Money demand continues to rise

We know this has been a miserable recovery—arguably the weakest ever—but exactly why is still a question that has not been answered to everyone's satisfaction. What follows is an attempt at a technical explanation based on the growth of the money supply and the nominal economy.

As the first of these two charts show, the M2 measure of money supply has grown at a fairly steady pace of about 6% per year for the past 17 years. As the second chart shows, the pace has picked up a bit since the Eurozone panic of last summer: since May '11, M2 is up at a 8.5% annualized pace. If all you knew were these two charts, you would guess that whatever has happened to the economy since the onset of the Great Recession hasn't involved any shortage of money.

Of course we all know that the Fed has been trying very hard to inject money into the economy for the past four years, and they have achieved a measure of success: since Sept. '08, the M2 money supply is up $2.2 billion, with $300 billion of that coming from additional currency in circulation and the rest from an increase in bank savings deposits. Banks now hold $6.5 trillion of savings deposits, and that represents almost two-thirds of M2. But so far, all this extra money hasn't had much impact on either the economy or inflation. The economy has only managed a bit more than 2% growth over the past three years, and inflation has only been about 2%; nominal GDP is growing only 4%, far less than the 8.3% annualized pace of the past 30 years. 

What's happened to all the money is that almost $1 trillion of the money that the Fed has succeeded in injecting into the economy over the past several years hasn't actually gone anywhere. People are holding on to it in bank savings accounts, and the banks in turn have invested the money in bank reserves that are sitting on the Fed's balance sheet. Most of the bank reserves that the Fed created to purchase notes and bonds have been willingly held by cautious savers and banks. The Fed has succeeded mainly in swapping bank reserves—essentially equivalent to T-bills since they pay about the same amount of interest and have an implicit government guarantee—for notes and bonds. 

As the chart above shows, there has been a huge increase in the world's demand for M2 money (M2 growth has been much faster than nominal GDP growth). Like corporations that are reluctant to reinvest their profits (which are at record levels in terms of GDP), individuals are reluctant to spend the money they have instead been stashing in their savings accounts. (For more detail, see my series on The Reluctant Recovery starting here.) Everyone wants to be more conservative, pay down debt, and build up their cash reserves. Why? Because there are too many uncertainties looming: the fiscal cliff, the trillion dollar deficits that portend a huge increase in tax burdens, the regulatory uncertainties created by things like ObamaCare, the Eurozone sovereign debt crisis, and the Fed's massive balance sheet expansion which could theoretically ignite a huge burst of inflation, to name just a few.

If money demand keeps increasing, then the Fed will not be able to achieve much in the way of real or nominal GDP growth. What's needed is a change in the fiscal policy outlook, more than anything. But if confidence in the future increases (or the uncertainties about the future lessen), then the demand for M2 would likely begin to decline, and there could therefore be a tidal wave of liquidity attempting to exit bank savings accounts in order to relocate in nominal GDP. In addition to that, we have the possibility that banks might decide to use some or all of their current $1.4 trillion of excess reserves in order to expand their lending activities. Either way there is enough money in the system to boost nominal GDP significantly in the years to come, if conditions are ripe. How and when that might happen is still uncertain, as is the issue of how much of the additional nominal GDP would would be attributable to real growth. 

But that is the essence of the problem today: there are some huge uncertainties out there, and that has simply dampened the animal spirits of nearly everyone. The November elections have the potential to create a great deal of change on the margin.