Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
ARE YOU LOVING YOUR SERVITUDE? - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Learning from Money Supply of the 1980s: The Power and Irony of “MDuh”

Economics / Money Supply Nov 20, 2017 - 02:08 PM GMT

By: F_F_Wiley

Economics

Forget about big hair, Ray-Bans, and Donkey Kong. Don’t even think about Live-Aid, Thriller, and E.T. Above all else, the 1980s were the gravy days of the money supply aggregates.

Beginning in late 1979, the Fed built its policy approach around the aggregates—primarily M1 but occasionally M2, and policy makers also monitored M3 while experimenting with M1B and, later, MZM. But those were just the “official” figures. Economists and pundits debated the Fed’s preferred measures while concocting their own home-brewed variations.


Notably, the Fed allowed interest rates to fluctuate as much as necessary to achieve its money growth targets. Fluctuate they did—rates soared and dipped wildly as a direct result of the Fed’s policy. The world, meanwhile, watched the action as attentively as a Yorkie watches breakfast, studying every wiggle in every M. Missing one wiggle could have meant the difference between exploiting the volatility that the Fed unleashed or being sunk by that same volatility.

And to make sense of it all, the world looked to the most famous economist of his day, Milton Friedman. By converting a large swath of his profession to his strict brand of Monetarism, Friedman more than anyone else had triggered the monetary frenzy.

But then, almost as quickly as the frenzy blew in, it blew right back out. With none of the Ms living up to their billings as economic indicators, the Monetarists drifted from view. Not in five minutes but in five years, give or take a couple, their period of fame was over. Friedman’s reputation as an economics savant fell particularly hard—his highly publicized forecasts proved inaccurate in each year from 1983 to 1986. And the Fed once again redesigned its approach, first deemphasizing and eventually dropping its money growth targets.

But maybe the Monetarists came closer to explaining the economy than their critics allowed?

Maybe the best indicator—I’ll call it “MDuh”—was somehow hidden in plain sight?

Those are the arguments I’ll make in this article, and I’ll back each one with up-to-date data. I’ll propose a way of thinking that’s considered common sense in some circles even as it’s blasphemous within the mainstream core of the economics profession. And I’ll explain why MDuh was the true lesson of Friedman’s research.

Before we get to MDuh, though, there are two things you should know about Friedman and his co-researcher Anna Schwartz (if you didn’t already know them). First, they relied on data, not theory, when they shaped their version of Monetarism. They found a strong historical correlation between money growth and economic activity, and they also found that money growth predicts activity. They published those results in a groundbreaking 1963 book, A Monetary History of the United States, 1867–1960.

Second, to their credit they never claimed to understand the monetary “transmission mechanism,” meaning the reasons the historical correlations were as strong as they were. But they offered their best guess, which lined up with prevailing Monetarist thinking. They believed that “there is a fairly definite real quantity of money that people wish to hold” and that our continual efforts to adjust money holdings to those fairly definite levels are the business cycle’s driving force. (See here for source.)

The Glaring but Rarely Acknowledged Problem with M1 and M2

The second point above explains why Monetarists defined the aggregates as they did. They defined each aggregate according to the characteristics that might influence the “fairly definite real quantity of money that people wish to hold.” But the characteristics they believed important, such as liquidity, stability, and value as a medium of exchange, led to unreliable indicators, as shown in the chart below:

The chart compares the most popular Monetarist measures, M1 and M2, to two measures that I created, MDuh and NBL. I’ll define MDuh and NBL in just a moment. I’ll first offer an explanation for why M1 and M2 lost their pre-1980s mojo as GDP correlates. And to do that, I’ll need to review a fallacy that underpins not only Monetarism but all of mainstream macro.

Mainstream theory relies on the false premise that bank loans are no different to other loan types. It ignores the reality that bank loans are unique, because banks are the only institutions that create deposits (money) while delivering loan proceeds. Bank borrowers receive money that banks create from thin air, and that brand new money has powerful effects. It boosts spending without requiring prior saving, meaning it’s mostly additive to economic activity. That is, it doesn’t have a large “crowding out” effect on other spending—bank-created money flows directly into nominal GDP. It might affect prices, real growth, or a combination of prices and real growth, depending on how the new money is spent. But it’s important to remember that the new money connects to a bank loan. The money–GDP correlation is merely a byproduct of a lending–GDP correlation. Bank lending, not money, is the driving force.

Back to M1 and M2: Why did those highly touted measures lose their strong correlations to GDP, whereas MDuh didn’t?

I would say it’s because they lost their connections to bank lending. The economists who created them made both additions to and subtractions from bank-created money, whereas I made no such adjustments when I calculated MDuh. I didn’t bother with the differences between checking, savings, and time deposits, and I didn’t bother with money that’s not created by banks, such as money market funds. In other words, I didn’t bother with the characteristics of money that absorb the attention of mainstream economists—liquidity, stability, and value as a medium of exchange. For what it’s worth, I doubt that people maintain definite money holdings, as the Monetarists claimed.

MDuh depends on a single question: Is a potential MDuh component initiated by a private entity with the legal authority to create money, meaning either a commercial bank or a similar deposit-taking institution? If the answer is yes, I include the component in MDuh. Otherwise, I don’t. By using only that criterion, I’m estimating the amount of new money that banks pump into the economy when they make loans and buy securities. Not surprisingly, MDuh correlates almost perfectly with net bank lending—the correlation between 1959 and 2016 was 0.97. And net bank lending, as you might have guessed, is “NBL” in the chart above.

To say it again, banking realities tell us that bank lending, not money, is the business cycle’s driving force, as shown by the data in my chart.

Why Friedman and Schwartz Were Almost “on the Money”

Now for the irony.

Over the 94-year period covered in Friedman and Schwartz’s Monetary History, data only existed for a few types of money. The authors couldn’t separate different types of bank accounts as finely as statisticians do today. They couldn’t measure any non-currency, non-bank-created money that may have existed over the period of study. In other words, they couldn’t add and subtract the various components of the Ms that disconnect them from bank lending.

So MDuh is far from an original measure. It consists of currency in circulation plus bank deposits less bank reserves, which is equivalent to the measure Friedman and Schwartz used in their book for the period until the Fed’s inception in 1913 (there were no central bank–held reserves) and almost equivalent thereafter. Their monetary history could have just as accurately been called “The History of MDuh.” In effect, their study of MDuh triggered the 1980s monetary frenzy in the first place.

(The only discrepancy between MDuh and Friedman–Schwartz is my adjustment for bank reserves, which isolates private sector–supplied credit by excluding deposits that arise though the Fed’s open market operations. Without the adjustment for bank reserves, MDuh would mix apples with oranges. It would combine private sector lending, which is pro-cyclical, with the Fed’s lending, which is intended to be counter-cyclical. Private sector lending is more strongly correlated to GDP, as you would expect.)

In an ideal world, Friedman and Schwartz’s followers would have recognized that MDuh mostly demonstrates the connections between business cycles, inflation, and bank credit cycles. But that’s not what happened. They stuck to their training, which told them that bank loans are identical to other types of lending. And then they obsessed over how to define money supply, as if economic insight comes down to whether to include, say, overnight repos in your favorite M. By so doing, they moved further and further from MDuh.

Next Steps for Those Who See Things as I Do

As mentioned above, my conclusions probably sound like common sense to many of you, even as they conflict with mainstream macro. You might wonder if you can exploit that discrepancy, and I explain how in my book Economics for Independent Thinkers (website here, Amazon link here).

For now, though, I’d say the next time your favorite analyst breaks down M1 or M2, comment politely that those indicators emerged from long-standing fallacies about money and banking. Suggest that maybe people don’t fine-tune their money holdings to a “fairly definite” level as Monetarist theory requires. Or, even if they do, the desired money holdings wouldn’t propel the economy in the same way bank loans do. And then ask her to look at MDuh instead. Or, better yet, ask her to look at net bank lending and be done with it. Money, while occasionally interesting, mostly sows confusion among those who study it.

Author’s note: I plan to post a follow-up or two with more detailed statistics, including correlations with real growth, and I’ll also consider the economics profession’s response to critiques such as mine. The follow-ups are unlikely to be widely published—if interested, you may need to check back to (or subscribe to) one of my proprietary sites (nevinsresearch.com/blog or ffwiley.com). Also, for more on the realities of banking and how they differ from textbook theory, see this Bank of England report.

F.F. Wiley

http://ffwiley.com

F.F. Wiley is a professional name for an experienced asset manager whose work has been included in the CFA program and featured in academic journals and other industry publications.  He has advised and managed money for large institutions, sovereigns, wealthy individuals and financial advisors.

© 2017 Copyright F.F. Wiley - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules