A key tenet of this journal is that economic and market cycles are driven by deviations between the supply of money and the demand to hold it. When supply outpaces demand, there is “excess” money available for spending on goods and services or investment in financial assets.
The supply of money can be measured but demand, of course, is unobservable. Monetarists, however, assume that demand is relatively stable so that supply swings are the key determinant of whether there is “excess” or “deficient” money. This assumption is reasonable under normal economic conditions but can break down under extreme circumstances, as currently.
Recent posts have drawn attention to a surge in US money supply measures, suggesting an improving monetary backdrop for the economy, allowing for the normal lag of about six months. Some commentators, however, suggest that this surge has been matched or exceeded by a rise in the demand to hold US bank deposits, reflecting increased risk aversion. The economy, on this view, is in a “liquidity trap”.
Scott Grannis, for example, argues that US money demand has been boosted by massive capital flight from the Eurozone as investors anticipate a break-up of the single currency. The US money supply gain, however, has not, to date, been fully offset by Eurozone weakness – G7 monetary growth, therefore, has risen. Eurozone figures for July, released next week, could conceivably change the story but would need to show a large decline to offset US strength.
The Grannis theory of a huge capital inflow to the US from Europe, in any case, is inconsistent with the stability of the euro / dollar exchange rate in recent weeks.
Other commentators have suggested that the rise in US M2 reflects a transfer of cash from money substitutes into bank deposits, partly reflecting perceived risks surrounding the substitutes (e.g. institutional money funds with exposure to European banks). On this view, a broad liquidity aggregate including such substitutes would look much weaker than the conventional measures.
Again, however, the theory runs aground against the facts. The chart shows six-month growth in M2 and two broader measures – “M2+” including large time deposits and institutional money funds and a wider liquidity aggregate additionally incorporating commercial paper and Treasury bills. These alternative measures are less strong than M2 but have still accelerated significantly in recent months.
It is impossible to be sure but recent US money supply strength is unlikely to have been fully offset by a rise in liquidity preference due to the current crisis, so monetary support for the economy and markets should be increasing, though will operate with a lag. Liquidity preference, of course, would fall back in the event of confidence-building policy measures – admittedly difficult to imagine given recent abject performance but not impossible.
