Money matters: post-Great Recession reappraisal

Posted by Tim Congdon in Article Archive | 0 comments

Evidence from the  years  of the  Great Recession justify renewed attention to  a broadly defined concept  of the quantity of money  in central  bank  research

money mattersControversy  over the use of monetary aggregates undermined the impact of the monetarist  counter-revolution  of the  1970s and early  1980s. Top central  bankers  accepted  Milton  Friedman‘s   dictum  “money  matters” was  valid  in some  sense,  but  they were  unsure  exactly  how  and why it mattered. Practical application was elusive when their research departments produced data on half-a-dozen  monetary aggregates.  Which concept  of money was of greatest  importance  –  or at any rate of some relevance – to the determination  of macroeconomic  outcomes? Anthony Harris,  one of the Financial  Times’ leading commentators,  compared the quarrel to that between the ‘Big-endians’    and ‘Little-endians’    about the best way to open a boiled egg in Jonathan  Swift‘s  Gulliver‘s  Travels.

Some economists  favoured  ‘broad  money’,  which included  all bank deposits  and  occasionally  even  included  liquid  assets  that  had  arisen outside  the  banking   system.    Others  supported   ‘narrow   money’    –   generally taken  to mean  notes  and coins  in circulation  plus   sight deposits.  The majority of monetary  economists  did not regard the monetary  base (the liabilities  of the central bank) as equivalent  to ‘the  quantity  of money’  based on any definition. Instead,  they believed   the change  in the base  influenced  the change  in narrow money  and  hence  affected  expenditure   at  a  further  remove.   However,   some participants  in the debate thought that the monetary  base by itself, regardless  of its role in banks’  creation  of money,  had a significant  bearing  on spending  and the economy.

The purpose  of this  article  is to propose  that  the  monetary  experiences  of the Great Recession  have settled the debate about the aggregates.  At least,  they ought  to have  settled  it to every  reasonable  observer.  In all of the prominent nations,  only broad money has continued to hold  a clear, roughly proportionate relationship   with  national   income   and  output   since  2008.   Of  course,   this relationship  is medium-term  and rather  imprecise  in nature,  but  Friedman  and his associates always contended that it worked best with large movements  in the relevant variables.  They did not claim exact short-term  correspondence  between money and income.

Two sets of facts, set out in two tables, are the basis for the proposition being made.  Table 1   gives key information on broad money and national income for economies that traditionally have accounted for well over half of world output. In the US, the  eurozone and the UK, the message is clear. Not only does a relationship hold in the long run between the rates of growth of broad money and nominal national output, but also this relationship  has survived the turmoil and uncertainties  of the Great Recession and its aftermath. Broad money has had a tendency to increase slightly faster in recent decades than income and output, with the gap typically being  1 % or 2% a year.

The  explanation  is probably  to be  sought  in the  increased  efficiency  and competitiveness  of banking systems, which have led to banks offering interest on a wider range of their deposit liabilities. Bank deposits, the dominant constituent in broad  money,  have become  higher-yielding  on average  and therefore  more attractive to hold. After allowing  for this pattern, the link between broad money and national income is robust and persistent.

A vital  feature  is that,  over  the  five  years  to  2015,  in all  of the  US,  the eurozone  member  states and the UK, the rates of money  growth have been the lowest since the 1930s, as have the rates of increase in nominal GDP.  The point is easy to establish for the US and the UK, as fairly consistent sources of pertinent statistics  are available.  To prove  the  claim  more precisely  for the  eurozone  is more problematic.  Strictly speaking,  data needs  to be prepared  for each of the eurozone  member  states before the introduction  of the single currency  in 1999 and that data should then be compared with the post-1999  statistics.2016-03-15_15-36-13

However,  there  can be little doubt that in the  immediate  post-war  decades, bank balance  sheets –  and hence broad money –  were growing  rapidly  in such nations as Germany, France and Italy, as they enjoyed economic recoveries  from wartime  devastation.  In the countries  of single-currency  Europe, too, it must be true that the last five years have seen the lowest increases since the 1930s in both the quantity of money, broadly defined, and nominal GpP.  The association  since the Great Recession  between,  on the one hand,  low money  growth  and, on the other,  low rises in nominal  GDP,  low inflation  and even occasional  deflation  is evident in the major nations of North America and Europe.

Japan does not fit so simply into the jigsaw.  The increase in nominal GDP in the five years to 2015,  at an average annual rate of0.4%,   is the most meagre in Table  1,  as is the increase in broad money.  But these are not the lowest numbers since the  1930s. In the five-year  periods  to all of 2001,   2002, 2003,  2004 and 2005 Japan’s  nominal GDP actually fell, according to the International  Financial Statistics database maintained  by the International  Monetary Fund.

Connecting the  dots 

Fortunately  for the  thesis  of this  article,   these  declines  again  had  an obvious connection  with  the behaviour  of money,  since in the  same  period  the rate  of increase in broad money was under 0.5% a year.  As far as Japan is concerned, it was the first five-year period in the new millennium  –  not the latest five-year period  –  that saw the lowest  increases  in both money  and nominal  GDP  since the 1930s.

Table 2 and the subsequent discussion are related only to the US. This could be justified by the liveliness of the US debate on the money aggregates, but space constraints prohibit a survey of the data in every nation of interest. The table shows the increases in two measures of broad money (M3 and M2),  narrow money (Ml), and the monetary base in the seven years to 2015 and in the preceding 49 years, and compares  them with the increases  in nominal  GDP.  One result is obvious. Whereas  the  growth  of nominal  GDP  and broad  money  (on the M3  measure) collapsed in the period of the Great Recession and after,  the growth rates of both narrow money and the monetary base were much higher in this period than they had been in preceding decades.  In the Great Recession and afterwards, the rise in nominal GDP has decelerated, while that in narrow money has accelerated.

Indeed, in the seven years to 2015, the growth of narrow money and the base far exceeded  the  contemporaneous   growth  of nominal  GDP. While  the recital of figures does not itself prove anything, the sharp divergence  between nominal GDP  and the narrow  money  concepts  (Ml  and the base)  is question-begging. On the face of it,  something  has gone wrong with narrow money.  In the  1980s, when officialdom’s   interest in monetarist  ideas was at its height, narrow money tended  to become  more popular  in central banks’  research  exercises  relative  to broad money. A common argument was that narrow money ought to have a good connection  with household  transactions,  particularly  retail sales. But retail sales in the US have certainly not advanced at double-digit annual rates since the Great Recession hit in early 2008

Narrow money  downside

 One drawback  of narrow money  concepts  has been compelling  in recent years. Although  sight  deposits  have  the  advantage  of  being  available  for  spending without notice,  they suffer from not paying interest. The general level of interest rates was at moderate  levels until the Great Recession,   with the Fed funds rate averaging  4%  in the  two  years  to mid-2008.   The  consequent  loss  of interest deterred  people  and companies  from holding  too much  of their overall  money balances  in sight deposits.  That kept down Ml  relative  to where it would  have been with a zero Fed funds rate. But interest rates were slashed in late 2008, as the Fed responded to the onset of the Great Recession.

An effective zero Fed funds rate became a major financial landmark as oflate October  2008. With time  deposits  and wholesale  deposits  no longer providing a meaningful return, non-interest-bearing  sight deposits increased in relative attraction. A big shift from time deposits into sight deposits then began, causing narrow  money  to expand  far more  quickly  than broad  money.  Ml  shot up by 18.1  % in the year to June 2009 and by 20.8%  in the year to August 2011.  But the explosions in Ml  did not mean that spending and output would revive strongly and over the medium term, they had no relationship  with nominal GDP.

Advocates  of broad money deny that sight deposits are of unique importance to  transactions.   They   insist   that  people   and  companies   regard   all  money balances,  including  time  deposits  and  even wholesale  money,  as available  for any transaction  with  little  inconvenience.  Their  view  has  surely become  more plausible  in the light of recent experience.  After all, banks must help customers or risk losing business.   On this basis, the split between  sight and time deposits, and transfers between the two categories of deposit, have little importance for the economy. The argument justifies  an emphasis on as comprehensive  a measure of broad money as possible,  since – by definition – a measure of money that includes every money balance cannot be altered by transfers between different balances.

A more  long-term  point  emerges  here.  As noted  earlier,  since  the  1950s, improvements  in financial  technology  and the extra competition  resulting  from deregulation  have  encouraged  banks  to pay  interest  on a higher  proportion  of their  liabilities.   The  lack of interest  on sight  deposits  ought  therefore  to have caused  Ml  to  decline  in size relative  to broader  measures  of money.  That  is exactly  what has happened.  The Fed’s  money  data series begin  in  1959, when Ml  was about $140 billion and nominal  GDP was little more than $500 billion. With M2 and M3 similar  in size at just  under  $300 billion,  Ml  accounted  for almost half of broad money.  In 2008, before the recent  surge in Ml  began,  Ml was about $1,400 billion, barely  10% ofM3,  which had almost reached $14,000 billion   and  modest   compared   with  nominal   GDP,  which  was  approaching $15,000 billion2016-03-15_15-42-19

In short, Ml  had dropped as a share of GDP from almost 30% in 1959 to less than 10% just before  the Great Recession.  In their 2009 book Animal spirits: how human psychology  drives the economy, and why it matters for global  capitalism (Princeton  University  Press),  Nobel-prize-winning   economists  George  Akerlof and  Robert   Shiller  observed  that  demand  and  cheque-able   deposits   in  Ml amounted to only $600 billion in 2008, which was “about  1 % ofnational  wealth”. They warned: “How can it be that by managing the quantity of demand deposits, the Fed can fix all the problems?  …  It can’t.”  The Akerlof-Shiller  comment  on Ml  was intended  as a rebuke  for those monetarist  economists  who persisted  in recommending  the analysis  of Ml  in research  work and the targeting  of Ml  in Fed policy-making.

Monetary Base

What  about  the  monetary  base?   It  has  two  components,    notes  and  coins  in circulation with the public, and banks’  cash reserves, which are mostly in central bank accounts.  Banks’  expenditure  (on staff,  premises  and so on) is a tiny part of aggregate  demand,  and is in any case not related to their cash reserves.   It has therefore  been  a long-standing  international  convention  to  exclude  these  cash reserves from officially recognised  ‘quantity  of money’  concepts.

In  the  Great  Recession,  it  was  the  cash  reserve  element  in the  base  that climbed dramatically  in the US,  as a by-product of the Fed’s  expansionary  open• market  operations.   The irrelevance  of cash reserves  by themselves  to aggregate demand has been amply confirmed,  since no connection can be observed between the base –  which more than quadrupled  between  mid-2008  and late 2014 –  and sluggish nominal GDP. The international  convention  has been vindicated.  Some authorities  have worried  about the inflationary  risks supposedly  inherent  in the Fed’s  ‘money  printing’,   appealing  to the textbook  multiplier  that  links –  or is claimed  to link –  the base  to the  overall  size  of bank  balance  sheets.  But  the increase in their base holdings has not prompted US banks to seek faster growth in their assets.  As economist  Charles  Goodhart  has demonstrated  in influential papers, the base multiplier model of money supply determination has been discredited.

An important problem with both the monetary base (dominated by cash) and Ml  is that nowadays  few large US businesses  or financial institutions keep sums in cash or sight deposits that are meaningful relative to their operations. Without doubt,  much of the instability in the Great Recession reflected decisions taken by ‘big business’  and in the financial sector, but the virtual absence of sight deposits from  their  assets  means  that  narrow  money  cannot  have  been  an explanatory variable behind those decisions.  In 2009, companies  complained  of shortfalls  in revenue  relative  to plans,  and squeezes  on their cashflow  and money  balances. The money aggregate at work must have been broad money.

However,  in the US context,  the idea of broad  money  is ambiguous  in two respects.  First, in the past, two measures  of broad money –  M2 and M3 –  were published  by the Fed. M2 was Friedman’s   favourite  aggregate  for most  of his career, and data for it are still prepared and published by the Fed. But it now has a major weakness.  The statisticians who put the numbers together have a tendency –  arguably a very unfortunate  tendency – to think that money exerts its influence on the economy because of its role in transactions,  where ‘transactions’  and ‘retail spending’  are virtually  synonymous.  In 1959 –  the first year of the Fed’s  money series  –  deposits  with  a value  of more than  $100,000   were rare,   and a sum of that size could not be readily spent ‘in the shops’.  Deposits with a value of over $100,000 were therefore excluded from M2.

Of course, inflation and the growth of incomes since 1959 mean that deposits over  $100,000  are  now  common.  In  fact,  the  bulk  of  bank  accounts  in  the ownership  of large  companies  and  financial  institutions  must,  individually,  be worth  more  than  $100,000.   It follows  that M2 no longer  captures  the money• holding  behaviour  of the corporate  US.  This  failing  ought  to have  caused  the Fed’s   statisticians  to rethink  their definitions  and procedures,  and to shift their focus towards  M3. But that has not been their response.  On the contrary,  in a bizarre,  move the Fed stopped publishing  M3 in February 2006.

A case can be made that the old Fed M3 –  composed  of all banks’  deposit liabilities  and  also  the  money  market  funds  that  have  long  been  non-bank financial  institutions’   main  form  of liquidity  –  was the  comprehensive  money measure that supporters of broad money wanted, and that they still want. Several critics  of the Fed’s  2006  decision  have  said that  M3  served  a vital  analytical purpose and should be restored. In the event, a private sector research company, Shadow Government  Statistics, has taken on the job  of guesstimating  M3 from publicly  available  information  on the  constituents  of M3  that  are  not  in M2. Shadow Government  Statistics’  post-2006  figures are used in tables  1   and 2

The  second  ambiguity  with  broad  money  arises  from  a difference  between the Fed’s  practice and the international  norm.  Since the early years,  International Monetary  Fund member  states have been obliged  to send it data on both  sides of their consolidated  banking  system’s  balance  sheet. (The consolidated  system combines the central bank and the commercial banking system.) The thinking was that the data would  help to identify  the monetary  origins  of external  payments imbalances,  in line with  an approach  pioneered  in the  late  1940s by  Edward Bernstein,   the  IMF’ s  first  director  of  research,   and  more  particularly  by  his successor, Jacques Polak. The IMF’s  data collection has over the decades created the world’s  most important body of monetary information,  embodied in the International  Financial  Statistics (IFS) database.

The   IFS  database   has   long-run   series   on  broad   money   and  its  credit counterparts  for scores of countries,   including  the US. Whether  the Fed likes it or not,  and regardless of its 2006 decision, an official US broad money number is available. Further,  the Paris-based  Organisation  for Economic  Co-operation  and Development  also includes broad money figures for its member states in its own publicly available economics  database. For the US, it calls them ‘M3’!  But there is a problem  for analysts.  The M3/broad  money  concept  endorsed  by the IMF and the OECD is not the same as the old Fed M3. The internationally  favoured M3  relates  specifically  to the  banking  system,   and  therefore  excludes  money market mutual funds.  Just before the Great Recession,  these funds were central to the financial sector’s   liquidity,  and  they  are still important today, but their growth  has  stopped  because  of new regulations.

To  conclude,  the Great Recession provoked central banks  into  an abrupt  cutting  of interest rates in 2008, causing money-holders to radically increase  the amounts  in their non-interest-bearing   accounts.  That change,  plus the multiplication  of the monetary base because  of quantitative  easing and other stimulatory   operations,    shattered  the  links  between   narrow  money  concepts and nominal  GDP  that  were  thought  to hold  by  some  monetarist  economists. By contrast,  broad  money  and nominal  GDP continued  to move together  over the medium  term.   In North  America  and  Europe,  the  Great  Recession  and  its aftermath saw the lowest rates of increases since the 1930s in both broad money and nominal GDP.

Parallel Lines

That parallelism  of movement  is striking. It surely goes a long way to revalidate  a monetary  approach  to  national  income  determination.   Can  a  case  be  made that in the US, in particular,  the Fed’s  economists  and statisticians  need to align themselves   more  closely   with  international   practice   and  other  central  bank research  departments?  If so, Fed economists need to reintroduce the measurement of M3 and analyse  it in their macroeconomic   prognoses.  Let it immediately  be conceded  that the  facts and figures  in this note  are far from being  a complete treatment of vexed and problematic  issues.

Nevertheless,   the  article  states  a position  and  marshals  a worthwhile  body of evidence to back it up. If money matters at all, then all money balances must matter  in  some  way  to  the  economy’s    equilibrium.  The  events  of  the  Great Recession justify  renewed attention to a broadly defined concept of the quantity of money in central bank research

Published in central Banking March 2016
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