Is the money supply contracting, or expanding?

March 17, 2008 11:39 AM

FinanceFilter: Is the money supply contracting, or expanding, after netting all the Fed action, bank closures, mortgage defaults, etc? The dollar falling seems to signal a net increase of money supply, but this is inconsistent with the thesis of a credit or liquidity crunch. If the money supply is growing at a slower rate due to tighter lending practices, shouldn't the dollar be rising, even in the face of Fed-rate cutting? Do we know the net expansion or contraction of the money supply due to the combination of rate cuts and mortgage defaults?

I understand that Fed rate cuts have the effect of increasing the money supply. I understand that lower rates lower the value of the dollar, because it puts more dollars into existence tomorrow than existed today, i.e. given a constant demand, the increase of supply lowers the price.

The housing boom that peaked in 2005 involved people borrowing money to buy houses that it turns out they could not afford. This borrowing of money expanded the money supply back then. I understand that as people defaulted on their mortgages, the money supply didn't recontract (as the money that was created was spent on the house and put into the system). But as the dominoes fell, and first the mortgage companies, then regional and national banks, then CDO-holding brokerages and hedge funds were hit and stopped lending out, there should have been an attendant lack of money (from mtge payments, etc.) to lend out to future borrowers. So the money supply in the future should be smaller than we expected it to be last year. Shouldn't this cause the dollar to rise (or fall slower)?

In other words, given the 2005-2006 money supply and interest rates, the dollar had a price. But given future lending trends, the money supply growth should be slower, which other things being equal should increase the value of the dollar, right?

Is it possible that the Fed knows quantitatively the extent of the default/CDO worthlessness problem (and future money supply contraction), and isn't revealing publicly what it knows? If so, wouldn't this mean that when the Fed cuts rates, we don't hear about the amount of the money supply contraction that the Fed's inflationary move is supposed to offset, we only hear about the inflationary part of it and conclude therefrom that the money supply is growing too fast?

posted by Pastabagel to work & money (8 comments total)

It appears to be increasing, if you believe this site's take on the data. The Fed stopped releasing M3 a while back, so they recreate it as best they can. The Fed data agrees. I am not an economist, but isn't part of the question how fast it is expanding as well?
posted by procrastination at 12:36 PM on March 17

Oops, sorry. I hope what I posted helps, but it is far from a complete answer.
posted by procrastination at 12:37 PM on March 17

When the Fed lowers short term interest rates, it increases the spread between short and long term rates. This increases the propensity of banks to make loans because they borrow short term and lend long term -- that is how they make their profit. The banks making more loans effectively increases the money supply.

But when the Fed pushes short term rates too low, then the dollar declines because the dollar competes with other currencies for savings. Why would foreigners keep their money in dollars that earn only 3% when they can keep it in euros that earn 3.5% or 4%? The problem becomes more acute when the Fed pushes the rates to near or below inflation. In that case you lose money by keep it in dollars.

Except in this case, because of the liquidity crunch, lower rates are not stimulating loans. Banks are still afraid to lend. But it has lowered the price of the dollar to foreigners.

The decline in the dollar is really the only thing in the economy that is going well now. A declining dollar makes U.S. products cheaper, increases exports, creates more domestic jobs and lowers the trade deficit.

The liquidity crunch is a domestic issue. The falling dollar is a foreign issue.
posted by JackFlash at 3:12 PM on March 17

You write, "The dollar falling seems to signal a net increase of money supply." I'm not an economist, but if you're talking about foreign exchange when you write "the value of the dollar," I don't think this follows. As investments in dollars become less attractive (falling interest rates along with increased risk), the demand for dollars is decreasing, driving down the price against other currencies. That's independent of whether there is deflation on the domestic market (and in the housing sector, we certainly have seen deflation, says the man who bought a house in summer 2005...).
posted by brianogilvie at 3:16 PM on March 17

Oops, forgot to preview, and Jack Flash got there first (and gave a more thorough answer).
posted by brianogilvie at 3:17 PM on March 17

What we want to know is the amount of liquidity in the system, how much stuff people can buy. Money supply has never been a perfect measure of that concept but it has been getting worse over time leading, ultimately, to the fed deciding to take it so seriously anymore. (note that the fed still calculates M1 and M2, but suspended Mx where x>2. Eat your spinach or I'll explain the whole thing.)

So what do we do? There is not a great answer. Some private forecasters try to construct indexes based on things like, the money supply, the level of interest rates, the stock market, commodity prices, currency prices etc. If you want to know more you can try googling Monetary Conditions Index. By the measures with which I am familiar, conditions are somewhat easier than over the summer, but not as much as the drastic cuts in short term interest rates might lead you to believe.
posted by shothotbot at 4:51 PM on March 17

I feel like defaults, in general, are a hugely deflationary influence on the money supply, especially when they cascade and result in the failures of multiple institutions (which are purchased for pennies per dollar of "book" value.)

I wrote about this in a blog I used for a while on the Motley Fool CAPS website. I got torn a new one by the couple of people who responded; they thought I was way off base.

My feeling was then, and continues to be, that "Fedspeak" is a lot of smoke and mirrors and that all this talk of inflationary risks was and continues to be pure and simple B.S.

But I think it's really hard to access good data to get at this thesis. Trends in M2, which is publically available, and M3, which is third-party publically reconstructed, start to edify but are far from conclusive because of the way they're cooked. I also know that you, Pastabagel, have disagreed with nearly everything I've ever said with regard to economics here on MeFi, so I'd encourage you to take this comment with the same grain of salt that you took all the other ones :)
posted by ikkyu2 at 8:38 PM on March 17

Stavros posted this link today which seems to indicate contraction.
My own limited view of economics says the massive rate cuts should be expanding supply, but if nobody is lending, they do nothing, and the defaults ikkyu2 alludes to indicate contraction.
Its certainly an interesting time (for chinese proverb values of interesting).
On the bright side, there are no doubt battalions of theoretical economists gathering data they never thought they would see, and theories are being ripped up all over the place.
I haven't read anything which gives me any insight to where this is going. I do tend to think that the markets not getting hammered on this level of bad news, due presumably to the promise of rate cuts is, well, out of character.
I feel (because I can't find the right angle to think it through) that this level of bad news can't be easily countered by rate cuts. Like Malor, and I think Mutant, have said before, there is a reckoning due that to my mind is still coming.
Whether it will be financially painful (Mutant) or hoard the guns and ammo (Malor) still remains to be seen. I am surprised it is taking a long time, usually a twitch is amplified in the markets, but the Fed rate attack seems to be pacifying the real reaction.
posted by bystander at 5:24 AM on March 18