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Money Money Everywhere But…..

January 31, 2012

While I had intended to write about tax reform and tax policy this week, the Fed’s action (and signals) last week reminded me of a more immediate discussion topic: our massively expanding money supply. I have alluded to this on both my previous postings, but felt it important to tackle this one now in light of the Feds actions and statements this past week.

First, let’s start with some basics. Generally speaking, U.S. money supply is defined as the amount of $$$ in circulation. However, there are multiple definitions of money supply though one commonly used by economists is the “monetary base”. This refers to the amount of currency in circulation plus the deposits held by banks at the federal reserve. (For more discussion of this definition, I would refer you to an excellent blog from I also highly recommend the book and analysis done by these authors, though I caution you that you may lose some sleep after reading their book!!! )

There is a strong correlation between the rate of growth in the money supply and the long-term rate of inflation. Notably, inflation lags money supply growth by a couple of  years and even longer when the economy is weak (e.g. today). However, eventually the growth in money supply results in inflation, and the higher the  growth rate in money, the higher the rate of inflation. The “After Shock” authors cite work by Ben Bernanke and others that found this correlation, but in order to prove it to myself, I downloaded the Fed data back to 1959 and took a look at the trends. Sure enough, an increase in money supply growth showed up as higher inflation a few years down the road, while a lower rate of growth in money supply growth typically helped reduce the inflation rate. Of course, Milton Friedman won a nobel prize for his work on monetary policy and his theories about the association between money supply growth and inflation.

We have had a “relatively” stable monetary policy historically with  “monetary base” growth averaging 6.3% per annum between 1959 and 2008, with most years growth falling between 2 and 8 percent. The exceptions have been when the Fed has pursued a very expansionary policy (e.g growing the money supply by 9-10 percent during the mid to late 1970s which occurred a few years prior to the double-digit inflation of 1979-1981) or has actually pursued a restrictive monetary policy often to curb inflation (e.g. zero growth during 2000-01 to curb inflationary pressures during the “irrational exuberance” period of the late 1990s). However, the largest exception of all is during 1929-1933 when the Fed REDUCED the money supply by one-third. This enormous restrictive action helped cause an enormous DEFLATION spiral which in turn fueled the Great Depression.

If you have made it this far, you may be asking why is this important TODAY? First, history and economic studies have proven the common sense notion that inflation is simply too many dollars in the US economy being used to buy a set of goods and services. The more dollars available in the system, the higher the prices (in $ terms) of those same goods and services. Second, and most importantly, after decades of monetary policy during which the average growth in the monetary base between 1959 and 2008 has been 6% per year(and almost always between 2 and 8 percent per year), we  have  MORE THAN TRIPLED the monetary base in only a bit more than the last 3 years. (e.g from $0.8 Trillion in late 2008 to $2.6 Trillion today). It is NOT an exaggeration to say we are in completely uncharted territory and no one knows what the ultimate outcome will be over the next few years as all this money eventually fully circulates thru the US economy. However, it is good bet that we will eventually see much higher inflation, quite possibly double-digit inflation, very high interest rates and a much weaker US dollar. This combined with a U.S. economy which is still heavily saddled with consumer debt , a housing market that is still inflated (relative to long-term history), and a still rapidly increasing US federal debt burden will almost certainly be enough to push us into a serious recession, which will probably make 2008-2009 look pretty good in comparison.

The recent Fed announcement indicates that it intends to hold interest rates to near zero levels thru 2014 and comes primarily as a reaction to the continuation of relatively slow growth that we have had of late. (NOTE: historically, US recoveries generally have very robust GDP growth rates of 5-6% or even more for a couple of years , but this recovery has been barely above the 2-2.5% growth needed to reduce unemployment levels.) The implication is that in order to keep rates to these very low levels, the Fed will almost certainly have to expand the money supply even more. This likely means a QE-3 (ie. the third “quantitative easing” program) in which the Fed will buy back US treasury bonds by printing enormous amounts of additional money. In my view at least, this will only exacerbate our problems in the long run.

Why is the Fed doing this? The Fed and a number of economists view that the US economy and the European economy are very weak and needs to be stimulated through near zero interest rates so more loans will be made, housing values will go up again and there will be greater capital investment to help  the US economy grow more rapidly. The Fed also views that it can reverse its monetary course if inflation begins to heat up.

The problem with this theory is that stimulation doesn’t work too well  (and certainly hasn’t for the past three and a half years) when consumers are laden with record amounts of debt already and home prices are still at very high levels relative to long run historic norms.  (Over the past 100 years, home values have roughly kept pace with inflation/personal income growth except during two periods, the Great depression when they dropped by some 30 percent in real terms , due to the deflationary policies of the Fed and during the first seven years of the past decade when they roughly DOUBLED in real terms). Second, reversing our monetary course (selling more US debt and retiring the money supply)  wont be at all easy politically (as it will in itself result in much higher interest rates) and probably wont be done unless we have a rapidly growing economy which now appears highly unlikely. So whatever reversal the Fed does ultimately pursue will almost certainly be too little too late.

What should the Fed do? Allow interest rates to rise moderately by turning off the monetary spigot and gradually beginning reversing its ultra-expansionary policies of the past 3 years NOW. This obviously isn’t going to happen because it will mean slower growth or even zero growth for a while and the Fed is watching today’s stubbornly high unemployment levels as well as inflation. 


I promise to move onto less depressing topics next week!

  1. William Hildeson permalink

    I’d naively hoped that we would slowly come out of this credit cruch. After reading here it seems clear that won’t be the case.

    And a future topic for you… not that you’re asking. I’d be interested in an analysis of how Regan’s deficit spending and the subsuquent interest rates correspond to 2006-2012.

    • Good suggestion. I will try and take it up in a future blog.

      Dont mean to sound too pessimistic or least not yet. Unlike the Aftershock authors, I think we can avoid a major depression, However, it will take a significant change in our current fiscal and monetary policy to do so.

  2. Neil from New England permalink

    I always thought they were increasing the money supply because there wasn’t enough in circulation to cover the Yankee’s payroll!
    Sorry – I’ll wait for one of your sports blog posts to cover that topic….

  3. I believe the Steinbrenners and Ben Bernanke are in cahoots. After all, very high inflation is just the ticket to make ARods $25 Million fixed contract payments more affordable!

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