Mish & Bob Murphy, On Deflation, Money Supply & Credit
Bob Murphy has an article on Mises.org criticizing Mike "Mish" Shedlock's deflationist views.
I basically agree with Murphy's main point, namely that what matters for price inflation is not the quantity of credit, but the quantity of money.
The reason why a higher money supply raises prices is because money represents a claim to real goods and services, and more claims to goods and services will given a certain amount of actual goods and services reduce the purchasing power of money. By contrast, a pure credit transaction which does not increase money supply will not raise prices, as the increased ability of the borrower to buy goods and services is cancelled out by the reduced ability of the lender to buy goods and services.
It was for this reason that Mish missed out on the big commodity price rally earlier this year, when money supply was booming while bank credit was stagnating (and even contracting somewhat).
Also, Mish is wrong to assert that central banks can't create inflation using sufficiently radical measures (Think about what legalizing counterfeiting would do, or if that is too anarchistic to you, how about the Fed sending a million dollar in cash to every American).
However, the recent deceleration of money supply growth suggests that in the short term, we may (It is not certain-but not implausible either) see another period of deflation.
In the current monetary system, where most money exists as deposits within a fractional reserve based system, money supply simply cannot (except for one scenario analyzed below) in the long run expand much faster than credit. Money supply growth can outpace credit growth for some time as long as banks substitute longer term financing for financing through money like deposits, but sooner or later (theoretically the end would be when 100% of financing comes through money like deposits, but in practice the process will end sooner)this substitution will not be able to go on.
So, while credit is not directly relevant as Mish claims, it is indirectly relevant, and for this reason it should be watched. And because of its role as a leading indicator of money supply, the recent contraction in bank credit certainly increases the odds that the recent money supply stagnation might continue for a while and even turn into outright contraction, which in turn means that the probability of renewed price deflation has increased.
As mentioned before, money supply can grow without any credit growth even in the long run if the Fed would implement some scheme (like my above suggested legalizing counterfeiting or sending a million dollar in cash to every American) to radically boost currency in circulation. However, such radical schemes are likely off the table, at least for the rest of the year, meaning that they do not pose a risk for the deflationist scenario during the rest of the year.
I basically agree with Murphy's main point, namely that what matters for price inflation is not the quantity of credit, but the quantity of money.
The reason why a higher money supply raises prices is because money represents a claim to real goods and services, and more claims to goods and services will given a certain amount of actual goods and services reduce the purchasing power of money. By contrast, a pure credit transaction which does not increase money supply will not raise prices, as the increased ability of the borrower to buy goods and services is cancelled out by the reduced ability of the lender to buy goods and services.
It was for this reason that Mish missed out on the big commodity price rally earlier this year, when money supply was booming while bank credit was stagnating (and even contracting somewhat).
Also, Mish is wrong to assert that central banks can't create inflation using sufficiently radical measures (Think about what legalizing counterfeiting would do, or if that is too anarchistic to you, how about the Fed sending a million dollar in cash to every American).
However, the recent deceleration of money supply growth suggests that in the short term, we may (It is not certain-but not implausible either) see another period of deflation.
In the current monetary system, where most money exists as deposits within a fractional reserve based system, money supply simply cannot (except for one scenario analyzed below) in the long run expand much faster than credit. Money supply growth can outpace credit growth for some time as long as banks substitute longer term financing for financing through money like deposits, but sooner or later (theoretically the end would be when 100% of financing comes through money like deposits, but in practice the process will end sooner)this substitution will not be able to go on.
So, while credit is not directly relevant as Mish claims, it is indirectly relevant, and for this reason it should be watched. And because of its role as a leading indicator of money supply, the recent contraction in bank credit certainly increases the odds that the recent money supply stagnation might continue for a while and even turn into outright contraction, which in turn means that the probability of renewed price deflation has increased.
As mentioned before, money supply can grow without any credit growth even in the long run if the Fed would implement some scheme (like my above suggested legalizing counterfeiting or sending a million dollar in cash to every American) to radically boost currency in circulation. However, such radical schemes are likely off the table, at least for the rest of the year, meaning that they do not pose a risk for the deflationist scenario during the rest of the year.
posted by stefankarlsson at 10:06 PM
20 Comments:
By contrast, a pure credit transaction which does not increase money supply will not raise prices, as the increased ability of the borrower to buy goods and services is cancelled out by the reduced ability of the lender to buy goods and services.
except when the lender is a bank which "lends" money (credit) created almost entirely out of thin air. (i know they're supposed to have reserve requirements, but those were bastardized long ago. if you look at total amount of credit outstanding vs. reserves, you'll see bank reserves are negligible in comparison) when times were good, they were willing to do this for anyone with a pulse --> inflation via credit expansion. now, not so much --> deflation via credit contraction.
Yes "notgreat", you are right about that. But you're overlooking that in the scenario you depicted, money supply will also be affected. What I discussed was another scenario when credit increased or decreasd without affcting money supply.
well, of course that's true, but in the US, at least, credit supply basically *is* money supply just due to the fact that the credit market dwarfs cash & fed reserves by comparison, which is probably why mish concentrates on it.
as a slight tangent, it depends on how you measure the money supply. do the money supply measures you use include things like SIVs and other off-balance sheet vehicles banks like Citi have used to make it look like they have fewer loans out than they actually do? M2 does not. these SPVs probably measure in the trillions, but can't really be captured by statistics because they are kept hidden by the banks for their own fraudulent purposes.
basically, looking at narrow money supply can lead you astray, and finding the right money supply measure is tricky. so you certainly want to watch things like M2, but that doesn't capture all the money in the system.
No, you're wrong about that. Credit is only money to the extent the lender keeps the right to use it as a means of payment without someone elese first relinquishing his right to that sum. Someone who holds a demand or savings deposit have that right, while someone who owns bonds or SIVs don't.
For this reason the quantity of credit is not identical to the quantity of money, it is in fact much larger.
So, while credit is not directly relevant as Mish claims, it is indirectly relevant, and for this reason it should be watched. And because of its role as a leading indicator of money supply, the recent contraction in bank credit certainly increases the odds that the recent money supply stagnation might continue for a while and even turn into outright contraction, which in turn means that the probability of renewed price deflation has increased.
Stefan can you please elaborate on this? I'm not sure I understand what you mean. E.g. what is the contraction of bank credit, and did it go hand-in-hand with movements in demand deposits?
the bank lent money to those SIVs, creating it out of thin air as they can in our system. if the loans had been kept on their books, they'd be counted in the money supply. but because they weren't, they're not.
Bob Murphy, you can find data on bank credit here.
As you can see if you look at the data, bank credit in June was slightly lower than in December 2008. The development is even more negative if you look at bank lending alone (By contrast, bank holdings of Treasuries have risen, limiting the decline in overall bank credit).
So far, this contraction have not stopped deposits (which are on the liability side of balance sheets, while bank credit is on the asset side) from increasing as banks have reduced non-money liabilities instead. However, the slower increase in deposits in the last few months is probably a result of the credit contraction.
Notgreat: Having SIV's in balance sheets wouldn't necessarily have increased money supply, if banks had financed them with non-money liabilities (which finance $4.5 trillion of the $12 trillion of bank assets.).
Sir, you say: "what matters for price inflation is not the quantity of credit, but the quantity of money."
This reminds me of the Austrian view that credit is not money.
However, I think the Austrian view neglects an actual trend in the economy: People *use* credit for money. This, and the definition of money as a medium of exchange, lead me to see credit-use as a contributor to inflation, and thus we might as well count it as money.
Also, the Austrians say credit is not money because it is not a "final" settlement of a debt. However, total credit-in-use (or total debt) keeps increasing (or, did until the crisis hit) so that the permanent base of total debt is for all intents and purposes, final.
Except, of course, it costs more.
"Arthurian": Many forms of credit, including bonds, cannot be used as means of payments. While they can be exchanged for means of payments, that cannot be done until someone else has first relinquished his claim to it. And as it can't be used as money until someone relinquishes an equal amount of money, it simply can't be seen as a form of money.
I think what most of you are ignoring is the fact that loans to SIVs and invested in other credit instruments, while not actually used as media of exchange, for a certain time create a perception in the mind of their owner.
He treats them as if they were money. For example, you hear people say "I have my money in mortgage backed securities." Thus they spend their real money as if these unsafe claims to future money were as good as money. They spend more of it than they would have, had they not been in an environment that created this false sense of safety.
I outlined this causality in detail here: http://www.economicsjunkie.com/inflation-deflation-revisited/
Nima, what you're talking about is the wealth effect of any asset. But if SIVs are to be treated as money on account of that then so should bonds, stocks, houses and other fixed assets.
And there is actually less reason to treat debt instruments as money on that account than stocks or fixed assets. The reason for that is that the people owing money are likely to feel the opposite way ("we shouldn't perhaps spend so much because we owe so much money")
while no such counteracting effect exists for stocks and fixed assets.
Stefan,
yes, what you are saying is of course correct. But it doesn't in any way make my statement wrong.
Best,
Nima
Actually I need to be a little more clear in my response:
"Nima, what you're talking about is the wealth effect of any asset. But if SIVs are to be treated as money on account of that then so should bonds, stocks, houses and other fixed assets."
NM: This is correct, but credit is much more at the root of generating the false sense of wealth than stocks and homes. Those come later. Also, credit claims are perceived to be safer than stocks or homes. In order to understand inflation/deflation, it is appears to be sufficient to focus on credit claims and outright money.
"And there is actually less reason to treat debt instruments as money on that account than stocks or fixed assets. The reason for that is that the people owing money are likely to feel the opposite way ("we shouldn't perhaps spend so much because we owe so much money")
while no such counteracting effect exists for stocks and fixed assets."
NM: I was not referring to people owing money. I was referring to people OWNING claims to future money and THINKING they are as good as money.
Nima, your assertion that credit (as opposed to money) is the root cause of general asset price movements is lacks any theoretical or empirical foundation, as far as I can see.
And as for your second point, you really don't get it, as I was not providing for you another example in which the wealth effect would encourage spending. Quite to the contrary, I was illustrating how the negative wealth effect from debt will discourage spending.
"Nima, your assertion that credit (as opposed to money) is the root cause of general asset price movements is lacks any theoretical or empirical foundation, as far as I can see."
NM: I established the theoretical foundation in my post http://www.economicsjunkie.com/inflation-deflation-revisited/. Regarding your statement that there is no empirical foundation that credit causes asset price bubbles: What data are you looking at?
"And as for your second point, you really don't get it, as I was not providing for you another example in which the wealth effect would encourage spending. Quite to the contrary, I was illustrating how the negative wealth effect from debt will discourage spending."
NM: I understand what you are saying. Those who owe the money will reduce their spending and it counteracts the high spending by those who are owed the money. This thesis obviously falls flat immediately in light of what you were able to witness in the US during the credit boom in the 90s. But let's assume, solely for the sake of your argument, that your theses is correct: Still, nothing of what you said refutes what I said in my original comment.
Nima, in your all too long post, I didn't see any theoretical justification that you didn't iffer here. If I missed one, please specify it. And no. I don't have any "empirical proof", but since yopu are offering a new theory, the burden of proof lies on you (Just like I don't have any empirical study proving that the back side of the Moon isn't made out of cheese).
And that last part was simply incomprehensible. Just in what way does it contradict what I've written before and why doesn't it contradict what you wrote.
Notgreat: Having SIV's in balance sheets wouldn't necessarily have increased money supply, if banks had financed them with non-money liabilities (which finance $4.5 trillion of the $12 trillion of bank assets.).
But the point is that the banks didn't finance them with anything (that's the whole point of having them off-balance sheet) -- at least that's what I'm arguing. They created this money out of thin air, and normally they'd have to show it on their balance sheet and it would impact M2, M3, etc. But by moving it off balance sheet, this new credit-money (which went to bid up prices of assets like housing, cars, or whatever) wasn't counted in "official" money supply figures.
No, "notgreat". It wouldn't have been included in M2 or M3 since M2 or even M3 doesn't include all bank liabilities.
OK, but that just makes my point: this credit-money was clearly used to bid up prices in the market, and yet it didn't show up in the money aggregates. Which is where we started this whole thing.
No, you are again failing to grasp what I've already written. When increases in credit doesn't increase money supply it will not have a inflationary impact since the increase in available purchasing power for the borrower is cancelled out by an equal decrease in avaliable purchasing power for the lender.
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