Tuesday, September 15, 2009
A few readers have raised the issue of whether we should be worried about the negative growth of money and credit in recent months. M2 money supply has fallen about $70 billion from its March high, and total bank credit has dropped by almost $400 billion since its peak of last October. Despite these declines, my argument continues to be (this is the longest-running theme on this blog I think) that there is no shortage of money in today's economy, and therefore no need to worry that the economy is being starved of money and therefore at risk.
This first chart illustrates the sharp swings in M2 money growth over the past year. David Rosenberg worries that "the deflation in credit, wages and rent is a toxic brew." But when money and credit growth were surging in late 2008, he was even more bearish on the economy than he is now. The problem lies in taking things out of context. The recent slowdown in money growth should be seen as a reversal of the explosive growth of money in the Sep. '08 through Mar. '09 period. Money growth took off because of a surge in money demand which was accommodated by the Fed's ultra-easy monetary policy. That surge in demand was in turn a by-product of extreme fear that the global financial system was on the verge of collapse. Now that these concerns are fading, it is only natural that money demand should fall and money balances should shrink. And in any event, the year over year growth rate of M2 is still a very healthy 7.6%. Any faster and monetarists would start worrying about a big acceleration in inflation.
This next chart shows the velocity of M2 (how many times each dollar of M2 is spent per year). I've used reasonable estimates for the growth rates of nominal GDP and M2 in the third quarter: 5.6% and -3.3%, respectively. I've highlighted the uptick in velocity that these numbers reflect, which works out to an annualized rate of growth of about 9% in the current quarter. If money velocity continues to rise at this rate, then money balances can shrink by 3-4% and the economy can still enjoy 3-4% real growth. That velocity is now rising is a very important development, since velocity is the inverse of money demand. Money demand is falling, and money balances are getting spent, and that is a major factor pushing the economy forward.
This next chart shows M2 growth over the past 50 years. As should be obvious, money growth almost always picks up in advance of recessions and almost always slows down as the economy moves from recession to recovery. The current pattern of declining money growth is exactly what we should expect to see. Indeed, this chart suggests that money growth could slow a lot more and the economy could still enjoy healthy rates of growth.
Finally, this last chart shows the growth in Total Bank Credit over the past 15 years. I've estimated a trend growth line of 7.5% per year, which is a bit more than the 6% average growth in M2 over this same period, and just a bit slower than the 7.8% annualized growth in this series since 1973. What you see is that the slowdown in bank credit since last October is mainly "payback" for the unusually rapid growth in bank credit in the 2005-2008 period. One reason for the slowdown in bank credit is that banks have tightened their lending standards, and that is reflected in surveys of lending officers. Another reason is that a lot of people want to reduce their debt burdens these days; deleveraging is being actively pursued by individuals and corporations alike. Another reason is that government borrowing has surged and is displacing private borrowing. Taken in isolation, any of these reasons could be cause for concern, but in today's context it's not obvious that the economy is starved for money. Indeed, the growth in M2 money balances remains very healthy, and above all, the Fed remains extremely accommodative. The current level of bank credit outstanding is exactly in line with historic growth trends.
UPDATE: As supply-sider, I should add that while the availability of credit certainly facilitates growth, it is not essential for growth. Growth is not created by extending credit; growth is fueled by work, productivity, investment and risk-taking. The bulk of the credit extended in any given year comes not from newly-created money, but from money that has been earned by others and subsequently lent to borrowers.
Posted by Scott Grannis at 11:20 AM