MONEY MATTERS
The nature of fiat money, as well as the means to keep fiat money inflation in check, in recent years has never been in doubt. As the iconic Milton Friedman once perceptively asserted, “inflation is always and everywhere a monetary phenomenon.”8 In fact, it could not be otherwise because prices are traditionally defined in units of money, such as cents per pound and dollars per square foot. While “price” is unambiguously defined, or nearly so, money, in the sense that Friedman used the term, regrettably is not. What economists seek is a universally accepted medium of exchange. If prices are indeed defined in units of money, we should be able to find some statistical measure of money such that, when it rose faster than an economy’s capacity to turn out goods and services, prices rose; and when money growth was negative relative to the capacity to produce, prices fell.9 In short, we want a measure whose numerator is money (or any financial instrument10) and whose denominator is capacity. I call the ratio unit money supply.
MONEY CHOICES
There are several series that can be credibly used for the denominator (capacity) of unit money supply. All, more or less, convey the same result. What constitutes money, or more exactly, a universal transaction balance, has been far more elusive.
There has never been any doubt that currency has to be part of any transaction balance. Currency and coin for modest-sized transactions have always been acceptable as payment for goods and services. A potential problem arises because of the very large American dollar currency holdings abroad, currently two fifths of the total.11 Foreign holdings of U.S. checkable, time, and savings deposits, however, account for less than 5 percent of total deposits. Overall, subtraction of foreign holdings of currency and deposits does not materially affect the trends of unit money supply. Accordingly, I have stayed with the more historically available data on money supply as published by the Federal Reserve.
I tested a number of choices for money supply and even a number of debt instruments as a substitute for money. The measures of money supply most economists use are variations of what we call M1, M2, and M3. M1 comprises currency, traveler’s checks, demand deposits, and other checkable deposits. M2 is equal to M1 plus savings deposits, small-denomination time deposits, and retail money funds. The broadest measure, M3, adds to M2 institutional money funds, large-denomination time deposits, overnight and term repurchase agreements, and overnight and term eurodollars. Publication of M3 was discontinued by the Federal Reserve in 2006 but can be approximated with data from other sources.
The data strongly suggest that the measure of money supply that, when divided by capacity, most closely follows price is Milton Friedman’s choice: M2. Both the narrower M1 and broader M3 measures do poorly relative to M2 in tracing price movements.
I use the price for personal consumption expenditures excluding food and fuel, long favored by the Federal Reserve, to represent U.S. domestic prices more generally.12
A TIGHT FIT
The closeness of fit of unit M2 and price over the decades is impressive (see Exhibit 12.1). From 1909 to 1933, prices exhibited little long-term trend, as was the case reaching back over the previous century. But from the onset of fiat money in 1933 to date, prices have risen at an annual rate of 3.4 percent on average. Unit M2 rose by an identical 3.4 percent annually. The two series parallel each other through World War I (1917 to 1918), the turbulence of the early twenties, the stability of 1925 to 1929, the Great Depression, World War II (1941‒45), the postwar “moderate” inflation (1946 to 1969), and most of the rapid inflation between 1969 and 1991. But starting in the late 1980s, unit M2 seemed to have lost its closeness of fit to the price level. Banks had become fearful that their capital positions were inadequate, inducing them to restrain lending. I described the economy at the time as confronting “fifty mile-per-hour headwinds.”13 Provisions for loan losses as a percent of loans rose to a then-postwar high.
The breakdown of M2 spawned a flurry of analyses. I found that the most credible was published several years later in an interesting joint paper by economists at the New York and Dallas Federal Reserve banks, which concluded that M2’s historic tie to inflation and economic growth had become unhinged and that “depository institutions’ capital difficulties during the late 1980s and early 1990s can account for a substantial part of the deterioration in the link between M2 and inflation and economic growth. With these problems now behind us, the link between M2 and economic growth has strengthened.”14 Although price inflation did slow somewhat as unit money supply stagnated, I still find the money supply to price relationship of that period puzzling.15
Money supply, of course, does not directly translate into price. That occurs only when M2 is drawn upon for the purchase of goods and services. Money velocity is the number of times M2 is turned over to facilitate the transactions that make up nominal GDP (see Exhibit 12.2). The ratio of price to unit money supply is the virtual algebraic equivalent of what economists call money velocity, the ratio of nominal GDP to M2.16 As can be seen in Exhibit 12.3, my alternative measure of money velocity (see footnote 16) can be explained by the degree of inflationary pressure on the economy (the operating rate), the level of short-term interest rates, and equity prices. The greater the degree of inflationary pressure, the more likely people will be to accelerate their turnover of transaction balances; the higher the interest rate or rate of return on equity, the more likely people are to hold income-earning assets in lieu of cash, thereby reducing M2 and raising money velocity. Combining these determinants of money turnover with money itself portrays an even closer historical fit to the general price level (Exhibit 12.4). Thus, in summary, money supply is by far the dominant determinant of price over the long run, but in the short run other variables are important as well.
Given all the other evidence of suppressed demand, money velocity in 2012 not unexpectedly was at its lowest level in more than a half century.
MONEY AND PRICES IN FOREIGN ECONOMIES
In most foreign countries, unit money supply and price moved in patterns similar to those in the United States, though with far less tightness of fit. In countries with substantial international trade, import prices materially affect the general price level and hence blur the relationship between price and domestic unit M2. But the most dramatic example of the inflation-money link outside the United States occurred in Brazil between the first quarter of 1993 and the third quarter of 1994, when the country’s fiscal and financial breakdown led to a near 150-fold increase in prices and a 180-fold increase in unit money supply.
THE LOAN/MONEY MULTIPLIER
Central bankers in London, Frankfurt, Tokyo, and Washington have responded to the aftermath of the 2008 crisis with a massive expansion of their balance sheets. The Fed more than tripled the size of its assets between late 2008 and mid-2013. Nine tenths of the U.S. expansion was funded by the Fed’s creation of central bank money: currency and reserve balances (the monetary base) held by depository institutions at the Fed. Those commercial and savings banks are currently being induced by the Fed to hold the bulge of reserve balances by paying an interest rate of 25 basis points on those funds.17
When the banks decide to lend their reserve balances to bank customers, they first have to set aside additional capital and loan loss reserves as insurance against default on the new loan. I estimate that during the years 1995 to 2007, the amount set aside (the monetary base divided by M2) averaged 12 percent of the loan (see Exhibit 12.5)18. But fear-gripped lending officers have been setting aside a much higher percentage of loan acquisitions since the Lehman collapse—26 percent in 2012 and more than 30 percent as of mid-2013. Loan officers in recent years have obviously become quite leery of lending to other than the soundest borrowers.
Virtually all of the proceeds of new loans are spent on inventories, capital equipment, cars, homes, and a variety of goods and services.19 The retail stores, contractors, and all other recipients of the new spending deposit their funds into one or more banks. Those banks, in turn, after their n
ecessary set-asides, relend them to customers who proceed to spend the borrowed funds.20
In short, the initial Fed deposit (or currency issuance) ends up financing a long series of ever-diminishing new loans, cumulating to a multiple of the Fed’s original central bank money injection. That process continues until the individual bank set-asides cumulate to the size of the original reserve balance injection.21 How long it takes to complete the multiple cycles of lending depends largely on the size of the set-asides that consecutively drain off the reserve balance. The larger the set-aside, the smaller the loan multiplier. Given the current near-record size of the set-asides and the rapid rate of spending loan proceeds, most of the loan multiplication process presumably takes less than six months after the initial injection of Fed reserves. Moreover, the pace of decline affects Fed policy. If policy requires a steady level of central bank assets, the Fed will need to replenish the reserve balances as they are converted to bank loans and currency.
REDUCING THE FED’S BALANCE SHEET
The ratio of M2 to the monetary base in mid-2013 matched its all-time low in 1940. The Fed, of course, is fully aware that the current amount of central bank money eventually needs to be reined in and, presumably, plans to reduce it prior to the onset of market pressure to do so. The simplest means is to sell Fed assets, almost wholly Treasury notes, bonds, and mortgage-backed securities. This, the conventional procedure by which the Fed tightens credit, will induce a significant rise in interest rates.22
The next most effective measures to absorb large amounts of reserves are a hike in reserve requirements and/or issuance of Federal Reserve bills. Again, interest rates would doubtless rise. But latter initiative, however, would require legislation that, in today’s climate, would be politically precarious for the independence of the Fed. Unless the economy unexpectedly moves quickly into high gear, any credit tightening will, as usual, run into considerable political opposition. It always has.
FEAR AND THE FUTURE
One of the themes of this book is that fear induces a far greater response than euphoria. Accordingly, asset prices and other fear-sensitive financial variables move far more rapidly when falling than they do when rising. Thus, while the collapse in the money multiplier was sharp and deep following the 2008 crash,23 its recovery is apt to be gradual. There’s not much history to give us guidance to recovery. But what we have most likely suggests that the pattern of recovery would be that which followed, for example, from 1952 to 1963. That represented a near doubling of the money multiplier, spread over the course of eleven years. That would suggest a rate of increase in unit money supply and hence in prices, through 2017, averaging more than 7 percent per year. A similar pace of rise in the multiplier between 1918 and 1930 yields an implicit annual rate of price rise from 2012 to 2017 of 6 percent.24 Given so few comparable periods during the past century, such forecasts need to be viewed as illustrative simulations only. It is easy to contemplate price acceleration, with today’s Federal Reserve balances unchanged, ranging from 3 percent per annum to double digits over the next five to ten years. Interest rates under any scenario will rise, as will arguments that the Fed’s tightening was premature.
The Fed somewhat surprisingly weathered virtually all assaults on its authority following the crisis of 2008. Approaching its one hundredth anniversary, it has a long history of resilience to political forays.
THIRTEEN
BUFFERS
Not a day goes by that does not reveal deterioration in some aspect of our nation’s public infrastructure, followed by a call for immediate action. The average age of highways and streets, as estimated by the Bureau of Economic Analysis, has increased from sixteen years to twenty-five years since the early 1970s. To those of us who have to drive over our increasingly pockmarked streets, numbers shouldn’t be necessary. Sewer systems and public hospital buildings have aged similarly. Even our national parks are falling behind in maintenance.
But the most visible aging of government assets, and possibly the most consequential, is that of our military. Had we not had excess manufacturing capacity and infrastructure as we entered World War II, we could not have countered our enemies with overwhelming capacity to produce. The size of budget deficits that prevailed during the war was a measure of the extent to which we marshaled the savings of the private sector to help fund the purchase of war materials. But in order to get consumption down and savings up, rationing proved necessary.
Since the end of the war, the average age of military buildings and other facilities has tripled. If there is such a thing as a poster child of aged military equipment, it surely must be the fleet of B-52s, the long-range strategic bomber. It has a long distinguished history. As I wrote in 1952, “The long-range intercontinental bomber tasks will be in the hands of a new swept-wing eight-jet bomber now undergoing test—the B-52.”1 Its latest version, the B-52H, whose final production run ended in 1964, did yeoman service as recently as 2003 in Iraq. It is scheduled to remain in service beyond 2040. I am certain that there are innumerable current B-52 pilots whose fathers, and conceivably grandfathers, flew earlier models of this renowned aircraft. There are still eighty-five H models, fitted with modern avionics, in our active inventory.
The aging of naval ships has gained even greater prominence in the press. Our aircraft carriers are expected to have a fifty-year service life, and many of them are well up in nautical adulthood. I hesitate to include the USS Constitution (“Old Ironsides”), the oldest commissioned warship afloat, a wooden-hulled frigate celebrated for its exploits in the War of 1812. It is in a class of its own. It was first deployed in October 1797 and most assuredly is the most renowned piece of military equipment still in our inventory. Its propulsion system is identified by the navy with mock seriousness as 42,710 square feet of sail on three masts.
If “Old Ironsides” is the oldest naval vessel in our arsenal, the newest, scheduled to be delivered in 2015, is the aircraft carrier Gerald R. Ford, the first in the Ford class of carriers that are being added to the aging Nimitz and Enterprise class carriers. I can think of no more appropriate tribute to my old boss, President Ford, than to have a leading edge of our military power named after him.
The Abrams tank, the main battle tank of the army, is more than thirty years old, as is the Bradley armored infantry carrier. Much of the army’s equipment, however, is new, fashioned largely for its operations in Iraq and Afghanistan. Some of it, such as the large special trucks engineered to meet the devastation of roadside mines in many sensitive combat areas, may not be relevant in the future.
It is not quite clear, however, how important the aging is to our national security. It all depends on a forecast of who our enemies are going to be five to fifteen years from today. Most analysts believe that the probability of head-to-head superpower confrontations like those that dominated the first four decades following World War II is very small, but no one seems sure. Our military structure cannot significantly change quickly—the very long delivery lead times preclude it. But the type of military hardware we procure in the years immediately ahead will depend very much on our longer-term balance of power perspectives.
The issue of equipment aging divides military and political tacticians and will likely continue to do so for the intermediate future. I would hope that this debate is not resolved by another conflict in which American military capabilities are sorely tested.
SO, TOO, THE PRIVATE SECTOR
The private sector has not been immune from the aging of infrastructure. Since the 1970s, the average age of manufacturing industry assets, for example, has increased from under eleven years to more than sixteen years. Similar aging is evident in wholesale trade, utilities, and air transport.
The share of private nonresidential buildings in real GDP has been in long-term decline since 1981, and those buildings are not being replaced, probably reflecting the slowdown in growth of the working-age population (fewer workers, fewer buildings), as well as the recent increased discounting since 2008 of expe
cted incomes from very long-lived assets.
THE TASK AHEAD
There can be little doubt that a major modernization of our infrastructure is long overdue. It is easy to demonstrate the time and motor fuel wasted in traffic jams owing to failure to keep road capacity growing in line with the number of vehicles on the road. But fixing the public infrastructure is no easy task. Funding is the major obstacle. Our fiscal position is daunting. To balance the budget, we need to raise revenue by a fourth or cut outlays by a fifth, or some combination of the two. We are unlikely to get close to balancing the budget even within ten years. Increasing federal outlays on infrastructure will increase the deficit (negative savings) and must be matched, ex post, by a comparable rise in savings less capital investment by households and private business or by increasing our rate of borrowing from abroad. To the extent that increased deficit spending curtails capital investment in other sectors, it is a depressant to economic growth in the short term and productivity in the long term. But unaddressed is the question of the effect of infrastructure on productivity. Rising outlays on infrastructure will, of course, increase nominal GDP, which, in turn, should increase the level of gross domestic private savings, but not nearly enough to be significant.
The Map and the Territory Page 24
