Money Supply: We're In Orbit Now

A few weeks ago I wrote that money supply was about to blast off. And, last week the data showed that the Fed was pumping money (as measured by M2 on a seasonally adjusted basis) into the system at greater than a 100% annualized rate. Well, this week we’ve reached orbit and are circling the globe in a holding position in outer space. For the week ending September 29, money supply was essentially unchanged from the week before but remains up almost $200 billion in just 30 days. Reflecting the reality of where money supply had already gone, the Federal Reserve, in a coordinated action with other central banks, lowered the Federal Funds rate by 0.50%. However, this move merely memorialized what had already taken place in the money markets (and arguably should have been deeper to more accurately reflect reality).

I am surprised that M2 did not continue its climb out of orbit and into another solar system. I suppose money supply could be holding at its current level because that is what the Federal Reserve wants it to do or it could be holding because despite the Federal Reserve’s best efforts to push money supply upward it is stuck. The deleveraging process destroys money supply and maybe M2 has gotten stuck because as fast as the Federal Reserve creates money, private enterprises destroy money through an acceleration of the deleveraging process.

While I don’t know why money supply is currently stalled, I do know that the global monetary system is clogged up in a liquidity trap and that the Federal Reserve and other central bankers haven’t been able to clear the blockage. A liquidity trap exists when interest rates are very low and monetary policy no longer is effective. Banks hoard money and are unwilling to take risk. When a liquidity trap exists it is very bad for the economy. Businesses can’t borrow, consumers can’t get financing and things spiral downward very quickly.

Conventional wisdom is that during a liquidity trap only fiscal stimulus will get things moving again. Clearly Hank Paulson and the crowd at Treasury have read the same economics text books as me because they are doing everything possible to use fiscal stimulus to clear the liquidity trap. However, government officials in the EU apparently didn’t take economics in college (or maybe they didn’t study hard) because they seem unwilling or unable to effectively respond to the crisis. EU officials remain convinced that this is an “American” problem and want to deal with their issues by blaming the U.S. but not taking coordinated action. This weekend they had coordinated talk but not coordinated action. They don’t seem to understand that the European banking system is even more overleveraged than most U.S. banks and that they are in danger of tanking the common market and the Euro. Hopefully the Federal Reserve and the Treasury are powerful enough to pull the U.S. through the crisis and restore America’s role as the economic engine that pulls the rest of the world forward.

Comments

[Simit Patel:]

Money supply is stalled because banks aren't trusting each other enough to lend to each other. The toxic debt and bad banks need to be expelled from the market; this will restore trust. This would result in significant deflation.

Instead the Fed is trying to print its way out of this mess, and thus is choosing an inflationary depression rather than a deflationary one. This is a poor idea and will result in more economic destruction.

2008 Oct 13 01:27 PM

[sieraromero:]

The banks don't trust each and won't lend to each other because, they know what would happen to themselves if other banks looked as bad as they themselves do. The whole system is now a house of cards and need magic tricks and government bailouts to keep them afloat, and of course they will. The consequences of them not doing so would be short term disasterous for not only the U.S., but for the whole world.

2008 Oct 14 08:44 AM