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Can the Fed Print Money?

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I'm an independent analyst and have been involved with financial markets for 31 years. I write economic and market analyses for independent research organizations and a European hedge fund consultancy. I'm the main author of the blog 'Acting Man', which presents articles on the markets and the economy, a mixture of commentary on current events as well as economic theory and history from an Austrian school of economics viewpoint.

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It Can and it Does

In light of the upcoming October Fed (non-)decision, we want to briefly revisit a subject that still appears to be causing some confusion. We most recently encountered this confusion again in a quarterly update by the Hoisington Investment Management Company. To be sure, we very often, if not to say almost always, have tended to agree with the economic conclusions of Lacy Hunt and Van Hoisington since we have first come across their work (we may arrive at these conclusions in a somewhat different manner, but the conclusions as such are usually not much different).

Image credit: dreamstime

US true money supply TMS-2: this broad aggregate contains all the items that can be properly defined as money – click to enlarge.

In their third quarter update we have come across one sentence that we believe requires comment, as we have seen similar things asserted elsewhere and we believe it is important to be 100% clear on the topic. In addition to the assertion we want to challenge, which is highlighted below, we also quote the preceding paragraph, because it serves to elucidate a few additional conceptual problems.

“Despite the unprecedented increase in the Federal Reserve’s balance sheet, growth in M2 over the first nine months of this year fell below its average rate of growth over the past 115 years, a time when the growth in the monetary base was stable and quite modest. In addition, velocity of money, which is an equal partner to money in determining nominal GDP, has moved even further outside the Fed’s control. The drop in velocity to a six decade low is consistent with a misallocation of capital and an increase in debt used for either unproductive or counterproductive purposes.

The evidence speaks for itself: the Fed cannot print money. The Fed does not have the authority or the mechanism to print money. They have not, they are not and they will not print money under present laws.”

We actually don’t really need to consult empirical evidence to know whether or not the Fed is able to “print” money (for all intents and purposes, creating its electronic equivalent is the same thing as “printing” it). All we really need to know is in what ways money can be created in the current monetary system. That will enable us to determine what can be done and who can do it. However, even if we were to consult exclusively the empirical evidence, we would still have to conclude that the Fed has been printing money between 2008 and 2014 as the chart below illustrates. If it wasn’t the Fed, it must have been Santa Claus. We don’t believe it was Santa.

2-TMS-2 and total credit - growth rates-a

The annualized rate of growth of TMS-2 and total bank credit in the US banking system. The most glaring evidence can be seen in the blue rectangle on the left hand side. The growth of fiduciary media (uncovered money substitutes) in the banking system first slowed dramatically and then turned deeply negative between 2008 and 2010 (more bank credit was called in than was extended). The exact opposite happened with the money supply: it soared. How could it do so if not for the Fed? – click to enlarge.

Defining Money

We should first explain why we employ TMS-2 rather than M2 (although this would make little difference with respect to the example shown above). Using M2 to determine the amount of money in the economy is somewhat problematic. Even though it can often be used as a serviceable approximation, there is a specific problem with it that is actually quite relevant to the current juncture.

Rothbard summarizes the guidelines laid down by Ludwig von Mises in the Theory of Money and Credit with respect to the proper definition of money as follows (in Austrian Definitions of the Money Supply, from New Directions in Austrian Economics, 1978, p.143-156):

“Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods on the market.”

Obviously, before one can determine what should be included in the money supply, one needs to have a proper concept of money. The concept as laid out above doesn’t provide a final answer to the question of what should be included though, as potential candidates for inclusion have to be considered separately to determine the degree of their “moneyness”.

We won’t go into all the details here, but only focus on the most important components of the “true money supply” and its main difference to M2 (an in-depth discussion of money supply definitions and the concepts behind them can be seen at Michael Pollaro’s “Austrian Money Supply” page at Forbes). Then we will consider who can create this money, and how it is created. Someone’s doing it, after all!

Given the above definition of money, we can state that the money supply in the broadest sense should include all standard money (currency/banknotes), as well as all money substitutes (covered and uncovered ones) that can be transformed into standard money on demand. In the US, this includes deposits in savings accounts, which are de facto available on demand (de iure, banks are able to withhold payment for 30 days – this is in the fine print – but this right is never invoked. If a bank did invoke it, it would start a run on the bank and regulators would be knocking on its doors within hours).

The most important difference between TMS-2 and M2 is money invested in retail money market funds, which is included in M2, but not in TMS-2. Why are retail money funds not money? One could argue that they are considered money from the perspective of the individual holding a check book or a credit card linked with his or her retail money fund. However, retail money fund investments as such can not be used for final payment: the fund manager must first sell the underlying investment (commercial paper or t-bills) before the money becomes available for settlement.

In reality, we are looking at short term credit transactions: the investor buys money fund units, the fund manager lends the investor’s money to companies and/or the government. Thereafter, the money is recorded as a deposit in the accounts of these borrowers. Hence, if one counts both retail money fund investments and demand deposits as part of the money supply, one is in fact double-counting this portion of the money supply.

There is another problem posed by retail money funds that is relevant for all those who want to use money supply growth data as a signal. The amount of money held by individuals in money market funds is often strongly linked with their confidence about the trend in risk asset prices (they move funds between these asset categories). Since risk asset prices tend to decline/increase with a lag relative to money supply growth, retail money fund holdings will often correlate inversely with actual money supply growth. M2 will therefore at times mask the actual rate of money supply growth in the economy. We have highlighted one such period of negative correlation below.

3-Retail money funds-a

Retail money market funds: not only are they not money according to the proper definition of money, but rather represent investments/credit transactions, they will also tend to distort money supply data at times – usually at times during which it is critical to have precise data at one’s disposal – click to enlarge.

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