Velocity, Kleenex, and Drugs

I had a cold last week. I blew my nose so many times that the stock of Kimberly-Clark Corporation increased by 10%. I also took some pills. The pills sometimes work for me but I must have waited too late – as the waterfall from my nose kept up for at least three days. Anyway, as my cold was appearing to diminish I wondered if I should stop taking the pills. It is a dicey situation – if you stop taking the pills your cold continues and maybe even worsens. If you continue taking them and you are really on the mend – it dries you out so badly that it starts a dry cough that sometimes makes you even sicker. The Fed is in a similar situation and I believe the Fed is about to give us all a major dry cough. Below I try to explain why something called monetary velocity is at the heart of the Fed’s dilemma.

According to the popular M2 measurement of money, the value of the money supply increased from $7.3 trillion in 2007 to over $10 trillion in 2012. The increase was about 38%.  More striking is the performance of something called bank reserves – something the Fed has more direct control over. Reserves went from $94 billion in 2007 to $1.6 trillion in 2012. What the Fed intentionally injected into the system increased by 17 times.

This is not news – but it does quantify two things – the Fed was extremely active in injecting money and the result is a lot more money in the financial system. Ordinarily this kind of aggressive stimulus administered in a recession does the following – reduce interest rates, increase bank borrowing, increase spending, and subsequently increase output and employment. In the case of 2007 to 2012, we are all frustrated that the monetary expansion did not have a larger impact on output and employment. Fed Chairman Bernanke and most of his advisors want to continue the stimulus. In a recent speech Bernanke intimated that the Fed (1) despite an economic recovery that begin in 2010 would not begin to remove the money from the system and (2) would not sell government bonds from its portfolio, simply allowing those bonds to mature. What do these two statements mean?

In Forbes the title of a recent article was “Fed’s Balance Sheet Swells to a Massive $2.9 trillion on Treasury Buys.”  I wish my balance sheet would swell a little too! That was in 2011 – now the balance sheet is up to $4 trillion. But this does not mean that the Fed is wealthier. It just means that it has created money (recall the $10 trillion M2 referred to above) by buying Federal government bonds from the public.  That is the usual way the Fed increases the money supply – it buys the bonds we hold and sends us money that we deposit into our bank accounts. It is a cool system. So long as there are a lot of government bonds out there – and as long as we are willing to sell them, the Fed has a great way to inject money into the system. And yes – the Fed can do this at will – they do not need any gold or any silver or permission from Nancy Pelosi to do this kind of thing.

When Bernanke says he will not sell any part of those $4 trillion of bonds he holds – he is saying that he is not going to take money out of the system. Note that when the Fed sells its holding of government bonds – they send the public a bond and you and I send money to the Fed. When the Fed sells bonds – money in the system decreases. Not selling the bonds means Bernanke will not take money out of the system. So the stimulus remains.

When Bernanke says he is going to hold those bonds until they expire or mature the plot thickens (sickens?). When the bonds expire, the Treasury will pay the holder of the bonds the face value on the bonds. Aha – so the Fed gets even richer! No it doesn’t because the Fed turns around and gives the money back to the government. In the first place the government does not have enough money to really give it to the Fed (unless it borrows even more). In the second place, the Fed is not allowed by law to get rich.

Notice that the government originally owed both interest and principal to the public. So when the Fed bought all these government bonds – the government essentially got to skate. That is, the Fed’s purchasing these bonds means the Treasury has reduced the interest and principal effectively owed by the government. The Fed bailed out the government with its monetary policy. This is what people call monetization of debt. It is tantamount to the Fed printing money so the government can spend more than it collects in tax revenue.

So basically what Bernanke is saying today is – we are bankrolling the government and we are going to continue doing it. And that gets me back to my cold and the pill dilemma. Bernanke is doing this because he is afraid that if he stops supporting the government, the economy will fail. He could not handle the Twitter buzz if the economy fails. But if the patient is really on the mend, then failing to withdraw the drug could cause some real complications or what I referred to last week as Unintended Complications.

My liberal friends say tone it down Larry – there is no inflation anywhere. Why are you so worried – all that money isn’t hurting a fly? Not true.  First, there is inflation and it is growing. But that was my point two weeks ago. This week I am making a different point and it has to do with a concept called monetary velocity (V).

I won’t go into the equations and all the technical mumbo jumbo, but let’s define something called the BAM (Bang Associated with Money). BAM tells you the potential impact of money on spending. BAM is the joint result of two things – (1) the amount of money times its (2) circulation or V. Look at the dollar bill in your pocket. That is part of M2. You have it now but when you spend it the hair stylist gets it. Then he spends it at the liquor store. That dollar bill may get used quite a few times during the year. Thus $1 of M2 supports a lot more than $1 of spending. How much more spending – how much more BAM – depends on both M2 and on V.  

BAM = M2 times V.

We know what happened to M2 between 2007 and 2012. It increased dramatically. But what about V? V equaled about 1.93 in 2007. It has been declining ever since. As of the end of 2012 it was about 1.54. That is a reduction of V of about 20%. Recall that M2 increased by 38%. So you might say that the BAM factor increased by about 18% (= 38% - 20%) between 2007 and 2012. So while the money supply might have been hoping for a BAM impact of 38% -- we didn’t get that much impact because V fell. M2 increased but V decreased. So BAM increased by 18%. As a result the monetary impact on output and employment was a lot less than the Fed hoped. That’s the past, what about the future?

What many people are worried about is that V will not stay down forever. The V being down is very much related to uncertainty about the future. It is very much determined by banks that are reluctant to lend money – and by people who are paying down their personal debts to get into better financial condition. But what happens if the economy keeps improving and at some point confidence surges? What happens if the Fed does not remove any M2 but V goes back to a more normal number? Instead of BAM equaling 18% today it could jump to 38%! It would equal 38% at a time when we no longer need stimulus!

In one way that sounds good. We will finally get some oomph in the economy. But keep in mind that this 20% increase of BAM will get distributed between output and inflation. For example – if BAM increases by 20% this year – we could get any of the following possibilities:

o   Output goes up by 20% and inflation increases by 0%

o   Output goes up by 10% and inflation increases by 10%

o   Output goes up by 0% and inflation increases by 20%.

Even in an extraordinary year national output would not go up by more than 6-8%. Can we handle an inflation rate of 12-14%? I don’t think so. That is a very sore throat! Bernanke says he won’t reduce M2 but so long as M2 remains high everything depends on the future course of V. Maybe it will not bounce back to 1.9 anytime soon. But clearly V is going to return to something more typical as the economy approaches normalcy. Leaving M2 fixed is a sure way to make sure that inflation becomes a major future economic problem. Of course so long as the Federal government does not deal with its long-term fiscal crisis there is enormous pressure on the Fed to keep monetizing the debt. A coordinated movement away from both monetary and fiscal policy is necessary for a stable economic future. Monetary policy needs to be reversed but we will not see this until the government joins the process. Our President says debt is not a major problem today. I totally disagree.