Posted on January 16, 2021 by Florian Buschek
… is the name of a recent IMF working paper by Peter Stella, Manmohan Singh and Apoorv Bhargava. The title is inspired by a 1995 paper “Some Monetary Facts” against which they argue amongst other things.
As the following charts show we have recently seen an explosion in both base money and M2 in the United States, Europe and Japan.
So based on the old monetarist notion expressed by Milton Friedman that “Inflation is always and everywhere a monetary phenomenon”, people think this expansion of monetary aggregates surely must lead to inflation. There has been historically a correlation between inflation and growth in the monetary aggregates:
And here is where the above paper comes into play. The authors demonstrate that this correlation was not causation at all. Specifically the only variables that central banks can control, namely currency in circulation (printed dollar bills) and reserves (deposits of banks at the central bank), have in reality a very weak correlation to inflation or even a negative one for the OECD (see tables below).
Specifically with regards to Japan, which is the example with the most data since QE was started there decades ago, most of the correlations are either just above 0 or negative. So growth in the monetary aggregates was disinflationary.
So how can this be and what does it mean? For the first question, the paper also presents some answers. Generally banks are not reserve constrained. They make loans based on their balance sheet, equity, regulatory aspects (Basel III, capital adequacy ratios, liquidity coverage ratios, etc etc) attractiveness of the loan and funding costs. This has nothing to do with reserves, to the contrary, it is literally a central bank’s job to provide enough reserves so that payments can be cleared. Japan again:
No correlation whatsoever between reserve growth and loan growth. Loans create deposits so the very fact that a bank makes a loan increases its deposits. When those deposits leave (to make payment to another bank for example) the bank needs to transfer reserves at the central bank to the receiving bank. But those can be borrowed in the intra banking system or from the central bank. There is almost never a reserve constraint.
The question then is, if there is more money around, why is inflation not picking up and its velocity going down. The paper questions the very framework of money velocity. What does it even mean in the sense of transactions? Usually it is expressed as MV=PQ or money times velocity equals real GDP times price level. But in fact there are many more payments involved in intermediate steps. A few facts from the paper:
At this point it is worth noting that the ratio of national income in the United States to currency, which is primarily used for payments of final goods and services was about 18 while the ratio of U.S. interbank payments to bank reserves (exclusively used in interbank payments) was 77,874 in 2007
Payments in the main interbank wholesale markets in the U.S., UK, and Eurozone (Fedwire, CHIPS, CHAPS, and TARGET2) are approximately 50X payments made for final goods and services in those economies
The sum of payments effected in 2017 through the two U.S. large value transfer systems alone (Fedwire and CHIPS), was 1 quadrillion 133 trillion dollars compared with U.S. GDP that same year of US$19.5 trillion
The table shows how the deposit turnover (and many other such ratios) went through the roof, mainly because of innovations in payment systems. Taken with the facts above the notion that money velocity is stable is nonsense. It is even futile to define one velocity. The same holds for reserves and currency:
Turning to wholesale payments, in 1947, US$ 316 billion in payments were made through Fedwire during which time the stock of reserves held at the FRBs was US$ 17.9 billion yielding an annual turnover of 58. In 2007, US$ 670.7 trillion in payments were made through Fedwire while reserves amounted to US$ 9.0 billion yielding an annual turnover of 77,784. Put differently, payments increased by 212,115 percent while reserves fell by 50 percent. There is no significant positive correlation between U.S. total reserve balances and any economic variable.
By 2007, C represented about 98 percent of M0 although we estimate it at most was involved in US$ 2 trillion in payments that year while payments made through the two U.S. LVPS (Large Value Payments System), Chips and Fedwire, during the same year amounted to US$ 1 quadrillion 156 trillion. 26 Given a 2007 average stock of U.S. currency outstanding of US$ 811.7 billion and assuming 50 percent is held outside the United States, this gives an annual turnover ratio of currency of about 5. The average 2007 stock of reserves was US$ 8.6 billion giving a gross LVPS turnover ratio of 134,453 per year.
Currency C and reserves are the only exogenous variables while the other parts of the monetary aggregates are endogenous. Exogenous means the central bank can at will change those any time any way it likes. Endogenous means the variables change withing and caused by the system, for example deposits grow with more credit creation. But a central bank doesn’t really change currency in circulation for policy goals. The Fed does not literally print more dollar bills to to create more inflation or the other way round. It aims to provide just as many as are demanded. In March 2020 there was a shortage since the paper was stuck as the payment flows in cash seized up due to the lock downs. So central banks provided as much physical currency as they could.
As mentioned above, reserves are provided as needed for clearing payments. They are also a byproduct of large scale asset purchases such as QE, but by themselves do not cause loan growth or inflation. It is just an asset swap, treasuries versus reserves. The former can be held by anybody and are of longer duration, the latter only by banks and have basically 0 duration.
So growth in money aggregates alone is no reason to worry about inflation. That does not mean inflation cannot happen, especially when the government runs massive deficits and plans to spend trillions of dollars in stimulus and infrastructure spending. In that case it is conceivable that demand will outstrip supply or productive capacity and prices will rise moderately. It should be noted however that if that spending increases potential GDP and productivity (through better infrastructure for example) then the additional debt is self liquidating and sustainable because it will cause GDP and tax receipts to grow faster than in the counterfactual where the money has not been spent.
An important point of the paper is that it is almost irrelevant how the debt is funded, via bond issuance or credit from the banking system (reserve growth as the Fed buys bonds from the banks) or that bonds are even superior
The recent increase in CBDL has not been in the form of “helicopter money” for which there is no purpose other than to spend, rather CBDL has merely substituted for financial assets already in the hands of the public. Increases in CBDL that have resulted from the central
bank purchases of domestic government debt have merely changed the composition of sovereign domestic debt and are essentially a debt management operation, a swap of treasury debt for less efficient central bank liabilities that may only be held by domestic banks whereas treasury securities may be held by any economic entity at home or abroad, and (iii) the notion that “helicopter money” or permanent monetary finance is superior, less expensive, or more efficient that bond finance rests on fragile and fallacious foundations. The current negative interest rates on most developed country medium term debt suggests that it is a superior way to finance temporary surges in expenditure such as those related to COVID-19. Moreover, prospering emerging market countries with ample experience with monetary finance in the 1980s and 1990s—Chile, Brazil, Peru, Mexico and Israel for example—have conspicuously steered clear of reliance on monetary finance during the current unprecedented crisis owing to their having established vibrant and well-functioning domestic government debt markets
This is a pushback against the idea that deficits don’t matter because the central bank can buy the debt or that the latter is even desirable. In fact once the central bank wants to raise rates, it has to do so by paying interest on reserves (IOR). This is just as a cost to the taxpayer as is interest on treasuries (the Fed pays the interest but that lowers its own income and therefore less of that income goes to treasury). The difference is that rising rates effect IOR immediately while it only affects interest coupons at newly issued bonds, not the outstanding ones. Put differently, reserves have variable rates while bonds have fixed rates. Additionally if rates rise the bonds held by the Fed will depreciate and the Fed could take losses if it bought them above par or wants to sell them below its purchase price. While a central bank’s equity does not really matter (it can operate with negative equity just as well) it is possible that some laws require recapitalization at the taxpayer’s cost. At the very least it is not a nice picture.
Moreover the fact that financing costs for ultra long bonds like 30 years or even century bonds are miniscule should make it obvious that locking in these rates for a very long time is beneficial. If the rate is 1% for 10 years, the money needs to have only a return of 1% or more to finance itself. That ought to be doable. This return has to be seen together with externalities of course. The government investment might lead to increased GDP growth and tax receipts but also to benefits accruing to citizens like less commute time in case of infrastructure. Or in case of green investments, better air and thus better health and reduced healthcare costs.
The bottom line is don’t worry about scary M0, M1 or M2 charts. Instead worry about how the money is spent by the government, meaning hopefully for productive investments like infrastructure, research or means to increase productivity, efficiency and wellbeing. Worry also about income and wealth inequality because (apart from ethical reasons) the higher inequality, the more money is saved in form of financial and nonproductive assets and not spent so that GDP growth is lower, which increases the real debt burden