Posted on 04/20/2003 5:21:01 PM PDT by sourcery
Does a Falling Money Stock Cause Economic Depression?
By Frank Shostak
[Posted April1 18, 2003]
Despite the aggressive lowering of the federal funds rate target from 6.5% in December, 2000 to the current level of 1.25%, U.S. economic activity remains subdued. Faced with a lackluster response to this aggressive monetary stance, it is tempting to draw parallels with the 1930's economic depression.
Most economists hold that such comparisons are not warranted. Following the writings of Milton Friedman, they are of the view that the policy makers of the Fed have learned the lesson of the Great Depression and know how to avoid a major economic slump.
In his writings Milton Friedman blamed central bank policies for causing the Great Depression. According to Friedman the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock (Milton and Rose Friedman's Free To Choose). In response to this failure, Friedman argues, money stock, M1, fell by 33% between late 1930 and early 1933 (see chart).
According to Friedman, as a result of the collapse in the money stock economic activity followed suit. Thus by July 1932 year-on-year industrial production fell by over 31% (see chart). Also, year-on-year the consumer price index (CPI) had plunged. By October 1932 the CPI fell by 10.7% (see chart).
However, a close examination of the historical data shows that contrary to Friedman the Fed was extremely loose and pumped reserves into the system in its attempt to revive the economy (on this see Murray Rothbard's America's Great Depression). The extent of monetary injections is depicted by changes in the Fed's holdings of U.S. government securities. Thus on January 1930 these holdings stood at $485 million. By December 1933 they had jumped to $2,432 million—an increase of 401% (see chart). Moreover, the average yearly rate of monetary injections by the Fed during this period stood at 98%.
Also, short-term interest rates fell from almost 4% at the beginning of 1930 to 0.9% by September 1931 (see chart). Another indication of a loose monetary stance on the part of the Fed was the widening in the differential between the yield on the 10-year T-Bond and the yield on the 90-day Bankers Acceptances. The differential rose from -0.51% in January 1930 to 2.37% by September 1931 (see chart).
The sharp fall in the money stock between 1930 to 1933, contrary to Friedman, is not indicative of the Federal Reserve's failure to pump money. Instead it is indicative of a shrinking base of investable capital brought about by the previous loose monetary policies of the central bank. Thus the yield spread increased from -0.9% in early 1920 to 1.9% by the end of 1925 (an upward sloping yield curve indicates loose monetary stance). The reversal of the stance by the Fed from 1926 to 1929 burst the monetary bubble (see chart).
In addition to this, at some stages monetary injections were massive. For instance, the yearly rate of growth of government securities holdings by the Fed jumped from 19.7% in April 1924 to 608% by November 1924. Then from 0.3% in July 1927 the yearly rate of growth accelerated to 92% by November 1927. Needless to say that such massive monetary pumping amounted to a massive exchange of nothing for something and to a severe depletion of the pool of real funding, that is, the essential source of current and future capital needed to sustain growth.
As long as the pool of real funding is expanding and banks are eager to expand credit (credit out of "thin air") various nonproductive activities continue to prosper. Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real funding is set in motion. Consequently, the performance of various activities starts to deteriorate and banks' bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock.
The fall in the money stock begins to further undermine various nonproductive activities, i.e. an economic depression emerges. In this regard after growing by 2.7% year-on-year in January 1930 bank loans had fallen by a massive 29% by March 1933 (see chart).
How is it possible that lenders can generate credit out "of thin air" which in turn can lead to the disappearance of money? Now, when loaned money is fully backed up by savings, on the day of the loan's maturity it is returned to the original lender. Thus, Bob—the borrower of $100—will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe, the lender, his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.
In contrast, when credit is created out of "thin air" and returned on the maturity day to the bank this amounts to a withdrawal of money from the economy, i.e, to a decline in the money stock. The reason for this is because there wasn't any original saver/lender, since this credit was created out of "thin air."
It follows then that the sole cause behind the wide swings in the stock of money is the existence of fractional reserve banking, which gives rise to unbacked-by-savings credit. (In the Mystery of Banking Murray Rothbard showed that it is the existence of the central bank that enables fractional reserve banking to thrive).
Observe that economic depressions are not caused by the collapse in the money stock (as suggested by Milton Friedman), but come in response to a shrinking pool of real funding on account of previous of loose money. Consequently, even if the central bank were to be successful in preventing the fall of the money stock, this would not be able to prevent a depression if the pool of real funding is declining. Also, even if loose monetary polices were to succeed in lifting prices and inflationary expectations (as suggested by Paul Krugman), this would not revive the economy as long as real funding is declining.
Again, note that contrary to popular thinking, depressions are not caused by tight monetary policies, but are rather the result of previous loose monetary policies. On the contrary, a tighter monetary stance arrests the depletion of the pool of real funding and thereby lays the foundations for economic recovery. Furthermore, the tighter stance reveals the damage that was done to the capital structure by previous monetary policies.
Have we learned the lesson of the Great Depression?
Do central banks have all the necessary tools to prevent a severe economic slump similar to the one that occurred in the 1930's? Most economists are adamant that modern central banks know how to counter the menace of a severe recession.
But if this is the case why has the central bank of Japan failed so far in reviving the Japanese economy? The Bank of Japan (BOJ) has used all the known tricks as far as monetary pumping is concerned. Thus interest rates were lowered to almost zero (see chart) while BOJ monetary pumping as depicted by its holdings of government securities increased by 323% between January 1990 and March 2003 (see chart).
It is likewise in the U.S. For over two years the Fed has been aggressively lowering interest rates and yet economic activity remains subdued (see chart). For instance, in relation to its long-term trend industrial production remains in free fall (see chart). The Fed's holdings of government securities have increased by 189% between 1990 Q1 and 2002 Q4. The yearly rate of growth of these holdings jumped to 14.1% in Q4 2002 from 9.8% in Q1 (see chart).
Moreover, a steep fall in the personal income to personal outlays ratio indicates that the pool of real funding is under pressure (see chart). Note that during the 1930's the fall in this ratio wasn't as steep as now (see chart).
We suspect that there is a strong likelihood that if the economy does not rebound soon, the Fed will lower interest rates further and will intensify its monetary pumping. This, however, will only further prolong the economic misery.
Richard W.
You cant call statements like that "denial" when empirically, they are no false statements. They are predictions.
It is quite likely that, indeed the stock market bottom of late 2002 is behind us for a long time, perhaps forever. Even 9000 is a fairly decent valuation on the dow, wich earnings-ratios well above interest rate levels for may solid companies and with earnings able to accelerate in future years.
"So my point is, ok, what does it take to make the denial analysis work--what makes the stock market go up; keep the real estate bubble from collapsing; and see a general economic recovery? What would you expect to see if the denial argument was going to be correct? And one of the things you would see very early is increasing tax revenues at the state, local, and federal income tax levels. "
Tax revenues are a trailing indicator ... the *LEADING* indicators would be: Investment levels (so the stock market level is a 'temperature reading' on that, so is VC activity); margin improvement (so a tax cut is a *leading indicator* of improved conditions) and margin levels at businesses (ie profitablility, often businesses cut spending until the margins are better, then they start hiring); unit demand (ignore the $ numbers, what about unit demand?).
Some of those numbers are turning around
"Fact we are not seeing those revenues is the most important indicator that those in denial will not be correct." Wrong. as a trailing indicator, tax revenues are only telling you how bad 2001 and 2002 were. you will have to wait for 2005 to find out how 2003 and 2004 stack up. Far better to use *leading* indicators, not trailing ones.
"The country is still generally in denial--"the stock market bottom is in"; "real estate has real value and can't go down"; "recovery in the second half"; denial that the real problem is an imbeded deflation resulting from excess levels of debt."
"You cant [sic] call statements like that "denial" when empirically, they are no [sic] false statements. They are predictions."
In context, the point of that text was not predictive at all--rather to suggest that the investor and personal use real estate owner does not recognize the risk that the "real values" analysis does not protect real estate pricing at current levels nor recognize the fundamental economic proposition that underlies the deflationary trend in pricing of all other durable goods.
We have deflation which is caused by the commitment of an excessive share of periodic liquidity flows to payment of existing debt, precluding new financial commitments in current transactions.
Consumers and stock market investors continue to expect a "recovery in the second half"--my observation was not predictive that one would not occur but rather an observation of the general state of denial of the possibility that it would not.
Under circumstances where there are no facts that imply a second half recovery and many real estate statistics in most real estate markets have topped, I think the characterization as a "state of denial" is reasonable.
Predictive? In fact, there won't be any second half recovery of any character. And the real estate bubble is about to pop, even in California.
" It is quite likely that, indeed the stock market bottom of late 2002 is behind us for a long time, perhaps forever. Even 9000 is a fairly decent valuation on the dow . . . . "
May not have noticed that the Dow is not above 9000 any more. More predictive? I don't know what you would characterize as a "long time"--in the case at hand, sixty days may not be long enough. My own fearless forecast--new lows will be seen well before Thanksgiving.
I don't see tax revenues as leading indicators. However as a guage of current conditions, tax revenues in various categories will give you some idea of what is happening. Given the large share of the overall economy represented by government spending (other than federal), the curtailment resulting from legal prohibitions on deficit spending is signficant as an indicator of future local government activity.
Margins are not better. Direct labor productivity has increased some because a smaller work force is putting out comparable levels of production but prices are going down fast enough that gross margins are also down. Unit demand at lower prices is not positive at all--I would love to have a new Porsche if I could get one for $10,000; I just can't afford one at $108,000.
My real point was not intended so much as predictive, although I have now reached the point where I am prepared to make some predictions but rather to ask the rhetorical question, what conditions would you have to see to believe that in fact there is going to be an economic recovery in the second half of 2003 (or are you giving up on 03 and now looking for 04), and what has to happen to hold real estate prices up.
There is some finite limit on how much current liquidity flow can be committed to debt payment. That limit is not subject to arithmetic calculation. But there is a basic level of minimal economic commitment, food, clothes, gasoline, etc. that will be met before debt service. At the point liquidity flow is fully committed, consumers and real estate buyer will not commit to additional debt to buy the next house or car.
Further, in the real estate market, liquidity flow requirements are going up independent of prices--insurance prices are up; real property taxes are up; utility bills are up significantly; all in a market where jobs are disappearing and incomes are threatened. Very difficult for me to see how prices can remain at current levels.
The issue is, what do you have to believe is happening to believe that stocks will go up; the real estate bubble won't pop; and that there will be a "recovery in the second half (of 2003 that is; or even in the second half of the first decade of the twenty-first century)".
I happen to be in the tax business so I can tell you from direct personal first hand experience that nothing in the Federal tax legislation is any kind of positive indicator of future economic activity--overall tax burden is up not down.
Margins are not improving and neither are profits. New cars are accumulating in every dealer storage facility. The available evidence is not for economic improvement at all--the economy is poised (as is the real estate market and the stock market) at the edge of the cliff.
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