Feb

19

Much of the creation of money over the last 15 years was induced by low Japanese interest rates on the order of 1% per annum. However since March of 2008 the Japanese money stock (M1) has fallen year over year in every single month.

In the US, part of the problem is the inherent contraction in money supply caused by people repaying their loans. When a loan is repaid money disappears from circulation.

There is another more insidious problem in the economy these days. It is really a form of fear. Everyone is afraid to make a decision, to invest, to spend or otherwise do something with their money. Thus the money that does exist has largely frozen up. This is best measured by the velocity of money also called the money multiplier. We recall that the multiplier is not an observable number but is simply given by the formula:

G = V * M or V = G / M

where G is the Gross Domestic Product, V the velocity and M is the Money Supply, in this case M1. The latest data shows that velocity has fallen from about 1.6 a year ago to .88 in the most recent numbers. A number below 1 means that the average dollar of M1 is turning over less than 1 time per year. A chart can be viewed at the St. Louis Fed site.

To compensate the Fed is aggressively easing M1, the monetary measure they can influence directly. In just a few months they increased M1 from 1.4 trillion to 1.6 trillion, an increase of $200 billion.

Part of the question of how we got here can be seen in the history of M1. On April 3, 2006 M1 peaked at $1402.5B. For the most part this peak was not exceeded and as late as Sept. 1, 2008 M1 was still at $1391.9B. That means there was essentially no growth in M1 for 17 months!

2006-04-03 1402.5
2008-09-01 1391.9 No growth for 17 months

Somebody at the Fed must have awakened from his snooze and noticed that TARP, TAF and alphabet soup was not quite working. So he started aggressively adding more than a trillion in garbage (the polite term) to the Fed balance sheet. This had the happy result of pushing more than a trillion in cash into the economy. So M1 money supply grew from 1391.9 in September to 1638.1 on Jan. 5th, 2009. The $1T bought us an increase of $200B or about 20 cents on the dollar. Don't ask where the other $800B went. After all they are still trying to figure out where the TARP money went.

2009-01-05 1638.1
2009-01-26 1548.2 -5.5% decline in January

More ominously during January M1 began to tank again. It was down 5.5% in January.

Looking at the broader measure of MZM, money supply with zero maturity we see that it has grown from about $8 T to about $9.3 T during the last year.

Thus M1 represents about 16% of the broader MZM metric. The current unpleasantness began with the decline in real estate and will not end until the real estate market stabilizes. There is more to be done.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Bud Conrad replies:

Bud CThe topic is one of great importance as to whether we return to inflation from the deflation we are experiencing, and when if it happens.

One of the problems in our fiat money system is that we have lost the definition of money. It used to be what we could turn into gold. M1 was distorted by the money market funds that replaced much of demand deposits at banks so under reported what was available for transactions. M2 included small savings. M3 had large savings. The Fed stopped reporting M3 which also included some strange measure of Eurodollar accounts and repos that they said they didn't want to spend the money to collect.

MZM seems the most sensible for the measure of money as it is accounts where money can be immediately used to buy things (Money of Zero Maturity).

When the M1 Money supply (Currency plus demand deposits including Reserves at the Fed) changes dramatically higher as it did from September because banks now have gargantuan ($700B) of excess reserves, which is higher than ever before even as a measure of GDP), it is logical to expect Velocity to decrease just from the increase in money supply. GDP is much less fast to respond, but was declining adding to the slowing of velocity. All we have done is let the banks hold a big bunch of money on deposit at the Fed, where they got the deposit invented out of thin air. The low velocity is not a reflection of consumer and business behavior, as much as it is a measure of money expansion. GDP movement was relatively, in % term small. The velocity concept is not wrong, it just shouldn't be a reflection of consumers, but a reaction of Central bank money creation that is stuck at the banks not yet flowing loans to the economy.

The measure to watch should be the Excess Reserves, which is declining some. As to whether this Fed buying assets is inflationary is crucial, and it is the lack of bank lending that eviscerates the Fed, as it is just pushing on a string. My own expectation is that foreigners may come back with their dollars accumulated form our trade deficits to buy real assets instead of financial assets to cause inflation. Such action would also increase Money supply measure sand be inflationary. But foreigners are reluctant to tell us that is what they are doing so we will only know after the fact. We would also see that action in the velocity measure.

Dr. Conrad is chief economist for Casey Research and teaches graduate courses at Golden Gate University.

Stefan Jovanovich comments:

These speculations assume that money is still somehow a "supply". Not now. It has become only a residual - the amount of stuff available to buy things and pay debts, including what can be instantly converted to legal tender. It is what is actually left over after businesses make or lose money, people borrow or save, governments borrow more than they spend. In an age of Bill Rafter and George Zachar and all the other smart people and smartly-programmed computers, central banks no longer enjoy the privileges of seignorage, nor can they conjure up "new" loans by using a magic wand to create reserves. Neither can the Congress and the Treasury "create" jobs using the magic wand of the multiplier. That is why Timmy looks so utterly helpless and Ben so tired. If you are looking for a physical metaphor for the monetary present, try water out here in the West. No one has yet to figured out how to make it rain; and when the ground supplies are depleted or the reservoirs not built and filled, you have a drought. Evaporation is not the source of your scarcity; it is simply the constant. Desalination, like "stimulation" (truly the appropriate metaphor for academic economics in the age of porn), offers the illusion of an answer but only if you ignore the fact that creating fresh from salt water is 2-3 times the cost of simply buying it from the people who have some to spare.

Bud Conrad responds:

Bud CI agree that there is no good definition of money, but the Fed can contribute to expanding the measures that are almost always included in the narrow measures of money, and then also therefore in the bigger measures. It seen best in conjunction with the real source of new credit (money), the deficit of the Federal government. The Treasury prints up new Treasuries. The Fed (usually through middle parties but leave them out for simplicity) creates a new demand deposit at the Federal Reserve Bank in the name of the Treasury out of thin air, in payment for the Treasuries. The Fed's books are balanced with more Treasuries as an asset, and a deposit as a liability that the Treasury can write checks on to buy bombers or pay Social Security. When the Social Security recipient deposits their check in their bank, the deposits of the whole banking system are increased. The usual narrow money measure is M1 that is basically currency plus demand deposits (checking accounts).

To be clear, If a foreigner with dollars from a trade surplus (our buying their products like computers) bought the Treasury, that would not add to the traditional money measures. That would then be considered that the Treasury borrowed the money for the deficit, rather than have it Monetized by the Fed. The distinction is probably over emphasized in money and banking texts, but the reason I bring it up is to be clear that the Fed can create what is generally called money.

You then need to know that the most of the money (demand deposits) is not created by the Fed. It is created by the banks making loans. The banks must set aside a little as a reserve against any new deposit but can loan out the rest. The borrower buys something like a house or car, the seller then deposits the proceeds, and that new deposit minus the reserve requirement can be loaned out again. In that fashion, banks make something like 6 times more money than the Fed does in total. The problem now of the Fed "printing" (= creating demand deposits out of thin air), doesn't work (have much effect), when banks don't lend. The Fed addition is not very big if the loans aren't made. That is called "pushing on a string", as we have now. And that is why we have deflation in the face of the most extreme Fed expansion and the Treasury $2 trillion deficit this year.

Dr. Conrad is chief economist for Casey Research and teaches graduate courses at Golden Gate University.

Legacy Daily comments:

It seems to me that a rosy outlook is in order. When the government and key "experts" say the worst is yet to come, I (and everyone else with me) fear to take on additional loans not knowing if 1) we can pay back 2) we'll make money from the loan. While the Fed/Treasury can create reserves (and pressure the bankers to state how much they're lending), unless there's increasing demand for loans, money will not be created to the degree it was created when every American thought they could buy a house and sell in a year with at least 20% profit.

Unfortunately, this type of shift in outlook will probably roughly coincide with the proverbial "capitulation" when I (and everyone else with me) can no longer imagine the situation getting worse. Until greed comes into the picture, money will not be multiplied to the degree it was multiplied in the past bubbles. The problem is that when greed becomes the key driver, we'll have incredible amounts of reserves - causing "sales" of money and the officials will be late to throttle back the system to prevent inflationary bubbles.

The "assets" are "toxic" because the outlook of getting the promised cash flows is negative. When that outlook changes (the poor guy who borrowed more than he should have sees the possibility of his house appreciating), the "toxic" will actually become like gold that never tarnishes.

What is the flaw in my logic?


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