The Continuing Significance of Money Supply
In a world filled with digital transactions and evolving financial systems, the question of whether money still matters has become more prominent than ever. Despite contracting money supply measures since mid-2022, total spending continues to advance at a relatively strong pace, creating an apparent disconnect. To understand the significance of money in today’s economy, we must consider historical evidence, alternative money measures, and the impact of Federal Reserve policies.
In their book, “A Monetary History of the United States to 1960,” Milton Friedman and Anna Schwartz provide extensive evidence of how monetary policies have historically destabilized the economy. They advocate for cautious and stable policies to promote economic stability. While Friedman’s preferred money measure, M2 (currency plus most bank deposits), has become less reliable as a guide to monetary policy, alternative money measures show that money still plays a powerful role in driving the economy.
The relationship between M2 and the economy remained close from the 1960s through the 1980s. However, starting in the 1990s, this relationship became less apparent. One significant failure of M2 occurred in the lead-up to the financial crisis of 2008–09. A rapid increase in M2 misled policymakers into believing that the money supply was increasing, when in reality, the Federal Reserve was aggressively selling securities and draining money from the economy. This resulted in a sharp reduction in money and created the worst liquidity crisis since the 1930s.
Despite its past failures, M2 experienced explosive growth beginning in late 2020, correctly anticipating the subsequent surge in spending and inflation. However, it is important to note that there is no ideal measure of money for all times and all places. The concept of money is not clearly defined, and attempts to quantify and define it are only useful if they relate to what happens in the economy.
To explore alternative money measures, let’s consider high-powered money. High-powered money consists of currency in circulation, securities held by the Federal Reserve, and bank reserves held at the Federal Reserve. It represents the primary source for the nation’s money supply and is directly controlled by the monetary authorities.
The relationship between high-powered money and the economy was fairly close until the early 1990s, similar to M2. However, after the 1990s, the relationship became looser. Despite this, changes in high-powered money have a better record of anticipating major changes in the economy compared to M2 or any other alternative money measure.
One potential explanation for the decreasing responsiveness of the economy to changes in money since 1990 is the progressively more erratic policy of the Federal Reserve regarding its purchases and sales of securities. The volatility of these actions reached new highs in 2008 and again after 2020, leading to a less sensitive economy.
The impact of the Federal Reserve’s policy on the transmission mechanism between money and the economy has become evident. As the Fed’s purchases and sales of securities have become more erratic, the economy has become less sensitive to changes in money. The greater stability of the economy, along with an excess of money since 2020, may account for a longer lag between the Fed’s recent tight money policy and its impact on the economy.
Given these changing dynamics, it becomes challenging to determine when the Federal Reserve’s target interest rate is appropriate. Historical examples highlight how an incorrect target rate can lead to financial crises or soaring inflation. In 2008, the Fed’s target rate was too high, resulting in a financial crisis. In 2020 to 2022, the Fed’s guess about its target rate was too low, leading to high inflation.
To promote a more stable monetary policy, Fed officials should reconsider their approach. Instead of setting arbitrary targets, they should allow financial markets to determine short-term interest rates. This would involve discontinuing the selling of securities and letting the market set the appropriate rate. If the market rate moves above the Fed’s target, it would indicate that the target was too low, justifying the sale of securities. Conversely, if the market rate falls below the target, it would suggest that the target is too high, making continued sales of securities destructive.
Fed officials should acknowledge that they do not possess divine insight into the appropriate market interest rates. Like prices in the rest of the economy, interest rates should respond to supply and demand rather than government officials’ dictates. By limiting their purchases and sales of securities and allowing credit markets to allocate resources efficiently, the Fed can promote a more stable monetary policy.
In conclusion, while money supply measures may not provide a clear-cut guide to monetary policy, money still holds significant importance in driving the economy. The relationship between money and spending has evolved over time, influenced by factors such as Federal Reserve policies and institutional changes in the financial system. To ensure stability, it is crucial for the Federal Reserve to adopt a more coherent approach, allowing financial markets to determine interest rates and avoiding arbitrary targets. By doing so, they can better navigate the complexities of the modern financial landscape and promote a more stable economy.
