Friday, November 11, 2011

When It Makes Sense to Print Money

This post may seem incompatible with previous items but there are times when the data is just so startling that it changes the math.  Recently I learned that M4, a broad measure of the country's money supply which is no longer published by the Federal Reserve but is still tabulated by private sources, may have fallen by as much as 4% during the latest 12 months.  Such a number implies that not only is the American economy not on the verge of recovery but it is actually most certain to double-dip into recession next year.

That being the case, I will suggest the following:  one of the few times that printing money makes sense is when the overall money supply is actually declining.  In such an instance, the inflationary effect of printing would simply offset the deflationary effects of the decline.

Years ago, believe it or not, I used to correspond with Milton Friedman.  What I enjoyed most about Dr. Friedman was his openness to discussion with a non-academic like myself.  One of the major topics we discussed was which measure of the money supply was appropriate to follow insofar as monetary policy is concerned.  He felt that M2, which is the broadest measure the government now discloses and is directly influenced by government policy, was appropriate.  I felt that M3 or M4, which the government disclosed until 2005 and includes monetary measures that are less influenced by the government--primarily credit related--should be used.  He liked to use M2 as a shorthand way to look at monetary policy because the relationship between M2 and broader measures like M4 had always been fairly stable.  

While that may have been true, the relationship has clearly been broken.  Recent M2 growth figures show a nearly 10% year-over-year increase and M4. as stated earlier, may have fallen by 4% in the same period.  To have such a dislocation implies that the components that make up the difference between the two measures--primarily credit--must have fallen precipitously.  Since housing demand--the major source of credit expansion--has collapsed, this makes perfect sense.

The Fed has tried to increase the money supply through "quantitative easing" but the so-called "multiplier" that would be expected to result in expanded credit has failed to function.  The Fed has literally been pushing on a string because credit is contracting faster than money has been printed!  This is the recipe for deflation, i.e., prices actually falling, which we may not have seen at the gas pump, but we sure as well have seen in the prices of our homes.

Which gets us back to the point of this post.  Home prices are in a death spiral that needs to be reversed if people are to regain confidence in their future.  And the way to do that now is to increase M2 by an amount large enough to offset the decline in M4.  How does the Fed actually do this?  Deficit funded stimulus--taking money from one person and giving it to another--won't work because it yields no net increase.  That leaves more--significantly more--of the dreaded quantitative easing, which in the current situation would act to stabilize M4 rather than expand it.  And until the money supply--the broad M4 money supply--stabilizes, the economy can't restart.  Expanding M2 is easily accomplished--the Fed buys and buys and buys U.S. government treasury bills until M4 stops declining and begins to expand.  [This would yield a secondary benefit of reducing  the country's total debt, helping to reduce the annual deficit as well.]

The problem with addressing the M4 decline in this manner, however, is that the Fed has never shown an ability to do so without going too far in the other direction, i.e., increasing past the point of stability into the realm of inflation.  It's likely that long bond yields will begin to rise once M4 has stabilized and that credit will expand as well.  At that point, to counteract increasing inflationary forces, the Fed would have to act quickly in the other direction.  That is when its independence would truly be tested.

Alan Greenspan kept the punch bowl on the table far too long and helped contribute to our current economic and fiscal malaise.  Ben Bernanke needs to put an even bigger bowl on the table--and then pull it away just as the party gets started.  Whether he can do that will be the real test.      


No comments:

Post a Comment