Wednesday, 14 January 2015

Money Makes The U.S. Economy Appear To Go Round. Until It Does So No More.

Bank's reserve balances are not counted as part of the quantity of money (money supply) in an economy. Instead it forms part of the monetary base, the "base" on which the quantity of money is "built". 

The growth rate in the quantity of money is what central banks try to control, though they fail regularly in their not so earnest attempts to tame it. What really gives banks their fire-power is their reserves, or more specifically, their excess reserves. Whenever banks are in possession of excess reserves, they are in position not only to buy qualified securities with it, but also to increase lending by a multiple of more than 10 times these excess reserves. When they do so, the quantity of money in the economy grows which sooner or later shows up in both the nominal and CPI adjusted economic aggregates which are, after all, usually measured in monetary terms. Economic pundits (and even seasoned economics professor) regularly confuse this money-driven growth with real economic growth. In banks' quest for higher returns and profits, politicians and Federal Reserve officials are happy, not to mention complacent, as long as asset prices rise and borrower defaults remain manageable. 

The growth rate in both the money supply and bank reserves are therefore important indicators of not only the current state of the economy, but also of what can be expected from it going forward. As most bank reserves these days are made up of excess reserves*, combining both the money supply and bank reserves in one measure provides an indication of the overall current and potential monetary growth in an economy. The chart below shows the growth rate in this combined measure on a 5-year annualised basis to better capture the longer term trends (the lines do not portray a serious attempt at technical analysis, but are merely meant to highlight certain broad trends and simple similarities).


Since peaking at 16.9% on 11 September 2013, the growth rate has steadily dropped to the current 11.9%, a decline of 29.6%. Such a sharp drop in the growth rate was last seen in the run-up to the 2008 banking crisis, though there is some way to go to match the difference between the prior peak in 2005 and trough in 2008 (see lower blue line). The current difference between the most recent peak in 2013 and the current level is now however closing in on the difference between the 1994 peak and the 1998 trough. This could signal that QE4 will be implemented around the corner unless banks further increase the already aggressive credit expansion.

Little conclusive, certainly timing wise, can ever be drawn from looking at any single monetary and economic aggregate. The same applies to the above chart. However, for some time now many economic indicators have been peaking while others are simply off the charts and already in a better place somewhere far above earth (access some of these here, also see bottom links). Considered together, these indicators combined are undoubtedly, in my opinion, suggesting the U.S. economy never recovered post Lehman. And things are certainly not improving now. Rather, the U.S. economy is instead heading for a sharp downturn soon in my opinion, both in nominal and in real terms, that is likely much worse than the previous one. I'll leave you with one final chart to ponder together with the wise words of a late economist.


A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit [money] supply.
Fritz Machlup 



* As of 31 December 2014, total reserves of U.S. depository institutions amounted to $2.5748 trillion of which $142 billion, or only 5.5%, was required reserves. 


Related: 

Recap 2014: The Short Version of the "Austrian" True Money Supply (TMS)