Friday, October 26, 2012

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.  


Gloeschi said...

One word for you, Scott: de-le-ve-ra-ging.

Even your friend Mitt won't be able to change anything about that.

Money is not credit. In a debt-driven economy, demand is dependent on availability of credit (not M2 or other nonsense).

William said...

Gloeschi = troll looking for attention.

Thank God they never stay around long. Best to ignore them which I failed to do.

Benjamin said...

Unfortunately, the Fed has not been aggressive enough.

It doesn't matter how much air you pumped into your flat front tire, and that it was more air than you ever pumped before. What matters is if the tire is inflated or not.

The US tire is not fully inflated, due to a timid Fed--worse, a Fed that until very recently followed a hide-and-seek, peek-a-boo policy that gave to assurance to markets.

Transparency is great for democracies and government. The Fed should say it will target 8 percent NGDP growth that Scott Grannis alludes to.

I hope the best for a Mitt Romney election, but history suggests the GOP loves agency spending, and too many old people vote to cut entitlement spending.

Ergo, deficits might actually be larger under Romney than they would have been under Obama. If you doubt that, remember the GOP-controlled DC of the Bush years, and tell me what exactly inspires you about that epoch.

Romney is already honking up defense spending, yet Defense, VA and Homeland Security spending already tops $1 trillion annually. Romney says it is not enough. The Soviet Union has collapsed, no other nation poses the slimmest military threat--we are spending $1 trillion a year to fight a few punk terrorists.

Where is the gimlet eye of the GOP-businessman when it come to that outlay?

steve said...

embrace fossil fuel speculation. free up regs that bind the aformentioned and watch free enterprise do the rest. you'd see a boom the likes of which we haven't seen since the 90's

Dr William J McKibbin said...

Unfortunately, Scott is missing the emerging reality of bifurcation of money availability between Main Street (real estate, consumer lending, very small business lending, etc) and money availability for public corporations (very large companies) and government -- said another way, the Federal layer of the US economy enjoys higher supplies of money than the Main Street economy -- herein lies the root cause of the economic malaise emerging in the US -- money is scarce for real estate projects and mortgages, very small businesses, and consumer credit, while heavy manufacturing (e.g., the defense industry) and the Federal government seems to have access to unlimited capital via taxpayers -- a reversal of this situation is critical or the American people will seek to overthrow the Federal government at some point (while the government seeks to suppress civil uprisings at gunpoint).

Scott is right when he says that very large public corporations and the government have access to vast money supplies -- but Scott is incorrect when he then implies that the money supply is also available to Main Street uses, including real estate, very small business lending, consumer purchases, and so forth -- this has been a recurring error in Scott's money supply estimates over the past few years.

Overall, I agree with Scott regarding his assessment of the money supply -- however, the money supply that Scott is describing has only benefited the nation's largest "to big to fail" corporations and the government since the economic crisis began in 2007.

Hope this is useful...

Family Man said...

PSR as % of DPI is still low, 3,7% vs 1960-1990 level of above 7,5%.

As we are in balance sheet recession period, the only agent who can borrow and spend is goverment. Households and corporations will be saving. US avoided recession because gov sector was investing (not optimally of course). Small goverment for US means recession.
That would be good if there would be economical downturn with households able to spend.

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bob wright said...
This comment has been removed by the author.
bob wright said...


I'd be interested in your take on comments made by Steve Hanke relative to money supply in this Econtalk interview:

He argues that bank money is tight.


" state money is 15% of the total amount of the money supply--meaning that state money is peanuts. What really is important is bank money--and bank money is created by the commercial banking system and shadow banking system, and that's what really counts. So, in a way we have had the following scenario develop after Lehman: We've had ultra-loose monetary policy with regard to state money and the Federal Reserve. But with the financial regulation, that it was legislated with Dodd-Frank, and also with what is called the Basel capital requirements, and specifically Basel III, which is being imposed on banks--to increase the capital-asset ratios of the banks. These two things--financial regulation and Basel--have in effect imposed ultra-tight monetary policy on the banking system and bank money. So, as a result of the two, we've had the total amount of the money supply actually being very anemic, not growing very much at all. And in fact, if you look at a trend line since 2009 and look at the endpoint today of the trend line as you are going left to right, that point is about 7.5% higher than the actual level of the money supply that we have. So, you could argue that relative to trend we've got a deficiency of about 7.5% in broad money."

Scott Grannis said...

I don't think my view is inconsistent with Hanke's. I would quibble about whether we really have a deficiency of broad money, but we both argue against the popular view that the Fed has printed massive amounts of money.

I've noted several times that banks are still very risk-averse and reluctant to lend. This is improving with time, but it is still a problem.