Problems with Europe’s and indeed the world’s money supply

Yesterday was a day where yet again we saw extreme moves in equity markets and to an extent currency markets too. European equity markets had opened lower and the main 3 of the FTSE,Dax and Cac 40 were all falling by around 2%. Then we saw a rally around the time of the opening of US markets and in the end the FTSE for example only fell by 25 points or 0.5% which when you allow for BP’s current problems means most shares were in fact up. However this morning shares are falling fairly heavily again with the main 3 European equity markets down by 1.5%. As I wrote on the 26th May these are very difficult markets for the private investor. With the time lag that takes place between instructing a pension or investment fund and it operating those instructions such volatility and uncertainty means that trades may take place at quite different prices or levels to those intended. As to someone vesting a pension fund with all the administrative delays that can take place it must be at best frustrating.

European Money Supply

I was asked a question on this subject and thought that I would update further on it because what is happening with the euro zones money supply is indicative of what is also happening in the UK and US. On Monday new figures for money supply growth were published and they were as follows. The European Central Bank  has 3 measures of money supply but the 2 main ones are the narrow one M1 and the wider one M3. Their annual growth rates for April were 10.7% for M1  and -0.1% for M3. In a nutshell those figures explain the problem of being a central banker in these times as you can pump money into the system which will impact on your narrow money measure (M1) but wont affect your wide measure (M3). The ECB is far from alone in this as UK and US money supply measures have similar themes. In essence they can force cash into the system but they cannot get people to borrow (or perhaps more accurately banks to lend).

I wish to expound on this subject and explain some more. When the credit crunch began the wider measure of money supply was growing much more quickly than the narrow. Even in 2008 as a whole we saw M3 grow by 7.6% and M1 grow by 3.4% and this includes a slowdown at the end of the year as the credit crunch began. However you could define the boom that came before by money supply growth and in its latter stages M3 growth exceeding M1 growth. This reflects the credit expansion that came before the crunch. However this changed in 2009 as annual M3 growth was -0.3% in its last quarter  but annual M1 growth had risen to 12.4%. What we are seeing here is a central bank responding to a credit crunch.

What did the European Central Bank do?

The first move by a central bank is to cut interest rates and the ECB’s main refinancing rate was cut by a cumulative 325 basis points between October 2008 and May 2009 bringing it to its current level of just 1%. This is a level not seen in the countries of the euro area since at least the Second World War. However this was not enough in its view and so it undertook some non-standard or extraordinary measures which it calls “enhanced credit support”. These were or are.

1.Fixed rate tenders with full allotment in all liquidity-providing operations.

2.Additional refinancing operations with one-month and three-month maturities, as well as the provision of funding at longer maturities of six months and one year.

3.A broadened collateral framework, notably the lowering of the rating threshold to BBB- and the acceptance of selected foreign currency assets and of securities issued in some non-regulated markets, all these with commensurate additional risk control measures. (Putting this in English the ECB would supply liquidity (cash) in return for lower quality assets than previously)

4.The covered bond purchase programme (approximately 70 billion Euros worth).

5.The introduction of foreign currency-providing operations.

6.More recently can be added the purchase of sovereign government debt.

What happened?

I wish to just re-emphasise how extraordinary the measures above are. But money supply did not respond as expected for the ECB was able to affect the narrow version M1 which is growing in double-digits but the wider measure M3 did not respond as expected and is still negative.

If we look at the definitions of the two measures we can see the root of the problem. M1 is currency in circulation and overnight deposits. This is easy to influence by a central bank. M3 adds to the definition deposits with an agreed maturity up to 2 years, deposits redeemable at a period of notice up to 3 months,repurchase agreements,money market fund (MMF) shares/units and debt securities of up to 2 years. These extra factors have proved very difficult to influence and if you remember that the M1 component of M3 is growing strongly it must be that the others are in fact shrinking by more than the total growth rate of -0.1%.

Fishers formula

The monetary system was represented many years ago in the simple formula of MV=PT. Where  represents the stock of money, P is the price level, is the amount of transactions carried out using money, and V  is the velocity of circulation of money. There are variations in this quantity theory of money but if you look at what is happening now in such terms then it is V or the velocity of money which has changed. Furthermore it has changed such that central banks seem unable to adjust the balance even by raising narrow measures of money supply quite substantially. As fast as they raise M they seem to be finding V falling.

Whilst the equation is a little simplistic it does highlight the problem.

The problem is worldwide

If you look at broad money growth in the UK (we call it M4) then growth is also around zero,for example the UK headline M4 money supply growth was flat on the month in April, in the US the chairman of the Federal Reserve Ben Bernanke has got so frustrated with the growth figures for the wide measure of money supply (M3 for the US) he has said he will ignore it. One can argue over what aggregate to use but there is a disturbing trend in US M3 where it has fallen heavily recently. Whilst the Federal Reserve no longer publishes M3 statistics it still publishes the underlying data and M3 is currently falling quite rapidly,in the latest figures for the three months to April it was falling at an annualised rate of 9.6%. There are differing explanations for this but the fact remains it is falling.

Conclusion

The transmission mechanism of monetary policy has changed over the period of the  credit crunch as we have been reminded that increases in narrow money can be provided by a central bank but for this to be reflected in wider monetary aggregates then this process is conditional on the private sector’s appetite to borrow. We had got so used to a thirst to borrow that I think it became an assumed part of the environment and little thought was given to what might happen if it declined or ended. Once a central bank has pumped money into an economy then for “wide” money to be created  we need private commercial banks to grant credit to private agents in response to the provision of reserve or high-powered money by the central bank. The problem in the euro zone at this moment in time as well as the UK and US  is that due to the prior over-leveraging of private sector balance sheets, there is almost no appetite to borrow (in aggregate), and hence monetary policy is unable to play its normal role of providing new credit and simultaneously expanding the stock of broad money in the economy. This is why broad money growth rates in Europe the US and the UK are currently all close to zero, and in some cases negative. Until private sector balance sheets have been de-leveraged and the appetite to borrow has begun to return then it is unlikely we will see any great improvement.

More simply I think that the banks are taking the liquidity and using it to repair their own balance sheets to some extent so the banking multiplier one might expect is not happening. Now here is a question for you to think about. If you knew in advance what would happen in terms of the effectiveness of monetary policy would you if you were a central banker have done what they have in terms of a raft of extraordinary measures?

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13 thoughts on “Problems with Europe’s and indeed the world’s money supply

  1. Great post. Forgive my ignorance, but would it make sense to infer that even though inflation seems to be picking up in UK that these figures of M3 point more to deflation in UK,US and Eurozone?

      • No problem, thanks for your great blog.

        I only noticed it when I rearranged the equation and inferred that increasing the money supply would put a brake on tranactions. I scratched my head for a minute and then wiki’d it.

        Keep up the good work!

    • Hi Max
      It is dangerous to draw a straight line from the figures in my view. Economic figures are very rarely as accurate as they appear and links between them are particularly likely to break down in an uncertain period like now. However there are plainly deflationary ( and I use this in terms of the old definition of falling aggregate demand in an economy not the strange use these days that includes falling prices) forces at work which wider monetary signals are telling us.
      There are others such as the sovereign debt crisis leading to austerity programmes in the UK and Europe.
      Another way of looking at this is to see what central banks are doing. They have their concerns too as for example the ECB is returning to some of the measures it used in the credit crunch as well as some new ones and the Federal Reserve has reinstated the swap lines it had with other world central banks. This is a long way away from the beginning of the year when 2010 was expected to be the year stimulus measures were removed……
      On my definition the UK is just hanging onto slow growth but the year is yet young and we may get deflation later on. Our inflation picture is quite different from the others but under my definition of deflation both inflation and deflation are possible at once.

      • Hi Shaun,

        Surely the present “strange” use of what “deflation” means is an inevitable result of the wrong use for what “inflation” means? This becomes essential in fact, since otherwise deflation and inflation would become strange bedfellows? This is typical of the problems which transpire when people come along who want to change all the real lessons our forefathers have already learned and quantified with such elegance, by changing all the names or their meanings, rather than coining new words to indicate a new phenomenon which they may wish to refer to.

        For example, originally rising prices were one of the consequences of inflation, not the root of it. One of the reasons that I empathize with the Austrian school is that they tend to stick to the original definitions, and are economically responsible rather than politically reckless as are Keynesianists . The original meanings of inflation and deflation were clear, but of course particularly as inflation became used as a tool to compensate for political profligacy (rather than raising taxes which is too overt and loses votes) then it became too difficult and too politically disadvantageous to accurately quantify actual inflation; so the trick was invented to monitor only one of the effects (rising prices), so as to camouflage the others. Once that was done you cannot really continue to use “deflation” with its original meaning either, since it is algebraically opposite of and the complement to inflation. This I would suggest is what led to the problem of strange us as you term it?

        The greatest weakness I feel of the resulting confusion is that prices may rise or fall in cycles due to other causes than inflation. So when you re-define inflation and deflation in terms of rising or falling prices only all you get is significant confusion. For example, if a government increases taxes to balance a deficit, this statistically becomes interpreted as inflationary when monitoring only prices, since total prices including taxes have risen; whereas raising taxes is the very opposite of inflationary in terms of the original definition !

        Oh what a confused world we live in?

        • Hi Drf
          The end of common usage of the word disinflation is a shame I think as it ends up with deflation having several meanings not all of which are consistent. Perhaps the worst example is Japan where it’s lost decade is often referred to as deflation whereas it has had periods of growth in this time. Disinflation is a much better description for her as she has had falling prices for the vast majority of the period.

  2. so its indeflation.is it .what do you do with your money now.the attacks are coming from everywhere.CGT.BANKRUPT BANKS.MARKET MANIPULATION.QE.etc.etc.
    it is truly a time where acting with sense makes no sense .may as well aim the darts at the economic dartboard.
    your analysis as ever is in depth and usually spot on .keep up the good work
    chris

    • Hi Chris
      Welcome and thanks for the compliment. Actually the same analysis can lead to different conclusions as to where to put your money! For example deflation and disinflation would lead to conventional gilts and be bad for index linked ones. However if you feel that in the UK we could get deflation and inflation then index linked gilts come back into play. Furthermore if you think that slowdowns will lead to central banks thinking up more extraordinary monetary measures then in the UK at at least we could get deflation and then inflation again. So following my logic the investment response to a slowdown should be take profits on ordinary bonds and invest them in index linked ones as the Bank of England will be using QE and other measures again….
      The irony is that the private investor needs to be fleet of foot just at the time that markets are volatile and so it is hard for them to pick levels to invest at.Just look at equity markets today, Europe opens down 1.5% and then the Dow Jones closes 2% up.

  3. Hi Shaun
    Thanks for your commentary.Its very instructive. I have only recently come across it from Francesca’s alerts on the BBC.

    I have followed QE and its justifications. The BoE started out with a mechanical target for broad money at which QE was aimed.It was said to boost nominal output and was therefore factored into the government’s growth projections. Adam Posen came in later to say that it didnt work that way which was why it wasnt a threat to inflation.He pointed to bank deleveraging as an inhibitor.Should then it have been factored into growth projections? The BoE relied on alternative/adjacent arguments ( influencing yields,portfolio transfers) as backup in justification. This was the policy that was supposed to boost the real economy in particular SMEs, not act as another bank bail-out. If the aim was to ease credit, why did they buy mainly gilts, not private assets. It is said they did so to avoid credit risks on their balance sheet.Now they ( sorry we) are exposed to the market risks on gilt valuations – fiscal capture risks to which the OECD refer in their outlooks. Tucked away in last years figures I found that the APF contributed £18bn to PSND due to falling gilt values in the APF indemnified by the taxpayer- receiving hardly any publicity. The portfolio transfer argument was supposed to provide the transmission to higher yeilding private assets.

    IF foreign investors and pension funds were the main sellers of gilts, I couldnt see that transmission route being effective. What guarantee was there that these investors would buy riskier sterling assets. They may well have bought publicly-backed bank capital/debt or new gilts/FTSE 100 tripleA equity to refinance FTSE 100 bank debt. But, this was not the stated purpose, was it. One by one the objectives have failed to materialise for the SMEs.

    We are now pointed to the counterfactual – ah but what if we had not taken the action, how bad would it have been then? Its supporters say, ah well its all about confidence, isnt it?

    What I would really like to know is the statistics on which institutions sold gilts to BoE, and what did they then do with the liquidity. How much of that new liquidity was rolled over into either new gilts or bank debt/capital/refinacing of FTSE 100 company bank debt. Only with these stats can we start to bring this policy to account.

    Turning briefly to the ECB’s recent announcement that it would buy sovereign debt, I cannot find out who will indemnify the ECB’s potential market losses on those purchases. Do you know the answer?

    • Hi shireblogger and welcome
      As to the question you ask it is the shareholders of the ECB who are also euro zone members who underwrite its finances and any losses,so 16 of the 27 ECB shareholders. The relevant section in its constitution says

      “Net profits and losses of the ECB are allocated among the euro-area NCBs according to Article 33 of the Statute:

      Allocation of net profits and losses of the ECB
      33.1. The net profit of the ECB shall be transferred in the following order:

      (a) an amount to be determined by the Governing Council, which may not exceed 20% of the net profit, shall be transferred to the general reserve fund subject to a limit equal to 100% of the capital;

      (b) the remaining net profit shall be distributed to the shareholders of the ECB in proportion to their paid-up shares.

      33.2. In the event of a loss incurred by the ECB, the shortfall may be offset against the general reserve fund of the ECB and, if necessary, following a decision by the Governing Council, against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the national central banks in accordance with Article 32.5. ”

      As to our own UK QE I have seen figures which suggest that foreign ownership of UK gilts fell from 35% of the total to 30% over the period of QE. To that extent then it is likely that this amount was a leakage I agree. However such numbers are notoriously unreliable in my view and I counsel caution in using them. As to changes in view from the Bank of England which should have the most accurate data there have been plenty and this is highlighted I think by an excerpt from a speech from a Monetary Policy Comittee member (David Miles) back in February.

      “The effects are a bit like those from pumping water into a dry area: it is hard to know which channels the water will flow down, and much of it will seem to disappear, but that does not mean we are clueless on the nature of its impact. Most of the channels through which the money might be flowing are helpful in alleviating the problems in the financial sector, and with banks in particular, where confidence had been shattered. One can be unsure which are the most important channels. I know I am. But most of them are helpful and it seems to me that none, in the current environment, are obviously harmful.”

      So the MPC does not know either…

      • Thank you for this useful response. In addition to the £18bn added to the National Accounts measure of PSND I mentioned, I see from the 2010 BoE accounts that the BoE charged interest of £626m to the Asset Purchase Fund for its QE ‘loan’ as well as a £5m ‘management fee’.The BoE doesnt consolidate the financial statements of the QE gilt-buying subsidiary because it says it has no economic interest in the fund which taxpayers indemnify. I hope eurozone taxpayers are told what the ECB operations will cost them, losses/interest/management fees etc.

        I accept that gilt values go up as well as down – indeed the BoE may hold QE gilts to maturity – who knows. But, as they are held as a monetary policy tool of the MPC ( who have no economic interest) they may need to be sold to tighten policy as opposed to making a surplus for the taxpayer. All a bit worrying, at least to me. I hope the QE ‘loan’ gets repaid with interest obviously.

  4. Modern humans were born into the money system and will likely die during the continuation of the money system. Humans have designed exchanges such that “to some degree, every decision depends on money while money directly accomplishes nothing that could not be accomplished by replacing it with pure cooperation.”

    Money exists where some receive and some do not receive. Therefore, it cannot sustain humanity for thousands of years in our future.

    Money, currency, debt, finance, amortize, refund, garnish, repossess, tax, salary, pay raise, inflation, deflation, recession, depression – all attempt to add or remove essential goods and services from one human to another. Humans must soon realize that this model is now globally unintelligent from a future evolution perspective.

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