## Tuesday, September 13, 2011

### Desperate Measures

In the notes for this graph...

...FRED says

The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.

If the multiplier is less than one, then M1 must be less than the Base:

Sure enough.

nanute said...

Art,
Sure enough it is. After reading the comments from the previous thread, I was struck by this observation by Clonal:
The direction of causation to explain inflation as postulated in the quantity theory of money is in reality reversed: it is not growth in the money supply causing inflation and wage rises, but wage rises and rises in factor input costs financed by business credit/debt from banks that cause money supply growth. Clonal,Art,anyone,is this the Multiplier effect in action? I've been trying for quite a while to understand the nexus between the velocity of money and the multiplier effect. As I noted in an earlier comment, when the multiplier is below zero, it seems to "discount" the money supply. It would appear that your graph confirms this.

The Arthurian said...

Nanute,

From FRED's M1V page:

Velocity is a ratio of nominal GDP to a measure of the money supply.

From FRED's MULT page:

The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.

For either, you could use M2 in place of M1, or MZM, or Total Credit Market Debt Outstanding (TCMDO) if you wanted. FRED lists only the M1 Multiplier, that I could find. But for Velocity they list M1, M2, and MZM velocity. As M2 and MZM are bigger than M1, and are used as the denominator, they give slower (or lower) velocity numbers.

As for myself, I have a problem with the numerator of the Velocity calculation. More properly, I guess, it is called "Income Velocity" because GDP is equivalent to a measure of income... see
GDP and GDI: Two Sides of the Same Coin (Theoretically) at EconProph.

But GDP, or GDI, or total income, or final spending, none of these is a measure of total spending. Specifically, GDP is a measure of only final spending.

The economists' measure of Velocity is similar to you figuring your average rate of speed on a cross-country driving trip, if you only count the times you were going less than 40 MPH.

//

As for the Multiplier... Neither Billy Mitchell nor Steve Keen like it very much. Their objection (I think) is that reserves do not prevent lending (because lenders can always get more reserves if needed).

However (it seems to me) if a bank has more reserves than it needs, it can make loans without worrying about getting more reserves. For example, the huge number of "excess reserves" that's been in the news for a year or more now, the banks can lend all of that out ten times over, give or take.

The reserve requirement sets a limit on how much bank-money can be created from each dollar of base-money.

Funny thing, though, when a bank lends money, it generally puts the money into your checking account, which is counted in M1 money. But M1 is the smallest money measure -- smaller even than base money, these days. Before total debt started to decline, there was 35 times as much debt as M1 money.

And *THAT* (M1) is the money that's used to figure both velocity and the multiplier.

Such is my understanding, anyhow.

Clonal said...

Nanute

Once the gold standard went away, the reserve requirements for banks became meaningless, and only important for determining the interest rates.

The banks are constrained from lending by two other much more effective constraints.

First is demand for loans - in other words, if nobody want to borrow, the banks cannot lend. In a down economy, where unemployment is high, neither business nor households are willing to take on more debt.

Second is capital requirements. This is much hairier for the banks. This is shareholder equity. This is where the bank losses go. The only way to increase bank capital is to raise more equity. This can be done in two ways. First is the private capital market, however, given the fact that any additional capital raised is at risk of being written off because of the bad loans, nobody in their right minds will put any money in. The second is for the government to acquire equity - in other words nationalization of the banks. This option while viable, leads to a lot of pain for existing bank shareholders, and is also seen as ideologically verboten.

In the graphs, the base money increases are the effects of the Fed's actions.

However, you will also see that M1 did rise, but seems to bear no relationship to the increase in the base money. So where did the increase in M1 come from, if not from increases in the base money? That came from the fiscal stimulus spending by the US government. It just happens that the stimulus spending was nowhere near enough to get the economy out of the hole it was in.

nanute said...

Art,
I left a comment earlier this morning. Did blogger eat it? Or, maybe it was so early that I previewed and didn't hit publish. In any case, I enjoyed reading your comment as much as you enjoyed writing it. If I read your comment correctly, it would appear that by using M1 as the measure of both the multiplier and velocity, both values are understated. Clonal: I think the verboten government equity option might come into play at some point. Bank of America, Buffet's 5Billion equity stake notwithstanding, may be the test case. Interesting observation on reserves vs. capital requirements. Perhaps this is the primary reason why Jamie Dimon is calling Basel III rules "un-American?" On your point on the increase in M1 relative to the stimulus, it would appear that Krugman, and others, were right. Too little, and a misallocation of resources. It would seem that when you have a demand problem, you'd focus on it.

The Arthurian said...

Blogger: "No spam comments were found."

If Blogger ate your comment, it ain't gonna cough it up!.

Velocity is certainly understated, because not all transactions are considered in the calculation.

Before all this financial innovation, M1 was the money in the spending stream; that's what makes it important.

The increase in velocity for the whole post WWII period shows that M1 has declined relative to GDP -- a result of fighting inflation, I think. Meanwhile credit-use continued to be encouraged, and that increased other measures of money.