Financial System Liquidity

The broad, credit driven measure of liquidity is up 1.8% yr/yr.
My weekly lending proxy -- banking system credit + commercial
paper in force -- is up a scant 2.2% yr/yr. Realistically, these
paltry gains would likely not have been achieved without the massive
liquidity supports extended by the Fed and Treasury, including the
recent Fed program to purchase commercial paper. The collapse
of the comm. paper market over the last 15 months has been the
dominant negative factor within the credit system. The rapid drop
of paper in force has forced the contraction of downstreaming asset
backed loan participations to smaller banks and likewise the
upstreaming of deposits to buy large bank holding company paper.
Total bank lending has risen appreciably in part because banks
have been unable to move loan participations out to nonbank
financial outfits and foreign banks as well. The banking system has
remained functional and has absorbed the sharp rise in loan losses,
but it has clearly been sheltered from the worst ravages of the
unwinding of the commercial paper market by the Fed and Treasury.

However, one has to take note also that when an economy falters,
private sector credit demand weakens as capital projects are shelved
and working capital needs ease. The guys who really need the loans in
an economic downturn have cash flow problems and are not the
ones the banks want to see. So, slow private sector credit creation
and demand are typical in a downturn, but the large shifting of
risk to the public arena is not.

The Fed has finally allowed monetary liquidity to expand rapidly to
offset the weak credit situation. This effort is a cardinal step in
paving the way for an eventual economic recovery. The expansion
of the basic money supply has been very rapid, advancing at a 20.3%
annual rate over the past 3 months, but growth of the basic money
supply has been so low over the past 5 years that it may need to be
allowed to expand at a continued rapid pace for a while longer to
sustain the economy in the face of such sluggish private sector
credit creation. Long term readers of the blog know how often I
have cautioned that reliance on credit to drive the economy can be
disastrous if monetary liquidity is not injected quickly once the
well of credit starts to dry.

The Fed is moving in the right direction now on liquidity, but
Bernanke was way, way too slow in stepping up on this score.