Guest Post: The Perils of Credit Money Systems Managed by Private Corporations

In this instance the 'paper money' system would be analagous to money created by private banks by means of expanding credit. The Second Bank of the United States is the predecessor to the Federal Reserve Bank System which was established in 1913.

"The paper system being founded on public confidence and having of itself no intrinsic value, is liable to great and sudden fluctuations, thereby rendering property insecure and the wages of labor unsteady and uncertain.

The corporations which create the paper money cannot be relied upon to keep the circulating medium uniform in amount. In times of prosperity, when confidence is high, they are tempted by the prospect of gain or by the influence of those who hope to profit by it to extend their issues of paper beyond the bounds of discretion and the reasonable demands of business.

And when these issues have been pushed on from day to day until the public confidence is at length shaken, then a reaction takes place, and they immediately withdraw the credits they have given; suddenly curtail their issues; and produce an unexpected and ruinous contraction of the circulating medium which is felt by the whole community.

The banks, by this means, save themselves, and the mischievous consequences of their imprudence or cupidity are visited upon the public. Nor does the evil stop here. These ebbs and flows in the currency and these indiscreet extensions of credit naturally engender a spirit of speculation injurious to the habits and character of the people. We have already seen its effects in the wild spirit of speculation in the public lands and various kinds of stock which, within the last year or two, seized upon such a multitude of our citizens and threatened to pervade all classes of society and to withdraw their attention from the sober pursuits of honest industry. It is not by encouraging this spirit that we shall best preserve public virtue and promote the true interests of our country.

But if your currency continues as exclusively paper as it now is, it will foster this eager desire to amass wealth without labor; it will multiply the number of dependents on bank accommodations and bank favors; the temptation to obtain money at any sacrifice will become stronger and stronger, and inevitably lead to corruption which will find its way into your public councils and destroy, at no distant day, the purity of your government. Some of the evils which arise from this system of paper press, with peculiar hardship, upon the class of society least able to bear it...

Recent events have proved that the paper money system of this country may be used as an engine to undermine your free institutions; and that those who desire to engross all power in the hands of the few and to govern by corruption or force are aware of its power and prepared to employ it. Your banks now furnish your only circulating medium, and money is plenty or scarce according to the quantity of notes issued by them. While they have capitals not greatly disproportioned to each other, they are competitors in business, and no one of them can exercise dominion over the rest. And although, in the present state of the currency, these banks may and do operate injuriously upon the habits of business, the pecuniary concerns, and the moral tone of society, yet, from their number and dispersed situation, they cannot combine for the purpose of political influence; and whatever may be the dispositions of some of them their power of mischief must necessarily be confined to a narrow space and felt only in their immediate neighborhoods.

But when the charter of the Bank of the United States was obtained from Congress, it perfected the schemes of the paper system and gave its advocates the position they have struggled to obtain from the commencement of the federal government down to the present hour. The immense capital and peculiar privileges bestowed upon it enabled it to exercise despotic sway over the other banks in every part of the country. From its superior strength it could seriously injure, if not destroy, the business of any one of them which might incur its resentment; and it openly claimed for itself the power of regulating the currency throughout the United States. In other words, it asserted (and it undoubtedly possessed) the power to make money plenty or scarce, at its pleasure, at any time, and in any quarter of the Union, by controlling the issues of other banks and permitting an expansion or compelling a general contraction of the circulating medium according to its own will.

The other banking institutions were sensible of its strength, and they soon generally became its obedient instruments, ready at all times to execute its mandates; and with the banks necessarily went, also, that numerous class of persons in our commercial cities who depend altogether on bank credits for their solvency and means of business; and who are, therefore, obliged for their own safety to propitiate the favor of the money power by distinguished zeal and devotion in its service.

The result of the ill-advised legislation which established this great monopoly was to concentrate the whole money power of the Union, with its boundless means of corruption and its numerous dependents, under the direction and command of one acknowledged head; thus organizing this particular interest as one body and securing to it unity and concert of action throughout the United States and enabling it to bring forward, upon any occasion, its entire and undivided strength to support or defeat any measure of the government. In the hands of this formidable power, thus perfectly organized, was also placed unlimited dominion over the amount of the circulating medium, giving it the power to regulate the value of property and the fruits of labor in every quarter of the Union and to bestow prosperity or bring ruin upon any city or section of the country as might best comport with its own interest or policy.

We are not left to conjecture how the moneyed power, thus organized and with such a weapon in its hands, would be likely to use it. The distress and alarm which pervaded and agitated the whole country when the Bank of the United States waged war upon the people in order to compel them to submit to its demands cannot yet be forgotten. The ruthless and unsparing temper with which whole cities and communities were oppressed, individuals impoverished and ruined, and a scene of cheerful prosperity suddenly changed into one of gloom and despondency ought to be indelibly impressed on the memory of the people of the United States.

If such was its power in a time of peace, what would it not have been in a season of war with an enemy at your doors? No nation but the freemen of the United States could have come out victorious from such a contest; yet, if you had not conquered, the government would have passed from the hands of the many to the hands of the few; and this organized money power, from its secret conclave, would have directed the choice of your highest officers and compelled you to make peace or war as best suited their own wishes. The forms of your government might, for a time, have remained; but its living spirit would have departed from it.

The distress and sufferings inflicted on the people by the Bank are some of the fruits of that system of policy which is continually striving to enlarge the authority of the federal government beyond the limits fixed by the Constitution. The powers enumerated in that instrument do not confer on Congress the right to establish such a corporation as the Bank of the United States; and the evil consequences which followed may warn us of the danger of departing from the true rule of construction and of permitting temporary circumstances or the hope of better promoting the public welfare to influence, in any degree, our decisions upon the extent of the authority of the general government. Let us abide by the Constitution as it is written or amend it in the constitutional mode if it is found defective.

The severe lessons of experience will, I doubt not, be sufficient to prevent Congress from again chartering such a monopoly, even if the Constitution did not present an insuperable objection to it. But you must remember, my fellow citizens, that eternal vigilance by the people is the price of liberty; and that you must pay the price if you wish to secure the blessing. It behooves you, therefore, to be watchful in your states as well as in the federal government.

The power which the moneyed interest can exercise, when concentrated under a single head, and with our present system of currency, was sufficiently demonstrated in the struggle made by the Bank of the United States. Defeated in the general government, the same class of intriguers and politicians will now resort to the states and endeavor to obtain there the same organization which they failed to perpetuate in the Union; and with specious and deceitful plans of public advantages and state interests and state pride they will endeavor to establish, in the different states, one moneyed institution with overgrown capital and exclusive privileges sufficient to enable it to control the operations of the other banks.

Such an institution will be pregnant with the same evils produced by the Bank of the United States, although its sphere of action is more confined; and in the state in which it is chartered the money power will be able to embody its whole strength and to move together with undivided force to accomplish any object it may wish to attain. You have already had abundant evidence of its power to inflict injury upon the agricultural, mechanical, and laboring classes of society, and over whose engagements in trade or speculation render them dependent on bank facilities, the dominion of the state monopoly will be absolute, and their obedience unlimited. With such a bank and a paper currency, the money power would, in a few years, govern the state and control its measures; and if a sufficient number of states can be induced to create such establishments, the time will soon come when it will again take the field against the United States and succeed in perfecting and perpetuating its organization by a charter from Congress.

It is one of the serious evils of our present system of banking that it enables one class of society, and that by no means a numerous one, by its control over the currency to act injuriously upon the interests of all the others and to exercise more than its just proportion of influence in political affairs. The agricultural, the mechanical, and the laboring classes have little or no share in the direction of the great moneyed corporations; and from their habits and the nature of their pursuits, they are incapable of forming extensive combinations to act together with united force. Such concert of action may sometimes be produced in a single city or in a small district of country by means of personal communications with each other; but they have no regular or active correspondence with those who are engaged in similar pursuits in distant places. They have but little patronage to give the press and exercise but a small share of influence over it; they have no crowd of dependents about them who hope to grow rich without labor by their countenance and favor and who are, therefore, always ready to exercise their wishes.

The planter, the farmer, the mechanic, and the laborer all know that their success depends upon their own industry and economy and that they must not expect to become suddenly rich by the fruits of their toil. Yet these classes of society form the great body of the people of the United States; they are the bone and sinew of the country; men who love liberty and desire nothing but equal rights and equal laws and who, moreover, hold the great mass of our national wealth, although it is distributed in moderate amounts among the millions of freemen who possess it. But, with overwhelming numbers and wealth on their side, they are in constant danger of losing their fair influence in the government, and with difficulty maintain their just rights against the incessant efforts daily made to encroach upon them.

The mischief springs from the power which the moneyed interest derives from a paper currency which they are able to control; from the multitude of corporations with exclusive privileges which they have succeeded in obtaining in the different states and which are employed altogether for their benefit; and unless you become more watchful in your states and check this spirit of monopoly and thirst for exclusive privileges, you will, in the end, find that the most important powers of government have been given or bartered away, and the control over your dearest interests has passed into the hands of these corporations.

The paper money system and its natural associates, monopoly and exclusive privileges, have already struck their roots deep in the soil; and it will require all your efforts to check its further growth and to eradicate the evil. The men who profit by the abuses and desire to perpetuate them will continue to besiege the halls of legislation in the general government as well as in the states and will seek, by every artifice, to mislead and deceive the public servants. It is to yourselves that you must look for safety and the means of guarding and perpetuating your free institutions. In your hands is rightfully placed the sovereignty of the country and to you everyone placed in authority is ultimately responsible. It is always in your power to see that the wishes of the people are carried into faithful execution, and their will, when once made known, must sooner or later be obeyed. And while the people remain, as I trust they ever will, uncorrupted and incorruptible and continue watchful and jealous of their rights, the government is safe, and the cause of freedom will continue to triumph over all its enemies.

But it will require steady and persevering exertions on your part to rid yourselves of the iniquities and mischiefs of the paper system and to check the spirit of monopoly and other abuses which have sprung up with it and of which it is the main support. So many interests are united to resist all reform on this subject that you must not hope the conflict will be a short one nor success easy. My humble efforts have not been spared during my administration of the government to restore the constitutional currency of gold and silver; and something, I trust, has been done toward the accomplishment of this most desirable object. But enough yet remains to require all your energy and perseverance. The power, however, is in your hands, and the remedy must and will be applied if you determine upon it."

Andrew Jackson, Farewell Address, March 4, 1837

Money Supply and Demand, and the Monetization of Debt

The growth of the broad short term money supply remains strong for a slack economy, although not quite as robust as when there was a flight to quality out of equities and Ben did his moonshot with the Fed's balance sheet.



Demand for money? What demand? This is something new in the post World War II era.



Relative to the growth of bank credit, the growth of broad short term money as measured in MZM is outsized as the Fed intends it to be.



The limit of the Fed's ability to monetize various debt instruments already in existence is the value of the dollar relative to the purchasing power of the other major fiat currencies.



Do people realize that a monetization of the dollar is occurring? Some do.



As one might expect the velocity of money, which is the ratio of money supply to the aggregate demand for money (GNP), is very low. This is helping the Fed to keep inflation selectively low, because although there is a lot of money relative to bank credit demand, that increased money is not doing much chasing of goods. It seems to be flowing once again into financial assets, which is probably an artifact of where the money has been allocated. How many cars and meals can a wealthy person or corporation consume? They do not create consumption out of their excess, they increase their speculation and the acquisition of the means of future production.

As the velocity of money starts increasing then the Fed will have to change its stance on quantitative easing, which is really nothing more than the monetization of existing debt.

Consumer Credit Contracting at Record Levels

Total Consumer Credit Outstanding in the US is contracting at a year-over-rate of almost 5 percent, which is a record for the post 1960 economy.



The challenge facing Bernanke and the Obama economic team is how to get the US consumer spending again, if they cannot be paid a living wage, and if they can no longer be encouraged to borrow beyoned their means, by using their homes as a cash machine with variable interest rates, as they were encouraged to do by Fed Chairman Greenspan.

This is as much a public policy question as it is an economic question. Large segment of the population which are homeless and and jobless tend to be destabilizing to the community. The liquidationist school is not without its attraction to the let-them-eat-cake frame of mind, but from a societal perspective it is fraught with peril and unintended consequences.

For now the remedy being utilized by Bernanke and associates is to prop the financial system and allow the dollar to decline while artificially supporting the long bond. They may also be attempting to control certain indicators of monetary inflation such as gold and oil by using position limits exclusively on long positions and 'speculation.' while exempting the naked short selling. Similarly, pumping up equities provides a flowback into financial assets that helps to support the banks.

This is obviously no solution. The Fed is in maintenance mode, trying to coddle the banks through their ongoing crisis despite the recent appearances of vitality, which are an illusion.

The Obama Administration is not engaging in the systemic and financial reform that really is their responsibility. So what we have here is a bit of a mess with no clear way out at least to us, except to weaken the dollar, and perform their particular version of 'pray.'

I believe the colloquial American characterization of Team Obama's current policy might best be described as 'throwing shit at the wall and hoping something sticks.'



Yes, there is often a lag between credit contraction and the appearance of decline in the broader money stock. This may be a direct correlation with a lagged, or a colinearity resulting from the effects of the recession in the real economy on both, again with uneven impacts over time.

There can be no denying that the Fed is promoting money supply growth in ways never seen before in the US. Whether they can be successful is open to question. We think they will keep at it until they break something.

Wall Street has a gun to the head of the public, in the form of derivatives positions that are 'weapons of mass destruction.' For now it is a standoff. But there should be little doubt that this is artificial and unsustainable, and that something has got to give.

A Final Word on Inflation and Deflation

A serious bout of inflation is rarely caused by normal business activity, such as commercial bank lending and private debt.

In almost every case that I have studied, a very serious monetary inflation is triggered by excessive government debt obligations, and not private debt, that can no longer be adequately serviced by a productive real economy and domestic taxation.

That unserviceable debt becomes 'monetized' and a serious inflation results. It is a form of debt default.

Devaluation of a currency is a form of inflation which specifically addresses external debt obligations, as well as default on bonds which is a form of selective national bankruptcy.

The reason that the output gap is no sure barrier to this type of inflation is that it ironically serves to feed it in the presence of profligate government spending, since it dampens tax revenues and domestic GDP.

Private debt bubbles, asset bubbles, stock bubbles all seem to be the symptoms, the side effects, of an over easy monetary policy from a central monetary authority. In some instances they have been caused by exogenous events, even in the face of a hard monetary standard, by events such as a precipitous decline of the population from disease, or a sudden influx of a new wealth from discovery, such as the influx of silver and gold to Spain from the New World.

But the notion that banks must always lend to create inflation, or employment must be at robust levels, absolutely flies in the face of all historical experience.

And it does raise the issue, despite his protestations of innocence, impotence, and confusion, that Fed chairman Greenspan and the Federal Reserve itself, owns a unique culpability in the creation of several bubbles, from tech to housing, and the eventual outcome.

Price, Demand, and Money Supply as They Relate to Inflation and Deflation

There are three basic inputs to the market price of something:

1. Level of Aggregate Supply
2. Level of Aggregate Demand
3. Relative Value (purchasing power) of the Medium of Exchange

Let's consider supply and demand first, since they are the most intuitively obvious.

The market presents an overall demand, and within that demand for individual products in particular.



Supply is the second key component to price. We are not going to go into more detail on it since what we are facing now is a decrease in Aggregate Demand.


It can seem a little confusing perhaps. Just keep in mind that if the aggregate demand decreases for goods and services for whatever reasons, such as severe unemployment, and supply remains available then prices will drop overall, with some variance across products because of their differing elasticity to price changes.

This is known as the Law of Supply and Demand.

How we do know when aggregate Demand is decreasing?

Gross Domestic Product = Consumption + Investment + Government spending + (exports − imports),
or the famous economic equation GDP = C + I + G + (X − M).

Consumption, or Aggregate Demand, is a measurable and key component of our GDP figures.

Given the huge slump in GDP, it should be obvious that we are in a demand driven price deflation on many goods and services. People are saving more and consuming less.

Now, that covers supply and demand as components of price, but what about money?

Money

Notice in the above examples we talk about Price as a value without a label.

Money is a medium of exchange. It is the label which we apply to give a meaning to our economic transactions.

If you are in England, or France, or Argentina, or China, the value label you apply to Price is going to be different according to local laws and customs.

Money is the predominant medium of exchange that a group of people have agreed to use when engaging in economic transactions that are not based on pure trading of goods, known as barter.

The source and store of wealth are the 'credits' within the system which one uses to exchange for products. The money is the medium of exchange.

If you work for a living, you are exchanging your time and your talent, which is your source of wealth, for products. The way in which this is labeled and facilitated in the United States is through the US dollar. I n Russia and China is it something else completely.

The Value of Money

How do we know what some unit of money is worth? Try not to think about your domestic currency. Since we use it so often every day, we tend to think of it with a set of assumptions and biases. Most Americans have little practical exposure to foreign exchange, and tend to think of themselves as living in a dollar-centric world.

Let's use the Chinese yuan. What is the yuan worth? What if I offered you a roll of yuan in exchange for a day's work? How would you know if it was a 'fair trade?"

Since there is no fixed standard for money in our world, you would most likely inquire in the markets what you could obtain for those yuan I offered to you in an accessible market.

But what sets the rate at which yuan are exchanged for a given product?

In a free market system, it is a very dynamic system of barter. When you offer something for money, I know how much of my source or store of wealth I must exchange for the yuan to provide for the product offered.

Money is just a placeholder. We hold it because we expect to be able to trade it for something else which we really desire. You don't eat or wear money; you exchange it for things which you wish to eat or wear.

If the value of money changes, the price of all the things to which you have been applying that label changes. This is why it is important to distinguish between price changes because of changes in demand, and changes because of money supply. They are different, and require very different responses.

Money supply

In a very real sense, there is a relationship between how many goods and services are available, and how much money exists.

Let's say we are in China. I give you 100 yuan. Tomorrow the Chinese government triples the amount of yuan in the economy by giving each of its citizens ten thousand yuan for essentially doing nothing, for not producing anything more or less.

Do you think the 100 yuan will be worth as much as they were the day before? No, obviously not.

In real economies these changes tend to happen with a time lag, or gradually, between the action and the reaction. This is necessary because people can only adjust their daily habits, their economic transactions, gradually. Otherwise it becomes too stressful, since our daily routines and decisions are based so heavily on habits and assumptions of value and consequences.

But in general, if the supply of money is increasing faster than real per capita GDP over a longer term average the money supply is inflating, that is, losing real purchasing power.

Seems simple? Well its a bit more complicated than that unfortunately since these things relate to free markets, and if there is any other thing you need to remember, we do not have free markets, only free to varying degrees.

The logical question at this point is to ask, "What is the money supply?" That is, what is money and what is not?

We dealt with this at some length, and suggest you look at this Money Supply: A Primer in order to gain more knowledge of what is money and money supply.

We would like to note here though, that there is a difference between money supply and credit, between real money and potential money.

If I have 100 Yuan in my pocket, there is a real difference between that money, and my ability to work at some job tomorrow and be paid 100 yuan, or have you repay 100 yuan to me which I gave to you yesterday, or my hopes that I can borrow 100 yuan from some third party.

If you do not understand this, you will not understand money. It is one of the great charades of our time that risk has been so badly distorted out of our calculations. We cannot help but think that some future generation will look at us as though we had all gone barking mad.

The subject becomes even more complicated these days because we are in what is called a fiat regime. Fiat means 'let it be done' as we will it, and we are if anything in a very relativistic age in which we think we can will just about anything.

The major nations of the world get together and attempt to manage the value of their currencies relative to one another, primarily through their finance ministries and central banks.

Countries will interfere in the markets, much more than they will admit, to attempt to maintain certain relationships among currencies of importance to them. Sometimes they are overt about it, as when nations 'peg' one currency to another, and at other times they are more subtle and merely influence other currencies through mass purchases of debt and other forms of persuasion and the molding of perception.

I hope this helps. I don't intend to answer loads of questions on this, particularly from those who immediately start inventing complex examples to try and disprove this. Most of the time the examples betray a bias that person has that defies patience and a stubborn belief that everything is relative. In the longer term it is most assuredly not.

Each will learn at their own pace what is real and what is not. But they will not be able to say that they have not been warned that sometimes appearance is different than reality.

Here are some examples of money supply growth in the US. If you read our Primer you will know that MZM is by far the most important now that M3 is no longer reliably available.



Is money supply growing faster than real per capita GDP? Yes, decidedly so. And unless this trend changes significantly we will face a whopping monetary inflation.





Here is a chart that shows the buying of US debt that other countries have been doing through the NY Fed Custodial Accounts for a variety of motivations. Without this absorption of US money supply the value of the dollar would be greatly diminished relative to several other currencies. This is probably not a sustainable relationship but it has had a good long run because it is supported by the US as the world's superpower.

Other countries are essentially exchanging their productivity, their per capita GDP, for our excess money supply. This is why a US monetary inflation has remained manageable. Other countries are providing an artificial Demand for US debt at non-market prices.



One of the great errors of our generation has been the gradual and erroneous mispricing of risk through a variety of bad assumptions and convenient fallacies. Without the appropriate allowance for risk, there is no ability to discover valid pricing and allocation of capital.

The consequences of this abuse of reason are going to be enormous.

I do not see this improving quickly because the manipulation of risk for the benefit of the few, and the transfer of that risk to the public and the rest of the world, has tremendous value to the powerful status quo.

But the day of reckoning and settlement of accounts is coming, and as it approaches it will accelerate and come with a vengeance. For after all,

"Life is a school of probability." Walter Bagehot

School is almost out.

This Is Your Economy on Credit Crack - and Heading for a Crack-Up

Here is a clear and simple explanation of why we may have already passed the point at which the Fed and Treasury will have no choice but to substantially devalue the bonds and reissue a 'new US dollar' as part of a managed default on our sovereign debt.


Ben's Un-shrinkable Balance Sheet
Delta Global Advisors
April 14, 2009

As he stated again clearly today, the Chairman of the Federal Reserve has deluded himself into thinking that when the time comes, he will be able to shrink the size of the Fed's balance sheet and reduce the monetary base with both ease and impunity. He also has deluded himself into thinking inflation will be easily contained.

It is very important that he does not fool you as well.

The Fed believes low interest rates should not be the result of a high savings rate, but instead can exist by decree, a conviction which has directly led consumers to believe their spending can outstrip disposable income.

The result of such thinking has been a rise in household debt from 47% of GDP in 1980 to 97% of total output in Q4 2008. As a result of this ever increasing burden, the Fed has been forced into a series of lower lows and lower highs on its benchmark lending rate. Keeping rates low is an attempt to make debt service levels manageable and keep the consumer afloat. Problem is, this endless pursuit of unnaturally low rates has so altered the Fed's balance sheet that Mr. Bernanke will be hard-pressed to substantially raise rates to combat inflation once consumer and wholesale prices begin to significantly increase.

Banana Ben Bernanke has grown the monetary base from just $842 billion in August 2008 to a record high of $1,723 billion as of April 2009. But it's not only the size of the balance sheet that is so daunting; it's the makeup that's becoming truly scary.

Historically speaking, the composition of the Fed's balance sheet has been mostly Treasuries. And the Federal Open Market Committee would typically raise rates by selling Treasuries from its balance sheet into the market to soak up excess liquidity. However, because of the Fed's decision to purchase up to $1 trillion in Mortgage Backed Securities (and other unorthodox holdings), it will not be selling highly-liquid US debt to drain reserves from banks. Rather, it will be unwinding highly distressed MBS and packaged loans to AIG. Not to mention the fact the Fed would have to break its promise of being a "hold-to-maturity investor" of such assets.

Moreover, not only are the new assets on the Fed's balance sheet less liquid but the durations of the loans are being extended. According to Bloomberg, the Fed is contemplating extending TALF loans to buy mortgaged backed securities to five years from three after pressure it received from lobbyists and a failed second monthly round of auctions. That means when it finally decides it's time to fight inflation, the Fed will find it much more difficult to reverse course.

But because of the extraordinary and unprecedented (some would say illegal) measures Mr. Bernanke has implemented, only $505 billion of the $2 trillion balance sheet is composed of U.S. Treasury debt. Today, most Fed assets are derived from the alphabet soup of lending programs including $250 billion in commercial paper, $312 billion of Central Bank liquidity swaps and $236 billion in mortgage-backed securities.

Thus, our economy has become more addicted than ever to low interest rates. But because bank assets will now be collecting income at record low rates, when and if the Fed tries to raise rates it will only be able to do so on the margin. If Bernanke raises rates substantially to fight inflation, banks will be paying out more on deposits than they collect on their income streams. Couple that with their already distressed balances sheets and look out!

Additionally, not only do the consumers need low rates to keep their Financial Obligation Ratio low, but the Federal government also needs low rates to ensure interest rates on the skyrocketing national debt can be serviced. Our projected $1.8 trillion annual deficit stems from the belief that the government must expand its balance sheet as the consumer begins to deleverage. In fact, both the consumer and government need to deleverage for total debt relief to occur, else we're just shuffling debts around and avoiding a healthy deleveraging entirely.

In order to have viable and sustainable growth total debt levels must decrease, savings must increase and interest rates must rise. But that would require an extended period of negative GDP growth-a completely untenable position for politicians of all stripes. Ben Bernanke would like you to believe inflation will be quiescent and he can vanquish it if it ever becomes a problem. Just make sure you don't invest as though you believe him.

Money Supply Growth

For those of you who are not familiar with the various measures of money supply here is a relatively easy to understand reference.

Money Supply: A Primer

MZM is currently the preferred measure of broad money supply 'liquidity' growth with M2 as the longer term measure standing in place of M3 which was the best and broadest measurement.

The Price of Gold and the Growth of the Money Supply

We have seen comparisons of the price of gold to the adjusted monetary base and to M1. Based on intense study and reasoning about the current trends in money supply we are convinced that this comparison of growth in MZM with a lag to the change in the price of gold is significantly much more valid than any other we have been able to produce, if one only considers the correlation of the graphs. And it makes logical sense.

MZM is the most valid measure of broad 'liquid' money in the system. We formerly used M3 but this has not been available, with any published certainty, since 2006.

It would make sense that in a free market, the growth trend of a broad measure of 'liquid money,' as opposed to credit or potential money, would be statistically valid with the price of an alternative currency, or wealth asset, like gold over the longer term.



Speaking wonkishly, our preferred comparison would be to be able to measure the difference in growth between real GDP and the growth in broad money supply, and then trend and compare that with the growth in the price of gold.

Since we have no honest measure of price inflation that task is difficult. Our second preference would be to make a similar comparison per capita the economically active rather than real GDP. Is there an accurate measure of job population growth fluctuations with the ebb and flow of the illegals? We are not sure, but are looking into it.

Inflationists vs. Deflationists: Economics as Bread and Circuses

In a purely fiat currency regime, a sustained inflation or deflation is a policy decision.

Since few systems in this world are pure, one has to account for exogenous factors and endogenous lags.

But it remains, deflation or inflation are the result of policy decisions in a fiat regime. If one does not understand that, then there is a fundamental misunderstanding of how things work in a modern monetary system which operates free from a hard external standard.

It is not an idle point, by the way, to understand that in a fiat regime there is a significantly greater latitude in policy decision than otherwise.

That is why central banks wish to maintain a fiat regime, and not to be encumbered by an external standard such as gold.

Once one realizes that it is a policy decision, one realizes that this 'inflation versus deflation" is not about some deterministic outcome based on market forces, but rather on a policy decision, what the governance thinks "should" be done.

Granted the Fed does not have perfect latitude. There are the restraints of law and the Congress, and the necessary cooperation of the Treasury and the banking system.

However, the most legitimate, the least endogenous limitation in a fiat system is the value of the bond and the dollar to external market actors. This is the tradeoff that the Fed and Treasury must make in weighing the outcome of their actions.

All this backslapping and scoring of points between the inflation and deflation 'camps' is particularly obtuse because this monetary chess match is most heatedly being argued about by people who think they are watching a game of ping pong.

Yes we will likely see a deflationary episode in the short term, certainly in prices as the aggregate demand contracts, as the Fed fights the credit collapse. We briefly saw deflation at the trough in 2002, depending on how one chooses to define deflation.

But, make no mistake, the Fed can print money and monetize Treasury debt until the cows come home. Bernanke was not lying when he put his cards on the table in his famous helicopter speech some years ago. He wasn't just trying to fool us as some would hypothesize.

They will monetize debt and 'print money' covertly and quietly because they do not wish to trash the Bond and Dollar, since this is the fuel of their machine.

Economic cargo cultists frequently resort to imaginary restrictions on the Fed, such as they can't do this or they can't do that. Growth in money supply must come from the lending of the private banking system. The Fed "only controls the monetary base" and "doesn't set interest rates."

That is all bollocks. It is playing with words, parsing the truth, Clintonesque.

First, there are some gray areas in the statutes that prohibit the Fed from DIRECTLY buying debt from the Treasury without subjecting it to the discipline of the marketplace, ie. taking through a public auction first. The law is soft on this point, but one might contend it is not necessary to change it if the Fed has one or two banks that are policy captives. We believe they do.

Second, growth in the money supply has to come from the lending of banks, the creation of new debt, only when you have run out of 'old debt' and prior obligations to spending.

Does ANYONE who has been following the fiscal discussions in the US believe that we will run out of debt in our lifetimes? The lending of the banks, the creation of new debt, is a measure of economic vitality in some dimensions yes. But growth by debt creation is NOT the only way for an economic system to function, and it may indeed may not be the best. But regardless, it is not necessary while there is debt that can be monetized, and certainly we have a surfeit of that.

The only limitation on the Fed and Treasury are the Congress and the acceptance of the dollar and the Bond in a fiat regime. Period.

Unless there is some greater conspiratorial policy reason, any net debtor that chooses deflation rather than inflation of the means of the repayment of their debt should have their head examined.

There are those who believe that the US "creditor class" will seek to encourage liquidationism and deflation to protect their private fortunes, created during the bubble period.

This is not actually a bad theory, except that the real creditor class lives in China, Japan, and Saudi Arabia. Since two of them are virtual client states of the US and the third is bound to its industrial policy the status quo seems to have some momentum, despite the best attempts of Zimbabwe Ben and His Merry Banksters to denigrate our currency and their customers' sovereign wealth.

One might suspect that the domestically wealthy (note the distinction between that and 'creditor class') would like to channel the bulk of the inflationary effort into their own pockets and benefits for the bulk of the effort before it stops short of hyperinflation, and then cut off the spending.

Hey, we're already doing that! Isn't it nice to see how things work?

People forget that in many ways this is a replay of the Great Depression, wherein a Republican minority in the Congress, and ultimately the Republican appointees on the Supreme Court, fought the New Deal tooth and nail, to the point of class warfare and a suspected plan to take the country into fascism in sympathy with the industrialists of Germany and Italy.

It was interesting to see the "Chicago School" A Dark Age of Economics making arguments against fiscal stimulus that would be worthy of freshmen economics students. One can make the case that these mighty brains are so highly specialized that they have forgotten the basics. An alternative reason might be a willingness to declare that 2+2=5 if it suits your ideological bias and those who must be obeyed. It was just a tiny bit satisfying to see Krugman and DeLong administer and intellectual beating to these luminaries.

So, as you may have noticed, Jesse is cranky today, and not merely because he was rousted from a warm bed to clear a snow-covered driveway. It is also because this country is in a dangerous, potentially fatal, situation and is suffering from an absolutely incredible, ongoing lack of adult supervision and serious discussion about the basic issues. Deception and spin is no longer an exception, but standard operating procedure.

Right now we are still in a 'credit crunch' which is a predictable (and we did predict it last year and even earlier than that) result of a collapsing bubble. In the very short term it was a liquidity problem, as the system seized, but as that was addressed the true problem is exposed as a solvency, not a liquidity, problem. And that problem exists because those that should take the hit for the writeoffs to resolve their insolvency want desperately to pass it on to someone else, eg. the public. There is still an enormous amount of accounting legerdemain (or would that be "ledgerdemain?")

There is not a shortage of liquidity; there is a scarcity of trustworthy market information in terms of value and risk that is causing a seizure in credit growth from fear. Why take 5% from someone who may already be bankrupt when you can accept a relatively no-risk 2% from the Fed? As the waters reced in this recession one would think the nakedness would be more apparent, except that the Treasury and Fed have been supplying portable cabanas to their favorite emperors, to spare their tender sensitivies and enormous bonuses.

We allow that a deflation can occur. If the Fed raised short term rates to 20% tomorrow and started draining, and raised reserve requirements to 50%, we would see a true monetary deflation in short order. But with regards to the here and now, as opposed to some alternate hypothetical universe, currently The Fed Is Monetizing Debt and Inflating the Money Supply.

We would like to see an intelligent examination of the series of policy errors that created the one decent example of a contemporaneous deflation in a fiat regime, that of modern Japan. Because it would then help people to get beyond it, and consider the other twenty or more examples of countries facing serious inflation or even hyperinflation since World War II. But let's just suffice to say that the problems in Japan were somewhat particular to their situation and it was a genuine policy choice which they made.

We might also make the same errors, or even repeat the errors of the Fed in the 1930 of withdrawing liquidity too precipitously because of a misplaced fear of inflation. But with a Democratic administration and a more knowledgable, almost complacent Fed in place this does not seem probable to us at all.

The country is still drunk on easy money and hubris and preoccupied with bread-and-circuses debate between political and financial strategists masquerading as policy experts, while insiders loot the country.

All this noise serves to do is to distract the nation from a identifying the causes of the current crisis and instituting meaningful reforms to keep us from throwing a quick fix at our latest disaster and setting up another cycle of bubble, boom and bust again.

There can be no sustained recovery in the economy until there is financial reform, and a revival of the individual consumer through an increase in the median wage. Right now consumers are attempting to repair their balance sheets by defaulting on debt. This is not productive in the longer term. And it is a bit of an ironic exercise as well, since the debt is being tacked right back on to the taxpayers through the public balance sheet in the government bailouts.

Why is every solution being addressed to and through the unreformed corporate sector? Is it because the best way to deal with a scandal which you caused is to put your own people in charge of investigating it, and setting the agenda for the discussion of potential reactions to maintain the status quo? Anyone who has been in a large corporation should be well familiar with such an obvious tactic. This is likely a reflection of our distorted economic and public policy infrastructure.

A proper examination of relative value and risk cannot be expected yet until we sober up. Let's hope that happens soon, and not as the result of critically damaging economic and social pain.

Is Money Supply a Relative Absolute?

There has been discussion over the weekend regarding an intriguing blog entry from friend Cassandra Inflation v. Deflation with regard to the Fed's monetization of debt. The principle assertion seems to be that if the Fed is merely replacing existing credit dollar for dollar as it is written off, then the result is not inflationary.

If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.

Implicit in this of course are two conditions. The first, that the level of wholesale borrowing and lending had not been and would have continued not to be inflationary, and secondly, that the expansion of the Fed's balance sheet is equivalent dollar for dollar with the debt it is said to be replacing.

These distinctions will be lost on most, but they are quite important, and we urge to reader not to gloss over them in preparing a rebuttal to support their bias du jour.

Let's consider an hypothesis someone put to us some time ago. They claimed that the appropriate rate of growth for any money supply is zero, which they considered 'neutral.'

To this we put the question, "If one holds the money supply static for a long period of time in a country whose population is growing at 10% per annum, and GDP is growing at 10% as well, is this a neutral money supply growth rate?

The answer of course is no. Money supply that remains static in a growth situation, whether one measures it in a ratio to economic growth or per capita, is obviously on a deflationary trend because supply is not growing at a rate equivalent to the increase in demand.

Seems obvious in this perspective right? We are not saying it is good or bad, appropriate or not. It is what it is, a growth in money supply that is lagging the growth in demand for money.

Conversely, if money supply is kept static in a country where the population is decreasing, and economic growth contracting, is it neutral? No it is inflationary, since the growth rate of money supply (zero) is greater than the growth rate of the demand for money, which is in decline presumably.

Now, one can imagine all sorts of possible scenarios as exceptions because there are lags in all economic cause and effect. To complicate matters there is no instantaneously correct rate of money supply growth without a context since reality is inherently in a state of flux.

However, though, it is clear that a static money supply is not necessarily neutral compared to the state of the growth of the money supply in a different economic context.

Secondly, we will postulate something we are not quite ready to prove yet, and that is that credit is not the same as money supply. We offer a piece instead that was blogged some time ago in which the various components of money supply are discussed.

Money Supply: a Primer

Its something to consider, and has received too little attention in our opinion.

If you have one thousand dollars in cash, in your pocket, is it completely equivalent to one thousand dollars worth of honey which you have at home in your pantry, in terms of its affect on inflation or deflation?

Forgiving the pun, the honey is decidedly less liquid than the cash.

What if you have one thousand dollars in cash, and another thousand is owed to you by an acquaintance in a distant city who promised to pay it back on demand the last time you spoke to them a year ago. Are those equivalent dollars?

Does it matter who is holding the money? What if the bulk of the money being added to to the economy is being given to gamblers in Las Vegas, rather than lets say farmers in Pennsylvania. Is there a difference in that money's effect on inflation or deflation? Yes there are few differences in the very long run, but sometimes the run becomes so long that it is irrelevant to the policy questions at hand.

This essay does not seek to provide answer to these questions at this time, since this is basis for a new perspective in economics. And unfortunately the discussion is premature. It is rather like a room full of well seasoned drunks, after a week long binge, gathering to attend a lecture on sober thought. We have so utterly lost the conception and relationship of value and risk that we must sober up a bit before we can even think about it once again.

Rather, the purpose of this essay is to cast doubt on the certainty that what we call money is always and everywhere equivalent in force and power and influence as an economic actor no matter where and how it is held.

Having said all that, it is obvious that the Money Supply as measured by the means at our disposal is growing at a rate more significant than economic growth, and that difference is now even greater as the economy slows and contracts. As an engineer and an operational business unit manager we always tend to fall back on what can be measured, what is real and knowable, when theory fails and the bosses are lost in flights of fancy.

The Fed is Monetizing Debt and Inflating the Money Supply

As water is added to the ecosphere, it flows and pools in many places. Money as water in the econosphere is evaporating through debt retirement, but perhaps not through debt destruction, or at least not in the same way. Someone must lose if a debt is written off right? What if that loss is booked at the Fed, and they realize that loss by simply 'making it go away' at least as far as the real economy is concerned? Is there a contraction in the money supply anywhere?

There are all questions worth considering, and we will have much more data as the results of Mr. Bernanke's experiments produce additional data.

But one thing is certain in our minds, and that is certainty in this situation is an illusion. We do not think that even the Fed knows exactly what they are doing. Rather, they are feeling their way through uncharted waters, projecting perhaps a confidence, but this is primarily for effect, not as a genuine state of mind.

And based on first principles, deflation, while possible, is never a certainty in a fiat regime where there is a central monetary authority that holds the power to monetize debt. The only boundary on their power is the acceptability, or value, of the money they produce, and that is also known as inflation.

Obviously the Fed may do a poor job or an outstanding job of managing the nation's money supply and economy. We will not really know until after the fact given the lags in these sorts of machinations.

But what is different, what is dangerous, is that the Fed has grasped the reins of a highly complex system, that is now more global than at any time before, and is trying to pull it in a certain direction, without immediate feedback on what it is that is happening. The last five or six times in which the Fed has done this something 'unexpected' has occurred.

Another factor most do not consider which is of some importance is the potential for systemic reform in the economy that is the context for the actions of the money supply. Without serious financial reform we most likely will take spin on the wheel of boom and bust again, with a greater disparity of wealth and a greater loss of democratic freedoms.

Either state is possible, make no mistake, but the probability is highest that the loss of control will be an inflation, with the key metric being 'how bad' and 'how difficult to subdue once it is unleashed.' Why? Because inflation is the default condition of a fiat currency that becomes uncontrolled. Deflation requires a sustained effort for whatever reasons, generally policy error or a conflict in desired outcomes.

A softer, much more judgemental reason, is that those who are now telling us that inflation is not an issue are the very ones who have been acutely wrong, for whatever reason, since this crisis began, if not years before that. They speak their book, and shamelessly. But that is no determinant, merely a confirmation of sorts.

What concerns us most is that the Fed is quite confident, in their own words, that they know how to deal with inflation after Volcker. That reminds us too much of hubris, and the classical myth of Phaëton who confidently took the reins of the chariot of the Sun from the golden Apollo, and very nearly burned down the world in the process.

The Fed is Monetizing Debt and Inflating the Money Supply

Here are the latest figures on the growth of the various money supply measures.

See Money Supply: A Primer for a review of measures and their differences.

The charts indicate that the growth in the money supply is due to a significant monetization of debt by the Fed in expanding its balance sheet and deficit spending by the Treasury, rather than organic growth from credit expansion from commercial sources and economic activity. The negative GDP figures confirm this.

You could imagine this as a tug of war if you wish. On one side is the deflationary force of bad debt and falling aggregate demand. On the other is the Treasury, the Fed, and the Congress, using the triple threat of deficit spending, monetization of debt, and stimulus programs. The limits of the power of the Feds are the value of the dollar and the acceptability of Treasury debt.

There is no lack of debt that can be monetized. To think otherwise is fantasy. But there are limitations about how much the dollar can bear, which is why the banks and moneyed interests have shoved their way to the front of the line, and are gorging themselves now with a little help from their friends in the Treasury and the Fed. When the time comes they intend to throw the public agenda under the bus. Its an old script, many times performed with minor enhancements.

If the current trend continues, it will have an inflationary effect on certain financial assets and commodities, and a negative impact on the dollar. There are lags in the appearance of this, but it will come.

Because the Dollar Index (DX) is an outmoded and artificial measure of dollar strength, containing nothing to account for the Chinese renminbi for example, it may not be a true reflection of the progress of this inflation. Time will tell.

A similar case might be made for certain strategic commodities, gold and oil, which are the instrument of government policy. Although it is much less important, silver may be one of the first commodities to break out because the government maintains no significant physical inventory of it as it does for gold and oil.

The huge short interest in silver may be an ignored scandal on the order of the Madoff Ponzi fund, not in dollar magnitude, but likely in terms of regulatory lapse and deep capture.



M1 has become a much less useful measure of the money supply these days because of changes in banking rules and technology. However, M1 is a good intermediate measure of the impact of the growth in the Fed's balance sheet as it feeds through the system.





Growth in MZM frequently results in financial asset expansion once it gains traction.



The US Dollar does not generally react well to aggressive growth in MZM.



The growth of credit, organic growth from economic activity, is sluggish.



The growth in the Monetary Base due to Fed inflationary activity has been nothing short of spectacular, without equal in US monetary history. This makes all Money Multiplier measures that use the AMB in the denominator meaningless for now.



The spike in Treasury settlement failures is one measure of the stress in the financial system. It seems to be quieter now, after spiking in response to seizures in the bonds trading. We will maintain a watch on this.

The Fed's Game Plan: What Ben Bernanke Is Thinking

Bernanke's game plan is becoming more apparent. Based on a reading of his papers and his public statements, here is a distilled view of what we think is his game plan.

1. Grow the money supply quickly and abundantly

2. Stabilize the Banking System to avoid destructive banking failures

3. Do not withdraw the monetary stimulus prematurely to fight inflation.

4. Manage 'confidence' aggressively to dampen the expectation of inflation later, and a panic liquidation now.

Each of these legs of his policy is a reaction to lessons he believes the Fed learned from the Great Depression.

As you consider the specific things he is doing, it is likely that they will fit very nicely into this framework.

He is obviously fighting the 'last war,' the last great battle that the Fed is known to have waged, and lost. For it did lose, as there was no lasting recovery until the world suffered through the Second World War.

Whether he will be successful or not remains to be seen. It is important to bear in mind that the Fed is absolutely confident that they know how to stop inflation once it gets started, even if it becomes rather serious.

The over-arching theme is that this is an emergency, and so long term niceties like moral hazard and systemic reform will be left for later: the ends justify the means.

William Poole says that this is a dangerous approach, because longer term consequences like inflation appear with a one to two year lag after a significant monetary stimulus such as we have just seen.

The timing of the Fed's dampening of inflation will be critical, and perhaps constrained by the real economy. How can the Fed tighten sufficiently if the real economy remains sluggish?

Bernanke is determined to err on the side of too much stimulus, given the trauma of the Fed's experience in the Great Depression. Coupled with the Fed's confidence in their ability to stop any monetary inflation, this raises a higher level of probability in the most likely outcome of the Fed's latest and greatest monetary experiment.

We cannot help but wonder what he thinks the Fed will be doing this time that will be different than 2003-2007 when they reflated the financial system after a market crash the last time without meaningful reforms, resulting in the stock market and housing bubbles.

Whatever happens, it will certainly provide the raw material for economic papers yet unwritten.

Money Supply: A Primer

You walk into a Merchant and a sign says, "All Items on Sale Today for Cash Only No Credit."

You are interested in purchasing an item. The Merchant, being a crafty sort asks "How much money do you have to spend(in US dollars)?"

How would you answer that if you are being truthful?

You might start by looking into your wallet and pockets, and counting all the cash and coins you have with you at that moment.

M0: Monetary Base

This is equivalent to the monetary base, or M0. It is money you have that is immediately available requiring no change or conversion. There is very little risk to the merchant, unless it happens to be counterfeit which is easily verified.

"Not enough" says the Merchant. "I am sorry, but do you have more?"

M1

Then you remember that in addition to cash, you have your checkbook with a current balance in it, and a debit card to an account you maintain in a local bank, but with no overdraft or lines of credit provisions.

That plus the currency in your pockets is M1. See the difference? You do not have ALL your money in your pockets for immediate presentation, but with a little transactional effort the money is readily available and it is inherently your money, it belongs to you. It is just being held elsewhere besides your pockets and wallet. The merchant assumes a little more risk, but he can quickly call your bank to verify that the funds are available for the check, and the debit card is even more mechanized. More risk, a little more delay, but almost as 'good as cash.'

"I am sorry sir," says the Merchant, "but this is still not enough to exchange for such a valuable object as I have for sale here."

M2

You think about it, and remember that you have a savings account across the street at the bank, and a money market fund at your brokerage office next door, that have more of your money on deposit. You have no cards for those accounts, but it would be an easy thing to walk next door or across the street and obtain the cash.

This is M2. There is a more complex transaction involved, since the transfer is not electronic as in the case of a debit card, and you must leave the store to obtain the money in the form of currency unless they bring it over to you. But it is your money that is available to you on demand. There is a small amount of risk of your bank not being solvent when you need the money, but these are slight inconveniences compared to the safety of not carrying around large sums of money that earn no interest in the form of cash.

"I am so sorry," says the Merchant. "But this item is far too valuable to part with for such a sum as you have offered."

M3

You think about it, and remember that you have a large Certificate of Deposit at the bank across the street that matures in one year. There is a small penalty if you redeem it today to receive your money since you promised it to them for a time in exchange for a specific return, and you must fill out some paperwork, but it is still your money. It involves no sale of an asset or conversion.

That is M3. It involves money that is still yours without borrowing, but has additional conditions set up on it for its retrieval.

One could make the case, and perhaps appropriately so, that while certificates of deposit with a term contract that might effect their value are money, they are not readily available money since the terms of the CD's may differ greatly. They are not 'liquid' and the value before maturity is not always certain due to a penalty.

MZM

If one takes all the things we describe as M2, but takes out the time deposits or certificates of deposit, and includes ALL money market funds, that is what the Fed considers to be the broadest measure of liquid money, or Money of Zero Maturity (MZM). "Zero maturity" means that the money is not tied up for a period of time to mature to its full value.

Are credit cards or loans Money? No,those are all forms of borrowing something that is not yours that you promise to return with conditions. You are receiving money that was not yours.

Credit Is Not Money.

Credit, or debt, is the 'potential' for money, a way of receiving it.

Whether water is held in a canteen, a well, a cistern, or a private lake, it is still water and it is yours if you own it. So too money is still money if it is yours, no matter under what conditions you hold it or save it for your use.

The cloud of credit, or debt depending on your perspective, is the potential for money as it is defined in our economy. It is a source of money. At a given point in time, you either have the money as your property or you do not.

But the source is not the money itself, and the source can be different and can change over time. In our society borrowing is so common and so technologically convenient that there is little difference in most people's mind between credit and money.

But the difference is that if you spend real money, you incur no obligation for it in the future. You receive no payment request from another at the end of the month.

That is what money is, at least in our economy, and the various measure of money as it is held and shifts through the economy and a variety of transactions, where it flows and rest in pools, and moves again. A measure of the money supply is a snapshot in time.

How money increases or decreases, and how it is stored or held, is a significant indicator of economic activity for those who study such things. It is also significantly affected by custom, technology, and the prevailing mood and perception of the public.

The best and broadest measures of money supply are either MZM, or M2, now that M3 is no longer being reported by the Fed. This can easily be seen from the illustrations.

As springs feed into brooks, and brooks streams, and streams into rivers, and rivers into lakes, so the money supply components change in size and shape over time as money flows from its various sources. The speed of the flow is the 'velocity of money' and as one can easily understand that flow will have a different force and speed depending on when you measure it, and whether you are measuring one of the streams or a major river.

People often prefer to jump into discussions and turn them into debates (arguments) with hair-splitting definitions (what is 'control' of the money supply) and red herrings (why does a dollar cross the road?) before defining any terms or facts and setting some boundaries for the analysis, because their goal too often is not understanding, but to promote some theory or point of view. 'Winning the argument' is their objective, not a search for the truth.

Money is the instrument of the official economy. This gives money a certain arbitrariness over time because, after all, it is the product of a committee. Official money is the creation of government, managed by its agents, validated by the people who use it.

Official money rises and falls from favor to disfavor, as do governments. What if you were a citizen of Zimbabwe? Or the US in the 1860's? Or Germany in 1922? How would you feel about your official money then? Why is it different for you now? What would change your opinion?

What is the 'natural growth rate' of the money supply? Zero?

The discussion of how money supply increases, and who or what determines the supply, and what an appropriate level of growth would be is a matter for discussion on another day. So too is the strange phenomenon of 'natural forms of money' that keep turning up in every era and nearly every society.

But for now at least you have the means to understand what money supply is and how it is measured, and how it is different from potential money, or credit, the representations of money, and asset stores of wealth.

US Monetary Deflation

There isn't any monetary deflation visible in the data, at least so far.

This is despite the drop in the Consumer Price Index which appears to be driven by quickly weakening aggregate demand, as reflected in the National GDP numbers, in conjunction with a powerful short squeeze in the eurodollar which we have documented earlier that had a dampening effect on key import prices, in particular oil.

Whether a true monetary deflation develops later is another matter. We are still early in this economic downsizing of the financial sector and a massive credit bubble created by lax banking regulation and an over-accommodative Federal Reserve.

Granted there is credit creation outside of the banking system that was and still is significant, particularly with regard to feeding asset bubbles. But the role of the banks has been underplayed in this. The banks, in conjunction with the Fed, were key enablers of this series of credit and asset bubbles we have seen. Fannie and Freddie were bagmen, to borrow an analogy, but the banks were the capos with Greenspan as consigliere.

The growth of credit (indebtedness) is not money supply. It is potential money that feeds into inflationary expectations, most obviously in asset prices and consumption based on debt taken on against inflated assets. Whether my house if valued at $690,000 or $500,000 means little unless one is a speculator, or financing their daily consumption through HELOCs rather than productive growth in the median wage.

Along the same line of thought, the liquidity being added by the Treasury and the Fed to the banking system, reflected in the spike in the Adjusted Monetary base, is not feeding a monetary inflation yet either, but rather a parabolic bubble in Treasuries, and perhaps the Dollar although this is not yet demonstrable given the many degrees of freedom in the calculation.

There is an even more sophisticated linkage, with the expected lags, which we will be exploring in future charts and discussions. But if one considers the percentage growth in money supply and credit shown below against the growth in GDP which is now negative the hand of the Fed and Treasury in the economy is pronounced.

As a warning however, there are lags, and we still will expect a contraction in money supply to show up next year, probably coindicent with a trough in financial asset prices as occurred in 2002.

Money Supply, Paul Krugman, and the Great Depression

We like Paul Krugman and enjoy reading his columns. But every so often he writes a column that is so off his normal standards that it makes us wonder if he is on vacation and the task of producing the column has been delegated to a graduate assistant.

Here is one such example.

NY Times
Was the Great Depression a monetary phenomenon?
By Paul Krugman
November 28, 2008, 1:47 pm



Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history?

A central theme of Keynes’s General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Fed could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Fed caused the Depression.

Now, what the Fed really controlled was the monetary base — currency plus bank reserves. As the figure shows, the base actually rose during the great slump, which is why it’s hard to make the case that the Fed caused the Depression. But arguably the Depression could have been prevented if the Fed had done more — if it had expanded the monetary base faster and done more to rescue banks in trouble.

So here we are, facing a new crisis reminiscent of the 1930s. And this time the Fed has been spectacularly aggressive about expanding the monetary base:



And guess what — it doesn’t seem to be working.

I think the thesis of the Monetary History has just taken a hit.

We have mixed emotions on this one since we think the monetarist approach is a too one-dimensional to explain what happened then and now, and agree with Keynes that monetary policy alone is incapable of dealing with a complex economic event such as we are now facing. We also do not believe that the Fed 'caused' the Great Depression.

However, to try and make the case that the Fed can "only" control reserves and the currency base, the monetary base, is an old canard trotted out by the likes of Greenspan and his ilk when they wish to make the case that things are happening, like enormous bubbles, that are beyond the Fed's control. This is a Clintonian use of the word 'control' and is always and everywhere rubbish.

The Fed's power, its influence, is profound, and ever moreso in this era of aggressive financial engineering. Krugman uses the narrow argument of literal control to point to the Adjusted Monetary Base as his sole metric and say, "See the monetary base went up in the Depression in his Chart 1, just as it is today in Chart 2. Therefore there was no error from the Fed at that time because it was all that they could do."

Here are two other charts that help to provide a better view of what really happened.



Please note in the above chart that after the British abandoned the gold standard, the Federal Reserve RAISED the discount rate for US banks in the spring of 1931 from 1.5 to 3.5 percent, or 200 basis points.



To emphasize the policy error look at this estimate of real interest rates leading into the bottom of the Great Depression in 1933. Nine out of ten economists might notice that, relative to the price deflation which was obviously occurring, that the increase in Discount Rate was motivated by other than monetary and domestic considerations.

Finally, let's take a look at a broader money supply for the period, M1, against the change in GDP.



Please notice the decline in M1 tracking the changes in GDP.

So, what might the Fed had done differently?

It is obvious that devaluing the dollar was the right thing to do. To that end, the Fed might have cut the discount rate to less than one percent, instead of raising it, which was likely in response to the movement of the British pound and the Bank of England's abandonment of the gold standard. They also might have lent in size to any bank requiring deposits, so that there would be no more bank failures for banks that were in otherwise reasonably good shape, that is, because of depositor runs.

And this is where we do part company with Mr. Friedman and Ms. Schwarz and join Lord Keynes in his observation that it requires fiscal and legislative actions to repair an economic shock such as the country was experiencing in the early 1930's.



Notice that Government Purchase drop, and rather sharply, into the trough of 1933, along with aggregate demand. This would have been the point where Keynes would have likely observed that supply money was not enough, but was only a first step in stabilizing the system. The 'real cure' was to get people working again, to provide wages and gainful employment, to encourage consumption and economic activity.

As an aside, notice that net exports were negative and remained so throughout the period of 1929 through 1933. Much has been made of the Smoot-Hawley tariff, and indeed exports did nominally decrease. But the proportion of decline to imports makes it clear that protectionism was rampant throughout the rest of the world, and had not been caused by anything the United States was doing per se.

We don't have the chart at hand, and will continue to look for it, but the United States was one of the last of the developed nations to emerge from the Depression with positive GDP growth. We think that this was caused by exactly the phenomenon that Keynes observed, which was a lack of government fiscal and legislative activity to promote economic activity, as well as a relatively open market for imports and a "business first" bias, to the disadvantage of the unemployed working people.

In conclusion we would say that contrary to what Mr. Krugman asserts it is apparent that the Fed made a significant policy error in raising the discount rate in early 1931. It is less clear what latitude they might have had to do more to stem the tide of bank failures because of depositor fears, but they clearly could have done more to react to the contracting money supply. We have heard that they only were able to think in termed of the monetary base and had no statistics beyond that with which to guide their efforts.

We think that this is a weak rationale at best for their failure as bankers to respond to the obviously dire situation of the economy which evident in and of itself. We would not accuse them of lacking imagination, inventiveness, determination, and a spirit of pragmatic activism. In fact, they strike us as 'clubbable men' acting for their club.

We shall see this time perhaps if monetary activism alone is sufficient, especially if the Republicans and corporate banking interests have their way. But it does not appear to be the case since making money available to lend does not solve the problem of helping to create an economic environment in which profits might be made.

Indeed, we can imagine an outcome in which misbegotten monetary policy results in an oligopoly of corporate interests and an economy that is permanently frozen in a series of de facto monopolies based on central planning, not all that dissimilar to the experience of the Soviet Union prior to its dissolution and some countries in which a hundred or so powerful families control the government and its economy in a state of permanent corruption and malaise.