Thursday, February 18, 2016

No shortage of money

Markets continue to fret over weak oil and commodity prices, a slowdown in Chinese growth, and the threat of contagion from defaults in the oil patch. Are central banks too tight? Are negative interest rates the solution?

I think negative interest rates would be a mistake. You can't fix anything by destroying the demand for money with negative interest rates. Sure, negative interest rates will encourage people to spend their money rather than keep it in the bank, and it will encourage banks to utilize their excess reserves to boost lending. But that is not necessarily going to result in stronger economic growth. More likely, it will just boost inflation, which would further undermine the demand for money and ultimately weaken the economy.

It's true that there is a whole lot of money out there that isn't being spent. But that's because people—and banks—feel a need to accumulate money and deleverage. Tampering with that demand for money might not be a smart thing to do.

Why is it that central banks are everyone's go-to solution for solving the problem of weak economic growth? They shouldn't be. Taking money out of your savings account and spending it isn't going to increase anyone's productivity, and productivity is what creates growth. This is the supply-sider's main belief: spending doesn't drive an economy, producing does. We need to produce before we can consume.

What follows is a brief review of the state of money. There's plenty of it out there, both here and in the Eurozone.

One important measure of money is the amount of money relative to the size of the economy, shown in the chart above. This is a good proxy for the demand for money, and it can be thought of as the amount of one's annual income that is kept in ready cash form (checking accounts, savings accounts, money market funds, cash). Money demand in the U.S. has been rising since the late 1990s, and it has now reached an all-time high.

The best measure of the money supply is M2, shown in the charts above. M2 has been growing at an annualized rate of just over 6% for the past 20 some years. Most of the growth in M2 has been in bank savings deposits. That's unusual, because for many years these accounts have paid little if any interest. That must mean the demand for the safety of these accounts is very strong, since they offer little benefit beyond being a safe repository of money that is easily accessible.

The chart above tracks the history of bank savings deposits, which have been growing at about an 8% annual rate in recent years. Following the 2008 financial crisis, these accounts grew at double-digit rates for several years. It may not be a coincidence that the $4+ trillion increase in bank savings accounts since the beginning of QE1 is of the same order of magnitude as the Fed's QE purchases. In effect, banks took in $4 trillion of savings deposits and used that cash to purchase notes and bonds which were in turn sold to the Fed in exchange for bank reserves. Banks invested their deposit inflows with the Fed.

Today, banks hold about $2.3 trillion of excess reserves. Mike Bazdarich, a former colleague of mine at Western Asset Management, tells me that as a result of a series of regulatory requirements that have been implemented since 2008, (e.g., reserves required to collateralize deposits, the risk-weighted capital requirements imposed by the Basel Accords, plus the soon-to-come Fed-imposed requirement that banks hold highly liquid assets (mainly bank reserves) equal to 100% of the amount that Fed stress tests indicate they would need to survive another liquidity crisis), banks' demand for reserves has skyrocketed. It's possible that half or more of the current excess reserves held by banks today is effectively dictated by various requirements and requirements to come, some of which are still difficult to estimate.

In other words, banks have accumulated a mountain of excess reserves not because they don't want to lend against those reserves but because they had to accumulate them in order to survive. Banks may therefore not be as flush with excess reserves as the numbers suggest. They have responded to changing regulatory burdens by becoming more conservative and hoarding cash. Consumers have done the same in response to the loss of confidence that still persists in the wake of the 2008 financial crisis. In short, there are lots of reasons why the demand for money is strong.

Meanwhile, the supply of money has grown at generous rates all over the world. As the chart above shows, Eurozone M2 has increased almost as fast as M2 in the U.S. over the past two decades.

Seemingly buried in all the hand-wringing about slow growth and tight money, Commercial & Industrial Loans (loans to small and medium-sized businesses) have been growing at double-digit rates for years.

For the past 20 years, Total Bank Credit has been growing at almost the same rate, on average, as M2. Banks, after all, are the only ones who have the ability to create new money. The growth of credit and of the money supply (a bit more than 6% per year) has been well in excess of the growth of nominal GDP. From these facts, it would be hard to make the case that our problems today stem from any lack of money or lack of lending.

So what is holding the economy back? It's time to turn the focus on fiscal policy. Central banks have done all they can. What's standing in the way of progress are burdensome regulations, high marginal tax rates, intrusive government, subsidies for uneconomical green projects, and fear and uncertainty.

Negative interest rates are a solution for a non-existent problem that undermines the demand for money in a way that might have unwanted and inflationary consequences.


Benjamin Cole said...

By the way, the economist Michael Woodford suggests that QE should be married to tax cuts. In effect QE would finance tax cuts.

As for reducing structural impediments in the US economy, go for it. However I must confess, watching the two recent parties' debates, I see no evidence that will happen. And state and local governments are even worse. Consider a property zoning, now taken for granted, and which results in housing scarcity up and down the Pacific coast.

Monetary policy has to be made for the facts on the ground, not a world of lower structural impediments that every sensible economist would prefer.

Andrew said...


Agree with much of the post, but take exception with comment about high marginal tax rates being a significant problem. Simply don't see how those rates holds back the economy as a whole.

What seems to be the problem is that our country taxes lower wage jobs in many ways. It's very difficult to turn a profit by hiring people. Consider social security taxes, unemployment tax, workers comp, health insurance as well as normal income tax and sales taxes. These all makes it difficult for a small business owner to see a profit by creating jobs.

Nearly everybody wants tax cuts for themselves, but our political system is hamstrung against taking meaningful action.

Scott Grannis said...

Very high marginal tax rates hit people all across the income spectrum, especially those at the bottom who receive subsidies that phase out as their income increases. I myself would face a 65% marginal tax rate if I decided to return to work. I'd rather make less than pay the government two thirds of what I make. Many who subsist on welfare would be worse off working since the value of the benefits they would lose would exceed the income they would gain. It's a horrible system. And of course small businesses face crushing burdens of taxes and regulatory compliance. It's amazing that the economy is still able to grow.

marcusbalbus said...

give us QE

EEE said...

Scott, if, as you say "It's possible that half or more of the current excess reserves held by banks today is effectively dictated by various requirements and requirements to come, some of which are still difficult to estimate." do we need to redefine "excess reserves"? Are some of those "excess" reserves in fact NOT excess?

Scott Grannis said...

Excess reserves are reserves that are not needed to collateralize deposits. But considering the new requirements, I'm suggesting that "excess reserves" are not the same as reserves that serve no purpose for the bank that holds them. That in fact reserves that banks don't need for any purpose are much less than "excess reserves."

John said...

Interesting post and discussion. The biggest expense category for our family of 5 is insurance, not taxes like you guys, I expect. Of the insurances, health and auto are the two biggest. Health along with copays and deductibles are really putting the breaks on, for us anyway.

Scott Grannis said...

Health insurance would be a lot more affordable if it weren't highly regulated