The meaninglessness of “money supply”

Where are modern economists most at sea?  Some may think it is their over-reliance on GDP to represent the welfare of an economy.  But economists are quite comfortable with the theory of all that, even if they often fail to put it into practice.  No, the real problem is money supply.  It used to be a central concept, but now it is useless.

Economistsused to be very confident about it all, even while I was taking my Economics degree in the mid 2000s.  Their ideas had been developed most famously by Milton Friedman, the 100th anniversary of whose birth is being celebrated this year.  He was the first to say that managing the money supply was a critical part of managing an economy as a whole.  He was an iconoclast at first but gradually the idea became conventional wisdom.

The imagery that economists used to explain money’s role was endearingly folksy but also revealing.  Money was explained in terms of dollar bills or pound notes.  To increase the supply of money, a central bank simply printed more of it.  The role in macroeconomic policy of increasing money supply was often talked of in terms of a helicopter drop of bundles of banknotes.  If an economy was suffering from unemployment, then people would rush out of their homes, grab the cash dropped by the helicopter, spend it, and soon the unemployed would be back in work with no harm done!  (Of course if there was no unemployment, people would spend the new money, but the result would be inflation).  Friedman thought that the Great Depression of the 1930s could be simply explained by a lack of money (banks kept on going bust), and not a lack of government expenditure.

But it’s obvious to everybody that cash plays a very small role in a modern economy.  The money we spend is in bank accounts, and often spent via credit cards; pound notes just don’t come into it.  But economic theory hasn’t caught up.  It is simply assumed that modern money could be managed by a central bank in an analogous way to printing banknotes.  A couple of theories were used to justify this.  First was an idea of a “monetary base” of deposits held by commercial banks at the central bank, which limited the amount of money these banks could supply to their customers, but this clearly did not reflect reality.  A more enduring theory was based on the central bank controlling money supply through the interest rates it set on the deposit, and influenced through “open market operations”.  Raise interest rates  and money supply would fall as people moved money into interest bearing securities.  This seemed to work – though it was hard to reconcile it to the complexities of what was actually going on – the line between non-interest bearing “money” and interest-bearing securities being hardly a firm one.  There was no no better idea, though, and an elaborate macroeconomic theory was constructed on the back of of it.

Two ideas were central to this theory.  First that people responded to an increase money supply by spending more (or a decrease by spending less), and second that the money supply could be controlled centrally.  If an economy was suffering from a lack of demand, you could correct this by loosening the money supply, as an alternative to fiscal policy – increasing government spending or reducing taxes.  This was irrestiable to the polical right, who hated the idea of using taxes and public spending to manage the business cycle – since this raised the size of the state sector.

But the idea is now in tatters, though some economists don’t seem to realise it, especially those of an amateur sort, which unfortunately seems to include the UK Chancellor of the Exchequer, George Osborne.  Both assumptions are problematic.  First, do people respond to an increased money supply by spending more?  What if, in the banknotes in the helicopter example, people are so frightened about the future that they simply grab the banknotes and stuff them into their mattresses?  There is no extra spending, and no effect on unemployment.  This is an old challenge.  Maynard Keynes talked of increasing money supply in a recession as “pushing against a string”.  With money now a much more complex thing held in bank accounts, this problem is worse.  It can be quite rational to leave money in a bank account without wanting to spend it – especially when interest rates are low.

That could be used to explain why very loose money policy by central banks in the developed economies currently has had so little effect, which is indeed what people like the US economist Paul Krugman are saying.  But in fact money supply itself does not seem to be responding to the central banks’ wishes.  It has been shrinking even as interest rates fall.  This causes certain commentators angst – pleading for central banks to loosen policy yet further.

But how is money actually created?  Apart from notes and coins it is mainly created by commercial banks.  They do so by advancing their customers money.  If you borrow £1,000 from your bank, the bank simply adds the money to your current account, increasing the overall money supply, and the bank puts a loan on the asset side of its balance sheet.  No central bank or other authority plays any role in this.  And if banks decide to cut back their lending, money supply shrinks.  What counts is not money supply but credit.

Governments and central banks can use the creation or withdrawal of money to wreck an economy, as Zimbabwe has done, but not to fine tune it.  The sensation of doing so in the 1990s and early 2000s was in fact an illusion.  What actually counts is mood and the supply of credit.  Movements in the money supply follow what is going on in the economy at large rather than lead it.

There is in fact no alternative for policy makers but to get their hands dirty in the detailed workings of the banking system as a whole, rather than simply adjust central bank interest rates.  As the world’s banking crisis continues to rumble on, nobody argues with this – but there is a distinct air of crisis management and an absence of strategy.

What people in practice mean by “monetary policy” is series of policy interventions, such central bank interest rates, bank regulation, managing government debt, credit policy, exchange rate interventions, and so on.  Each of these interventions has its impact – but it is disinctly unhelpful to view this impact in terms of any concept called “money supply”.

But we are left with a theoretical vacuum in economics.  We know credit and banking are important parts of an economy, and critical to an understanding of the business cycle.  But how on earth to manage them?  Giving commercial banks free reign subject to a few central bank interventions does not look a good idea any more.