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A return to the primacy of money

A return to the primacy of money

If only the Fed (as a whole) understood money ….
St. Louis Fed paper is required reading

by Gabriel Stein, OMFIF Chief Executive

Wed 25 Jul 2012

One of (many) peculiar elements of the Great Recession has been how little importance central banks have placed on money supply developments. Even the European Central Bank, ostensibly a monetarist central bank – one of the ECB’s two pillars is the growth of M3 – has stood blithely by and watched how the growth of broad money not only has slowed, but also has gone into negative territory.

Instead, central banks have concentrated almost exclusively on credit. But a moment’s thought should have made it obvious that this not only illogical, but futile. The Great Recession in its many manifestations was essentially a debt-induced crisis. A number of countries had excessive savings; these depressed interest rates globally and led to a surge of borrowing to the point where households (as well as companies and governments, varying from country to country) became over-indebted and could no longer service their debt.

It must be perfectly clear that it is impossible to solve a debt-induced crisis by making households and companies take on more debt! Yet this was – and to some extent remains – the policy of a number of central banks. The most important one here is the Federal Reserve; the Fed – as a whole – doesn’t seem to understand money, nor does it ascribe any importance whatsoever to it.

By contrast, concentrating on money supply, specifically on broad money developments, could help bring the crisis to an end. The way to do this is to buy assets from the non-bank private sector, essentially giving households and companies as much money as they wish to hold in the form of money – that is to say, in their bank accounts – and then to give them more.

What is the advantage of this process? It is that when you hold more of your assets in the form of money than you wish to do, you try to adjust your holdings. There are only four ways of doing this: You can buy a good, a service or an asset; or you can destroy money by paying down debt. In the first three cases, while it is possible for each individual actor to adjust their holdings, it is not possible for the economy as a whole. The money therefore goes around continually, creating activity and eventually higher prices. In the last case, the money is indeed destroyed, but it speeds up the deleveraging process.

One of the key differences between the Federal Reserve and the Bank of England is that the Bank has (somewhat belatedly) understood this. Its version of QE has been to buy assets generally held by the non-bank private sector. By contrast, the Fed’s QE has been directed to buying assets generally held by the financial sector, which has had little impact on money supply. (Fears that the Fed’s QE has swollen money supply and that this will cause a surge of inflation are thus misguided!) The ECB, meanwhile, has done little or nothing at all.

For all these reasons, it is a pleasure to read a paper by Daniel Thornton, Vice-President of the St Louis Fed, called Monetary Policy: Why Money Matters and Interest Rates Don’t (http://research.stlouisfed.org/wp/more/2012-020). (The St. Louis Fed President, Jim Bullard, gave a talk in London on 10 July in OMFIF’s Golden Series.)

The paper essentially says that the ignorance of money in economic models is wrong and unfortunate. It also points out that interest rates matter little (actually, the paper’s Section 4 is entitled Monetary Policy: Why Interest Rates Don’t Matter). Given how much of central banks’ time, money and energy is spent on temporarily affecting interest rates, frequently with little impact, this is a refreshing point. It is true that Thornton, in the American tradition tends to concentrate on the monetary base instead of on broad money (which I consider paramount). But this is quibbling; the main point is that the arguments in favour of a role for money in monetary policy decision-making are strongly made.

Even if central banks had paid greater attention to broad money developments, the Great Recession would not have been avoided; but its effects could have been mitigated earlier on. Even now, greater attention to money and attempts to spur broad money growth would have beneficial effects on the world economy.

We cannot hope that the Board of Governors and the FOMC will immediately see the truth in Thornton’s views and be converted. But, when in the words of today's Financial Times, the time has come for a more radical Fed approach, it is perhaps not too much to hope that this will be a first chink in the Fed’s ‘creditist’ armour and that, eventually, the Fed will begin to use money supply again in its deliberations. Doing so could only improve the Fed’s decision-making. Not only the US, but also the whole world would benefit. So, Thornton’s paper should be required reading.

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