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  • The Real Value Of The US Money Supply 32 comments
    Oct 2, 2012 12:29 AM

    The real value of the US money supply

    Among investors and financial commentators we see continued controversy over the Fed's current loose monetary policy of active quantitative easing. My previous post covered the financial sector deflation I see as driving the Fed's actions, which many participants in that debate seem to have missed or to be unaware has been happening. Here I want to examine the question whether the Fed adding money has simply goosed prices in response as so many claimed on theoretical grounds must be the result, or whether it has actually added value. Theory and ideology leads many participants in the debate over policy to expect that all additions to the money supply merely transfer real purchasing power from some actors to others. They then frequently indulge in extreme rhetoric against that supposedly automatic result. There is a strong belief among these observers that increasing the money supply can never actually add value, that instead it merely devalues existing money claims.

    I consider the theoretical case for those propositions to be much weaker than is generally believed. And empirically I think they are demonstrably false. In this post I want to present some of the evidence for my position, from both empirical time series and theoretical argument. I begin with the bare facts, in the form of 2 time series showing the inflation adjusted purchasing power of the US money supply, measured by M1 and by M2. The inflation adjustment is done by the CPI for all urban consumers, with everything turned into current dollars. Here are the resulting charts -

    The first thing to notice is just that the series are increasing and steadily so, particularly the broader M2 measure. This should be completely unsurprising - there is real economic growth, the real value of all assets in the US increases continually. Money is a small subset of those assets, but grows in real purchasing power along with everything else. Over the full period 1959 to now, the average growth rate of raw unadjusted M2 is 7.4% per year, of which only 4.5% is price inflation and 2.8% is real growth in total value. For M1 the raw growth rate is slower, only 6%, with 1.4% real value growth and the rest price change.

    The high portion of the total increase that reflects price changes partly justifies the common intuition that increasing the supply of money increases prices -and other things being equal, it certainly does. The underlying monetarist point that inflation is always and everywhere a monetary phenomenon has a sound basis. But the further, naive monetarist belief that all changes in money supply cause equal and opposite declines in the purchasing power of the monetary unit, is false. The higher quantity of dollars outstanding today compared to 1960 would purchase more in real value, not the same amount of real value. Each dollar exchanges for less, check, that is ongoing inflation. But the total does not exchange for the same amount, it exchanges for more. In the case of broader money including the savings forms in M2, a lot more. The total change in real M1 is more than a factor of 2, and of M2 more than a factor of 4.

    It is also worth noticing that M2 grows considerably faster than M1, and the ratio of M2 to M1 has more than doubled, itself. Less of the total value of all assets in the society are in the form of narrow money than in the past. Greater efficiency of money substitutes and clearing "support" more broad money and more total credit per unit of narrow money base. Moreover, the rate of growth of M2 is in line with total GDP and the value of all dollar assets, as measured by the top line of the household sector balance sheet in the Z.1 "flow of funds" dataset. But the growth rate of M1 is considerably less than that overall growth rate, slower by about 1.4% per year.

    The next important thing to notice about the series and especially the top, real M1 series, are the departures from trend and the changing direction of the series for some subperiods. For example, there is a real peak in December 1972 followed by a downtrend with its minimum in February of 1982. Over this period, the real value of M1 money supply fell by 24%, a decline of 3% per year. Prices were galloping along faster than narrow money. In my analysis, this reflects a declining real demand for money. In the following period, from that 1982 low to late 1993, the real value of the M1 money supply rose 73%, an increase of 4.7% per year. Prices were increasing in this period but modestly, at considerably slower rates than in the previous inflation. Narrow money grew much more rapidly than prices. Demand for money was increasing. This reflects a dramatic reversal in inflation expectations. Most investors are very familiar with that Volcker Fed success story, but many may not realize just how much narrow money supply grew over this period - without goosing prices.

    The next period to notice is that from March 2006 to August 2008. In this period the Fed was standing on the brake, keeping M1 nearly flat while increasing short rates. The real value of the narrow money supply fell by 8.3% over this stretch, a decline of 3.5% per year. Then the emergency actions of the Fed in late 2008 push real narrow money sharply higher, with both M1 increasing and prices briefly falling outright. The real value of M1 jumps by 20.5% in the space of 4 months. And it has gone on increasing since, farther overall though not as sharply as that short period.

    Now a theoretical point, one that seems so counterintuitive to monetarists that I expect its truth will be resisted stubbornly, but that I believe is justified by both the empirical data and sound theory. When the real value of the money supply increases from monetary expansion, real wealth can be and is being printed into existence by fiat. Not a mere reallocation from one holder to another. Not a mere pricing change or monetary illusion effect, but real value added.

    Why do I say that sound theory supports this conclusion, when so many textbooks and monetarist tracts, thinking of the 1970s case and others like it, assert the opposite as a supposedly necessary theoretical proposition? I answer that I am merely applying econ 101 - the revenue maximizing point on intersecting supply and demand curves may occur at a higher quantity and lower price per item - down and to the right on the usual crossing curves - and is always the result of two forces, one of them the demand curve, and not just one, the supplied quantity. When demand for anything shifts to the right, the clearing price of that item would change upward if the quantity did not move. But the quantity moving to the right instead, may very well produce a higher product for price times quantity, or total value.

    In my analysis, that is what happened on the financial crisis. The demand for money including for narrow money specifically, jumped sharply. Every sell order for every kind of risk asset was a buy order for money. The Fed met this panic safety demand by supplying the demanded item in much higher quantity, and the total value of that supplied quantity was sharply higher than previously. If they had not moved its quantity, its value would still have increased on the higher demand, in the form of higher exchange value for money, lower prices for everything else, aka a falling broad price level. But it likely increased by more, by letting its quantity move to meet the higher demand, instead.

    Some reasons monetarist theory might not expect this result, are too glib "other things being equal" handwaving, that effectively assumes that the demand for money is a constant (which I believe the top graphic proves to a demonstration it is not), or the classical economics mistake of predicting something's exchange value from its *costs*. It is certainly true that the marginal cost of a new unit of fiat money is zero, and classical economists might expect that nothing with a zero marginal cost could add real value in anything like a general equilibrium. But in the age of software we ought to know better than that - the marginal cost of an additional copy of Microsoft Office is also essentially zero, but we all recognize it can and does have a positive exchange value. The prices picked for items with very low marginal cost are determined by demand and revenue maximization points, not by their marginal cost. In all such cases there are barriers to just anyone supplying more of the item at its marginal cost, to be sure. But it is a common experience that items with zero marginal cost but in demand, have positive exchange value and supplying more of those items can and does add total value.

    So, one fundamental point - increasing the supply of money can and sometimes does simply print real value into existence. Men's demand for money is not directly inversely proportional to the quantity of it in existence. The demand curve for money is not a straight line, but curves, and also moves with time, as all other demand curves do.

    Cases like the 1972 to 1982 period show that high inflation with increasing inflation expectations can result in a declining real money supply, as prices increase faster than money, demand to hold money falls, and the incentives needed to convince men to hold nominal assets get harder to meet, in the form of higher interest rates and similar. Monetary policy can be too loose, and in such periods it is too loose, and the monetarists are right about the corrective needed in such cases. But that is not the only case that happens. When demand for money is high and increasing, it is possible to create real value by meeting that demand, by letting people hold the asset they want. When the real value of the money supply is increasing, empirically, this is what is happening, not the 1970s inflation case.

    As for the most naive monetarist expectation that the money supply "ought" to remain constant, and that any growth in the money supply simply moves value from some hands to others (unjustly, is the usual subtext), I think this analysis shows it is false empirically. Sometimes creating more money creates net value, and not just in nominal terms. It does so in the usual way, by accommodating a real demand to hold a specific item, in preference to other items. As such, as counterintuitive as it may seem, creating net new money can be a form of production that can and does add real value, as surely as moving goods from locations where they are in lower demand to others where they are wanted more urgently, adds value. Transportation does not create goods but it increases their value. Changing the form of financial claims does not increase the pool of real assets against which those claims run, but it still can increase their value, by accommodating the subjective asset preferences of all participants in the markets, more than an alternative.

    I hope this is interesting, and questions or comments are welcome.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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  • No Free Cake
    , contributor
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    I hope one day to know enough to ask insightful questions of you.

     

    Alas, I will have to resort to saying I find this fascinating. Please keep writing and commenting.

     

    I find your conclusions in this blog pretty straight-forward, even self-evident. But, it seems you expect a rebuttal so I hope a pure monetarist shows up. I'd love to see the debate.
    3 Oct 2012, 12:36 AM Reply Like
  • Westcoaster
    , contributor
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    JasonC,

     

    Thanks for your well thought out analysis further proving that correlation is not necessarily causation.

     

    Higher Money supply does not necessarily cause higher inflation.

     

    Help me with this that you write...

     

    "But the further, naive monetarist belief that all changes in money supply cause equal and opposite declines in the purchasing power of the monetary unit, is false."

     

    Isn't this the main belief monetarist hold? Hasn't our dollar lost 93% of its value to gold since moving off the gold standard? Isn't this the beef gold bugs have with increasing our money supply?

     

    And further proof for this that you wrote?....

     

    " The higher quantity of dollars outstanding today compared to 1960 would purchase more in real value, not the same amount of real value. Each dollar exchanges for less, check, that is ongoing inflation. But the total does not exchange for the same amount, it exchanges for more. In the case of broader money including the savings forms in M2, a lot more. The total change in real M1 is more than a factor of 2, and of M2 more than a factor of 4."

     

    I can understand what you wrote above, but where is the evidence for this? Don't you need to take your graphs and do purchasing power comparisons to a basket of goods? IE a dollar today buys so much grain vs a dollar in 1960 etc? Or did you just adjust these graphs for inflation and call it so? If so people aren't trusting inflation rates. They are saying there dollar doesn't go as far as the government thinks because the government excludes food and energy from their CPI.

     

    Thank you for your article, I agree with your general premise that money supply increases are necessary right now because the demand is so strong to hold money. It is pretty much one for one. The private sector kills some debt and Fed back fills with new money. The private sector saves, and saves and saves and this is reflected in the graphs above. If it ever works we should have a nice bout of inflation at some point. But your analysis shows that this will come when supply and demand aspects change for money. Not when money supply issues change.
    3 Oct 2012, 12:07 PM Reply Like
  • JasonC
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    Author’s reply » First, the graphs are already adjusted for inflation, as measured by the CPI for all urban consumers. Which is itself based on exactly such a basket of goods actually consumed by all urban consumers. And which most certainly does include food and energy, in the proportion people actually spend on those things.

     

    The confusion in that regard comes from the fact that the government calculates numerous versions of CPI, including versions with exclusions like food and energy - and the Fed has reported that it prefers to use the version that does exclude those categories for its internal inflation forecasting. It has that preference simply because the series without those inclusions is less volatile from month to month. But that is purely for its forecasting purposes, it doesn't want to whipsaw monetary policy due to month to month bounces in the price of gas.

     

    Some rather unscrupulous commentators - yellow journalism, really - try to pretend this means CPI doesn't take into account changes in prices consumers see most, but that is just slander. CPI takes into account what people actually pay for all categories of consumer goods.

     

    Next to the comment that the dollar has lost 93% of its value since leaving the gold standard, this somewhat innaccurate. The US didn't finally leave the gold standard until August of 1971, the end of the Bretton Woods system and the closing of the gold window. Until that time, governments could convert their dollar holdings into gold by requesting gold from the US, at a fixed price of $35 an ounce. The price level has indeed risen since 1971, by 5.5 times, so it would be accurate to say a physical dollar (without interest earned) has lost 82% of its purchasing power since the US left gold. That is a 4.2% rate of inflation, as the average over that period.

     

    The dollar has lost 94% of its purchasing power since an earlier date, January 1934, which is when private holdings of gold were outlawed by an act of congress. Or by 94.5% since the end of April 1933, when an executive order of the same effect was first issued. These are the likely end dates such commentators have in mind. But the US was still actually on a gold exchange standard for the full period between the end of April, 1933 and the middle of August, 1971. Being on a gold exchange standard over that period did not stop the dollar from losing 70% of its purchasing power. The average rate of inflation over that period was 3.2%. Thus, going from a gold exchange standard to a fiat standard only raised the rate of inflation seen by about 1% per year - and even that was all concentrated in the first decade. Inflation has been no higher since the Volcker Fed, under fiat money, that it was in the period 1933 to 1971, under a gold exchange standard but without retail convertibility of notes into gold.

     

    The Fed was founded in December of 1913. Prices more than doubled by June of 1920, but due to World War I. That was a rate of inflation of more than 11%. Prices then fell by 2% a year through October of 1929, to a level still 73% above the end of 1913 level.

     

    In the short period between the crash of that month and the executive order of 1933, the price level fell by over 27%, a rate of *deflation* of 8.7% per year. The gold devaluation of the depression - from $20.67 to $35 an ounce, a ratio of 1.69x, was an attempt to restore the price level of 1929. Not a terribly successful one, to be sure.

     

    My point in citing all of that history is that it is not remotely true that prices were broadly stable under the gold exchange standard that prevailed in the US before the present fiat money system. They weren't stable under the gold exchange standard with retail convertability of notes into gold, either. Instead they doubled one 7 year period and fell 25% in another 3-4 year period - volatile rather than stable.

     

    All such calculations assume that the holder of dollars earned nothing from them - they are the savings results of taking physical currency and putting it in a Mason jar to "keep" for decades at a time. No one should save that way, and at least for the last 40 years, it is doubtful anyone actually does. Money invested in short term loans, instead, and rolled over, has basically kept its real purchasing power, with the interest earned and inflation equal and opposite impacts on that purchasing power.

     

    All of which refers not to the purchasing power of the *whole* money supply - an increasing quantity, not a static quantity - but to the purchasing power of one unit of it, or one unit and its available interest earnings. My graphs show, instead, the aggregate purchasing power of the whole money supply.

     

    Which means, my graphs are rising when and if the total stock of money is rising *faster than prices*, and fall when and if prices rise faster than the stock of money grows. Naive monetarists often assume that the two must move in tandem, a belief that would require both series to be flat. I say "naive" because there are certainly more sophisticated monetary theorists who understand this and would not make such an assumption - I don't wish to put words into their mouths. But regardless, when the real value of the total money supply is rising, it cannot be literally true that all gains from money creation are taken from existing owners of money claims, because the pie is growing. It is positive sum, not a zero sum, change.

     

    The way I "read" those graphs, though, is as gauges of money *demand*. And indirectly, as report cards on the actions of the Fed. If the Fed is too loose without a reason to be in the form of a greater demand for money, the top M1 line will move downward, not upward. Trying to force more money into circulation that is not wanted will drive prices higher and real demand for money lower - that is what I see in the 1970s period on the top graph. But when, as in the latest period since late 2008, the top M1 line is moving sharply higher, I read that as money creation actually adding value, because prices are not increasing, while money is. I read that as, money is being created in response to a higher demand for that money, and that need not simply goose prices, but can instead add real value.

     

    I see lots of commentators "grading" the Fed harshly on the assumption that we are now in something like the 1970s situation, and to me we manifestly are not, and I "grade" its recent actions much more favorably. The demand for the money it is adding is there. To me, what the critics are missing is any gauge for the demand for money. They don't have one, they assume it must be a constant or nearly a constant, and they reach their conclusions by looking only at the supply variable.

     

    I hope that helps.
    3 Oct 2012, 01:51 PM Reply Like
  • Westcoaster
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    Thanks JasonC, it does help. You put a ton of belief behind M1 and M2. And I think your comments about us being "Naive monetarists", is most likely correct. I tend to fall into that category even though I don't see the results of that thinking happening in our economy today.

     

    So if I understand you points correctly you give a lot of support to QE and a lot of criticism towards the knee-jerk monetarists who instantly believe Larger Money Supply= Larger Inflation.

     

    Assuming you are absolutely correct would you label your thinking MMT? Would you label yourself a Post-Monetarist? A Neo-Monetarist?

     

    Also if I could ask another question, a while back Bush quit recording M3 and there was all of this talk about that being the end of the world and the end of us ever getting good economic data again and everyone pointed to the idea that Bush was gaming the system. Is M3 important to your analysis or do you disagree with Bush's critics and M3 was unimportant?

     

    Thanks in advance, I disagree with Whidbey's remarks I think you are making some very important points about M1, M2, and prices.
    5 Oct 2012, 12:20 PM Reply Like
  • JasonC
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    Author’s reply » On money measures, I don't think the discontinuation of M3 had anything to do with hiding anything, and all the yellow journalism talk directed at it was a mountain out of a molehill. If the Fed sneezes, its critics will allege a vast conspiracy to manipulate the price of gold by using up tissues. To me that is just noise. The real reason the Fed discontinued M3 is they didn't see any relationship between it and the goals of monetary policy.

     

    Understand, M1 matters because it is the measure of the money form against which commercial banks are required by statute to hold reserves. It is the only measure the Fed can actually control, all the others passing through free choices of banks and the public to a much greater extent.

     

    M2 matters because, empirically, it has the closest match to the growth rate of both the nominal economy and the value of all dollar assets, as tracked by the top "assets" line of the household sector balance sheet in the "Flow of Funds" dataset. I don't think that is any theoretically necessary result, by the way, or directly related to the definition of M2 and its inclusions.

     

    Instead, we know prices grow less than the economy - there is real growth - and the total debts of the financial sector (the broadest set of things that might be money-like) grows significantly faster than the economy. (Credit intermediation grows over time, with longer chains between end debtor and end creditor. Historically the debts of the financial sector have grown at twice the rate of nominal GDP). Ok, that is a "bracket", an "under" and an "over". Somewhere between narrowest money and broadest financial sector debts there will be some measure that roughly matches nominal GDP.

     

    It turns out M2 is the closest, among the standard definitions. It includes savings forms, both savings accounts and CDs, that most consumers would think of as bank account balances and thus as near-money. It isn't directly Fed regulated or controlled (if banks want to raise more in CDs and savers want to hold them, they can, with no impact on required reserves). But since it moves on long time scales about like nominal GDP or total asset values - up 7.5% a year nominal - it is a useful monetary measure. When people advocate a stable growth rate in a money measure to match nominal GDP growth, M2 is the only aggregate that would be a suitable target.

     

    I do track two other measures, but they aren't money aggregates. Instead they are credit and asset aggregates. Total dollar credit outstanding is broadest credit, much broader than money - it is the sum of domestic non financial sectors and domestic financial sectors in the Z.1 Flow of Funds dataset. And the top line of the household sector balance sheet, all assets at market value (and the net worth line off the same sheet, which is that number minus household sector debts), both as asset value measures.

     

    The labels I'd put on those are M1 - narrow money, M2 - money ("broader" being understood), all debts of the financial sector (broadest "money", really financial credit) ,all domestic sector debts - total credit - all assets - total assets. The size of the Fed's own sheet - monetary base - is another item to track. Those are the aggregates I view as economically meaningful.

     

    Adding in large CDs and other institutional term deposits without going up to total credit, doesn't seem meaningful to me (which is basically what M3 was). You can add other money market instruments to that to get near money substitutes in the sense of the "money market", as a short term savings outlet, but there really aren't bright definitional lines there, before financial sector credit and total credit. The Fed isn't trying to control those, they aren't a regulatory target, they show no more meaningful a relation to GDP or inflation, etc.

     

    Anyway, that is stuff about choices of aggregates, and the reasons I think of M1 as "narrow money" and M2 as "money" in meaningful senses.

     

    Next on labels or where I'd put my theoretical position, I think of myself as having learned from the Austrians (Bohm-Bawerk, Mises, and Hayek, mostly) without drinking the koolaid (Rothbard and his friends). I think my comments on the importance of financial and credit freedom is anticipated by the "free credit position" within the Austrian school, usually associated with Hayek but also a minority position among Austrians, compared to the more common "hard money", Mises' position.

     

    I also learned from Friedman and think that modern monetarists overlook how much his position was critical of the Fed for its excessive tightness not excessive looseness, back in the 1930s. He highlighted the fact that the demand for money varies. Later in his working life he was associated with tighter money because in the 1970s that was what the patient actually needed, and I think he was correct about that. So did Volcker, and so does Bernanke, come to that.

     

    I think most readers of the financial press would be shocked at how much of Bernanke's position is doctrinaire Friedman. He is routinely called "helicopter Ben" to paint him as excessively loose, without anyone bothering to notice his comments about helicopter drops of money to combat deflation were direct quotes from Milton Friedman. Whose point was merely that the Fed did not need to tolerate deflation and could prevent it if it was willing to pull out all the stops to do so.

     

    I also learned a lot from Charles Kindleberger about empirical financial history and the cycle. Kindleberger was a neo Keynesian but a moderate one. But his stuff is mostly straight descriptive history, not trying to apply doctrine. He argues by historical counterexample. His underlying thrust is that monetary expansion is endogenous, that the market will find new ways to evade restrictions on credit expansion pretty much regardless of how it is regulated, and that we get cycles from the interaction of that with ordinary human folly. I think that is largely a sound diagnosis.

     

    Other economists who taught me something about the subject are Bagehot on the empirical practice of central banking in the 19th century, Fisher on the instability of credit as a cycle cause or amplifier and on empirical index tracking of these things, instead of relying entirely on classical "just so" theorems, and Minsky for a neo Keynesian take on the same issue of credit instability and the robustness or lack there of, of financial structures, and how those move with the cycle. All of these have problems in other respects and I would not present them as guides without qualification. But they have useful perspectives and it is worthwhile to know them.

     

    I am not retailing a take on von Mises on the cycle that others have already advanced, however. I claim some originality there. Specifically, the point that all capital losses from misinvestment failure have the same impact as those he diagnosed specifically from monetary expansion, is mine. The free credit position among Austrians already pointed out that restricting government's role in money does not produce von Mises' prescription of "no issuance of fiduciary media without prior commodity cover", and that only heavy handed regulation could do so. Otherwise put, we don't need a Fed to get a growing money supply - commercial banks would do that themselves if not regulated at all.

     

    As for a "self label", I'd say I am for freedom of credit including the freedom to engage in credit expansion. I do not object (as some of the Austrian free credit position types do) to the role the Fed has in that in our present system.

     

    To me the right monetary policy is at bottom a practical matter and I judge it on tolerable vs broken, not to a perfectionist standard, and I'd say the recent actions of the Fed are on the tolerable side of that. I think they have called the right actions since say 2005 to a greater degree than any of their critics. (They were marginally too loose before then, and the criticism directed at them for that is fair, but should be limited. They weren't the only ones by a long stretch).

     

    Anyway, that may help to see background or sources of some of my thoughts, and to distinguish my position from others that may be better known. I hope it is helpful.
    5 Oct 2012, 04:56 PM Reply Like
  • Westcoaster
    , contributor
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    Thanks Jason, I had forgotten how much I enjoyed Kindleberger's "A Financial History of Western Europe". I have been meaning to read more Friedman again when I have time.

     

    Talk about him and "Monetarism" being dead is very far from the truth.

     

    I have always enjoyed Schumpeter and Glyn Davies. I really slowed down my economics studies after Schumpeter though, learning that the future is non-deterministic and every economic decision made creates winners and losers.

     

    Your insights above are great and you have shown there is a real value to our money supply outside of just creating inflation, it does indeed record our production.

     

    Thanks for all of the back ground and your comments.
    7 Oct 2012, 10:55 PM Reply Like
  • whidbey
    , contributor
    Comments (3395) | Send Message
     
    Interesting argument, but inconclusive: "They don't have one (demand function for money), they assume it must be a constant or nearly a constant, and they reach their conclusions by looking only at the supply variable." You hope, but that is not known or feasible to support your position.

     

    The liquidity preferences of an economy is a complex function which can not be specified easily, however the transactions demands, plus other uses, do allow estimates of the preferences instantly, but over time the integration of preferences is difficult since growth, etc., are unspecified and must be subjected to say Monte Carlo techniques to investigate the boundary conditions. Surly you would not argue that per se, the QE policy is justified based on your work because you have said the liquidity preference at any point in time is not known. Money has implicit value and if the holders of currency sense it is becoming less valuable they will shift their preferences instantly, perhaps ruinously for a currency. Thus most Central Bankers prefer a slight inflationary bias to accommodate growth and changes in preferences just because over time that policy has proven to be accommodative in the face of unknown demand. Historically this is to suggest that 2% is a fair estimate of the variance. Your self assurance is admirable, but unjustified. Keep working you have promise.
    4 Oct 2012, 03:39 PM Reply Like
  • JasonC
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    Comments (3951) | Send Message
     
    Author’s reply » "you have said the liquidity preference at any point in time is not known"

     

    You may wish to maintain that proposition, but no I most definitely did not say that.

     

    Instead I claim that my first graphic, the real purchasing power of the entire narrow money supply, is a gauge reporting the demand for narrow money, and specifically that its direction must be moving downward for the real demand for money to be falling significantly. When others diagnose an imminent demise of confidence in the currency, I reply that such a demise must be preceeded by and reflected in, that top line moving downward, not upward.

     

    And my thesis does not depend on monetarists having no gauge for money demand - that is merely my attempt at a charitable explanation of a basis of their position. But that the real value of the money supply is increasing when they say it shouldn't be, is already a fact they need to explain, themselves.

     

    Last, I notice that you say "liquidity preference" where I spoke of the demand for money. Your term implies an alternative of holding an asset with less liquidity, which may still be a nominal asset or a near-money in a savings form e.g. Notice that M2 grows faster than M1, M2 keeps pace with the value of all assets, while M1 lags it. This does not mean the total demand for money, in real terms, hasn't increased since 1960. It has - that is why the (larger) money supply exchanges for more than twice as much in real value as it did then. But narrow money specifically is used more efficiently, or a greater "tower" of broader money substitutes, total credit, and total asset values, rests on each unit of narrow money, than in 1960. In that sense, the relative demand for M1 vs savings forms or broader credit or non-nominal claims, can be said to have fallen.

     

    I prefer the term demand for money because it more directly relates to the usual way of assessing the price of any item, as involving intersecting supply and demand curves for that item. Your term seems to me more ambiguous as to whether an absolute demand or a relative demand is meant. If both the demand for M2 and for M1 grow, I see increasing demand for money, including increasing demand for M1. And if in addition the demand for M2 grows more than the demand for M1, that doesn't strike me as a decline in the demand for M1. But it could appear to be a declining demand for the most liquid form specifically, under one reading of the phrase "liquidity preference".

     

    I hope that helps.
    4 Oct 2012, 04:51 PM Reply Like
  • Economic Analyst
    , contributor
    Comments (2752) | Send Message
     
    Thanks Jason, for the presentation and much needed continued contribution to ongoing discussions.
    10 Jan 2013, 01:54 PM Reply Like
  • Jimyard
    , contributor
    Comment (1) | Send Message
     
    Jason, this is a very complicated matter and requires an in depth knowledge of Monetary policy and the interrelationship with inflation, the economy and the effect of easy credit on the money supply in general.

     

    I subscribe to Seeking Alpha, and read most of the articles, but before I attempt to parse your comments I would like to know your credentials. Mine are in the law, and accounting CPA/Attorney. Not being erudite, but I would like to know your bio before proceeding with attempting to understand your positions. Please let me know your educational background and experience.

     

    Jimyard
    2 Oct 2013, 05:04 PM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » I am currently a software consultant, doing technical computing solutions for corporate and government clients. Application of analytic tools in the social sciences (finance models, econ, statistics and formal modeling) is my specialty, and how I got into that line, but I also design the software systems involved, end to end, as a systems architect, basically.

     

    Before that I was a financial advisor - in the 1990s when it was kind of easy - and before that I was in grad school. (In fact the advising started just as a sideline, while still in grad school). I studied at the University of Chicago, both undergrad and grad. My formal major for both was political science, but undergrad I had enough math for a math degree as well, and the grad work included plenty of econ.

     

    I consider myself quite familiar with the entire history of economic thought on the matter of money and monetary economics. I believe I have "an in depth knowledge of monetary policy", the effects of monetary expansion and broader credit expansion, and all the rest of it.

     

    If you have any actual substantive comments I would love to hear them.
    2 Oct 2013, 05:35 PM Reply Like
  • Atle Willems, CFA
    , contributor
    Comments (21) | Send Message
     
    You write: "The first thing to notice is just that the series are increasing and steadily so, particularly the broader M2 measure. This should be completely unsurprising - there is real economic growth, the real value of all assets in the US increases continually".

     

    Firstly, the quantity of money is not, by any means, a measure of economic growth. Any country on a fiat standard can easily increase the money supply (the quantity of money) without this increasing overall real wealth (in fact, the opposite tend to happen).

     

    Secondly, adjusting the money supply series by CPI is as theoretically unsound as it can be for the simple reason that increases in money supply is inflation (while the CPI is an indicator of price inflation). One of the potential effects of an increase in the money supply is a general increase in prices of goods. Increases in CPI is a symptom, not a cause. This is why it makes sense to think about "inflation" in terms of money supply growth.
    28 Apr 2014, 03:04 PM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » EcPoFi - I am afraid you have completely missed the point. The fact is that the total value of all assets rises with time, not only when measured in nominal collars but also after adjustment for price changes. Total *real* value increases. Real incomes rise - that is real (not nominal) economic growth. Real total asset values also rise.

     

    And now, third point, so does the total real value of the entire money supply. All the dollars that exist today do not exchange for an equal amount of goods and services, in real values, as all the dollars in existence in 1965 exchanged for - the modern money supply exchanges for more. Far more. Not just in nominal terms, but in real terms - adjusted for changes in prices.

     

    Second, I am not measuring economic growth with the quantity of money. I am measuring the real value of the entire money supply. And no, just printing more money without limit does not in itself increase the real value of the entire money supply. If money were printed to the point where it was worthless, the total value of the vastly increased money supply could easily be zero.

     

    Yes its quantity increased - but its *price* fell - what each bit of that quantity exchanged for. The total value is a mathematical *product* - the quantity *times* the amount each bit of that quantity exchanges for.

     

    The price of money is what the CPI models. The CPI tells us how much real value one dollar exchanges for. It is a weighted average across all item with weights based on what is spent on that item, which means it is an aggregate price of all output actually purchased. The inverse of that price of all goods and services, is the price of one dollar - what one dollar actually buys. The price of anything is what it exchanges for, and CPI measures what one dollar exchanges for.

     

    Increase in the nominal money supply is a change in the quantity of money and not a change in its price.

     

    CPI measures the change in the price of money - how much each bit of money exchanges for.

     

    Monetarists believe and expect that increases in nominal money supply *will result* in falls in the value of each bit of money, or in other words that the CPI and the nominal quantity of money *will be correlated*. But how much that actually happens and when, is an *empircal* question, and not a definitional one. It cannot be decided by playing with the meaning of the term "inflation", switching back and forth between increases in the quantity of money on the one hand, and increases in the price level on the other.

     

    It is certainly true that, by the ordinary laws of supply in demand, *when all other things are equal*, increasing the supply of an item will typically result in a fall in its price. But that other thing being equal is the *demand* for the item in question. And the demand for money is not even remotely a constant, either cyclically or over the long term as the economy grows.

     

    My fundamental point is that the monetarists do not have an adequate gauge for that money demand, and that I do. The right gauge for money demand is the real value of the money supply. If the Fed is supply way too much money, money that is not actually in higher demand, prices will rise faster than the monetary aggregates (as people try to trade out of new money they do not want) and the real value of the money supply will fall. But if on the other hand, the Fed supplies new money that actually meets new real demand for money, then the real value of the money supply will rise.

     

    And whether monetarists like it or not, that means the provision of new money, when in response to an actual increase in demand for money, can be a form of *production* every bit as real as producing say software, or other valuable good with a near-zero marginal cost.
    28 Apr 2014, 05:17 PM Reply Like
  • The Last Boomer
    , contributor
    Comments (973) | Send Message
     
    Jason, I am working my way through your writing. I am not an economist so I apologize if I ask dumb questions.
    It looks like the Fed can print real wealth into existence in only very special circumstances like the ones in the fall of 2008. Do you think that we have completely overcome this special situation? Most other economists I read (Krugman, DeLong, Summers, Pettis, etc.) think that we are still in a very precarious situation that requires further accommodative policies by the Fed and the government.
    Do we need another QE? Paradoxically, after the end of the first two rounds of QE interest rates went down, not up. Same thing is happening now: QE is over and rates are plummeting. QE supposedly kept high the public inflation expectations and thus, the component of interest rates that relates to inflation expectations. If the goal is to keep inflation from plummeting and turning into deflation, isn't it better to implement policies other than QE, policies that for example will grow wages (such as minimum wage increase)?
    16 Jan, 08:26 AM Reply Like
  • JasonC
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    Comments (3951) | Send Message
     
    Author’s reply » I would say that the Fed - any producer of money, really - can print wealth into existence in limited quantities much of the time, but in large quantities only in very special circumstances - like those in the fall of 2008, yes. The necessary condition is that the money be truly demanded and won't just raise prices.

     

    Are we still in that situation today? Maybe a little. But employment in the US has increased substantially since the recession peaks of unemployment; there is a lot less slack in the economy; I don't see high "panic" demand for money for safety reasons. I think we are closer to late cycle today than to early.

     

    Europe is in a different situation, however. Some nations there have substantial unemployment, and their effective money supply is restrained by a still-weak banking system (still at 25 times leverage, total assets to equity net worth). I can see a reason for monetary ease in Europe today - along with reforms to fix their banks. But I don't see any great need for it in the US.

     

    The sort of economists you mention make a mistake, it seems to me, in regarding "stimulus" as desireable at any condition less than full employment at the top of a boom. To me that is a classic control theory mistake, and a recipe for leaving it on far too often and far too long. "Control theory" - probably way too obscure for you to follow me, so I will explain.

     

    Say you have a pendulum and it is set swinging. You can nudge the pendulum or leave it alone. The outcomes you like occur when the pendulum is way over to the right and the bad ones occur when it is over to the left. What happens if you adopt the rule "nudge it right at any point except the right end of its swing"? Answer, you get a "driven oscillator". You increase the amplitude of the swings.

     

    What if instead you adopt the rule "nudge toward the center of the swing on either side (while it is swinging outward)"? You get a "damped oscillator". You reduce the amplitude of the swings.

     

    You can't put the outcome at the right margin of its range and peg it there. Trying to may push you to that point faster, but the sequel is the backswing, not staying there. Pushing the economy as rapidly as possible into an overheating, increasing inflation, full employment condition does not minimize lost output. It just forces it into recession harder and sooner after a larger magnitude swing. Because interest rates have to come up in that situation, and will come up enough to kill (real) growth.

     

    I look at the actual past swings of the unemployment rate. I see peaks around 12% and troughs around 4%. In good cycles - mild recessions - we see peaks only up at 8%, but the troughs are still at 4%. We don't stay under 4% for very long in any cycle. Instead inflation, then interest rates rise, and real growth stalls, and unemployment comes up again. That is the natural variation seen. It isn't a constant, it is a cycle - like the pendulum.

     

    What is the center of that cycle, its midpoint or average? 6% unemployment, if we are lucky. What's the unemployment rate today? A bit under 6%, we just passed through that level heading down.

     

    The actual recession - outright falling GDP - ended back in 2009. We have had 6 years of slow expansion since. How long do economic expansions typically last, in the historical record? Many were as short at 3-4 years. Few have ever stretched as long as 10, most ending within 8. This is telling us the same story as unemployment - that we are past the midway point of this cycle. If we are lucky we have maybe 4 years of slow expansion left this cycle. If we aren't it could easily end in just 2.

     

    Let's look at fiscal policy and the budget deficit and the tax collections driving it. Same story. At the bottom of the last recession, it his a deficit of 10% of GDP. Now that has narrowed to a deficit of 3% of GDP. If anything that is lagging where it ought to be - with best management we'd be right around balanced now, and moving into surplus for the later portions of the cycle.

     

    You want rates normalized and the budget in surplus when the next recession hits. The next recession *will* hit - it is a delusion to think we can outlaw the cycle by stimulus or any other measure. We can keep the expansion going for a bit, we can make the amplitude of the fluctuation milder, and we can have our powder dry in a policy tool sense to react to it. That is all policy can prepare or deliver.

     

    That means 2 things have to happen on policy in the next 2-4 years. We need rates normalizing instead of stuck at zero, and we need the budget balancing. If we get those things and the expansion lasts a bit, we will be ready for the next recession when it comes along.

     

    All, US analysis. Europe has a serious deflation threat, and needs monetary policy to ease, and to fix its banks. If it get those things, then along with the lower Euro and the beneficial effects of low energy prices, it could get growing. Different issues. They are in this spot because they didn't use the last 6 years to fix their banks, and held off on active monetary expansion too long.

     

    I hope this helps.
    16 Jan, 06:51 PM Reply Like
  • Westcoaster
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    Comments (659) | Send Message
     
    Great summary, however recessions are triggered by too much mal-investment.

     

    I'm not seeing our economy any where near this so I would argue we are a long way to even beginning the cycle whereby we would be 2 to 4 years from a recession.

     

    Just my opinion.

     

    I understand your thesis that rates should be normalized before going into the next recession, but what if they nip this growth too early.

     

    I guess they are standing by what they said they will do and raise rates so we can all watch and learn.
    26 Jan, 01:21 PM Reply Like
  • JasonC
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    Comments (3951) | Send Message
     
    Author’s reply » "recessions are triggered by too much mal-investment."

     

    This is true, but it is also true that cyclical changes in prices make investments that look sound, become unsound at new prices. Including higher interest rates late cycle, rising wages, higher material prices both caused or tantamount to higher inflation, etc.

     

    As for malinvestment that may be going on now, a ton got invested in energy projects expecting $100 oil and it is under $50 now, and hundreds of billions of that investment may prove "malinvestment" if those prices persist, which I consider likely. Siting of production choices made before the Euro fell 20% likely need to be revisited afterward. Basically every major price change can cause past investments to become unsound if those changes persist.

     

    The point is what counts as a "malinvestment" is a moving target as relative prices change. Recessions can be triggered by anything unexpected or incorrect as a prediction. When lots of plans are derailed, the economy has to adapt by withdrawing capital and labor from some uses to free it for others, and it doesn't redeploy seamlessly or on a dime.

     

    We know there will be a next recession. Do we know for certain that it is only 2 years out, not 4 or even longer? No, that is just an estimate from past experience. It could easily be wrong, but one is out there and the imbalances it will stress and reveal have probably already been building for some time.
    26 Jan, 01:54 PM Reply Like
  • The Last Boomer
    , contributor
    Comments (973) | Send Message
     
    Jason, thanks. Very helpful. Please keep writing. I have read almost all your comments in the last 3-4 years and have learned a lot. One lesson I think I'll remember forever is that nobody will be fat and happy until the bankers are fat and happy.
    16 Jan, 10:06 PM Reply Like
  • DigDeep
    , contributor
    Comments (2585) | Send Message
     
    I as well have learned much from Jason and others. As I read about the mechanics of CB actions and Jason's thoughts on moving away from ZIRP, gauging malinvestments and macro data, etc... prior to the next recession - it reinforces my opinion that massive CB interventions are too complicated to effectively manage by humans.

     

    The strength of market forces seems to trump interventions, fed guv included, eventually. The distortions created can't be worth the efforts to smooth out business cycles by CB's.

     

    Just throwing that out there. Jason and others have a great grasp on what thy're doing while my gut tells me don't trust the stated objectives.
    26 Jan, 04:53 PM Reply Like
  • JasonC
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    Comments (3951) | Send Message
     
    Author’s reply » DigDeep - markets are bigger than governments or policies, check. The cycle cannot be outlawed, check. But policy can still be sensible and relatively helpful, or fail to be. In the case of monetary policy, I think policy needs to listen to demand as it finds it - but that can be accomplished by a rule targeting the real value of the money supply. It is reasonably approximated by a rule targeting the rate of inflation and trying to keep it fairly low but positive.

     

    Money creation is not a function hostile to markets or alien to them. Free credit would give us looser money not tighter; it is commercial banks exercising their freedom of credit who grow the money supply, for the most part. Money growth is endogenous, in technical terms, and not something to be fought or to pretend is some socialist con. It isn't. It long predates modern central banks and is not a force hostile to financial capitalism.

     

    Stability is not a leading feature of financial capitalism to start with, and asking it of any economic system is a mistake in my opinion. Economy is the adaptive shifting of resources to urgent uses; change and turmoil are joined at the hip to growth and innovation. Instead of looking around for institutions to blame for persistent features of modern life, we should just work with them (features and institutions both), accepting them for what they are.

     

    To me that is a conservative position, temperamentally and even politically. (What it isn't is populist or "radical"). I likewise believe my take on freedom of credit is more of a liberty position than that of hard money advocates. (I don't want to outlaw issuance of new fiduciary media; they do; I leave that to banks; they would outlaw something merchants and financiers have been doing since the dawn of financial capitalism, etc).

     

    FWIW, and thanks for your kind comments...
    26 Jan, 05:12 PM Reply Like
  • DigDeep
    , contributor
    Comments (2585) | Send Message
     
    ...." change and turmoil are joined at the hip to growth and innovation"....
    This is my point, CB's are trying to smooth peaks and valleys. That's where the capital distortions occur. Carry trades, cap ex, etc boom and bust on CB attempts to influence behavior always seem to provide some sort of short term benefits - but also plenty of negative outcomes.

     

    As well, fed guv policy that promotes RE vs other endeavourers for example. The race to the bottom of underwriting standards were pressed (blessed?) by policy.

     

    I get the mechanics of it. I don't get why they have the power or assumption that they'll guide the economy in a sustainable direction. Especially at these levels of intervention.
    26 Jan, 07:40 PM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » "boom and bust on CB attempts"

     

    No. They boom and bust all on their lonesome, regardless. Policy isn't trying to do what you think it is trying to do, so indicting it for not succeeding at what it is not even attempting is a false charge. Boom and bust are original to financial capitalism and aren't going anywhere. Neither are central banks.
    26 Jan, 10:34 PM Reply Like
  • DigDeep
    , contributor
    Comments (2585) | Send Message
     
    The boom and busts from (relatively) free market cycles have tended to increase economic activity over time - organically.

     

    Effecting those swings creates capital dislocations and valuation distortions. i.e. oil and all commodities currently.

     

    Not saying we don't need interventions at times - not saying their shouldn't be a CB - it's a matter of degree. Relentless ZIRP and QE goes too far into creating those distortions IMO.

     

    thanks for your viewpoints and knowledge - I see a need for change of policy focus/degree and you're dealing with the current reality - I respect and understand that.
    27 Jan, 11:38 AM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » DigDeep - I am not just dealing with current reality, I am advocating and supporting it as positively good. I deny all the claims from all parties that the present economic or financial or monetary order are broken and require radical change. I claim those systems have brought us the greatest wealth and well being in human history and that those attacking them are not merely wrong intellectually, but also unjust. The system as it is, warts and all, does not deserve the brickbats thrown at it, almost all of which originate in misunderstandings of what it is and how it functions. Those that do originate in a correct understanding of what it is and how it functions are utopian, and the revisions they recommend to those systems are both unworkable, and in most cases would be worse - in many cases, far worse - than those systems are themselves. This is a far stronger set of claims than, "hey, its what we have and we've got to deal with it". I am deliberately making that far stronger set of claims.
    27 Jan, 12:14 PM Reply Like
  • longdistance
    , contributor
    Comments (56) | Send Message
     
    Fascinating and well written, but ...
    Should your figures also be normalized by population?

     

    The US population from 1960 to now has also almost doubled.
    Your M1 figure would then appear (to first order) to be 'flat'.
    Does the 'demand' for money really increase just because the population increases? I think not. 'Demand for money' should be calculated per person. The system gets bigger with time (more molecules/people) but the forces themselves (like demand for money) are not fundamentally increasing with time.

     

    For short periods of time, I agree that even normalized by population the slope is negative (and demand is low) in 70s, and now even normalized by population the slope is positive and demand is high. It is the long term trend in the charts that bothers me.

     

    And what about M2 you say (and the 4x factor). Well actually, the population of the US has doubled in the last 50 years, but the number of people outside the US holding and using US currency has boomed since the 60s. My guess is that 4x the number of US currency USERS is possibly even conservative. So then M2 is long term flat (based on the number of people using it), and M1 is actually dropping (because at least US citizens use cash and checking far far less than in the 60s).
    21 Mar, 04:19 PM Reply Like
  • JasonC
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    Comments (3951) | Send Message
     
    Author’s reply » longdistance - no it is not population, it is wealth. To a first approximation, people want to hold about the same portion of their wealth in money form.

     

    That includes savings money forms like CDs, savings accounts, and money market accounts. The payments system has become more efficient over time, allowing a larger volume of broad money and of transactions to be handled with a smaller narrow money stock, relative to wealth. But broad money and wealth are increasing together. Real wealth is increasing, and the money portion of it is increasing with it, not remaining stable.

     

    All over the long term, mind. In the short run, within one cycle, there are fairly strong movements in demand for money independent of that secular trend, and the portion of wealth held in money form can dip in boom periods (with overall wealth advancing quickly, and risk appetites large), and rise in bust periods (with risk aversion higher, "deleveraging", etc).
    21 Mar, 11:03 PM Reply Like
  • longdistance
    , contributor
    Comments (56) | Send Message
     
    Just my take but,

     

    When inflation happened in the 70s the Fed was not the cause. But ultimately (under Volker), it was the solution.

     

    When deflation (or not inflation) happens now, it is again not the cause of the Fed (despite its desperate desire to cause inflation).

     

    The Fed has very little causal ability (despite all the egos and hubris involved). But it may have considerable amelioration abilities (ie Volker).

     

    It seems to me that inflation happens when people are willing to spend more - not when the Fed wants them to spend more. In fact, for me personally, current Fed actions make me want to spend far less (and save more). They scream uncertainty (need more buffer), and low rates (need more capital saved for the return I desire).

     

    You have commented on European Banks being required to hoard more money. The Fed is effectively requiring the same of all investors. More cushion, and more capital.

     

    Do you have any thoughts on the differences in ability to push on a string and to pull on a string? Is there significant asymmetry in the Feds ability to actively dictate future economic activity and its ability to deal with present economic fluctuations?
    21 Mar, 04:43 PM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » longdistance - Yes the Fed was the cause in the 1970s, and they even knew better as an institution. It was political branch interference in the running of the Fed that "undid" their past lessons learned. The Fed tamed the Korean War inflation by asserting and winning its independence from the Treasury, and letting long rates rise. They didn't have to rise nearly as much as in the 1970s, and Eisenhower's administration cooperated (Truman fought it every step of the way).

     

    What happened in the 1970s was first the late Vietnam war period, with Burns being sent by Nixon to the Fed. "We are all Keynesians now". He closed the gold window, left Bretton Woods, and we got the first oil shock on top of all that. But both his presidency and the Democrat controlled congress after Watergate were committed to "full employment", and demanded monetary stimulus whenever real GDP turned down, no matter how briefly.

     

    The Fed analysis from the 1950s period was entirely sufficient to tell them what to do, but the political people put in over the technocrats resisted doing it. Until Carter, broken by the second oil shock in 1979, put in Volcker, who unlocked that technocratic understanding. He then needed political support in the 1982 recession to keep it up despite higher unemployment - and got it from Reagan. Notably, the move away from technocratic monetary policy in the early 1970s had been bipartisan. By a decade later, the move back to technocratic running of monetary policy was similarly bipartisan. The elected politicians had learned the hard way that they did not actually understand the subject, and that having their way with the Fed didn't produce good outcomes, for the country or for them.

     

    As for the comment that the Fed is "requiring" people to hoard more money, I deny it. People burned by the 2008 crisis are making that decision all on their own, despite strong pushing by the Fed to get out of risk free cash. It is true that the Fed and government more generally have increased capital requirements at the commercial banks and generally kept them in the doghouse, even suing their pants off in many cases. That has not helped broad credit growth. But in the US, we basically have made it through that stuff and the banks are sound again.

     

    In Europe, not so much. In Europe, equity is still only 4% of overall assets - 25 to 1 leverage. The European commercial banks cannot grow their sheets rapidly while that remains the case. They need to raise equity capital - my preferred solution there is debt for equity swaps, starting voluntary but with strong regulator push if necessary, to resolve it fast. It is more than a bit shameful that the Europeans have made so little progress fixing all of that, a full seven years after the 2008 crisis.

     

    On the string analogies, if the monetary authority has kept narrow money very tight, it can indeed restrict narrow money growth, mechanically. The US Fed did so in the 2004 to 2007 period, as it raised rates up above 5%. M1 barely moved in that stretch, and in real terms it was declining. Broad money could still grow and did, but that was a much stronger control over bank expansion (restraining it) than even the QEs have been at "telling them" to grow.

     

    The Fed's actions in the fall of 2008 were not pushing on a string, though. The move from banks being reserve constrained to only being capital constrained was a sea-change, and they have not needed to worry about reserves or narrow money controls since about mid 2009. That doesn't mean they can expand at will, however. They still face *capital* requirements.

     

    It isn't so much string as it is knowing where the leverage point is. When commercial banks didn't have enough reserves, $1000 more in new reserves could produce $10,000 in new loans. Now it doesn't, it only produces the $1000 in expanded credit, directly to the end borrowers, of the stuff the Fed actually monetizes and takes onto its own books. Basically, the Fed has no leverage there any more.

     

    But there is a leverage point. It is bank capital. If the banks make another $1000 in *profits*, they can and they will expand their sheets by something approaching another $10,000. The Fed just hasn't been focused on or aiming at that leverage point. Meanwhile other parts of the government, by suing the pants off the commercial banks, have been directly reducing that figure.

     

    When banks are capital constrained, total broad credit is a straight linear and leveraged function of their *net worth*, their stockholder equity. Anything that earns them money and raises that figure, has a multiplied impact on total credit. That's not string, it is solid leverage. Just, nobody is using it.
    21 Mar, 11:23 PM Reply Like
  • longdistance
    , contributor
    Comments (56) | Send Message
     
    Thanks for the fast, and interesting, answers. Does your analysis make ING an attractive European bank?

     

    ING seems to me to be raising lots of capital these days by selling its insurance operations (admittedly at some discount). Voya is cashed out about a month ago and NN will be spun off or sold within a year or two.

     

    How is preferred stock treated by Basel III? I thought ING would use the cash to call some of its perpetual preferred (which pays a now hefty 7% or so). But perhaps I am wrong and they will need to keep that expensive preferred on the books along with the new cash they have raised.

     

    My sense is that US banks have been calling and not re-issuing much in the way of preferred stock.

     

    I know there are probably better run banks, but I am looking for the best value and ING is about at tangible book I think.
    22 Mar, 08:19 AM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » longdistance - I want to like some of the better European banks, including some of the Scandanavian ones, including UBS, ING, Barlacys in England, and the like. But they still have serious leverage and profitability problems at this point.

     

    ING is trading at tangible book, but so are a lot of banks. It still have 25 times as much in total leverage as it has in tangible book, and in the last year its return on equity didn't break 5%. Admittedly that is a down year and in good times they might manage 10% - but they are earning 5-10% on equity while running at 25 times leverage. Their return on assets is abysmal by US standards.

     

    There are 4 key ratios to look at when evaluating a commercial bank.

     

    The most important is their efficiency ratio, which is the percentage of total gross income they spend on expenses, including their employee compensation and the like. 60% is an OK number, 50% is actually do-able and represent a very well run, lean bank with the common shareholders really earning their share for the risks they run. To be clear, you want to take a total expenses line item and divide it by a total gross income line item, and that is the number I am talking about here. Low is good - the difference between this number and 100% is the amount making it through to the shareholders.

     

    The second is the return on assets. 1% is a good figure, and another north of it is very good. Only 0.5% return in assets is poor, and will require quite high risk taking in the form of leverage.

     

    The third is the leverage ratio in the sense of total assets divided by tangible book value. 10 is quite safe, and anything in the low teens is likely livable and can sometimes be more profitable than very low leverage. But anything 20 and above is simply taking too much risk with the stockholder's equity - there isn't enough share capital actually "sharing" the risk, and junior debt is effectively doing the work of equity.

     

    And the fourth is a pure valuation measure - what is the ratio between the market cap at current prices and the tangible book value? Below 1 is a discounted bank. At 1 is a good price for a well run bank in other respects, but it not enough to merit a position in a badly run bank. A modest premium of market to tangible book is OK if it would be "earned through" in a year or three, and if you can be reasonably sure the next year or three will have no recession years.

     

    So in those terms, what does the "report card" on ING look like?

     

    Efficiency ratio - 78% quite poor, C- to D"
    Return on assets - 0.26%, very poor, "D to D-"
    Leverage ratio - 25 to 1, quite poor, "C- to D"
    Price to tangible book - 1.00, solid B"

     

    I don't want to invest in a report card that looks like that.

     

    Let's compare the same 4 measures for JPMorganChase, US Bank, and Goldman Sachs.

     

    JPM -

     

    Efficiency ratio - 58% good or better, B+
    Return on assets - 0.87%, solid, B
    Leverage ratio - 14.63, good or better, B+
    Price to tangible book - 1.30, bit rich, unexciting, C

     

    USB -

     

    Efficiency ratio - 53% Excellent, A
    Return on assets - 1.54%, outstanding, A+
    Leverage ratio - 13.0, very good, B+ or A-
    Price to tangible book - 2.58, very rich, D

     

    GS -

     

    Efficiency ratio - 64% fair to good, B-
    Return on assets - 0.96%, very good, B+
    Leverage ratio - 10.3, excellent, A
    Price to tangible book - 1.05, solid B

     

    Of those, GS isn't in quite the same business but is also near tangible book and it is a vastly better run company. The only mark against it is that it pays its employees well, and not everything falls to the common shareholders as a result - but that is a matter of wanting a 5% better efficiency ratio, not a big miss.

     

    USB shoots the lights out on every metric but valuation, and the valuation simply acknowledges that it leads the class. A return on assets over 1.5% with near 50% efficiency ratio and 13 times leverage is about perfect for a bank. It means the common shareholders are reliably earning close to 20% on their equity and it is actually going to them, not padding pay within the bank.

     

    JP Morgan is between those. Its valuation is richer than GS or ING, but its return on assets are little behind those Goldman achieves and its efficiency ratio marginally better, and squarely in the competitive range. Its premium over tangible book is an amount that 2-3 years of earnings fully covers.

     

    This is the way to grade banks. I hope it is useful.
    22 Mar, 06:21 PM Reply Like
  • longdistance
    , contributor
    Comments (56) | Send Message
     
    Thanks so much. I am risk prone. So I look for Co's with poor performance grades (first 3 of your metrics) that I think won't look that way much longer. I am trying to spot a pendulum at the bottom of its swing - not the top. So I like when the metrics look bad.

     

    Everyone knows the numbers now and prices accordingly. Yahoo has them. So I try to dig a bit deeper. And try not to assume the system is ever steady state. I think you may have said as much about the economy as a whole.

     

    For banks I have BAC (taking longer to recover than I thought) and BOFI (going faster than I thought), and some ING (because I occasionally work in the Netherlands and therefore have an ING bank account - and largely I get a good vibe from them). But with Europe in the dumps - I am thinking about going into ING bigger. Also partially as a currency play.

     

    Is the Euro done dropping? I took a shot in the dark and guessed it would bottom at $1.05 about a month ago. Based on no decent quantitative analysis.

     

    22 Mar, 08:36 PM Reply Like
  • JasonC
    , contributor
    Comments (3951) | Send Message
     
    Author’s reply » I understand. As I said, I would like to find things to like about the better European banks for the sort of "improvement possible" reasons you discuss, and also just to make use of the stronger dollar. But I still see pitfalls, so I explain them. So you know, the most promising to me at the moment look like UBS, Barclays, and Nordea. Deutsche Bank is also interesting though the riskiest in that set (highest leverage level). Each of those seems to me to have franchise value beyond the cire bank, in capital markets expertise and the like.

     

    On ING, I did bank with them some before they sold their US consumer business to Capital One. I haven't since.

     

    Some full disclosure in this area - I own modest direct positions in preferred series from Goldman and Chase, and I do most of my own consumer banking with Chase (bank accounts, mortgages, other loans, etc). Neither is my broker, however - I use TD Ameritrade for that (division of Canada's Toronto Dominion Bank). Most of my stock is however held through funds, Vanguard and Fidelity. I am looking to add Goldman common overbthe next few months, and would consider Chase too on any move down.

     

    For the Euro area owns, just watching them at the moment, not buying.

     

    On whether the Euro has bottomed, hard to say. Most of the move is done in my opinion, and it isn't crazy to want to buy Euro area stock with stronger dollars around now. I think that opportunity will persist for at least 3-6 months, however. Could be some Euro to dollar retrace, but it woukd prove temporary on that kind of time scale. I am saying averaging is fine this year, you won't have to call the bottom tick.

     

    I hope this helps. Good discussion...
    22 Mar, 09:03 PM Reply Like
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