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Sunday, November 20, 2016

Is High Money Growth Telling Us Anything?

Chart: U.S. M2 Growth 2010-

Although money supply growth has dropped off the radar of most analysts, I occasionally see references to it. Given the sentimental attachment to the Quantity Theory of Money that still exists, a figure like the one above may raise eyebrows. With the annual growth rate of M2 in the United States near 8%, is that a signal that nominal GDP growth is about to accelerate?

(As a technical note, I am using the seasonally adjusted monthly M2 series calculated by the St. Louis Federal Reserve in the charts in this article. I produced the charts as part of finishing up "Abolish Money (From Economics)".)

My best guess is that the correlation will hold, and that nominal GDP will rebound from its sub-4% pace. However, that is just based on mean reversion in growth, and that the money growth figures are not adding a lot of information to that call. The reason for my skepticism is found in the historical record.

Chart: US M2 Growth 1960-1980

If we look at the data period which validated the belief in Monetarism -- I use 1960-1980 as a rough sample period -- the correlation between the growth rates in the money supply and nominal GDP was strong. During that era, it was a good bet to use money supply growth to infer the direction of economic acceleration. (The velocity of money was not constant -- although it was relatively stable during that era -- so we still would need to be cautious about forecasting the level of growth rates based on money growth.)

Chart: US M2 Growth 1980-2007

However, the usefulness of money growth as an economic indicator faded by the mid-1980s. For example, the trends completely diverged in 1987 (as indicated by the vertical line), Furthermore, M2 growth essentially stopped dead during the expansion of the early 1990s, as well as during the expansion of the mid-2000s. (A period that commentators such as John Taylor argue was a period of excessively loose monetary policy.)

One possible response to such an analysis is the argument that the money supply needs to be adjusted to take into account various special factors. Unfortunately, that appears to be an analytical dead end: if we keep "correcting" almost any series, it can always explain historical data. Unless we have a way of knowing how to make such adjustments in real time, we do not have a useful forecasting indicator.

Instead of relying on such magical indicators, the best way forward is to focus on the fundamentals driving growth. This mainly revolves around forecasting the prospects for fixed investment, although a hefty loosening of fiscal policy would also change the outlook. I do not have a strong opinion about the strength of fiscal policy (although I expect some loosening as a result of tax cuts), while I do not see strong reasons for fixed investment to accelerate strongly in either direction. As a result, "muddling through" still looks like a reasonable base case.

(c) Brian Romanchuk 2016


  1. Good post.

    Does one dare whisper something related about the long term prospects for the usefulness of monetarism?


    I seem to recall MMT suggesting that “net financial assets” might be used instead of money supply as a sort of best efforts improvement on the quantity theory (although not strictly advisable). Have you had a look at that?

    1. Thanks.

      I'm "amonetarist." Money supply numbers could be useful (since they are related to credit growth), but I believe that "money" has warped economic theory.

      The MMT net financial assets analysis seems reasonable for some purposes (for example, during a financial crisis, there is a dash for cash, and the supply of government liabilities matters a lot), but I doubt that a mechanical rule like a quantity theory will stand up.

  2. I think you are right to question the usefulness of monetary aggregates in understanding the economy, but I still don't get why you call for money to be banned from economics or why you would say that money has warped economic theory. I am probably misunderstanding you terribly, but when you say money has warped economic theory are you setting yourself in opposition to the idea of a "monetary economy" where individuals and firms engage in production with the primary goal acquiring money almost as an end in and of itself? If so, are you suggesting that economics should move more towards a Say's Law type understanding where production occurs primarily in order to barter the product for other products and money just makes that process easier? Because this is what I think of when someone says that money should be banned from economics. And I am pretty sure that would be a step in the wrong direction. I know you are writing a book on this and am eager to read it. When will your book about this be available?

    1. I think you will have to get the book to really understand my logic. 🙂

      More seriously, this has nothing to do with microeconomics, only macro. We can develop macro theory without any reference to money; there is just assumed to be some form of way of settling multiple simultaneous transactions -- which is what happens within macro models. Why do we need to pretend that there is a magical financial asset called "money", which is assumed to have various effects, even though there is little to distinguish it from other financial assets within the model, such as t-bills? Money would matter if you are modelling the system, but no macro model is detailed enoughto actually model the payment system.

      I would question the idea that people go into business (or work) just for "money", they do it for "income" or "wealth", which exist independently of "money". I only take money out of an ATM as an afterthought (will I need some cash to buy drinks after my curling game tonight?).

    2. I will certainly get the book. If it doesn't cost too much "money". :)

    3. Actually, since you pretty much have to buy it online, you would have a hard time using anything in a monetary aggregate to pay for it. (Unless you can use debit cards online, which is a bad idea from a security point of view. Credit cards have much stronger fraud protection for consumers.)

      The pricing will be the same as my other books, other than I expect to run some time-limited offers on Amazon for the Kindle version. (Paperback prices are fairly close to the fixed cost, and so I could not discount them by much, even if I wanted to.) I will have more flexibility on pricing because the ebook will be Amazon-exclusive.

    4. When I buy the book, and I will, it will be through a paypal account linked to a debit card account that is maintained with a small balance. Debit cards definitely can be used online. It may be a dumb way to do it though. Thanks for the advice.

      But more seriously, as you say, is it your point that the various aggregates of what constitutes "money" are incorrectly defined and need to be expanded to include more near money things like T-bills and some other financial assets? I think that is the gist of the MMT argument that QE is ineffective- it is just an asset swap.

      Or are you saying something else entirely- something like money (no matter how you define it or what you include in the aggregates of it) is not a very important factor in the economic decisions that people and firms make and that therefore economists don't need to concern themselves with it?

      Maybe it is something else altogether? Man, I need to read this book. It is so difficult to comment on things you have not yet read! Please finish it soon.

    5. Going through Paypal might give you more protection; not familiar with that.

      The point is about macro models; singling out one aggregate amongst many financial assets is what causes various problems. It's not that deep a critique, but I have a long list of problems that arise from the obsession about money.

      I am getting back to work on the book now...

  3. "However, the usefulness of money growth as an economic indicator faded by the mid-1980s. For example, the trends completely diverged in 1987 (as indicated by the vertical line." Have you considered the effect of shadow banking liquidity? In fact, shadow banking liquidity surpassed traditional banking liquidity in the mid 1990s (and traditional banking liquidity is not M2, but rather the liabilities of all depository institutions).

    "One possible response to such an analysis is the argument that the money supply needs to be adjusted to take into account various special factors. Unfortunately, that appears to be an analytical dead end".Z.Pozsar, T. Adrian et all have written a lot on this and have good data.

    1. [1] Sure, shadow banking would affect things; perhaps using M3 would be better (although we then have to work around it being discontinued). However, once we start casting the net extremely wide for instruments to include in the "money supply," what relationship does it have to "money" as defined in theoretical models? It starts to look like credit growth, which changes the framework to Monetarist to post-Keynesian...

      [2] I should take a look at those authors. I spent enough time working with the raw data for a large number of countries that I became skeptical about money as an indicator. Doing a formal analysis of a negative result was not something that I wanted to do (and certainly not at the target writing level of my book; it is quite informal).


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