Money, so they say,
Is the root of all evil today.
-- Pink Floyd
Indeed, one would need to have spent entirely too much time on the dark side of the moon to question whether money supply, in some way, shape, manner or form, influences the economy. The question of how those influences occur, and to what extent, can ignite the closest thing to a barroom brawl among practitioners of the dismal science.
I'll leave the theological debates to others. The issue of whether we're stumbling into a stealth tightening, either through the actions of our good friends at the
or through our own slack credit demand, is one that has garnered an unusual amount of attention of late. Let's try to piece together some answers and then take a look back over the past quarter-century or so to see whether changes in the money supply have affected those things we hold near and dear, principally our own personal money supply.
Money is devilishly difficult to define, as it is bound inextricably to credit. Most of us remember from our long-ago economics classes that banks can create money within a fractional reserve system. If the reserve requirement, or the amount banks cannot lend, is 10%, an initial $1 billion deposit can be re-lent
to a maximum equilibrium quantity of $1 billion / 10%, or $10 billion. Eurodollar and other offshore banking deposits do not have a reserve requirement.
All of this was well and good during the era when banks and banks alone handled banking functions. This has not been the case since the growth of markets such as that for commercial paper, where large corporate borrowers borrow directly in capital markets, or since asset securitization took debt off of banks' books. The 1980 Depository Institution Deregulation Act recognized these changes and others like them. Finally, many consumers have lines of credit through home equity and asset-management accounts.
The old breakdown of the money supply had:
M1: Currency and demand deposits such as checking accounts.
M2: M1 plus savings accounts, time deposits (such as CDs) and retail money-market mutual funds.
M3: M2 plus institutional money market funds, eurodollars, repurchase agreements and large time deposits.
The St. Louis Federal Reserve created a new measure of money, zero-maturity, known as MZM, to handle the distortions produced by deregulation and financial innovations. While the traditional Ms are additive up to M3, MZM moves differently; it doesn't include small time deposits, for example, which don't have a zero maturity.
Seasonally Adjusted Money Supply Measures
Source: Federal Reserve
The Fed and Monetary Creation
The Federal Reserve can stimulate the expansion or effect the contraction of the money supply by its open-market operations. If it buys Treasury securities, it increases free bank reserves, and these reserves can be lent through the banking system. Conversely, the sale of Treasury securities contracts the supply of free reserves available for lending.
These activities affect the final money supply only indirectly. The Fed can be quite active in supplying reserves and driving the federal funds rate, the rate at which banks lend to each other, down to a target, but it can neither force banks to lend nor force businesses to borrow. Recent concern about a slow or declining growth in the money supply has to focus here: The level of commercial and industrial lending as a percentage of the GDP is the lowest since the data became available in 1959.
Where Has All the Lending Gone?
Source: Federal Reserve.
The low level of loan demand can be attributed to a number of causes, such as the aftermath of the equity bubble and the slack capacity in many industries -- why borrow when you do not need to expand? -- tighter controls on inventories, a structural shift in the U.S. economy to outsourcing production overseas and the growth of nonbank lending. Moreover, commercial and industrial loans are considered a lagging indicator of economic activity, and since the economy has started to reaccelerate only recently, we should expect loan demand to follow.
Relationship to GDP and Stocks
The velocity, or ratio of GDP to money supply, of the traditional monetary aggregates and MZM differs as well. In a July 1996 research letter, the Federal Reserve Bank of Cleveland attributed the different velocities to the outflow of small time deposits into mutual funds. It linked the outflow to the opportunity cost of keeping funds in T-bill instruments and measured a 4-percentage-point drop in demand for MZM for every percentage point increase in this opportunity cost.
The velocity of both M2 and MZM has been declining in the face of the Fed's aggressive rate-cutting campaign; the last datum is from the second quarter of 2003. This confirms the inefficacy of monetary policy in stimulating demand. Monetary policy may have prevented deflation, a real danger in the face of contracting credit demands.
It is axiomatic that excess liquidity finds its way first into financial assets; it is far easier to purchase a claim on a productive asset than to create the productive asset. Over the 1981-2000 period, the money supply as defined both by MZM and M3 had a very solid and near-linear percentage relationship with the growth of the
index. Once the bubble broke, however, stocks fell even as the money supply continued to grow.
The question is raised whether stocks, which eroded in the face of an expanding money supply during the bear market, will now crumble in the face of slower or negative monetary growth. Only if total credit continues to contract in the face of both low interest rates and a resumption of global demand; total credit includes the global supply of liquidity available for conversion into dollars.
Given slack capacity and improving productivity, it is quite possible for loan demand to remain soft, both in the U.S and globally. Viewed in this light, central banks may need to remain vigilant against further monetary contraction until global growth is confirmed.
This means the Fed's decision to keep the funds rate at 1% for a "considerable period," while notably ineffective in achieving other goals, is laudable in forestalling what could be further monetary contraction, and thus it is to be commended.
Howard L. Simons is a special academic adviser at Nasdaq Liffe Markets, a trading consultant and the author of
The Dynamic Option Selection System. At time of publication, Simons had no holdings related to this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. The views expressed in this article are those of Howard Simons and not necessarily those of NQLX. As a matter of policy, NQLX disclaims the private publication of materials by its employees. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to
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