Distributed Economics

In the great turkey shoot that is modern economic theory, one particular formula stands out: the Equation of Exchange, sometimes also known as the Quantity theory of Money.

The quantity theories of money – it turns out there are several – attempt to formulate the idea that the total quantity of money has some role in determining the price level. The Equation of Exchange is typically stated as:

MV = PQ

where M is the total quantity of money, V is the velocity of circulation of money, P is the price level and Q is the total quantity of aggregate transactions. The equation was  proposed in this form by the American economist Irving Fisher, in 1911 in his book The Purchasing Power of Money, its Determination and Relation to Credit, Interest and Crises. (Alternate forms use MV = PT, which replaces Q quantity of transactions with T value of aggregate transactions.)

Now this author takes no issue with the M = PQ part of the equation, but what exactly is the velocity of circulation of money and how does it affect the price level?

Velocity of circulation of money is the number of times a specific unit of money is spent in a given period of time. Quite what it means economically is a very interesting question, especially if you think about the wide range in the number of units of money that different currencies provide. In the rest of this post though, I’m going to concentrate on the role velocity of circulation plays in Fisher’s quantity theory of money, and specifically I am going to argue that it does not, and cannot influence the price level as suggested by that equation.

As a simple thought experiment, consider an economy with two economic agents, a single token of money, and a single widget.  The agents repeatedly swap the token of money for the widget. It seems quite obvious that it doesn’t matter how quickly or slowly they do this, the price of the widget (1 token of money) can’t change – there is only one token of money in the economy. Extending the example to more agents, widgets or tokens, it’s still fairly easy to see that it’s possession of widgets and tokens that determines the price level, not speed of exchange.

Engineers, it should be noted, are trained to check that the units in their equations are the same on both sides as a simple way to find errors. If the left hand side evaluates to furlongs per fortnight, and the right hand side is liters then something may have gone a little askew. In the equation of exchange, we have $/t on the left hand side (where t is time), $ and quantity of goods sold on the right. Interesting.

In Chapter 1 of his book Fisher helpfully illustrates his reasoning with an example:

Let us begin with the money side. If the number of dollars in a country is 5,000,000, and their velocity of circulation is twenty times per year, then the total amount of money changing hands (for goods) per year is 5,000,000 times twenty, or $100,000,000. This is the money side of the equation of exchange.

Since the money side of the equation is $100,000,000, the goods side must be the same. For if $100,000,000 has been spent for goods in the course of the year, then $100,000,000 worth of goods must have been sold in that year.

and then he shows a sample calculation:

$5,000,000 x 20 times a year
	=	200,000,000 loaves of bread x $.10 a loaf
	+	10,000,000 tons of coal x $5 a ton
	+	30,000,000 yards of cloth x $1 a yard

i.e. $5 million in physical notes and coins were used to purchase a total of 240 million items of goods. Now there isn’t enough information in Fisher’s examples to dissect out the actual number of transactions for each type of good. However, since we know that each note or coin was used 20 times (the velocity of circulation) we also know that there must have been at least 20 transactions, and that the total number of transactions will always be some multiple of V. In fact it’s implied by the very definition of the velocity of circulation of money that there must always be at least ‘velocity of circulation of money’ transactions.

In other words, V cancels on both sides of the equation.

The assumption that appears to have gone unquestioned here is that the velocity of circulation of money can increase, independently of the number of transactions, and affect the price level. How is it going to do that, in the real life that is to so many economists it seems, a special case?

There is I think, an implicit assumption hidden in Fisher’s work, that is substantially incorrect. That in some sense, there are only two sides of the equation, rather than a time series. Consider what we’re told – each token of money, each dollar bill or coin, is used on average 20 times. So it’s not the case that $100,000,000 is exchanged for some amount of goods in a straight swap as the accounting relationship represents. Rather, $5,000,000 is exchanged for some amount of loaves of bread, the bread maker then presumably exchanges those notes for some amount of coal, and the coal maker goes and buys cloth. Then the cloth makers go and buy the bread.

Or in other words, again going from the original example:

The other questionable assumption is that each item is only traded once. If the coal miners start selling on their cloth to the bread makers, then velocity will increase, but then so does the number of transactions, and so V cancels out again.

For a more empirical disproof, consider high frequency stock trading. The volume of shares sold, and the number of associated transactions has increased enormously over the last 20 years with computer automation and algorithmic trading. Now share valuations have increased – broadly in line with the quantitative increase in the respective money supplies, but they haven’t increased by anything close to the amount that Fisher’s equation would imply if the velocity of circulation could increase the price level. Leaving aside the fascinating question of how share prices would actually behave once hedge funds discovered they could dramatically affect the price by varying the frequency of trading.

So why did Fisher get it so badly wrong?

That turns out in and of itself to be quite interesting. Fisher wrote this in 1911, during the gold standard regime, and a large part of the book is in fact dedicated to explaining the banking system, and how bank deposits interact with the circulation of money, and gold. There’s even a chapter on bimetallism. One thing Fisher it at pains to point out is that bank deposits are not money:

But while a bank deposit transferable by check is included as circulating media, it is not money. A bank note, on the other hand, is both circulating medium and money. Between these two lies the final line of distinction between what is money and what is not. True, the line is delicately drawn, especially when we come to such checks as cashier’s checks or certified checks, for the latter are almost identical with bank notes. Each is a demand liability on a bank, and each confers on the holder the right to draw money. Yet while a note is generally acceptable in exchange, a check is specially acceptable only, i.e. only by the consent of the payee. Real money rights are what a payee accepts without question, because he is induced to do so either by “legal tender” laws or by a well-established custom.

The Purchasing Power of Money, Chapter 2, Section 1

Whatever the legal situation may be though, in 1911 in terms of their influence on the price level, bank deposits were most assuredly functioning as money.  Although Fisher does later extend his formula to include bank deposits (and a separate velocity of circulation), one other thing also becomes clear as he does so – he doesn’t really acknowledge the expansion of bank deposits  caused by lending.

Of course he doesn’t, it’s 1911 – it won’t be even partially explained for another 20 years. Economists are only just starting to explore the problem of what’s causing bank deposit expansion in a supposedly stable financial world of physical note regulation by the gold standard, and Keynes’ explanation of re-deposit expansion in the Macmillan Report won’t come out until 1931.  What Fisher has actually stumbled over, without apparently realizing it, is the need at that time for some kind of fudge factor to explain the independent expansion of bank deposits relative to the quantities of physical notes and coin, and gold that are supposedly regulating them. Velocity of circulation, almost impossible to measure accurately, and easy to find random explanations to adjust when needed, is a very convenient variable, and with Economics still in complete disarray when it comes to properly understanding how bank deposit expansion behaves as an economic force, it continues to be so.

It’s a little hard to know where to begin, in terms of illustrating the continued convenience of this non-existent effect, so with apologies for picking on the authors concerned, today’s prize goes to the Bank of England’s First Quarter report for 2011, which includes an article by Bridges, Rossiter and Thomas on “Understanding the recent weakness in Broad Money growth.”

The growth rate of nominal spending (nominal GDP) has picked up sharply over the past year, despite subdued money growth (Chart 2). This means that money has had to circulate at a greater rate in the economy to finance the higher value of transactions — in other words there has been an increase in the velocity of circulation of broad money.(5) That is in contrast to the long-run downward trend observed in velocity since the 1980s.

The incremental information in broad money growth about future nominal spending has to be conditioned on a view of the outlook for the velocity of circulation. Currently broad money growth is weak, which might signal a downside risk to future nominal spending and, ultimately, inflation. But there may be reasons why both the supply of, and demand for, broad money may have changed relative to spending. That would lead to a change in the equilibrium level of the velocity of circulation. So understanding the recent factors influencing velocity and the extent to which they might persist will be important for assessing future inflationary pressures.

Bank of England Quarterly Report 2011 Q1, p22

Broad Money appears to be the M4 measurement, which as noted previously, is a horrible mixture of money in the form of bank accounts, and various kinds of debt. The “weakness” in broad money growth appears to be a drop from an annual increase of 10% or so during the credit boom, to a mere 2-3% in the last few years. Perhaps the most alarming sentence in the report, which is quite entertaining to read from the perspective that velocity of circulation of money is actually irrelevant in terms of effecting the price level, is the last one:

Should money growth continue to remain weak, then analysing the causes of this, using the types of analysis employed in this article, will be important in judging whether that weakness is signalling weak nominal spending growth in the future.

Bank of England Quarterly Report 2011 Q1, p34

Are Economists at the Bank of England actually advocating money supply growth as a positive economic indicator? If they really do believe that, then it only remains to pass on the solution described by the great Douglas Adams.

MANAGEMENT CONSULTANT:
Since we decided a few weeks ago to adopt leaves as legal tender, we have, of course all become immensely rich…  But, we have also run into a small inflation problem on account of the high level of leaf availability. Which means that I gather the current going rate has something like three major deciduous forests buying one ship’s peanut. So, um, in order to obviate this problem and effectively revalue the leaf, we are about to embark on an extensive defoliation campaign, and um, burn down all the forests. I think that’s a sensible move don’t you?

Hitchiker’s Guide to the Galaxy, Douglas Adams.

Central Bankers to the B Ark please. Don’t mind the gap.
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The base money myth has reared its head again, this time in the form of a blog posting from Nobel laureate Dr. Krugman, posting from a conference this week in England on Keynes, and arguing for fiscal stimulus (Government spending to increase economic activity, funded by government borrowing), versus monetary policy – deliberate inflation of the money supply.

Titled Woodford on Monetary Policy, it features a chart from Dr. Mike Woodford, showing the effect of changes in the Japanese monetary base on GDP.

GDP vs Base Money in Japan (source Krugman NYT Blog)

It shows GDP as flat, and the monetary base manages to fluctuate between 600,000 and just under 1,200,000 somethings. Setting a new low for statistical presentation in Economics, units are not provided on the graph. Now, as discussed before, there is not and cannot be a mechanical relationship anymore between the monetary base and the money supply in most Basel regulated systems. The Basel accords changed the regulatory basis for the fractional reserve banking system from reserve based regulation on deposits, to a risk based calculation on  capital reserves. Base money however is defined as the sum of physical notes and coins, and reserves on deposits held at the central bank – and has no direct relationship with the capital reserves, which now regulate Bank lending.

Monetary statistics and other information on the Japanese Banking system are available from the Bank of Japan. The monetary base is defined here as:

Monetary base = Banknotes in Circulation + Coins in Circulation + Current Account Balances (Current Account Deposits in the Bank of Japan)

The Money supply is documented under “Money Stock”, and definitions are provided here. It seems, unlike certain other Banking Systems we could mention, that the BoJ has fairly clean definitions of money. M2 is physical currency and bank deposits, M3 includes savings accounts, and the funky, debt instrument stuff is lumped into their own “L” measurement.

Long term series data is provided under the BOJ Time-Series Data page, complete with charting tool. Unfortunately the  easy to use “Money Stock” button uses the “How to Lie with Statistics” percentage annual increase form for the data, rather than the actual quantity of M2. However, even with that presentation it tells an interesting story:

Japanese M2, Percentage Change 1980 - 2011

Contrary to Dr. Krugman’s claims, rather than quantitative monetary deflation, the Japanese money supply has been expanding at a fairly consistent rate of between 2-4% since 1992. Before that, during the Japanese real estate bubble that sent Tokyo property prices into the stratosphere and inflicted 100 year, multi-generational mortgages on some members of its population that is, it was expanding much faster.

Finding the actual figures is something of an adventure. The Bank of Japan makes over 16,000 data series available, but a clear, easy to find historical time series of the bank deposit supply isn’t one of them. There also appears to be a data break so the current MA’MAMS5ANM2 table for M2 only has data from 2003. For this post that’s all we need, but for the record the easiest way to find the longer series figures appears to be to go into the Currency(MA) page, under the Search by Statistics Box, and look at the “List of Statistics” on the left hand side. This gives headings for the various Money Stock series, and its possible to find the actual tables by drilling down further. It’s actually quite a nice tool if you play around a little, it’s possible to stack different series up, and get a graph of them together, like this:

Japanese Base Money vs M2 2003 - 2011 (Units: 100 million Yen)

Notice how base money is more or less completely stable, and M2 is slowly increasing every year, regardless? Nor is this an artifact of the base money amounts being significantly less than that for M2 – if we look at the actual data we can see that the ratio of M2 to base money varies between 6.3 and 8.3 over this period and does so without any particular correlation with the behaviour of M2. If we look at the overlapping discontinued data set that provides the earlier 1998-2008 figures Dr Woodward also showed, it’s the same story:

Japanese Base Money vs M2 1998 - 2008 (Units: 100 million Yen)

There are a quite a few periods when M2 grows and Base Money shrinks for example. This is even more remarkable, since the theory which Dr. Krugman is basing his pronouncements on, comes from the old gold standard regulatory framework where a change in base money would arise from a multiplied expansion of bank deposits, or from physical printing. So if that theory was still correct, any change in base money should be reflected with a much larger expansion (or contraction) in M2. (To be fair to Dr. Krugman, he is simply repeating what he was taught in school about the preceding regulatory framework. Nobody seems to have bothered to tell his generation of Economists that the banking system has been changed underneath them.)

Based on the empirical data then, let’s deconstruct Dr. Krugman’s posting a little. First he starts by stating:

Mike argued that monetary expansion once you’re at the ZLB mainly works, if it does, through affecting expectations. If people don’t perceive the expansion as representing a change in policy that will persist even after the economy has recovered, even big changes in the monetary base have hardly any effect.

ZLB is “Zero Lower Bound” – the problem posed to attempts to control the economy by playing around with interest rates when it’s not possible reduce them below zero. Dr. Woodward is basing his argument on his belief that increasing base money causes monetary expansion. If it doesn’t, then the rest of the discussion is somewhat irrelevant, since the primary thesis is incorrect.

But Dr. Krugman agrees with Dr. Woodward:

Note both that Japan reversed much of the initial expansion in the monetary base, confirming the expectations of those who might have regarded that expansion as temporary – and Japan did this even though deflation continued! Note also that nominal GDP never moved at all despite the huge amount of money “printed”.

Essentially what they have both done is taken two completely unrelated statistics, GDP and base money, and claimed that a relationship exists, and then argued for policy decisions based on this. Now you might think that printed being in quotation marks means that Dr. Krugman is about to point out that money creation didn’t in fact happen, but no.

Dr. Krugman is in fact going to invoke the Gods of the Marketplace as an explanation for everything:

That’s about what I was thinking in, say, January 2009. With the severe financial crisis still relatively recent, and many people still expecting a V-shaped recovery, it didn’t seem possible to persuade the Fed to commit to a permanent rise in the monetary base or a rise in the medium-run inflation target, nor did it seem possible to convince markets that there had been a long-run change in policy.

“Convince markets” – an interesting turn of phrase. The markets these days are high performance computer clusters running algorithms that look for penny differences in prices to turn a profit on. As blind machines will, if the money supply is in fact increased, then the markets will respond with price increases, but that’s a result of the relationship between price, supply and demand, and the money supply, not any act of will by the programs involved.

Ironically, the Federal Reserve has been sitting on a fairly substantial, and more permanent than I suspect anybody appreciates right now, increase in the monetary base ever since they started paying interest on the reserve accounts, and trapped a fair proportion of the TARP funds there, so the poor man didn’t even get that right.

Finally:

But as it turned out, that didn’t happen either; we got an inadequate stimulus, and the failure of that stimulus to do more was then taken as proof that Keynesian policies don’t work – in part because the Obama administration insisted and continues to insist that the size of that stimulus was just right.

All we can really deduce from this blog posting is that two senior Economists appear to have no idea how the actual banking system works, but have absolutely no problem cherry picking monetary statistics from it to support their arguments. This is not, to put it mildly, correct scientific practice. What the figures in fact show is that a fairly considerable monetary expansion has occurred in Japan, since 2% a year mounts up over time, in addition to a series of government stimulus programs that’s turned parts of the Japanese countryside into concrete wastelands. It’s not exactly a convincing argument for the effectiveness of Keynesian interventions.

Analysing any form of distributed system isn’t easy. There are often multiple causes for the same behaviour – say for example that a closed test tube mixture of gas explodes – is it that the gas became too hot and expanded too quickly, or that two chemicals were mixed that rapidly produced a large quantity of gas? Early chemists spent a long time figuring out that there even were different types of gas.

In the same way, disentangling the effects of regulatory failure in the banking system, from the economic consequences of these incredibly slow, but occasionally quite violent fluctuations in the money and loan supplies isn’t easy. It’s especially difficult of course, if you refuse to acknowledge that they’re occurring in the first place, and just choose whichever monetary statistics are either easiest to find (and base money, by virtue of its alphabetical position, is in indeed the easiest set of figures to get out of the BoJ’s site), or appear to support whatever political argument the individual economist wishes to propose.

Still, it could be worse. Look at the first chart of Japanese M2 again, the one that shows the annual percentage change. A naive interpretation might be that quantitative monetary expansion is a good thing, after all a noticeable feature of the Japanese lost decades is a comparatively low rate of monetary expansion compared to the greater than 10% per annum increases that characterised the 1980′s credit bubble.

Japanese households currently repaying 100 year mortgages would probably beg to differ. So would the Weimar Republic.

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Money is a measure.

The invention of standardised measurements was one of those minor seeming developments with far reaching consequences. We all take for granted today that meters and centimetres are the same length everywhere in the world, when there was a time that the length of a foot was a local variable. There’s a standard weight for the kilogram (albeit one which has  developed some unexplained variance) and for really accurate time measurements anywhere on the planet a small miracle of atomic technology called Stratum 1 clocks are freely available.

And then there’s Economics.

Many measurements in Economics are naturally made in units of money, it would be a hard thing to avoid when measuring statistics based on any form of price. In and of itself this would not be an issue, except that Money as a unit of measurement isn’t in any sense constant, and Central Bank measurements of how much money there is, aren’t in any way consistent.

Central Bank statistics are generally presented as a series of M measurements, and as described previously which actual measurements are used varies quite considerably between countries. That’s bad enough, but you would think though that when two countries used the same measurement, M2 say, they would be measuring the same things. Don’t be silly.

The American M2 measure for example, is defined as:

US M2

M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits inamounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds.

Money market funds it should be noted, are generally invested in short term debt of various kinds and no matter how liquid they may be,  selling or buying them still requires an exchange of money. Leaving that aside for a moment, the Euro M2 measure from the ECB is defined as:

Euro M2

M2 comprises currency in circulation, overnight deposits, deposits with agreed maturity up to 2 years and deposits redeemable at notice up to 3 months.

The European Central Bank’s M3 measurement is in fact closer to the American definition of M2:

Euro M3

M3 comprises monetary liabilities (currency, short-term deposits, repurchase agreements, money market fund shares/units and debt securities up to 2 years) of MFIs and central government (Post Office, Treasury) vis-à-vis non-MFI euro area residents excluding central government. M3 excludes holdings of money market fund shares/units and debt securities up to 2 years by non-residents of the euro area.

Kind of. Repurchase agreements? Repurchase agreements (Repos) are another form of debt, they’re a contractual agreement to sell a security, and buy it back in the future at a larger price than it was sold for. What’s that doing in a money supply measure? (Try not to think too hard about the implications of that one when the underlying ‘security’ is itself some form of debt instrument like a Treasury for example.)

Canada’s M2 measurement seems reasonable:

Canadian M2

Currency outside banks plus bank personal deposits, bank non-personal demand and notice deposits; less interbank deposits; plus continuity adjustments.

Until you look a little further down the page to the M2+  definition and start wondering about the implications of not including:

Canadian M2+

M2 (gross) plus deposits at trust and mortgage loan companies and at government savings institutions; deposits and shares at credit unions and caisses populaires; life insurance company individual annuities; money market mutual funds; plus continuity adjustments and other adjustments (see “Notes to the tables,” E1.)

Does this mean deposits at trust and mortgage loan companies aren’t included in M2? How does that work exactly? Are mortgage loan companies somehow not holding their money in an electronic bank deposits like everybody else is, or are Canadian central bank statisticians carefully going through every bank account and categorising who owns it?

Possibly in disgust at this cacophony of standards the British have invented a new one M4, which unfortunately seems to have inherited all of the problems above and a few new ones of its own:

UK M4
The M4 private sector’s (i.e. the UK private sector other than monetary financial institutions (MFIs)) holdings of:

• sterling notes and coin;
• sterling deposits, including certificates of deposit;
• commercial paper, bonds, FRNs and other instruments of up to and including five years’ original maturity issued by UK MFIs;
• claims on UK MFIs arising from repos (from December 1995);
• estimated holdings of sterling bank bills;

and

• from end-1986, 95% of the domestic sterling interbank (now inter-MFI) difference (allocated to wholesale deposits/other financial corporations, the remaining 5% being allocated to transits). This followed a review of its causes (see page 101 of the June 1992 Economic Trends).

Regardless of whether it is being issued by a Bank or not, commercial paper is debt, and so are bonds. The  ”interbank difference” postscript is also somewhat entertaining. From footnote 3 in a 1998 Bank of England review of monetary statistics:

In principle, banks’ reported deposits from other banks and banks’ reported lending to other banks should be equal , in practice this is not the case and this forms the ‘interbank difference’.

Which at least suggests that deep in the bowels of the Bank of England some poor soul is paying attention to what the data actually means.

Do standards matter? Look at it this way – at the heart of the banking system is a recursive feedback process that continuously varies the total amount of bank deposits as a function of loans made against those deposits. At the very least, it would be nice to know just how large the sum of deposits is, that banks can make loans against.  If for no other reason than it’s the only real way to make sure the underlying regulatory framework isn’t malfunctioning.

But there’s a larger issue here – money is a measure. Almost every Economic analysis is based on measurements of money, and these measurements are not being normalised for changes in the quantity of money, changes in other words in the size of the unit of measurement. We can be pretty confident that they aren’t being normalised without even bothering to read the relevant literature, because the data to do so correctly simply isn’t available. Correcting for the rate of inflation, or “real” measurements, doesn’t count, inflation is also a measure of supply and demand. Without knowing what the money supply change has been, it’s impossible to determine whether an increase in inflation is due to the money supply increasing, the supply of goods and services decreasing, or demand for the supply of goods and services increasing.

You can see the problem in just about any article that engages in macro-economic analysis. For example, here’s Dr. Gerard Lyons, Chief Economist at Standard Chartered Bank writing in the British Daily Telegraph today, and suggesting that the “UK can benefit from the East’s super-cycle” – the East in this case being China and India.   Emerging economies it seems are growing fast. As is the unit of measurement – their money supplies. You can infer that might be the case from the article as it happens, since the very next sentence mentions inflation problems due to rises in food and energy prices. Of course, these two very large countries may also be experiencing food shortages which are increasing the price of food. So the question of whether it is the economic demand for food that’s growing, or the unit of measurement is quite an important one for the people living there and the production decisions they individually make on the basis of price as a signal. Let’s have a look at the actual figures.

India’s is a little hard to find, they stick M3 under the weekly statistical supplement, Money Component section, here. As of May 6th 2011, their M3 measure which appears to include inter bank lending as well as bank deposits, is 66,48,565 Crore. In the May 7th 2010 report it was 56,63,416 Crore, a 15% annual increase.  The component growing most rapidly is bank time deposits. Not to be outdone by mere capitalism however, the People’s Bank of China is reporting a 15.7% increase in their broad money M2 measure as of February 2011.

I’m guessing there isn’t a food shortage, at least not until the monetary system is sufficiently screwed up to create one.

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Base Money creates some interesting discussions these days.

At the Econbrowser blog for example,  Professor Menzie Chin has an analysis on what link if any exists between base money, and inflation. The term Base money or M0,  sometimes also referred to as ‘high powered money’, is a carry over from gold standard era regulation, and is typically classified as physical notes and coins in circulation and held in vault cash,  plus reserves from the commercial banks held at the central bank. Professor Chin does a nicely detailed empirical comparison  with the Consumer Price Index and shows that there is no apparent link between base money and inflation.

One question which Professor Chin unfortunately didn’t discuss,  is what the exact mechanism would be by which an increase in the reserves component of the base money measure could influence the  money supply in a Basel regulated Banking system in order to cause any increase in monetary inflation? Not that I have anything against empirical analysis, quite the contrary – but the banking system is a system, it has rules and they affect its behaviour over time, it should be possible for Economists to discuss those rules in the context of the empirical data.

In the gold standard era there was only one way an increase in base money could cause an increase in the money supply, and that was printing physical money.  Reserves held at the central bank on bank deposits were a required percentage of deposits – usually 10%,  so an increase in reserves could only occur as a result of an increase in deposits  – not the other way around. For example, if a Bank had deposits of $1,000, it was required to hold $100 on deposit at the central bank. If it had deposits of $2,000 then the reserve would be $200.  If the total quantity of reserves on deposit at the central bank increased, then it meant that the total amount of deposits in the banking system had increased – by ten times the amount of the increase.

There is a  complication with base money, in that the definition is physical currency and reserves at the central bank. The base money measure itself could increase if more physical money was either printed, or in the case of gold, imported. If that money is then deposited in a Bank, then it would also act to increase deposits, and then reserves at the central bank. The causal relationship is clear though, the base money measure was something that responded to changes in other parts of the system, it wasn’t a trigger for such changes.

In a Basel based system however, reserve regulation is no longer used to control the money supply, capital regulation is used, and consequently reserve requirements have been steadily removed.  In the American banking system required reserves now only apply  to a minority of accounts classified as “Net Transaction Accounts”, so the Base Money measure  no longer plays even its previous informational role in allowing the central bank to know how much the banks have on deposit.

The reason everybody gets so excited about base money these days, is that serendipitously, the Federal Reserve Banks of America decided to conduct an empirical experiment called “what happens if we start paying interest on the reserves”. This was one of the TARP fund related bank bailout measures, and as can be seen below, it had an interesting and more or less instantaneous effect on the quantity of base money held by the Federal Reserve: it doubled.

US Base Money 1956 - 2010

The reason it doubled according to the Federal Reserve Bank of St. Louis’s report by Dr. Gavin was that Banks shifted excess money into their newly interest earning deposits at the Federal Reserve. Previously, the only reserve held at the Federal Reserve by banks was the required 10% of Net Transaction Accounts. Interpolating from the Base Money amounts, it seems these represented about $800 billion of total amounts on deposit in the banking system at that time, or somewhat less than 10% of total deposits in the system.

The source of the new reserves is also interesting. Dr. Gavin’s report strongly suggests that the money came directly from the TARP fund bailout. Another source would be the normal day to day reserves Banks have to keep, money for salaries, bonuses, monthly expenditures, and money that hasn’t been lent out yet. Reserve holdings at the central bank in an interest paying account, are as safe an investment as can be imagined, and assuming that access is electronic and instantaneous – then it seems a reasonable presumption that their reserve deposit at the Federal Reserve  became  every Commercial Bank’s sweep account for money that was temporarily lying around.

In the process, it also provided a rather nice test for theories that claim there is a  multiplier relationship between base money and various forms of monetary expansion in the current American Banking System.

In standard Economic textbook theory, reserves anchor the banking system, and essentially control its leverage, at a 10 times multiple. If there is then any connection at all between base money and the larger money supply measures, the total of all bank deposits for example, then the result of doubling the amount of base money over a four month period should stick out like a sore thumb as the monetary system subsequently evolves over time. If for example, base money regulates bank lending, then there should be visible increases in M1 and M2 measures, as lending and the associated money creation kicks off. This is indeed what many people have predicted. For example, here is Arthur Laffer in 2009 predicting consequent high inflation, and Paul Krugman attempting a rebuttal. Interestingly the counter reason Dr. Krugman provides is not that Basel regulated banking systems no longer have a relationship between base money and the larger money supply, but that because we’re in a liquidity trap, increases in base money don’t cause inflation. He then does a simple comparison with Japan’s monetary base over the last 20 years (Basel regulated) and the USA’s in the 1930′s (gold standard regulated), which is unfortunate given the significant differences between those two regulatory frameworks.

This is an example of one of the larger problems that currently bedevils macro-economics, and by extension macro economists such as Dr. Krugman who often seem to be blindly analysing the higher level statistics without considering the exact details of the underlying monetary mechanics. There are a couple of problems with that approach. One is simply that the high level data is so abstracted that it supports multiple explanations, and without knowing the detail it’s impossible to differentiate them. Another is that analysing the monetary system requires comparisons based on data gathered over decades – if the regulated behaviour of the system underneath that data is being changed within that same timescale, then the validity of these comparisons is more than slightly questionable.

Looking for example, at the components of M1 over the last ten years.

The US M1 measure is currency and a small number of bank and thrift deposits. Now there is a small increase in both of these shortly after the base money increase, but a considerably smaller one than the increase in base money. Bear in mind too, in textbook Economics, increases due to base money influence should be a ten times multiple to the increase in base money – that’s why some writers get so excited about this one. That’s not what we’re seeing here though. If anything, it looks like a certain number of bank accounts were hastily reclassified as Net Transaction Accounts in order to attract a reserve requirement. Also notice the divergent behaviour before the increase, where the amount in M1 bank deposits is clearly varying independently of  the base money  measure. M1 though is only about 20% of the total money supply – for the rest of the story we have to look at M2.

M2 and Base Money

This is the adjusted M2 with money market funds taken out, since they are mostly held in various forms of debt instruments, and are consequently not properly part of the money supply. All that can be really said here is isn’t it interesting how the money supply just keeps increasing year on year before and after the base money increase. There isn’t any evidence that the base money itself is having any effect>

There are incidentally a couple of other deductions that can be drawn from this. The monetary base is the total of physical currency and reserve deposits at the Federal Bank. Currency is classified as part of M1, and until 2008 was about 90% of the monetary base, with the remainder being reserves on Net Transaction Accounts. So it’s fair to assume that base money minus currency is the value of the reserve deposits with the central bank. The shifting of approximately $1 trillion into these accounts with the Central Bank however, doesn’t show as a reduction in any of the other measures.

Reserve accounts at the Federal Reserve don’t appear to get counted as part of M2 – their currency component does get counted as part of M1.  The St. Louis Reserve Bank report suggests that the origin of the excess reserves that increased the Base Money amounts was predominantly TARP funds. In other words, the Federal Reserve bailed out the banking system with just over $1 trillion of money, and that money was immediately moved to deposits at the central bank. If money held in Federal reserve accounts is removed from all the other statistics – i.e. it doesn’t count as either part of banking system deposits, or M2 then it truly is potentially inflationary, and when moved back into the system would have a multiplier effect, and the deposit-loan-redeposit process was kicked off.

This also raises an interesting question about what exactly the bailout itself was all about. The justification used for injecting these large amounts into the Banking System, come from the desire to avoid what happened in the Great Depression, where due to massive bank failures and an excess of loan repayment over new loans, the total quantity of money contracted considerably – monetary deflation. However, that doesn’t square up with all the TARP funds ending up in the Central Bank reserve deposits,  and there being no visible contraction in M1 or M2.

Then we have Dave Altig’s recent post on the Atlanta Federal Reserve Bank’s Blog. Dr. Altig is a Research Director for the Atlanta Fed, and he points out quite correctly that the US is not exporting inflation through increases in its money supply. However he then launches into a comparison between the behaviour of the Chinese monetary base and the American one, and claims that the monetary base is “the stuff that the central bank directly creates”. True for physical currency, not true for reserves – at least in the Chinese system – although assuming that really was where the TARP funds ended up, it may well now be true for the majority of the American reserves.  He then proceeds to show that the ratio of M2 to the monetary base isn’t a straight line in either system, and claims that this shows that base money is linked to the money supply.

Take an increasing value for the M2 money supply of 1000, 2000 and 3000 and assume there is a 10% reserve requirement. Base money is then 100, 200 and 300 respectively. If you then divide the hypothetical money supply M2, by the base money value, then the result is 10, or if you plot it a straight line.  Not something like this:

M2 / Base Money: Source Federal Reserve Bank of Atlanta

Let’s not also forget, since this is China we’re talking about that over the period shown in that graph, the reserve requirement has been steadily increased to over 19.5% as of the 18th February this year. Increasing the reserve requirement, increases the amount on reserve at the Central Bank, and hence base money. For example a 20% reserve ratio on a 3000 money supply, would mean base money was 600, and the  M2/Base money ratio would be 5. What you would in fact expect to see on that graph, is a steadily declining ratio between M2 and the monetary base over the last 5 years. You’d also expect to see a much higher ratio than 5 before 2010 when the reserve requirement was significantly lower.

Economists – it’s like shooting fish  in a barrel some days.

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Premier Wen of the People’s Republic of China is reported by the Wall Street Journal today as being confident that “China can subdue Prices”, on the same day that the Chinese Central Bank raised interest rates by a quarter of a percent. Chinese inflation is currently running at 5.1%.

Rising prices can of course have different causes. Actual shortage of food for example. However, since raising interest rates is unlikely to assist much with crop production, it seems fair to suspect that the proximate cause of the increasing Chinese inflation, that the authorities are concerned with is money supply growth. So how’s that going for them?

It’s fascinating how little attention this remarkable money supply series receives. This is the money supply of a country that has repeatedly raised reserve requirements and now interest rates in order to control its money supply and prevent rising inflation.

Standard, textbook monetary theory advice – which has failed.

Failed quite remarkably in fact, since the visible acceleration in M2 growth comes after the reserve requirements started being increased. It’s strange how there isn’t more attention to just how contradictory that is within the Economic theory of the banking system behaviour that is currently being taught. Increasing reserve requirements should cause a fairly sharp contraction in the money supply, as the reverse money multiplier goes into effect. If anything, growth in China is accelerating.

In an interesting article earlier in December, the Washington Post blamed this state of affairs on China’s “shadow banking system”, and suggests that the Chinese banks have found a backdoor way to perform loan securitisation called “Trusts”, which certainly helps explain the Chinese housing bubble.

Meanwhile the resulting loan induced increase in the money supply, which looks like it will be over 12% for 2010, suggests that inflation is likely to continue to accelerate. It’s all more than a little ironic given last months criticism from China of US quantitative easing.

But the real problems continue to be what the Banking system is doing outside of central bank control, not within it.

Or as it used to be known, printing money. Truth to be told, debasing the currency in one way or another – typically by mixing the precious metal of choice with something cheaper – has been a monetary tactic of those who control the supply of money for millenia.

Modern economics appears to be a little confused by the whole money thing. As was older economics in slightly different ways. 19th and early 20th century economists for example discussed whether bank accounts were properly money, most economists at that time only thought of physical notes and coins as being actual money.

There are enough different definitions of money within Economics, and public statistics on the banking system for that matter, to suggest genuine confusion even in the present day. The M2 measurement for most countries is the sum of all physical money, bank deposits and savings accounts, which in the era of electronic money really is all the official monetary tokens in the system. However in some countries like the USA, debt has also slipped into M2 measurements, since  money market funds are also included in M2. Money market funds are supposed to be extremely safe investments, equivalent to money, but they are certainly not identical to money. Digging around the Federal Reserve’s statistic site, it’s possible to find a breakdown for the composition of the funds that shows that a sizable amount of their holdings is credit market instruments, i.e. debt. Some of their holdings are in cash though. Presumably, cash held in bank accounts somewhere. Is that cash then being double counted, since it’s also included in the M2 aggregate bank deposits figures?

It’s less than reassuring to see that kind of confusion in official monetary statistics.

What is at some level even worse,  is the general confusion in economics over how much money there should be, how it’s defined, and whether it should be held quantitatively stable.

Let’s be very clear about this. No central bank that I’m aware of is currently operating with a mandate to maintain monetary stability. Rather they are given an inflation targeting goal – typically 2%. Now, on the face of it for most people who are not economists, the 2% targeting policy may sound like a commitment to a stable money supply, or at least to one that is “only” growing by 2% a year.

But what has been overlooked, especially in the general debate over the latest QE2 measures from the federal reserve, is what is actually going on with the money supply. The chart below is based on the Federal Reserve M2 figures from  the H6 historical tables. As described above, the USA’s M2 measurement  includes money market funds, even though most money market holdings are not in cash but in debt instruments. So what’s particularly interesting about the M2 figures,examining just the figures  for the last 2 years, is an interesting divergence. Within the components of M2, money within the banking system is steadily increasing.  It seems even without official quantitative easing the “natural” behaviour of the money supply is to somehow magically grow by about 5% every year. (Economists it should be said, really do seem to believe this is the natural order of things, rather than an artifact of the evolution of the current banking regulations over time.) Money market funds on the other hand, are contracting.

Examining just the last 5 years of the M2 components from the Federal Reserve we can see this quite clearly below.

Money market funds are sometimes described as being “the same as money” for investment purposes, but that shouldn’t be taken too literally. In  olden days, when various forms of savings actually paid interest, they typically paid some relatively lower amount of interest, but allowed you quick access to your money. A typical use might be parking funds for a short time when staging some kind of entertainment event for which tickets were sold, in order to take advantage of the period between collecting money for the tickets, and paying the costs for the event. In practice, the contents of  money market funds are some kind of cash float to cover cash outs, and a managed pool of very safe investments like treasuries to provide the yield.

So counting them as part of the money supply is simply erroneous. Money is not debt, debt is a flow of money. But with interest rates where they currently are, it’s not at all surprising that people are shifting money out of money market funds. At current rates of interest, why not just hold cash.

Which raises an interesting question. A somewhat legitimate reason to perform quantitative easing is to replace money being lost in the monetary system through loan default or loan repayment. A shrinking money supply for those two reasons is a mechanical artifact of fractional reserve banking, it doesn’t really provide any useful monetary supply/demand signals. This is otherwise known as the Fisher debt deflation problem.

So the question then is, is the Federal Reserve actually trying to deliberately increase the money supply with quantitative easing, or is it in fact reacting to a perceived shrinking of the money supply, caused by a shift in investments away from money market funds, and simply trying to offset that? There could be all sorts of reasons for investors to prefer other investments to money market funds, including tax treatments, and perceived investment opportunities. None of which would have anything at all to do with the actual money supply, but would cause the total amounts held in these funds to change, and hence cause changes in the perceived money supply, the aggregate of the M1, M2 figures.

From a peak of $11.1 trillion dollars in March 2009, the combined M1,M2 money supply has shrunk down to $10.5 trillion dollars in September 2010. Almost exactly the $600 billion that the Federal Reserve has just announced it plans to create.

Interesting times.

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Having over time slowly worked out more of the details of the current banking system, it’s time to clean up some earlier mistakes.

In the Equity Capital Snafu posting last year I incorrectly presented the relationship between Equity Capital, Liabilities and Assets. In that posting it shows the relationship being Deposits = Loans + Equity Capital. This was a mistake, based on the assumption that the relationship would be  the same as that created by reserve requirements. The actual relationship  is:

Equity Capital + Deposits = Loans

which can be verified (at least for the American system), by looking at the FDIC Call Report for a Bank of your choice.

The immediate observation on this way of regulating the system,  is that it  further removes the fractional relationship between deposits and loans that existed previously.  It doesn’t particularly matter for regulatory control, since that’s now done purely on the relationship between loans and equity capital. Where it probably does matter, although the effect is somewhat dwarfed by the similar problem Asset Backed Securities introduce to the economy, is in the relationship of the quantity of money, to the flows of money defined by loans. If the economy is split into things that are bought with loans, and things that are bought directly with transfers of money, then this increases the flow of money around the loan economy, at the expense of the money economy.

It’s also worth mentioning a further complexity.  When the Basel Treaties talk about the Tier  1 and Tier 2 capital ratios  for regulatory capital- which is the equity capital holdings shown above (most of the time Europeans describe this as regulatory capital whilst Americans use equity capital), what they are describing is the amount of equity capital that is required for different types of loans.

The exact relationship between equity capital and loans is determined by the type of the loan. Basel requires that the risk weighted percentage of Loans(assets) meets the required capital ratio – typically somewhere around 10%. For example, Government AAA rated loans have a risk weighting of 0% whilst Mortgages have a weighting of 50%. So within the requirement that Equity Capital + Deposits = Loans, the Banks also have to manage the relationship within their Loan portfolio of the different types of loan’s equity capital weighting to meet the requirement:

(Tier 1 + Tier 2 Capital)/Risk Weighted Assets > 10%

For example, if a Bank has loan portfolio of 100 in mortgages, with a risk weighting of  50%, then with 90 in Deposits, 10 in Equity Capital holdings, the risk weighted Tier Capital will be 10/(100 * 50%) = 20%. Well within regulation. The general idea being to control the risk of loan default in order to avoid having to use  equity capital. Loan default remains  an achiles heel of this system in that it still necessarily causes a monetary and credit supply contraction.

At least that’s one way to interpret it. But as a recent paper from Acharya, Schnabl, and Suarez shows, an alternate approach is to find ways to re-classify debt so that it meets a lower equity capital requirement. One way to do that is to setup some form of third party holding company or conduit, and provide some form of insurance or credit guarantee on the loans.

The received economic wisdom on Asset Backed Securities is that they remove risk from the banking system by essentially palming it off on everybody else. This is viewed as desirable, since it protects the individual banks – for which loan defaults have always been a major source of instability.  It fails however to recognize the accompanying systemic risk, that by effectively removing all limits on the amount of loans that Banks can issue against their deposit/equity capital holdings the source of instability has now been moved to the banking system itself, and the general societal level of debt. It also fails to recognise the problem that ownership of debt is disproportionately concentrated within the economy, and so as the total quantity of bank originated debt increases, and  interest payments are made on it over time, wealth is increasingly concentrated in fewer and fewer hands.

Ironically, what Acharya et al are now showing is that even the risk removal aspect of Asset Backed Securities didn’t work terribly well as the high interest rates that these instruments carried were too great a temptation for some Banks not to try to hold onto.

Poke around in the entrails of history, and a surprising number of revolutions, and coup’s of one form or the other of etat, can be attributed at least in part to some form of underlying monetary breakdown. Typically the form of breakdown that involves at its heart,too much debt being issued, for the available supply of peasants to support payment of. It would be nice to think that the very least a communist government, formed by and on behalf of the workers and peasants of its country could achieve, would be to avoid that one.

There are two very strange things about the news out of China these days. One, is that there have been clear signs of a loan induced housing bubble for some time now. The other is the succession of increases the People’s Bank of China has made in the required reserve rate for its banks in order to constrain that bubble. The latest increase on May 10th to 17%, follows a raise to 16.5% in February 2010,  and a set of increases over the last couple of years.

According  to the existing Economic theory of how the banking system works, each one of these should have triggered a large contraction in the available money and loan supplies, given that the removal of money from  the system triggered by the reserve increases – is a multiple of the reserve change.

Despite this, there is in China today a rapidly increasing CPI, and a raging housing bubble, alongside  a steadily increasing reserve ratio. The situation gets even worse, if the  underlying non-monetary economy is considered, which in China is one of steadily increasing production. Since production increases cause deflation, as the existing money supply is used to trade and purchase more things, this suggests money and loan supply expansion, rather than the contraction that should have been triggered by the reserve changes.

All of which suggests something has gone very badly wrong indeed, in the Chinese banking system.

Monetary statistics are available on the People’s Bank of China’s web site for the period since 1999.  They are unfortunately not at the same level of detail as the USA, or indeed Iceland.  In particular since there is no break out of the M series components, it’s not possible to know how much debt instrument contamination is present in these series. There is a format change in 2005, and since the number’s don’t quite match up for the different series, the chart below is just for the last 5 years.

Chinese Money Supply

The data for the entire period, assuming that measurement has been reasonably consistent, shows that M1 has increased by approximately 4x in 10 years, about twice the quantitative  increase in the the Dollar and the Euro over the same period. It would also appear from the chart that the process has begun to accelerate.

The data shown is certainly consistent with reports of a credit fueled housing bubble, originating from uncontrolled lending within the banking sector, triggering asset inflation and commercial bank expansion of the money supply. What is perhaps most remarkable about the chart above, is the complete absence of any affects from the reserve increases that the Chinese central bank has been imposing to try and throttle the system back. It has been steadily ratcheting the reserve rate up for the last 3 years, it’s now at 17%, but there has been no corresponding contraction in the money supply. It’s probably the case that the expansion would have been even greater had they not increased the reserve requirements. But still. If economic theory was correct, what the chart should be showing is a massive contraction in the money supply – since changes in the reserve requirements theoretically  have a 10x multiplier effect on the money and loan supplies – and it’s plainly not.

Given the reports of a housing bubble, increasingly lowered lending standards, and CPI, it sounds like this is probably the Equity Capital exploit cutting loose again. Whether this  is because the banks are abusing inter-bank lending mechanisms as occurred in Iceland, or have just figured out they can stuff some form of debt into their equity capital holdings is very hard to say – there simply isn’t the kind of publicly available data to properly analyze the Chinese banking system. Given the repeated increases in the reserve ratio, it seems highly unlikely that any part of this is deliberate government policy though.

Which points to another aspect of this entire problem. Both the exploits discussed here, the Equity Capital exploit, and the Asset backed security loophole, are outlined for a system with full reserve requirements. De facto, the European and American banking systems don’t use reserve requirements for central bank control any more, and rely on market operations. Those don’t in fact work, but as China is currently demonstrating, neither do the textbook, central bank control mechanisms via the reserve requirements either.

The other interesting implication of this, particularly if the expansion continues to accelerate, is that if the Yuan were to be allowed to free float, it would probably depreciate against the Euro and the dollar, rather than appreciate as is being called for by American and European economists.

& won’t that be fun.

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Today, May 9th, is is 39 days since the Federal Reserve Banks of the United states of America stopped buying Mortgage Backed Securities at the end of March 2010 with TARP funds.

Strictly, as Calculated Risk and others have pointed out, actual purchases won’t finish until mid year, since some payments won’t be settled for a few weeks after purchase. But to all intents and purposes, after a year where credit issuance was held fairly constant courtesy of the US taxpayer, approximately $100 billion dollars of credit is now being removed from the US credit economy each and every month.

This is the backdrop to the Greek crisis. All the time Mortgage Backed Securities are being sold by the Banking system, credit is effectively unlimited. As soon as it stops or slows down though, then credit begins to dry up. The large majority of today’s debtors, be they Governments, companies, or private citizens, don’t plan on repaying their debt, but on continuously renewing it. This works as a strategy while the total quantity of available debt is continuously expanding, as it has been for the last 2 decades, it fails very quickly once any credit contraction sets in. So as the withdrawal of Federal Reserve support for the credit suppliers starts to impact, debt renewal becomes a problem again, and the axe falls on the biggest, weakest, debtors first – in this case Greece.

Not that Greece has ever been a poster child for fiscal responsibility, even before Goldman Sachs decided to help them out with their Euro application, but that brings up a well known problem in engineering, avoiding single points of failure.  Greece has a population of a little over 11 million, and is a member of a currency union of something over 300 million people. If the underlying system regulating that currency union is so fragile that it can be endangered by one, rather small country misbehaving itself, then it’s reasonable to argue that the problem isn’t Greece per se, it’s the system itself.

The singular failure that the creators of the Euro committed,was the failure to completely standardize banking practices across all countries. Although mechanisms exist to regulate the creation of money by banks and countries, there was no separate regulation of debt. Presumably the creators thought that debt was implicitly regulated by the money supply, but unfortunately the introduction of securitized loans had broken that assumption. So within the Euro zone there are countries whose banking systems have issued large amounts of Mortgage Backed Securities such as Belgium and Ireland, and others who haven’t. The increased amount of private, bank originated debt, now competes with Government debt for renewal, and either the amount of total credit available  spirals increasingly out of control, or somewhere, somebody’s debt isn’t renewed. Failure of  debt to be repaid in this system isn’t a matter of borrower whim, it’s a mathematical inevitability.

The US and European  economies, and through them the rest of a highly interlinked global financial system, are now caught in the red queen’s securitization trap. The financial system can’t keep issuing Mortgage Backed Securities without buyers, but it can’t stop either. Stopping triggers the same credit crisis, and the same Fisher debt deflation cascade that was avoided by creating the TARP fund purchase scheme. But continuing, or to be more accurate, restarting federal MBS purchases, simply continues to transfer fractional reserve originated debt from the Banks to the federal government, and from there to the taxpayer.

And while there is no systemic control on the total amount of debt that Banks can originate, the runaway global debt spiral can only continue.

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In memorium: Paraskeui Zoulia, Aggeliki Papathanasopoulou,  and Epameinondas Tsakalis.

Over in the land of the rising Volcano,  the first full report on a banking system collapse has just been released.

Interestingly, even with a report that goes into a fair amount of detail on the extraordinarily contrived web of lending and borrowing between a small circle of Icelandic  businessmen, the main Icelandic banks, and their overseas Creditors, there seems to have been relatively little attention paid to the problems in the underlying monetary mechanics that allowed it to happen. In particular, the  approximately ten times expansion in the money supply that accompanied the businessmen’s sleight of loan practices, appears to have been overlooked.

Money supply figures for Iceland are available from the Icelandic Central Bank. The following analysis is based on the “Monetary Aggregate” (Peningamagn og tengdir liðir) spreadsheet which is the only statistical series that appears to have been updated since the collapse in September 2008. It labels figures since Sept 2008 as ‘provisional’.

This series covers M1, M2 and M3 statistics up until 2009. As previously discussed, the M series monetary statistics are not an entirely pure measure of the total amount of money in any given monetary system, as they can include some forms of debt instruments. In the Icelandic case, two adjustments need to be made to get a quantitative estimate purely of Icelandic Krona: the removal of Money market accounts from M3 which eventually amount to about 10%, and also foreign currency accounts which are included as part of M2. Foreign currency savings accounts incidentally, as a percentage of krona denominated M2, vary between 15-43% of total M2 over this period – which suggests there are other potential stability issues, especially for small currencies, lurking in the background connected to the fractional reserve banking system.  Iceland’s banking and currency system has never been a haven of price stability.

The issue illustrated here is both scientifically fascinating, and utterly appalling in its eventual effects. Iceland deregulated its banking system in 2001. Two of the banks, Kaupthing [nee Búnaðarbanki] and Landesbanki, were sold to private businessmen, who in at least one case used money borrowed from one bank, to purchase shares in the other. Now let’s think about that for a moment, in the context of fractional reserve banking. You borrow money from one bank, and use it to buy control in another. How does that borrowed money get treated? If – and it seems to have been the case – that money is put into Equity Capital holdings at the second bank, then the total amount  the second bank  can lend, and thereby increase the overall money supply by, has just increased. As a result of a debt somewhere else in the banking system. It’s a feedback loop entirely within the commercial banking system, increasing the money and debt supply, independent of any control by the central bank.

The statistics are divided into two series, with considerably less detail available from the earlier period. We can see from the first series below, that quantitatively the currency was relatively stable up until 1997 when M3 began to diverge from the other measures. Unfortunately, there is no detail in the first series to suggest exactly why.

The second series is over a shorter time period, slightly over 6 years. Although the most dramatic behaviour of the currency is in 2007-8, what happens before then shouldn’t be overlooked. Between September and October 2003 for example, M1 and M2 double.

Iceland is a very small country, of approximately 300,000 people, which is why these effects are so obvious. M2 as shown here is the total amount of bank deposits in the country, aside from longer term time deposits which are counted as part of M3. Iceland, as elsewhere, stores its currency electronically – physical notes are printed as needed. But the size of the country, and the electronic nature of its storage, doesn’t change the quantitative nature of what happened in September 2003.

Looking rather closely at those two months, it looks like there was approximately an 100,000 M.Kr. increase in bank deposits. At a guess, and that’s all it is, the proximate cause of the increase was probably the first payments by the Icelandic banks of the money being lent for the Icelandic Power Companies then latest venture into Aluminium production, to the tune of  $20 million in locally sourced loans. This at some level just represents how fractional reserve banking works, and if nothing else, demonstrates the dangers of making big loans within a small currency base. In terms of nuts and bolts economics, the production of things, the support of livelihoods, and general improvements in living standards,  the loan certainly made sense, in increasing total electrical power available to the economy. It’s the monetary side effects, inflation as a result of a loan, and then presumably deflation as it’s repaid -  although it seems that’s an increasingly old fashioned concept these days  -  resulting purely from the mechanics of the underlying system where the loans are created, that don’t.

The money supply continues to increase over the next 3 years. It’s masked to some extent by the rather dramatic increases in 2007, but M1 doubles by the end of 2006, M2 increases by about 1.8 times, and M3 by a factor of 1.6. CPI Inflation rises from 2% in 2004, to 8% in 2006, and this causes other problems. Icelandic krona loans are index linked, something that was introduced to deal with a previous bout of severe inflation – in fact, i’d guarantee that historically Iceland got severe inflation anytime their power company decided to expand their electricity supply, and borrowed money to finance it. Fractional reserve banking is far from problem free even when it’s not being deliberately exploited.  The increase in the last decade though, had another cause.  In the background of the Icelandic economy, a small cabal of Icelandic businessmen had effectively turned their businesses, in conjunction with their relationships with the owner’s of the three main Icelandic banks, into what appears to have been a co-ordinated exploit of the Equity Capital loophole.

As a result of this, the Icelandic money supply measures double again in the year between January 2007 and September 2008, when the collapse of Lehman Brothers intervenes, and turns Iceland into, were anyone paying any attention to the actual systemic issues behind the credit crises of the early 21st century, the canary in the goldmine.

Doubling the money supply in slightly over a year, is by any standards extraordinary. As is having it increase by an order of magnitude in  7 years. It’s not Weimar levels of increase, but neither is it something that should just be occurring without any comment. It also makes any and all economic statistics for that period from Iceland highly suspect. Money is used as an economic measurement. If the quantity of money is changing, and this isn’t corrected for, it’s akin to trying to measure with an elastic band.

Quantitative changes in the ratio’s between currencies don’t necessarily play themselves out in immediate adjustments to currency trading, the relationships themselves seem to be quite sticky with sudden, abrupt changes. The Icelandic Krona’s exchange rate was relatively stable up until the crisis hit in 2008 in an 80-100 band. The high interest rates being paid because of central bank attempts to control the monetary expansion acted to attract foreign investment, and damp down the quantitative impacts of the increase.  In Iceland as elsewhere, a lot of the quantitative increase in the money supply is essentially getting trapped within the monetary system, which limits the impact on general inflation. Iceland did experience a severe housing bubble though, and there as elsewhere, the shells of uncompleted luxury condominium projects litter the countryside.  What is clear today, is that anybody holding Icelandic Krona at the 2008 rate of 90 to the Euro, has lost about half of their purchasing power with the current, capital control protected rate of 172.

The total quantity of Icelandic M1 and M2 in circulation over the 2003-2009 period in fact increased by about 10 times. Measurements of M2 can’t be compared exactly between countries, because they aren’t consistently defined, but driven by similar systemic factors, US M2 doubled in roughly the same time frame, and the Euro increases by about 50%. This would counterbalance the Icelandic increase to some extent, and any increased production would also have had a counterbalancing deflationary effect.  While it’s also certainly not the case that all currency is local, neither is all currency available for foreign currency trading.

Although the Icelandic Central Bank has been heavily and rightly criticised for its role in this, it has a  simple defense on the behaviour of the monetary mechanics. It followed the Economics textbook. It raised interest rates, to try and control the money supply expansion being created by a business culture that had devolved to simply making as many loans as possible, and extricating the proceeds abroad. All this achieved though, was to attract more foreign currency into the economy in pursuit of higher interest rates. Enabling increased expansion, and more loans, rather than the careful control and regulation suggested by Economics theory.  The Economics textbook is wrong at a very basic level, but since its false assumptions are so embedded and central to the discussion itself, it seems impossible to break its hold on the debate.

But perhaps we can start with a simple question.  In Economics’ textbooks, control of the money supply is consistently described as being solely the responsibility of the Central Bank, and for very good reason. Changes in the total supply of money effect everybody, double the money supply, halve the value of people’s savings. Weimar was just the extreme case.  So perhaps somebody could ask the Icelandic Central bank if they deliberately increased their money supply by ten times over the last 7 years?

And if they didn’t, who did?

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