No Willy, this wasn\’t the consensus

Two years ago the world was agreed that the aftermath of the banking crisis required the most delicate handling. World leaders were alert to the example of the United States in the 1930s and Japan in the 1990s after its financial crash. In both cases a too-early return to the principles of good housekeeping and premature public belt-tightening caused a terrible wobble in the recovery.

This time it would be different. Governments would spend and borrow to keep the recovery going, recognising their special responsibilities while both consumers and businesses were carrying enormous levels of private debt – and banks were crippled. They would spend to compensate.

Actually the consensus was that Milton Friedman and Anna Schwartz were right. That what turned the 1929 stock market crash and recession into the Depression was the disastrous collapse in the money supply.

This collapse caused partly by the banking system failing, partly by the Fed itself.

So, what have we done this time around? We\’ve slashed interest rates and come up against the lower bound. To beat that we\’ve done quantitative easing. We\’ve also supported the banks, to make sure that their role in credit creation…..or rather their absence leading to no credit creation…..does not shrink the money supply.

And do note that this is entirely consistent with Keynes. All that stuff about pissing money at bureaucrats only comes *after* you\’ve pushed all of the monetary buttons.

Anyway, moving on from Willy\’s misconceptions, here\’s my prediction for what they\’re likely to be saying about now in 30 years\’ time.

Yes, it\’s still monetary, yes, we do need to make sure that the money supply can and will expand. And yes, the BoE and the Fed are doing their best….except for one point. And I\’m really very surprised at the people who are missing it.

It\’s the usual lefty whine that it\’s the banks that create credit. Which is true, that it\’s the banking system which does so (not \”a bank\” but \”banks\”). Credit is of course part of that money supply (sorry, too bored to look up by which measure. Cash is M0, bankd deposits and loans etc are M3 or M4?). OK, we can keep feeding M0 or M1 whatever into the system but what we\’re really interested in is what is the effect of that on M3 (or M4?)?

For that\’s the form of he money supply that is actually important for that real economy.

OK, so, what is the limitation on how M1 gets transformed into M3? Err, the banks, no? Specifically, how much credit can they create from whatever lower M is pumped in?

Something which is determined (at least in part) by the capital ratios that we insist the banks have. The higher the capital ratio we demand, for preautionary purposes, the less M3/M4 there will be for any given stock of M0/M1.

What are we currently doing with the banks? Insisting that they double their capital ratios no? Tier 1 capital requirements are being increased from 4% ish to 8% ish?

So that\’s my prediction. That there will be some monetary economist in a few decades time who points out the seemingly obvious. That it\’s insane to be whining about shrinking credit, a falling money supply, when you\’re deliberately shrinking credit, that money supply, by insisting upon higher capital ratios for the banks.

I agree, we might well want for other reasons for the banks to have those higher capital ratios. But then economics is always about trade offs: there are no solutions.

10 thoughts on “No Willy, this wasn\’t the consensus”

  1. So more credit creation by the central banks (via artificially low interest rates) and lower capital ratio requirements are what will get us out of this. Ummm, what was it that got us into it again?

  2. PeterB,

    Last time it was those nasty capitalists bankers wot done it. This time it will be managed by those munificent (with our money) and omniscient statists and because they have good intentions and not profit as their motive all will be well.

    Although when you ask why those arch statists the Labour Government didn’t see the banking crisis coming and regulate it away you are met with bluster and obfuscation.

  3. Err… On this credit thingy? Isn’t their some sort of demand side of the equation?

    I mean, if people, or businesses, or whoever don’t want any credit, or feel they can’t afford or risk any credit, then it doesn’t matter if the real interest rates are negative and there’s mega-tonnes of money floating around; they just ain’t biting.

  4. You know, I’ve thought and thought about this, but having a very little brain, it makes steam come out.

    But, only M0 is available for transactions. That’s all there is, however much M3 there is. M3 isn’t money. It’s a paper claim on money. To actually make a transaction, you have to get your hands on some M0, don’t you? So the more M3 you have, the more claims there are on M0. And at some point, that gets unsustainable. And the banks fall over.

    I looked up the money velocity a while ago, and it was about 2. That is ridiculously low, if M3 is really the “M” in the MV=PQ thing. Any pound only gets transacted twice a year? Pull the other one. But you get a much more reasonable figure if it’s M0.

    The only people for whom M3 is “real” is the financial markets. But any time they actually start trying to realise their paper holdings in significant amounts, the M0 runs out rapidly and the whole thing crashes down.

    That’s my take on it, anyway.

  5. Does anyone else get the instinctive feeling that raising capital adequacy requirements from 4% to 8% will result in a doubling of the return period between credit crunches but also make them twice as bad? Or that (with all the talk about breaking up “too big to fail” banks) we will end up with a system that has a dripfeed of small bank failures rather than occasional big ones, and that the cost of either option is roughly the same, over the longer term?

  6. Oh dear. A rare mixup, Tim. The credit creation process mainly inflates M1 because of the use of demand deposits (including deposits arising directly from lending) as collateral against further lending. To inflate M2 you need to expand long-term savings – which are actually falling at the moment because of rubbish returns on savings and people withdrawing from savings to meet daily needs due to inflation. M2 does feed M3, but the credit creation process that inflates M1 has no effect on M3. If you wish to expand M3 you need to encourage people to save more in pensions, ISAs and the like – not borrow more.

  7. Sorry, I should have said though – I agree with your point about higher capital requirements depressing the money supply. M1 is shrinking due to squeeze on lending and people paying off debts, and M2 is reduced by low interest rates on savings and people drawing on their savings. M3 is therefore shrinking. Higher capital requirements are in my view one cause of the low rates on savings and squeeze on lending. But they aren’t the only reason.

  8. Oh, and correction to comment 1) above – if M1 expands M3 does of course also expand by the same amount. I meant that there is no multiplier effect between M1 and M3 as a consequence of bank lending.

  9. All the people bleating about fractional reserve banking seem to glide over the rather important aspect of the deposit multiplier and its effects on the money supply. I am not an economist, but that would seem to be a fairly important thing.

  10. David, the deposit multiplier is a one time thing. Any new inflation has to be caused by the government.

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