Money Still Matters 2

1. The monetary base

The monetary base – also referred to as base money, high-powered money or reserve money – is highly liquid money that consists of coins, paper money (both as bank vault cash and as currency circulating in the public domain) and commercial banks’ reserves with the central bank. The monetary base is the most acceptable (or liquid) form of final payment. It is the smallest measure of money and is referred to as M0.

The monetary base is controlled by the central bank – the Federal Reserve in the United States – which prints currency and releases it into the economy or withdraws it from the economy through open market transactions. Open market transactions involve the central bank in buying and selling government bonds, or (recently) other financial securities.

The monetary base is referred to as high-powered money because an increase in the base (M0) is allowed to increase through the so-called bank or money multiplier, as the commercial banks make leveraged loans and investments on the basis of their cash reserves. They can do so because of the fractional reserve nature of modern banking systems.

2.  Broader measures of the money supply

The money supply is the amount of financial instruments within a specific economy available for purchasing goods or services.  It is measured in three escalating categories, M1, M2, and M3. The smallest measure, M1, comprises M0 plus checking account deposits. The intermediate measure, M2, comprises M1 plus savings account deposits. The largest measure, M3, comprises M2 plus time deposits. As the measures move upwards, so they include increasingly illiquid components. For the most part, monetarists focus on M1 and/or M2 as key measures of the supply of money for policy purposes, though M3 should not be ignored.

3.  The September 2008-June 2010 monetary puzzle

In September 2008, M0, or high-powered money, in the United States was measured at some $850 billion.  Against this liability, the Federal Reserve held an equivalent volume of U.S. Treasury notes. Treasury notes are considered to be high-quality assets in view of the low likehood of a default by the U.S. government. Therefore, had the Federal Reserve chosen to tighten M0, it could have done so at any time by selling back some of its Treasury notes to the public.

However, in September 2008, the Federal Reserve panicked in response to the financial crisis amnd economic contraction. Its panic took the form of a massive increase in the size of M0, from $850 billion in mid-September 2008 to approximately $2,200 billion in mid-November 2008 ( an increase of  258 per cent). This enormous increase in M0 was achieved primarily by the Federal Reserve purchasing securitized mortgage bonds from the public.  Unlike Treasury notes, these bonds are not just low quality. They are highly illiquid and highly toxic. They now lie in the vaults of the Federal Reserve as worthless pieces of paper. For the most part they have no resale value. They could not be used in open market transactions should the Federal Reserve ever choose to reduce the magnitude of M0.

M0 has fluctuated a little through the period November 2008 -June 2010 without ever falling below $2000 billion. Under normal circumstances, the money multiplier would by now have kicked in with M1,  M2 and M3 also increasing by more than 200 per cent, in response to the increase in base money.  In such circumstances, the United States economy would be teetering on the edge of hyper-inflation, instead of confronting a slight risk of price deflation.

During the period of the credit and housing bubble, increases in M0 were clearly reflected in increases in the broader measures of the money supply, with M3 exploding at a rate of 17 per cent per annum, with M2 expanding at 8 per cent per annum and with M1 essentially stagnant. Since September 2008, this relationship has broken down. On a year-to-year basis, M3 is contracting by 2.6 per cent in nominal terms and 5.2 per cent in real terms. M2 is growing at a meager 1.9 per cent per annum in nominal terms and is declining in real terms. M1 is also rising only slowly in nominal terms and declining in real terms.

In such circumstances, the apparent recklessness of the Federal Reserve has not resulted in massive price inflation because it has barely impacted the supply of money in the U.S. economy.

4. Solving the puzzle

There are two competing explanations for this apparent puzzle. The first – which I do not share – is the Keynesian notion that the U.S. economy presently is locked into a liquidity trap. A liquidity trap exists when the demand for money on the part of the public becomes infinitely elastic. In such circumstances, as the money supply (M1, M2 or M3)  increases there is no impact on the economy because the public holds the increased money supply as a store of value. There is, if you like, a break-down on the demand side of the money market.  Note, however, that this break-down would not manifest itself in a failure in the link between M0 and the higher Ms.

The second explanation – which I strongly support -  is that the decoupling of M0 from the higher Ms is indicative of continuing financial stress within the commercial banking system. Remember that excessive leveraging within the banking sector was a prime cause of the financial collapse of 2008. Subsequently, the commercial banks were stress-tested by the Department of the Treasury and were given a clean bill of health, each and every one of them.  In my judgment, the stress tests were fraudulent. Many of the banks are still teetering on the edge of insolvency. In such circumstances, they deploy M0 increases as a mechanism to shore up low cash ratios. They do not lend because of threatening insolvency, not because of a dearth of demand for credit on the part of households and firms.

A time will come, however, when the banks are fully recovered. At that point in time, the excess supply of high-powered money will work its way via a reignited money multiplier into the higher Ms. At that point in time, inflationary expectations will rocket. The Federal Reserve cannot mop up the excess money supply quickly, even if its assets are marketable. It may well be all but impotent to engage in open market operations without eliminating its remaining balances of Treasury notes.

That is why the specter of significant price inflation still stalks the land, notwithstanding the absence of any current shadow indicating its presence.

 

Tags: absence of a liquidity trap, decouping of link between M0 and higher Ms, long-term specter of price inflation, massive increase in M0, The Federal Reserve bebases its balance sheet, the insolvency of many US banks