeing that play out in real-time as the rates of return diminish on QE with time.

  • DJ

    Precisely why zero rates is a misguided policy. Rates needn’t be at zero and write-downs need to be taken by banks (creditors need to pay) by principal adjustment. Foreclosure is fine too but that doesn’t help either. Yes, households over-borrowed by banks over-lent as well and the pain has to be taken by both in the form of early write-downs, not by waiting for the asset price to re-inflate. Artificial depression in prices due to liquidity constraints is not a problem any more, so why bother with zero rates, QE, etc.

  • Entenschnabel

    Cullen – you say “… government can influence the cost of this money via monetary policy..”
    Couldn’t you argue that since the banks don’t “borrow to lend” but create money out of thin air, there is no “cost” other than covering credit risk (neglecting the bank’s cost of capital, which should be small given how they can lever up they capital)?
    Essentially, what I am asking is : How does in your opinion the transmission mechanism from monetary policy to bank’s rates on inside money work?

  • http://Macronomy.blogspot.com Martin

    Great post Cullen!

    I would add that velocity M2 being as well at a very low level is also a sign of the broken credit transmission mechanism.



  • BT London

    Is the scale correct? 30-yr mortgage rates his 25% in 2005? Wow.

  • http://www.orcamgroup.com Cullen Roche

    Mtg rates are the red. Maxed at 18% in the 70s. Still very high….

  • KB

    “And the economy won’t feel quite right until this part of the monetary system starts working normally again…”.

    Oh, how I like these statements! So, using this concrete example, what is normal? What new home sales are “normal”? 1200k or 300k? Or, maybe, 250k? Some econometric clown at the fed would easily answer this by building a complicated regression model. Some communist planner clown in North Korea would also easily answer based on number of sq feets per person, according to a party decree.
    The reality is, nobody knows. And economy would feel quite right when no clowns are meddling with it through various “home ownership support” programs, inlcuding government-sponsored mortgages. Then market would clear, and new home sales would resume its normal pace, whatever it is.

  • freemarketeer

    Do you have a ballpark estimate for the importance of each kind of credit (home loans, revolvers, etc.) in the interest rate transmission mechanism? Is it about the same as the weighted proportion of total credit?