“During the 1992 presidential campaign, former President Clinton’s rallying cry was ‘It’s the Economy, Stupid.’ He sang it to perfection and won the election. Today, the smart politicians (and economists) should realize that ‘It’s the Money Supply, Stupid.’ ” Steve H. Hanke, ‘It’s the money supply, stupid.’ GlobeAsia, July 2012
Steve Hanke tells only half the truth in his fascinating article. He focuses on aggregate statistics on the amount of money circulating in the U.S. economy without acknowledging that this statistic is a money market equilibrium based on forces of demand as well as supply. Nevertheless, his analysis is important, not least because it draws attention, albeit indirectly, into the role played by insolvent and illiquid banks in prolonging the current economic downturn.
1. What counts as money?
Money takes the form of various types of financial assets that are used for transaction purposes and as a store of value. Money created by a monetary authority – notes, coins, and banks’ deposits at the monetary authority – represents the monetary base of an economy, sometimes called high-powered money. This category is imbued with the greates moneyness of all the categories of financial assets that are called money. The monetary base is ready to use wherever goods and services are exchanged for money.
In addition, there are many other financial assets, running from bank deposits at the commercial bank to short-term private securities, that possess varying degrees of moneyness. These other assets, in varying degrees, are substitutes for money, depending on the opportunity costs associated with exchanging them for base money. Note that when we sum these assets to the base to obtain an aggregate money statistic, they should not receive the same weights as the base. The weight indeed should decline the greater the opportunity cost of exchanging a particular financial asset for the base. Steve Hanke refers to the weight adjusted measure of money as ‘Divisia’ and recommends using the broadest measure available, namely Divisia 4. The divisia measure is composed of publicly-produced money (the base) and privately-produced money (the financial institutions).
2. What is happening to Divisia 4 money?
This is where Hanke’s story bcomes interesting. In August 2008, base money, provided by the Federal Reserve amounted to just 5 percent of Divisia 4 money. The remaining 95 per cent was privately produced by financial institutions, including the banks. Since August 2008, the supply of publicly-produced money has more than tripled while privately-produced money has shrunk by 12.5 per cent. This has resulted in a decline in Divisia 4 money of almost 2 per cent. So in June 2012, base money has increased from 5 to 15 per cent of Divisia 4 money.
Should the earlier relationship between base and non-base money re-emerge (i.e. should the so-called money multiplier attaain its earlier magnitude) massive inflation would occur unless the Federal Reserve somehow could claw back the monetary base by two-thirds of its present size (without wrecking the economy).
3. Why is Divisia 4 so low?
That is the $64,000 question. In these columns I have argued that money supply is playing the major role in this suppressed equilibrium between supply and demand. The major banks and financial institutions in the United States had played themselves into insolvency or massive illiquidity by September 2008. They should have been liquidated, cleansing their failure and allowing new banks to emerge unemcumbered by past debt.
Government bailouts prevented that solution. In consequence, banks and financial institutions are unable or unwilling to lend to small businesses and to finance consumer borrowing. This constrains the money multiplier and significantly retards economic recovery.
Secondly, because of uncertainties raised by poor Keynesian macro-policies on the part of the Obama administration, money demand has been lowered within the private sector. There is, if you will, a capital strike afoot against the Obama administration, right across the business sector.
If Obama is tossed out of office in November 2012, the capital strike will disappear and a significant increase in money demand will occur. At that point, investors who have protected themselves against inflation will fare well. Others will suffer greatly.
So Moody’s downgrading of five of the six biggest U.S. banks on June 21, 2012, will further reduce the Divisia 4 monetary equilibrium, will further retard economic recovery, and should, if voters are sufficiently alert, hammer the final nails into Barack Obama’s one-term presidential coffin on November 6, 2012.
The downgrading may also set in motion market cleansing forces that lead to bank liquidations and provide the basis for a sustainable long-term recovery on the basis of competitive- instead of crony-capitalism throughout the U.S. financial sector.