Money Multipliers, Velocity, and Excess Reserves

Inquiring minds are reading the Quarterly Review and Outlook by Van Hoisington and Dr. Lacy Hunt. It's an excellent report so let's take a look at some commentary and charts.

Record Expansion of the Fed's Balance Sheet and M2

In the past year, the Fed's balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion, and potentially larger increases are indicated for the future. The increases already posted are far above the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts. They recall Milton Friedman's famous quote that "inflation is always and everywhere a monetary phenomenon."

These gigantic increases in the monetary base (or the Fed's balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public's preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank's needs for excess reserves. These factors, beyond the Fed's control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall (Chart 3). Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments. Not surprisingly, from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline.



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Hoisington is correct that the Fed is not in control. However, the statement "Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments" places the cart in front of the horse.

The money is available to lend in theory (It's not really for reasons we will get to in a moment) but banks simply do not want to lend as the pool of credit worthy borrowers is shrinking. Moreover consumers and corporate borrowers are showing a huge demand for dollars (a reluctance to borrow and spend).

Excess reserves are rising because of the increased demand for money and because banks are preparing in advance for future writeoffs, not because the increased demand for money means there is less money to lend. It's important to place the horse in front of the cart.

Nonetheless, it's important to note that "from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline."

Total Bank Credit



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While not yet negative, total bank credit is plunging. Now conceptualize what that chart would look like if banks marked that credit to market (my preferred way of looking at things). No doubt that chart would be deep into negative territory.

We do not know the full extent of what that chart would look like with credit marked to market because banks are playing games with level 3 assets, hiding bad debts in off balance sheet SIVs, and otherwise pretending that many loans that will never be paid, will be paid back.

Factors Affecting Banks Unwillingness To Lend

• Rising unemployment will cause ...
• Rising credit card defaults
• Rising home equity loan defaults
• Rising mortgage loan defaults
• Rising commercial loan defaults

On top of that there is an increased demand for money by cash starved boomers headed into retirement who finally realize they do not have enough savings.

Excess Reserve Mirage

Factor all of upcoming defaults and much of those so called Excess Reserves are pure fantasy!

Is it any wonder banks are reluctant to lend? The irony in this situation is that bank lending is the most responsible it has been in a decade, and neither the Fed nor Congress is happy about it.

With that let's return to the article with and discussion about M2 and Velocity.

What about the M2 Surge?

M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system. The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed.



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The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.

In regards to velocity it is important to understand that falling velocity does not cause anything to happen. Falling velocity is a result of two phenomena.

1. Increased demand for money
2. Undertaking projects that make no economic sense (i.e. there is negative cost benefit payback).

Most government sponsored work efforts have a negative payback as do the various "ingenious monetary policy devices developed by the Bernanke Fed", as did the lending practices of Fannie Mae, etc.

Moreover those "highly ingenious monetary policy devices" are guaranteed to prolong the recovery process if not make the ultimate calamity worse. This is what happened when Japan tried the same measures.

Let's return once again to Hoisington.

Japan Government Debt vs. Economic Recovery

By weakening the private economy, government borrowing is not an inflationary threat. Much light on this matter can be shed by examining Japan from 1988 to the 2008 and the U.S. from 1929 to 1941. In the case of Japan government debt to GDP ratio surged from 50% to almost 170%. So, if large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time. Instead, their economy is in shambles. After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5% (Chart 6). As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector (Chart 7). Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.


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Other than an occasional putting the cart in front of the horse syndrome, this was an excellent read by Van Hoisington and Dr. Lacy Hunt. It's well worth a complete review.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Homeland Security Declares Public Health Emergency Over Swine Flu Outbreak

Swine Flu outbreaks have been reported in New York, Texas, California, Kansas and Ohio. In Mexico, the health minister has requested (voluntarily at this point) suspension of public events (movie theaters, church gatherings, bars).

In addition Russian has suspended meat imports from Mexico and the US over swine flu concerns. Here are the headline items.

Mexico Seeks to Contain Swine Flu, Economic Impact

Mexican President Felipe Calderon, operating under emergency powers declared yesterday, stopped short today of shutting down work places in the Mexico City area, the most populated and productive of the country, amid a deadly swine flu outbreak to ease the economic impact.

Calderon is holding powers to order quarantines and suspend public events. So far, the government has closed schools in Mexico City and the states of Mexico and San Luis Potosi and has canceled government activities that draw crowds.

Health Minister Jose Cordoba requested, but didn’t order, the closure of bars, movie theaters and churches to help contain the outbreak.

At least 20 deaths are confirmed in Mexico and 1,324 patients are hospitalized with flu-like symptoms, Cordova said yesterday at a Mexico City news conference. The strain is a variant of the H1N1 swine influenza that has infected 11 people in Kansas, California and Texas and may have sickened at least eight students in New York.

Museums, theaters and other venues in the Mexico City area, where large crowds gather, have shut down voluntarily and concerts and other events have been canceled to help contain the disease. Two professional soccer games will be played today in different Mexico City stadiums without any fans.

“We request the collaboration to reduce the sources of contact by suspending events in closed or open spaces of any type,” Cordoba said.

The emergency decree lets Calderon regulate transportation, send inspectors into any home or building, order quarantines and assign any task to all federal, state and local authorities as well as health professionals to combat the disease.

Swine Flu Confirmed in US

The Center for Disease Control says Swine Flu Confirmed in 20 People in the U.S.

Twenty people in the U.S. have confirmed cases of swine flu linked to the virus that has spread in Mexico, and the acting head of the Centers for Disease Control and Prevention said officials expect more severe infections to begin showing up.

Richard Besser, the CDC’s acting director, said the virus has been identified in New York, Texas, California, Kansas and Ohio. So far, the cases have been relatively mild and only one person has reported being hospitalized.

“It looks to be the same virus that is causing the situation in Mexico,” Besser said at a briefing at the White House. Scientists are trying to determine why the virus, normally transmitted among pigs, has been more severe in Mexico, where as many as 81 deaths have been linked to the infection.

There is no vaccine for the virus, he said.

Homeland Security Secretary Janet Napolitano said stockpiles of drugs to treat patients will be made available. The government is issuing a health emergency declaration to free up more resources to combat the spread of the virus.

Swine Flu Outbreak at Private New York School

Swine Flu Virus Outbreak Confirmed at New York School

Health officials have confirmed an outbreak at a New York private school of swine flu that may have come from Mexico where the virus is suspected of killing 81 people.

The virus may have been brought back by students who were vacationing in Mexico during a recent spring break, though that couldn’t be confirmed, Bloomberg said. The virus has sickened more than 1,000 in Mexico. There have been 20 confirmed cases in five U.S. states requiring one hospitalization, the Centers for Disease Control and Prevention said today. New York health officials have been urging people not to go to the hospital unless they are severely ill.

About 200 students at St. Francis were ill last week with flu-like symptoms, the New York Department for Public Health and Mental Hygiene said yesterday.

Public Health Emergency Declared

In the US, the Department of Homeland Security Declares Public Health Emergency.

A public health emergency has been declared in the U.S. to free up resources to deal with the swine flu, Janet Napolitano, secretary of the Department of Homeland Security, said at a White House briefing today.

No official travel advisories have been issued by the U.S. State Department in relation to the disease, Napolitano said. A follow-on flu outbreak is possible in several months, she said.

Russia Suspends Meat Imports

Russia Suspends Mexican, Some U.S. Meat Imports on Swine Flu

Russia suspended imports of all meat from Mexico and the U.S. states of Texas, California and Kansas shipped after April 21 on concern about the spread of swine flu, the country’s veterinary watchdog said.

The suspension also affects pork from Guatemala, Honduras, the Dominican Republic, Columbia, Costa Rica, Cuba, Nicaragua, Panama, Salvador, and the U.S. states of Alabama, Arizona, Arkansas, Georgia, Kansas, Louisiana, New Mexico, Oklahoma and Florida, the watchdog added in a statement on its Web site today.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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ECB's Lord Voldemort Policy

Inquiring minds are reading ECB Likely to Make Moderate Rate Cut.

European Central Bank governing council member Guy Quaden said the bank will probably cut its benchmark interest rate by a “moderate” amount next month.

“A new cut for our main interest rate is surely not excluded,” Quaden told reporters in Washington today. “It will probably be moderate, but it would bring our main rate to a new historically low level. We will also discuss and probably decide other non-conventional measures.”

Bank of Italy Governor Mario Draghi said today that there is now a “long list of indicators that are less ugly.” Bank of France Governor Christian Noyer said confidence was improving and consumption was holding up “quite well,” while colleague Ewald Nowotny of Austria said he sees positive signs and high uncertainty in the economy.

Both Draghi and Quaden said deflation was a risk to the economy. Nowotny said while the ECB expected prices to shrink for some months, they will rise over this year and next.

“We, as the ECB, don’t speak of deflation but disinflation,” Nowotny said in Washington. “At the moment, we have certainly the need for an expansionary policy.”

Like the wizards in Harry Potter afraid to say "Voldemort" the dark lord's name, the ECB is afraid to speak of deflation. Whether they are willing to speak of deflation or not, it has arrived.

ECB Options to Fight Recession Include Rate Floor

ECB Governor Nout Wellink says ECB Options to Fight Recession Include Rate Floor.

The European Central Bank is considering several options including a floor for its benchmark interest rate to fight the recession, said Nout Wellink, a member of its governing council.

The ECB’s 22 council members appear split over how to counter the worst economic slump since World War II, at a time when the bank’s main rate is already at a record low of 1.25 percent. Germany’s Axel Weber has said the bank shouldn’t cut the rate below 1 percent. Others, including Athanasios Orphanides of Greece, want to keep open the option of deeper rate reductions and have argued in favor of asset purchases.

The Federal Reserve and Bank of England have already cut lending rates close to zero and are buying government and corporate debt to bolster their economies. The Bank of Canada this week cut its key rate to 0.25 percent and said it plans to leave it there for more than a year.

Trichet Signals

While ECB President Jean-Claude Trichet has signaled another quarter point reduction in the main lending rate is likely next month, he has declined to comment on what new tools the bank will adopt. He said in Washington on April 24 that growth was unlikely to return “rapidly.”

“A negative inflation rate by itself is not a problem, on the contrary it increases real disposable income,” Wellink said. “The lower and the longer the disinflationary process is, the greater of course the chance that in a certain moment people are going to react in a way we don’t want them to react. That is at this very moment not an issue.”

Inflation hawk Trichet signals things are much worse than anyone suspects by suggesting growth is unlikely to return “rapidly.” Moreover, Wellink, like Nowotny just cannot bring himself to say the dreaded D word, confirming the ECB's Lord Voldemort policy on deflation.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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