David R. Henderson  

M3 Plummeting

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Hayek on Social Justice... What I've Been Reading...
The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc.
This is from Ambrose Evans-Pritchard in the Telegraph, a British publication. It goes on:
"It's frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.
Congdon is a well-known British monetarist economist. The deck line--that's the line just under the title that tells the gist of the story--says:
The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.
The strange word in there is "despite." This was the mistake made in the Great Depression when the Fed looked at low interest rates and said, "See? Monetary policy must be loose." Of course, as Milton Friedman pointed out many times, always crediting Irving Fisher, all we observe are nominal rates. Nominal interest = real interest + expected inflation. A tight monetary policy leads to low or negative expected inflation, making nominal rates, for a given real rate, low. I caution, though, that because the Fed quit reporting M3 a few years ago, the data on M3 are from John Williams. I've never found him persuasive in his claims that the CPI dramatically understates inflation.

HT to Jeff Hummel and Mark Brady.


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COMMENTS (22 to date)
Elvin writes:

David,

Please expland on your view that the CPI does not dramatically understate inflation. There are a lot people who believe that the government deliberately understates inflation.

David R. Henderson writes:

Sure, Elvin. Read the piece in the Encyclopedia:
http://www.econlib.org/library/Enc/ConsumerPriceIndexes.html

Wilmot of Rochester writes:

Dr. Henderson,

Are you alarmed about this?


I am. For the life of me I don't understand what these people are doing? What else is the central bank supposed to do if not insure that the money supply doesn't plummet?

mulp writes:

Let's see, with nominal interest at near zero and inflation certain to be 5-10%, the interest rates are negative. So, what the Fed should do it tighten money to head off inflation, just like they did in the late 20s. Right??

With everyone irate that the Fed is pouring money into the shadow banking system which is what determines M3 today, clearly the problem is tight money by the private banking system. What will make Citi, BoA, et al make easy money available?

Maybe tax rebates to promote a new surge of pump and dump - for every $100 in stock you buy and sell a week later, the IRS matches any profit you make?

Maybe it is time to hike taxes, like in 1983 when job creation finally began after the 1981 tax cuts caused millions of job cuts. Or the 1990 tax hike that reversed the job losses of the 1990 recession, boosted into the highest employment rate by the 1993 tax hikes.

A decade of tax cut after tax cut after tax cu after tax cut after tax cut after tax cut has killed lots of jobs, driving the employment rate down to the levels they fell to after the 1981 tax cuts.

D Benson writes:

The Fed already more than doubled the monetary base. What more can they do?

Should they quit paying interest on reserves?

Should they continue to purchase mortgage-backed securities?

Maybe a falling money supply is a necessary evil.

david (not henderson) writes:

If the central bank is doing its job properly (a long shot, I'll grant you), a falling money supply could also be an indicator of falling money demand (from an elevated crisis level) and that, in response, the central bank is withdrawing liquidity. The key issue is not the level of the money supply itself but the relationship between money supply and demand.

David R. Henderson writes:

@Wilmot of Rochester,
Yes. If it's true, I am alarmed.

@D Benson,
Yes, I think the Fed should quit paying interest on reserves.

david writes:

Scott Sumner has been writing a lot about this, I do recommend reading his blog.

He advocates targeting NGDP.

Tom Grey writes:

There should also be some M4 (or Mx?) of money investing in housing.

The $60 Trillion of CDS/ CDO derivatives on MBS market has tanked, to what? $15 trillion? (Really, I haven't heard and don't know where to follow this. I did hear of the %50-60 tril often, before.)

There was a HUGE inflation, and malinvestment/ overinvestment, into housing, and related house furnishing industries. There was also the wealth effect, of folks thinking that had a lot of equity wealth, which disappeared with the bubble pop.

The Fed should print more money, until non-energy prices start increasing again.

Tax cut deficits, allowing the wealth creators who pay taxes to have more money, are far superior to increased gov't program deficits, because the Return on Investment of the tax cut amount will be much higher than the ROI of gov't spending (usually a little negative).

David R. Henderson writes:

Ditto david's recommendation about Scott Sumner's blog. I'm a regular reader. Don't remember his addressing M3 lately, though, although I might have missed it.

randy writes:

FYI, John Williams' assertions about the CPI have been utterly crushed by the BLS. See the Monthly Labor Review article:
http://www.bls.gov/opub/mlr/2008/08/art1full.pdf

Josh writes:

David,

I would caution the use of M3 as meaningful regardless of the source because it is a simple sum index. In other words, monetary aggregates simply add up all of the components even though each component might serve a different purpose. For example, time deposits and currency are substitutes, but they are not perfect substitutes. The simple sum aggregation implies that they are. If we wanted an index of transaction services, we would not simply add roller skates, bus rides, and airplane flights together and we shouldn't for money. What's more, the problem of simple sum aggregation gets worse the broader the aggregate.

There has been a lot of work over the years on this, but the St. Louis Fed does produce Monetary Services Indexes that correspond to the typically defined aggregates. Unfortunately, they are in the process of updating their samples and data only exists up through 2005. However, those aggregates would provide a much better guide.

Now, I am notably biased on this as one chapter of my dissertation is devoted to re-examining results of previous work on simple sum aggregates using the monetary services index measures, but nevertheless I would caution the use of the simple sum metric -- especially for M3.

David R. Henderson writes:

Josh,
Thanks for your thoughful comment. I agree that they cannot be added with extra weights. Did you come up with another way? Or did you conclude that M3 is not useful at all? Did you publish anything on this?
Best,
David

Vangel writes:

The Fed has no business manipulating the money supply and playing the role of a central planner. Money is far too important to be controlled by the government or a central bank.

Vangel writes:

I caution, though, that because the Fed quit reporting M3 a few years ago, the data on M3 are from John Williams. I've never found him persuasive in his claims that the CPI dramatically understates inflation.

I disagree. Williams has shown that he knows what he is talking about and uses the pre-Boskin method of calculating CPI so an apples to apples comparison can be made between price changes now and in the past.

...This was the mistake made in the Great Depression when the Fed looked at low interest rates and said, "See? Monetary policy must be loose." Of course, as Milton Friedman pointed out many times, always crediting Irving Fisher, all we observe are nominal rates...

I suggest that you need to look at Rothbard's great book, America's Great Depression. Rothbard makes clear that the Fed used extraordinary measures that Friedman and others looking at the period have failed to adequately account for. He writes:

"In an act unprecedented in its history, the Federal Reserve moved in during the week of the crash—the final week of October—and in that brief period added almost $300 million to the reserves of the nation’s banks. During that week, the Federal Reserve doubled its holdings of government securities, adding over $150 million to reserves, and it discounted about $200 million more for member banks. Instead of going through a healthy and rapid liquidation of unsound positions, the economy was fated to be continually bolstered by governmental measures that could only prolong its diseased state. This enormous expansion was generated to prevent liquidation on the stock market and to permit the New York City banks to take over the brokers’ loans that the “other,” non-bank, lenders were liquidating. The great bulk of the increased reserves—all “controlled”—were pumped into New York. As a result, the weekly reporting member banks expanded their deposits during the fateful last week of October by $1.8 billion (a monetary expansion of nearly 10 percent in one week), of which $1.6 billion were increased deposits in New York City banks, and only $0.2 billion were in banks outside of New York. The Federal Reserve also promptly and sharply lowered its rediscount rate, from 6 percent at the beginning of the crash to 42 percent by mid-November. Acceptance rates were also reduced considerably."

Hoover and the Fed did not stand aside and fiddle with interest rates hoping that things would improve. They acted quickly and firmly in an attempt to prevent an economic collapse that was necessary before a true recovery could take place.

As Rothbard showed, the depression became the 'Great Depression' because of the unwillingness of Hoover and the Fed to permit liquidation, as Harding allowed when he first came to office. Instead of fighting market forces Harding cut government spending and reduced taxes as he stood aside and let the crisis to run its course without much interference. As a result the US economy had a sharp but short contraction and began to recover quite rapidly.

Sadly, few people really know what happened during the Great Depression and are pushing for the policies followed by Hoover/FDR instead of admitting that Harding's method of inaction works much better.

Vangel writes:

Sure, Elvin. Read the piece in the Encyclopedia:
Consumer Price Indexes

You are quoting a piece written by Boskin? He was the guy who said that when the price of beef went up we should not count it as an increase because people would substitute chicken instead. Or that we should count price increases for cars with government mandated features that we do not want as price decreases because of 'quality improvements' which we never wanted and were not willing to pay for. If you use the same method as was used under Carter/Reagan you would see that the CPI is understated by a significant amount. I suggest that you look to another source.

How to Rewrite Economic History: The Great CPI Fix

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Richard A. writes:

Take a look at what M2 has been doing.

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Harrison Searles writes:

"The Fed has no business manipulating the money supply and playing the role of a central planner. Money is far too important to be controlled by the government or a central bank."

While I for one do agree with me, this is a moot point right now because, for the time being, we are stuck with a central bank, and while we are saddled by such misfortunes it is still important to have an efficient policy for that central bank to follow. It does not follow from the assertion that a central bank should not exist that the existing central bank should not have an effective monetary policy.

Justin Rietz writes:

Re: Rothbard -

I once agreed with his position, but having learned more about monetary theory (courtesy of David and Jeffrey Hummel - so obviously I am biased here) there seems to me several flaws in the Austrian position on the Great Depression.

With the risk of over simplifying, I think what Rothbard et. al. missed out on is that money is a good and like other goods responds to supply and demand. However, by maintaining an inflexible money supply, the change in demand for money causes its value to fluctuate and in extreme cases such as the Great Depression, to fluctuate greatly. For other goods, an increase in demand, and hence an increase in prices, causes suppliers to increase production and thus stabilize prices.

Anecdotally, during the Great Depression countries that went off of the gold standard earlier also rebounded earlier, as did the U.S. when it eventually went off of the gold standard. Of course, one could argue that this was just another inflationary bubble that would lead to a bust, but I think it is more likely that allowing the supply of money to adjust to demand helped stabilize prices and therefore restore a modicum of stability to markets.

Bob Layson writes:

The money that nobody saved was credited into existance and spent. Hence the boom.

In the bust people are spooked into a rush for liquidity. Prices fall and wages don't fall enough. Hence the slump.

Loans are called in or not renewed or finally written-off and an equal loan not extended to new borrowers. The fairy money has melted away. But with a commodity money the money does not disappear. With a commodity money, commercially provided, although manias and bubbles may occur massive malinvestments years in the making cannot as monetary creation used to lower interest rates is not an option.

Austrians are still in thrall to Keynes if they suppose that the answer to the need for real adjustments in prices and investments is to hose more fiat money around.

A jump in the demand for money is a consequence of a previous monetary manipulation which was utterly unnecessary for sustained economic growth and co-ordination to have taken place.

The silly tail chasing has to stop sometime. Not having the disease - a yo-yo money supply system -is better than any cure.

Josh writes:

David,

I emailed a copy of the paper to your academic address (assuming that I have it correct).

emo writes:
Maybe it is time to hike taxes, like in 1983 when job creation finally began after the 1981 tax cuts caused millions of job cuts. Or the 1990 tax hike that reversed the job losses of the 1990 recession, boosted into the highest employment rate by the 1993 tax hikes.

A decade of tax cut after tax cut after tax cu after tax cut after tax cut after tax cut has killed lots of jobs, driving the employment rate down to the levels they fell to after the 1981 tax cuts.


Youre reading of history couldnt be more wrong. After Reagan's 1983 tax RATE cut, 20 million new jobs were created. The 1990 tax increase prolonged the 1990 recession and made the 1992 recovery slower than it other wise would have been.

Your last sentence is utter nonsense.

Tell me how as a business person, I would hire more people if govt takes more of my income. You obviously believe that one dollar taxed and spent by govt, provides more economic growth than one dollar spent by the private sector

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