The Money View

Shadow money, still contracting

These days, one hears worries of impending inflation. These worries are misguided, and get taken down by informed commentators who point to low core inflation, low TIPS yields, or to high unemployment and low wage growth. There's another response, which responds more directly to the indictment and which I don't often hear articulated. Here goes.

The Fed's balance sheet has expanded, to be sure. I discussed the asset side recently. Here's the liability side:

One of the things that this graph says is that the monetary base (liabilities of the Federal Reserve, mostly currency and the reserves of the banking system) was expanded dramatically after Lehman and a bit more since then, and that the net expansion was effected through the creation of reserves.

The inflation argument, charitably interpreted, must stand on a mechanical interpretation of the equation of exchange, which would then say that expanded monetary base must lead to higher prices: inflation. I don't think that the equation of exchange actually says much that is of interest. But whether it does or not, there is a fundamental question here, which is whether the money supply has expanded at all.

Base money has, to be sure. But other things are money too—retail bank deposits, for example, which are part of the M1 measure of money supply, but not of M0. You could pull up lots of measures of the amount of money and start comparing them.

I will just look at one such measure, which focuses on banking activity done outside of traditional banks. The following is a recreation of Figure 1 of Zoltan Pozsar et al.'s (2010) Fed staff report Shadow Banking, following their footnote on the same page. (Errors are my own, but it does seem to agree with their figure.)

Like the deposit liabilities of commercial banks (black line), the liabilities of shadow banks, or parallel banks if you like, can serve as money. Money funds (MMMFs) issue shares that can usually substitute for FDIC-insured deposits. Repo lending is money too, as you go a bit deeper into the financial system. And so on.

What the figure makes clear is that, from the peak of the crisis to the present, this measure of shadow money has collapsed, by at least $5 trillion. This dwarfs the expansion of base money, and commercial bank liabilities are stagnant, not making up the difference.

All this is to say that when someone argues that post-crisis money creation will lead to inflation, we can challenge not only the effect, but also whether there has even been post-crisis money creation.



In judging the growth of money by its effect on inflation aren't you committing the same error that the Fed made between 2002 and the beginning of 2006?

Inflation may be low but that doesn't mean that high money growth is not inflating the price of some assets to bubble levels. What those assets are we may not even know until after the next crash. But there can scarcely be any doubt that both stock and commodity prices are going through the roof.

My graph of Corrected Money Supply shows that its absolute level is not far below the peak at the beginning of 2006. A crash, I fear, is very much in the works.


I would maintain that the key concept to understand is the concept of 'value'. Capitalism is based on this concept and Keynesianism is based on a continual growth in asset values. Asset values must increase as most of the underlying value is composed of debt. And most debt is longer term which requires asset values to increase if this debt is to be serviced.

As new debt is used to refinance the older debt this means that asset values must increase over time. What stops this increase is a change in the psychology of people (investors, borrowers, lenders, etc.). What has happened since the crash of 2008 is a recognition by many that asset values have grown fastser then the people's ability to service this underlying debt. We witness this situation in the real estate sectors in the United States and also Spain, Austrailia, China, etc. Affordability has declined as wages have not kept pace with the growth in debt and people can not afford more increases in real estate assets.

What has emerged as a consequence of this is a deflation in asset values (in real estate). This same trend is now developing in other sectors of our economy. Bubbles in commodities are mostly financed with more debt (leverage). As these bubbles deflate via asset declines, additional debt gets exposed as unpayable. Deflation is now the trend...not because Bernanke and other Central Bankers want this result...but because the marketplace needs deflation. Asset values need to deflate over time so that a new base can emerge.

Since credit is the main source of asset inflation, a drop in credit demand creates the environment for deflation. We are now at that point where the demand for additional credit to reinflate our economy is lacking. This will lead to deflation and eventually a depression. Cause and effect is at work in our economy.

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