For months now, the biggest economic question in Washington and even the world has been, when will the U.S. Federal Reserve raise interest rates. After all, since 2008, the Fed has more than doubled M1 (the narrowest and most widely followed measure of money in the economy). If ultra-easy money policies aren’t reversed, won’t inflation take off any day now?
Except after seven years, it hasn’t. Just the opposite.
Since 2011 and particularly this year, commodity prices have dropped (http://bit.ly/1Se9fpN). Not just gas and food prices either. According to recent reports, venerable retailer Macy’s (while growing as a proportion of mid-to-upper price level department store sales) has lost market share to discount retailers across the board.
And, of course, as everyone knows, median family income has declined since President Obama took office.
Add all this up and isn’t it clear? Inflation is not our issue. The United States is in its first sustained DEflation since the Great Depression.
But how can that be?
Didn’t Milton Friedman settle the inflation-deflation issue once and for all? In 1970 he wrote, “Inflation is everywhere and always a monetary phenomenon.” Particularly after the early 1980s when then-Fed-chair Paul Volker stopped U.S. inflation with a brake on money supply growth, Friedman’s rule has ranked as received wisdom.
How about this answer: The fault is not in Friedman’s rule; it is in how we apply his rule.
Here is what I mean:
From the 1980s on, the movement of U.S. lending out of banks and into the markets effectively resulted in new sources of money that the government was not measuring in its various “M” metrics. Banks themselves began to depend heavily on those non-bank markets, too, in particular by packaging the mortgages they were writing into what appeared to be highly diversified instruments that they sold to investors.
As a result of both the freeze of the non-bank lending markets in 2009 and the impact that the freeze had on formal banking, the financial crisis made a great deal of the U.S. money supply vanish, at least temporarily.
Then, thanks to regulation (especially Dodd-Frank and the tightening of international bank reserve standards coming out of the 2010-11 Basel III accord) after the crisis eased the money supply failed return to where long-term trends would have put it.
Of Basel and Dodd-Frank, Johns Hopkins-Cato Institute economist Steve Hanke wrote recently (http://www.omfif.org/media/1122795/the-omfif-july-august-bulletin.pdf , see page 23), “These new regulations have [left] bank money [i.e. non-high powered money, which make up 80% of the total U.S. money supply] struggling under a very tight monetary policy regime since the financial crisis…. This has forced the Fed to keep state money [i.e. high-powered money] on a very loose leash…. The net result… has been… a continued growth recession, absent inflation, in the U.S.”
So, yes, M1 has shot up since September 2008.
But a broader aggregate, M4 (which includes all bank deposits), has grown slowly, very slowly (http://bit.ly/1HhM8KH), and that stagnation tells our monetary story.
Despite the run-up in M1, not once since the financial crisis began has money creation has been too robust. But there is more to the slow growth-deflation story than monetary aggregates alone.
In addition, regulators have 1) demanded that banks expand their overall reserves, effectively mandating (via both Basel and Dodd-Frank) that banks hold more government instruments, which are counted as part of bank reserves, and 2) put banks under stricter safety scoring even as they demanded that banks resume subprime (or at least semi-subprime) mortgage lending. The result has effectively been politically driven capital allocation.
Government debt, high quality corporate debt, and mortgages have been favored — highly rated corporate debt all the more so to balance off the impact on bank scores of low quality but mandated mortgages.
Squeezed have been small and medium sized businesses, the same entities that higher marginal tax rates, the piling on of regulation in so many other areas, and vulnerability to the erosion of the rule of law have hit hardest.
As the Wall Street Journal reported recently, “The U.S. is now 12th in the world in new business creation… and significantly fewer new businesses are starting up today than in the 1970s, when the U.S. population was much larger. Loans to large companies are up, but lending to small businesses has contracted.”
Meanwhile, of course, from the mid-1970s until, it appears, sometime in the last seven years, small and medium companies were also the nation’s principle source of new jobs, jobs that created an overall demand for labor that pushed up incomes in the very parts of the workforce that is seeing its incomes fall now.
So how are we misreading Friedman?
The Nobel Prize winner assumed that every dollar the government created (roughly what he call “high-powered money”) would create in the form of loans a more or less constant number of bank-created dollars and that those loans would be allocated by market force not government mandate. Thanks to a wide range of regulations but most directly Dodd-Frank and the Basel Accords, those assumptions no longer hold.
Loans are scarcer and mandates have pushed the allocation of money to sectors that produce fewer jobs, less new technology, and less economic growth.
Reporting in the IMF Finance Ministers’ October meeting in Lima, the Financial Times wrote recently, “The IMF has delivered a series of reports full of gloom. There are grim financial risks hanging over the global economy. Such a downbeat view has been borne out by data coming out of the U.S. and Germany in recent weeks.”