Tuesday, September 21, 2010

It's in the Percentages

If we allow the money supply to grow 3 percent per year, and we allow credit-use to grow 5 percent per year, and we do it year after year after year, what will happen?

Well obviously credit-use will get bigger and bigger and bigger, relative to the quantity of money. And at some point there might not be enough money to pay off the debt that has to be paid. So then we'd have a financial crisis.

I'm sure you know this, but if you want to reduce debt, you can't do it on credit. You need money in order to reduce debt.

Oh, and I'm sure you know this, too: Debt is the measure of credit in use. If you have debt it means you have credit in use, and it is because you used credit and did not yet pay it off.

Okay. So if we let credit-use grow faster than the quantity of money, after a while we cannot afford the debt anymore, and we have to have a financial crisis. But surely, nobody would be dumb enough to let that happen. Surely, policymakers would never let credit grow faster than money...

There is a PDF available from the New York Fed: Monetary Aggregates and Federal Reserve Open Market Operations by Paul Meek and Rudolf Thunberg. It is from the "Monthly Review" of April, 1971.

The opening paragraph of the PDF comes immediately to our topic:

In 1970 the Federal Open Market Committee (FOMC) began to establish longer term objectives for the growth of selected monetary and credit aggregates as an integral part of its instructions for the conduct of open market operations...

On the following page, we get to the interesting part:

The policy record for [the March 10] meeting indicates that the Committee was setting as its objectives a growth rate of 3 percent for the money supply (currency outside banks and private demand deposits) and 5 percent for the adjusted bank credit proxy over the second quarter.

The Federal Reserve's goal was to have credit-use grow faster than the money supply. Granted, the March 10 directive was the plan only for a period of weeks. But they wanted credit-use to grow faster than the money supply.

I'm thinking if they did it once, they did it often. I don't know all the details of the historical record of Fed policy. But I know that what happens in the economy happens because of policy. And I know credit-use grew faster than the quantity of money, because that's what this graph shows:

Because of policy, credit-use grew faster than the money grew. Credit-use grew a lot faster than money grew. We had to have a financial crisis, eventually. I'm just surprised we avoided it for as long as we did.

A better economic policy would mind the balance between money and credit-in-use.

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