God is a Capitalist

Sunday, April 2, 2017

Show me the money

Most business cycle models include the money supply as a leading indicator of the economy, meaning that changes in the money supply tend to precede and signal changes in the economy in the near future. The money supply year-to-year change spiked late last year, giving some money watchers goose bumps.

According to Ryan McMaken at the Mises Institute, the money supply jumped 11.3 percent on the Austrian money supply (AMS) index late last year. Murray Rothbard and Joseph Salerno created the Austrian money supply index to provide a better measure than the Fed’s M2. That spurt in money occurred after a several years of sedate money growth. 

McMaken wrote that since 2014, money supply growth has ranged from about 7 percent to 8.5 percent. In October of last year, money supply growth hit a seven-year low of 6.8 percent. The AMS spiked to 11.3 percent in the fourth quarter, then in February it collapsed back to a year-to-year growth rate of 7.7 percent.

Although many economists use money supply data as a leading indicator, it’s probably best thought of as a coincident indicator. To understand why, recall from Econ 101 how the money supply grows. In a pure gold standard where only gold coins are money, some lucky miner like Yosemite Sam would have to find a new deposit of gold, mine it, smelt it and turn it into coins in order for the money supply to expand.

But it’s much simpler if you add credit as money. Credit worked well as money even during the gold standard, which is why boom and bust cycles go back into the centuries before Christ. Say that Yosemite Sam deposited $100K in gold coins in his account at the Bank of Oklahoma (BOK). He increased the money supply by $100K. According to the law, the bank must keep 3 percent on reserve and can loan out 97 percent of that deposit to others. Most economics teachers use a 10 percent reserve requirement so we can do the math in our heads.

So if the bank loans out $90K of Yosemite Sam’s deposit, say to Elmer Fudd to build houses, then the money supply grows another $90K when Elmer deposits his loan in his bank. Elmer's bank can loan 90 percent of his deposit, or $81K, to another business, in which case the money supply will have grown by $100K + $90K + $81K = $271K. $171K of that is nothing but credit expansion. About 90 percent of the money in the US financial system is credit money and that means that if everyone decided to take their money out of the bank in cash and put it in their freezers, as the Japanese do, they would manage to get only 10 percent of what they think they have in the bank.

So when the money supply growth slows as it has recently it means that businesses are borrowing and spending less, and consumers are borrowing and spending less on cars and houses. That’s not a good sign for the near term of the economy.

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