Friday, September 11, 2009

What would Friedman say?

I have argued that the ECB didn't do enough to support the Eurozone (a few examples here, here, here) - further monetary policy was warranted. As the financial crisis abates and key economies mend, I want to revisit this issue just one more time. Now, it seems that the Fed could beef up its lending, as the money supply growth rate turns red.

To be fair, the ECB's balance sheet is large relative to the size of the Eurozone, but nevertheless, its monetary support has relatively small compared to the BoE and the Fed (they did provide credit support by purchasing covered bonds, but nothing of the quantitative easing flare like in the US and the UK).

The chart illustrates the size of the central bank balance sheet as a % of GDP for the Federal Reserve (Fed), the Bank of England (BoE), and the European Central Bank (ECB) as of September 2, 2009. Relative to the size of its economy, the Fed and the BoE engaged in large expansionary policies by growing their balance sheets in order to stablilize the financial system. On the other hand, the ECB, while dropping its rate to 1% and supporting the credit system through its covered bond purchase program, did not.

However, credit is still quite restricted (see previous post on the US credit crunch) - so much so that the 3-month annualized growth rate of the money supply - M4 in the UK, M3 in the Eurozone, and M2 in the US - is low, even negative.

I wonder what Friedman would say....more deflation is on the way? It's way too early to turn off the money valve - the lack of credit flow precludes much money growth right now. Just look at how weak was the consumer credit report.

Rebecca Wilder


  1. That's interesting. Channelling Friedman and his general distrust of government intervention versus his advocacy in monetary policy as the clear Depression killer, I really wonder what he would think.

    Would he see this as a repudiation of his advocating monetary interventions for stabilization (blaming early, relatively smaller, interventions for contributing to worse and worse downturns)? Or would he keep advocating expanded monetary policies? Would he blame the fiscal stimulus for mucking up interest rate and quantitative easing efforts? Would he call for larger QE?

    I'm expecting conditions to not only worsen, but at this point I think monetary and fiscal policies are both contributory- stimulating as you are going bankrupt just makes you go bankrupt faster. At this point, I think everyone has painted themselves into a corner. I just wonder if anyone else is going to draw the same conclusions.

  2. "As [the financial crisis abates and] key economies mend"

    Rebecca - a tad prematurely presumptuous perhaps?

  3. Business Week put it this way from Bloomberg:

    The Reuters/University of Michigan preliminary index of consumer sentiment rose to 70.2 in September from 65.7 in August. Economists had expected a smaller rise, to 67.5. Analysts opined that the bigger jump resulted from job losses slowing down and the economy showing many signs of turning around.

  4. Rebecca,

    I think most market commentators, and even many economists, characterize U.S. monetary policy as "expansionary" or "stimulative". The charts show this is not the case, as does the fact that the Fed's balance sheet expansion has merely returned, dollar-for-dollar, into Excess Reserves. I wonder, what are the implications of the Fed creating, even inadvertently, such a huge mis-perception?

    One potential answer is, the Fed will be under intense political pressure should we fall into deflation, because it will be argued that they did not do enough.

    The Fed, to be clear, should have said, "we are not stimulating Aggregate Demand, just the financial system, and we think that's enough".

  5. Friedman espoused income velocity. As such, Friedman is "on a ship without a rudder". Economists are like sheep. There is a gospel, and the gospel is is inviolate & sacrosanct.

  6. Hi you all,

    Thank you for the comments! I am in Newport, RI right now, having to be quite sneaky to get in and check the blog (my husband prohibited blogging over the weekend). As such, this will be short.

    Irrational, I like your take on this - I imagine from the point of view that you describe, Friedman is likely turning in his grave right now.

    And Stevie b. - I understand your skepticism, but I do feel that key economies are in fact mending. I give the double dip scenario just a 10% probability.

    James - thank you for the update...I was actually thinking about this report. Will look into it when I get back to the "real world". I wonder what the home-buying survey questions revealed.

    David - I completely agree. The Fed is supporting the financial could be doing more to "stimulate" the economy - even in a liquidity trap. Scott Sumner calls for the Fed to charge a fee for those banks holding high levels of excess reserves. In effect, it would be the opposite of its current IOR policy.

    Thanks, Rebecca

  7. Rebecca "I give the double dip scenario just a 10% probability."

    Wow! Appreciate your clarity on this and it's cerainly refreshing food for thought, especially as I love being a contrarian (at the right moment naturally...), and clearly (to me) you are in a small yet perhaps predictably (as the market rallies) growing minority.

  8. I ran across this today, and thought Anna Schwartz probably is close to what I imagine Friedman would say:

  9. For those who need a reminder, the equation of exchange is an algebraic way of stating a truism; that the product of the unit prices, and quantities of goods and services exchanged, is equal (for the same time period), to the product of the volume, and velocity of money. Velocity is the rate of speed at which money is being spent.

    It is self-evident from the equation that an increase in the volume, and or velocity of money, will cause a rise in unit prices, if the volume of transactions increases less, and vice versa.

    This is merely algebra, but it has an important economic application.

    The economic question arises from differing opinions as to whether the monetary authorities (The Board of Governors of the Federal Reserve System and the Federal Open Market Committee) can control both the volume and velocity of money, and the effects of changes to the volume and velocity of money, in production and employment, as well as on prices:

    In the past, all the demand drafts (our means-of-payment money times its rate of turnover), that were drawn on all money creating depository instutions, once cleared (reported), through demand deposits – except those drawn on Mutual Savings Banks, interbank, and the U.S. government (the G.6 release).

    The Sept. 1981 peak in AAA yields was 1/10 of a basis point off the 1977 "base period". That is no happenstance.

  10. See: Milton Friedman’s income velocity (WSJ Sept 1, 1983).

    See: 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics).

    This study was withheld from the public until it was declassified in March 1983. I.e., it was declassified after legislation rendered it obsolete, e.g., the DICMCA of March 31st 1980 & the Garn-St. Germain Act of 1982