May 26, 2019

On Leading Horses to Water

The Flow of Funds Accounts of the Federal Reserve System for the last five years goes a great distance in explaining the ongoing financial and economic malaise of the U.S. economy. The total credit creation was trending upward and reached a peak in 2007 at $4.483 trillion. It fell to $2.582 trillion in 2008 and dropped further, turning negative, (-$634) billion in 2009. This means that in a net sense, no new net credit creation was occurring and outstanding credit was allowed to run off by either credit recipients paying off some of their debt or because lenders undertook bad debt write-offs. A very slight revival occurred in 2010 with $736 billion credit being created. This was 83.6% less credit that was created in 2007. The Flow of Funds data for the first quarter of 2011 is not yet available.

Just as Keynes shattered the neoclassical vision of what was to be called macroeconomics, John Gurley and Edward Shaw shattered the accepted view of credit creation. What it boils down to is that credit creation has two sources:

credit can be created by creating new M1 money as depositories such as banks and credit unions do, or it can be created by non-depositories such as finance companies, insurance companies, mutual funds and pension funds, to name but a few, by offering the holders of existing M1 money, nearly always in a checkable deposit form, a substitute such as a certificate of deposit or pension fund claim or the cash surrender value of a life insurance policy and then “lending out” or investing the just acquired M1 money.

Gurley and Shaw viewed these substitutes as near M1 money. Many of these substitutes are the non-M1 components of the more inclusive monetary aggregates such as M2, M3, etc.

The monetary aggregate M1 will support a larger GDP and thus the GDP velocity of M1 is increased. In other words, the financial intermediaries can also create credit by increasing the velocity of M1 money. While credit creation is related to M1 money, the greater is the velocity of M1 money, the greater the creation can be in relation to a given quantity of M1 money. This has been implicit in continental monetary theory and policy making. Especially in post WWII Germany where the monetary authority mandated required legal reserves for a much broader spectrum of monetary assets than in for example, the United States. The “spiritual father” of monetary policy on this side of the Atlantic Ocean has been the classical-neoclassical versions of the quantity theory, called monetarism in its modern form.

When the velocity of M1 was stable or at least unstable but reliably predictable, monetarism dominated the FED’s policy-making activities. Hence defining, estimating their size, publicly reporting their size, and targeting the growth rates of five monetary aggregates, M1 though M5 were characteristics of monetary policy.

With the inflation driven explosion of substitutes for M1, moving from M1 to the broader aggregates or from those broader aggregates back to the narrower aggregates including M1, caused the predictability of the velocity of the monetary aggregates to become increasingly unreliable, as the basis for monetary policy decisions. The reign of monetarism ended as did the estimating and reporting of the broader aggregates M3, M4, and M5.

Even when Monetarism was gaining wider acceptability, Monetarists disagreed on just what was the monetary aggregate that was a chief cause of price level changes. Most argued M1 as being too narrow a measure. Many chose a broader and more inclusive monetary aggregate such as M2 or M3. The broader the aggregate, the less the impact on the velocity of these more inclusive monetary aggregates such movements between its components had. Some chose to define the appropriate aggregate differently than did the FED.

Velocity changes can become quantity changes in the broader aggregates. As the monetary aggregate is more broadly defined and more inclusive, it approaches the totality of credit creation. Estimates of such a broad aggregate become more difficult to make and time lags in the availability of their estimates become increasingly problematic. While the velocity problem is reduced, other such problems as just mentioned make the use of monetarism more difficult as the basis for money policy deliberations and policy choices.

Since the explosion of substitute financial assets, the FED has gradually returned to influence economic and financial behavior by attempting to control the cost and availability of credit.

There is an old expression that warns us,

“You can lead a horse to water but you can’t make him drink”.

To paraphrase it for purposes of this article:

“You can supply all the legal reserves you want to the depositories but you cannot make them create M1 money and credit.”

Professor Donald Byrne holds a Ph.D. in economics from the University of Notre Dame and is a long-time Professor of Economics at the University of Detroit Mercy. For the past several years, he has been active in developing his New Paradigm in Economics. He and his colleagues are contributors to Catholic Journal. The full version of this article may be found at their website: 

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Donald Byrne

DONALD BYRNE was a retired Professor of Economics at the University of Detroit Mercy and held a Ph.D. in Economics from the University of Notre Dame. He taught at other institutions, including: University of California-Berkeley, Notre Dame, Wayne State University, and Walsh College. In 2003, he helped launch an economics and finance oriented online newsletter: He also served on several financial-institution boards and as a Visiting Scholar at the Federal Reserve Bank of Chicago. A devout Catholic and family man, Dr. Byrne passed into eternity on May 7, 2018. May God rest his soul.

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Written by Donald Byrne