Monday, November 21, 2011

The Suppression of Money

I got numbers for M1 money from the Historical Statistics (1915-1970) and from FRED (1959-2011). The HS numbers are annual, so I decided to use annual values for this whole project.

I got GDP numbers from my Google Docs files. They came from Measuringworth. Again, annual values.

I divided the M1 numbers by the GDP numbers, to see how much spending-money there is in the economy relative to the stuff we buy each year. To see the history of that relation.

Graph #1: Money in Circulation relative to Output at Actual Prices
The blue part comes from the Historical Statistics. The red part comes from FRED. The M1 numbers from the two sources match up well.

I got "percent change from year ago" numbers for the Consumer Price Index from FRED. I used their CPIAUCNS, which goes back to 1913. (The "change from year ago" numbers go back to 1914.) I start the graph at 1915, because that's how far back the M1 money numbers go.

The blue line on Graph #2 shows inflation as "percent change from year ago" of the CPI. The abbreviation "PCYA" is awkward shorthand for "percent change from year ago":

Graph #2: Inflation (annual change in prices) plus trend lines

I put a 5-year moving average line on the graph (in red). And (in yellow) a 5-year moving average of the 5-year moving average values. Something I've been looking at a bit, lately.

For the next graph I got rid of the moving averages. I took the change-in-CPI line (since 1921) from Graph #2 and fitted it to Graph #1. To look for similarity, I scaled and shifted the CPI numbers: multiplied by a number that made the height difference of the CPI about the same as the height difference of the M1/GDP, and added a constant to slide the whole set of CPI numbers up and get them close to the M1/GDP numbers. My goal was to make the two lines close. I got them pretty close, on the left half of the graph. Not so close on the right half.

Graph #3: Combining Inflation from Graph #2 with MRTO from Graph #1
Look at the left half, and look at the peaks of the yellow change-in-CPI line. Those peaks pretty well fall within the limits set by the blue M1/GDP line. As the blue line rises, the yellow inflation peaks also rise, to a high point just at the end of World War II.

After the war the blue line falls, and so do the inflation peaks.

But then, on the right half of the graph the lines don't match up. Inflation spikes up three times in the 1970s while the quantity of money relative to GDP (now shown in red) continues to fall. Then in the Reagan years, inflation is suppressed. Perhaps surprisingly, the M1/GDP line stops declining at the same time. It runs horizontal for 10 or 15 years and shows the bumps that I point out all the time.

Inflation moderated when they stopped suppressing the money.

After the third bump, the M1/GDP decline resumes, reaching a low (ten cents) just at the start of the financial crisis and recession, 2007-08.

Anyone who says "they're printing too much money" has not spent enough time looking at this graph.

But the point is that in the years after the red and yellow lines cross, there really is not much similarity between M1/GDP and inflation. U.S. anti-inflation policy quit working in 1960.

Before 1960, inflation rose and fell within the limits set by the money ratio. Since 1960, the relation between M1/GDP and inflation has disappeared.

This failure on the graph, this loss of trend similarity, has a real-world counterpart. The inflationary peaks of the 1970s occurred while the quantity of money was being suppressed. And then inflation quieted down when they stopped suppressing the money. That's evidence of an astonishing loss of policy effectiveness.

A lot of people feel that inflation is proof that "they must have been printing too much money". But the graph shows that they were not printing too much money. The graph shows that since 1960 M1 money was severely suppressed but the suppression did not restrain inflation. There was a loss of trend similarity. The thing that used to work to fight inflation stopped working. That is what Graph #3 shows.

Why did inflation policy stop working? What caused the loss of trend similarity? What changed?

We increased our reliance on credit.

To fight inflation, the Fed suppressed circulating money. To stimulate growth, Congress encouraged credit use. They suppressed the money and encouraged credit use, and our reliance on credit increased.

Essentially our economy did not change, except that money was suppressed and credit-use was encouraged and we found ourselves using less money and more credit. The thing that changed was the thing we use for money.

The difference between money and credit is that credit is more costly to use. An economy that shifts from a low reliance on credit to a high reliance on credit will find itself with financial costs rising relative to other costs. It will find itself with interest costs rising relative to wages and profits. It will find itself with living standards squeezed, business growth below par, and financial activity as its growth industry.

An economy that shifts from a low reliance on credit to a high reliance on credit will see rising costs that are associated with the cost of interest.

I got interest rate numbers from FRED. I picked their Moody's Seasoned Aaa Corporate Bond Yield (AAA) because the numbers go all the way back to 1919.

Graph #4: Adding Moody's AAA Corporate Bond Yield to Graph #3
Again, I tried to make the lines similar by scaling the green line and shifting it up a bit. After 1960, the green and yellow lines are a very good match: Inflation and interest rates show similar patterns. Before 1960, there is little similarity.

Before 1960, money was dominant. After 1960, credit was dominant. Graph #4 shows the change from reliance on money to reliance on credit.

Graph #5 shows a close-up of the transition:

Graph #5: "X" Marks the Spot
Don't forget: the yellow line shows inflation. Inflation was at its lowest, and stable for a few years in the early 1960s, just at the balance-point between excessive money and excessive credit-use.

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