Thursday, July 7, 2011

Growth: a tangent

In the continuing saga of Dean Baker on growth, we have this from yesterday:

If the Fed bought and held $3tn in government bonds, it would lead to interest savings of close to $1.8tn over the course of the next decade.

Well, you know I couldn't let that go.

What I said yesterday was

I might agree with Baker's solution that the Fed should buy and hold $3 trillion in government bonds. Why? Because the plan could be used to increase M1, money in circulation, by $3 trillion.

Suppose all of that $3 trillion of new money ends up in M1 where it can add to the spending stream. Before the crisis, in 2008, the quantity of M1 money was less than 1.5 trillion. Adding $3T would have tripled it. You might think it the worst of all possible worlds, at least with regard to inflation.

That's not what I'm saying.

Increasing Fed holdings by a given amount does not guarantee an equal increase in the quantity of M1 money. The blue line here is debt per dollar of base money. The red line is debt per dollar of M1 money:

Graph #1

The components of base money are notes and coins in circulation and in bank vaults, and reserves held at the Fed. The components of M1 money are notes and coins in circulation, plus checking account balances and travelers' checks. M1 counts money in circulation; money in bank vaults and reserve accounts is not circulating. (See Wikipedia)

During that most recent recession the red line fell *much* less than the blue. In other words, M1 increased much less than base money.

But just for the sake of argument, say all of Dean Baker's three trillion dollars find their way into M1 money. What does that mean? Well it means there's more "notes and coins" in your pocket, more money in your checking account, and maybe more travelers' checks in your suitcase. Your pocket or somebody's, depending on the politics.

What would a three-trillion-dollar increase in the quantity of money look like? Like the yellow line at the right side of this graph:

Graph #2

Graph #2 shows a history of money relative to output: Before the Great Depression, about 28 cents in someone's pocket for every dollar's worth of output produced. Then until the end of World War II, increase to near 50 cents. After that, pretty much continuous decline, reaching about ten cents when the crisis hit.

Before the Great Depression and again in the mid-1950s, people had three times the spending-money we had when the crisis hit, compared to our spending on GDP.

The older data is from the Historical Statistics (Bicentennial Edition). The newer data is from FRED. The GDP numbers are from Measuringworth. The yellow line shows a hypothetical three-trillion-dollar increase in M1, occurring during 2008.

The hypothetical increase lifts the quantity of money relative to output, back to about 32 cents -- right where it was in the mid-1950s when the economy was settling down to a few years of one percent inflation:

Graph #3

Back then, we had three times the money but almost no inflation. How can this be?

In those days, we didn't have a financial system that could turn one dollar of money into thirty-five dollars of credit use and new debt. In those days, the system was creating less than ten dollars of debt from each dollar of money.

We had less debt in those days. So we had less inflation from credit use.

Graph #4

Graph #4 shows a history of total (public and private) debt as compared to spending-money. The older data is from the Historical Statistics; the newer is from FRED.

The yellow line again shows the result of a hypothetical three-trillion-dollar increase in M1 money, occurring in 2008. It pushes DPD back to what it was around 1980, when the financial system was generating about $12 for each dollar of M1 money.

Today we can turn a dollar of money into $35 of debt. We could turn $3 trillion into thirty-five times as much new debt, more than $100 trillion. That would be a problem.

We need to do the Dean Baker thing, and add three trillion or so to M1 money. But at the same time, we have to reduce the debt-generating efficiency of the financial sector. If we can do that, we will remove debt from the economy and replace it with money, thereby reducing the cost of interest throughout the economy, reducing cost-push forces at home and making our products more competitive globally.

If we do not do it, our inflation fears will be justified by events.

But if we do it, everyone will have lower interest costs. Not just the government.

No comments: