Blowing bubbles and the wall of money
February 19, 2006
Alan Greenspan, worried about a recession, revved up the Fed’s printing presses in 2001, driving money into the housing and other asset markets. The Fed’s printing presses are “running white hot,” fueling inflation and “blowing bubbles” worldwide. Danger danger!
You hear a lot of this sort of thing these days, although it is demonstrably false. That said, it does contain, I believe, a kernel of truth, so we will try to extract that kernel from the chaff of sloppy analysis, which these days consists (even on the professional level) of little more than mixing metaphors into tasty new cocktails for another week’s entertainment.
First of all, let’s figure out what the Fed actually does. The Fed (besides its shadier activities like possible money laundering for the Bush family) does only one thing: it increases or decreases the amount of dollar base money in the world. It primarily alters the fraction of base money that is bank reserves held electronically at the Fed (about 10% of the total), but this translates automatically into adjustments in base money worldwide, which consists primarily of paper banknotes (the other 90%). The Fed alters base money in accordance with its interest rate target policy, and by this method effectively manipulates short-term interest rates.
There you go. The Fed does not loan money, and thus cannot be faulted for a lending boom, except to the extent that its interest rate policy target may inspire private borrowers and lenders to do business with each other.
This base money adjustment can be considered the “printing press,” so let’s see how much the Fed has been “running the printing press” these days. Here we go:
Are you getting the impression that maybe the Fed is not running the printing presses “white hot”? Indeed, the rate of base money growth is rather low, historically speaking. (Except for the printing presses in Iran, which are reportedly running “white hot” churning out counterfeit dollar bills. Those Iranians are kinda smart.)
This does not mean that there isn’t inflation. Inflation is often caused by a dramatic decline in demand for a currency, rather than a dramatic increase in supply. One reason for such a dramatic decline in demand is that the currency’s value begins to sag, and the central bank does nothing about it, so demand falls more and the value of the currency also falls further. Look at the 1970s. The rate of nominal base money creation was not all that much different than the 1960s. However, the value of the currency collapsed, because demand collapsed, because of central bank mismanagement! (The dramatic blip around 2000 was due to the printing of large amounts of banknotes before Y2K, on the possibility that banks would experience heavy withdrawals of cash.)
Much of the demand for the US dollar comes from outside the United States, from anyone in the world who wishes to do their business in dollars. Indeed, something like 60% of the entire dollar monetary base consists of $100 bills, a denomination almost never seen in the US. The bills are being used in the illegal drug industry and in countries where, due to an unreliable financial system, large business transactions are done in cash. If, for whatever reason, such people decide to use euro banknotes instead of dollars, then demand for US dollar paper banknotes may collapse. There is some evidence that this is already happening, which probably helps explain the rather low rate of base money expansion recently.
Now, even if the Fed was “running the printing presses,” which it is not, there is a metaphor (most economics these days seems to be metaphor-juggling) which says that the (non-existent) “excess” money “flows” into various asset classes, blowing them up like a balloon full of cash. From the standpoint of an investor, it seems like they take their cash and “put it into” the housing market or the emerging market stock markets. But of course there is no money “in the market.” Show me where it is? What actually happens of course, is that A has some cash and B has some stock in Petrobras, and then after A “puts his money in the market,” B has A’s cash and A has B’s stock in Petrobras. The amount of cash and Petrobras stock doesn’t change, only the ratio of cash/stock that the transaction was done at (i.e. the price of the stock).
Another threadbare metaphor bites the dust, but there is something interesting going on here: the amount of cash doesn’t change. Well, first of all, what is this “cash”? It is not banknotes (i.e., base money), but the various forms of short-term debt that most people consider “cash,” including short-term loans to banks (bank deposits) or short-term loans to the government (T-bills), or possibly equity holdings of funds that buy the short-term debt of corporations (money market funds). These various forms of “cash,” which are not money (base money) but rather short-term debt, are known as M2 and M3.
M1: Base money, traveler’s checks and checkable demand deposits (bank deposits, i.e., short-term loans to banks).
M2: M1 plus savings and time deposits (more short-term loans to banks).
M3: M2 plus large-denomination ($100,000 or more) time deposits, balances in institutional money funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents at foreign branches of U.S. banks and at all banks in the United Kingdom and Canada.
What about money-market funds? What about 6-month T-Bills, which is a short-term loan to the government, which should be just like a 6-month time deposit, which is a short-term loan to a bank? What about 30-year Treasury bonds, which are similar to T-bills, and can be liquidated at a moment’s notice just like a demand deposit? What about 6-month bills of the Brazilian government, denominated in dollars? What about 6-month bills of the German government, denominated in euros? What about the 6-month bonds of Fannie Mae, or GMAC, which is what money market funds own? These are all good questions, and you should ponder them to fully understand the extreme arbitrary nature of calling short-term bank loans “money” but short-term government billsäsomething besides money. Indeed, back in the days when people took Friedman-style monetarism seriously (believe it or not, it was the early 80s), I think the various economic goofballs kept statistics on Ms up to “M14” or something like that.
The point is: there is real, actual money, which is base money, and everything else, for which all categorizations are necessarily arbitrary. The difference between base money and everything else is that everything else is a contract, with a counterparty, while base money is something like a manufactured good (manufactured by the Fed). When you hold dollar bills in your pocket, there is no counterparty, not even the Fed, as the Fed is not legally obligated to do one damn thing just because you have some dollar bills.
However, for our purposes, we can use M3 as an approximation of what people today consider “cash.” And US dollar M3, unlike base money, has been rising relatively briskly, at least compared to nominal GDP:
To be honest, this M3 statistic does not quite describe the feeling of the moment, which is of a “wall of money” being thrown at virtually every asset class worldwide. This “money” is cash, of course, and where is it coming from? The basic fact of the matter, it seems to me at this moment, is that the cash isn’t really coming from anywhere; the “problem” is that it doesn’t go away. The conventional wisdom of this moment is that an investor (at least a professional one, and professionals are managing most of the assets) should not hold cash. Thus, if Fund Manager A buys Petrobras from Fund Manager B, then A “uses” his cash but B now has more cash, and the only way to “get rid of it” is to buy something else, at a price that Fund Manager C is willing to part with it at (i.e., a higher one).
That said, there is one source of new cash, and that is debt: when a homeowner buys a house and borrows a big mortgage, the seller of the house (let’s say an older couple downsizing) gets a pile of cash, which the seller may then use to buy some other asset. At the same time, certain hedge funds have been levering up, borrowing money to buy all manner of assets, while other funds have been levering up corporate balance sheets and “taking cash out,” which of course goes somewhere yet again. Something like this process seems to be affecting asset markets worldwide. It is not caused by the Fed per se, but the cash-adverse habits of money managers combined with debt expansion worldwide. This process is not happening only in dollars, either, but in all manner of currencies, particularly since this property/lending boom has been global.
How does it play out? I’m not quite sure, although I would guess it involves a) recession, combined with b) a “cash is king” mentality rather than a “cash-adverse” one among investors, and c) a reduction in debt creation worldwide, probably related to a major reversal in property-related lending. We can see a big unwinding of M3 creation leading up to the 1990-91 recession, which is quite suggestive.
All that said, it is hard to fault Alan Greenspan and the Fed for such a situation directly, except to the extent that the Fed creates a currency and interest-rate environment that inspires the private market to do funny things. Thus, this strange boom must be considered, in large part, to be a natural feature of the market economy, and indeed such a thing could happen even under a gold standard. We are not under a gold standard, however, and it will be most interesting to see how all of it plays out in terms of debt dynamics, asset values, currency values and interest rates. A big chaotic mess, most likely, in which I am perfectly happy to hold large amounts of gold and, yes, cash.