Friday, November 28, 2008

Collapse of the Money Multiplier

Paul Krugman writes:

A central theme of Keynes’s General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Fed could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Fed caused the Depression. Now, what the Fed really controlled was the monetary base — currency plus bank reserves. As the figure shows, the base actually rose during the great slump, which is why it’s hard to make the case that the Fed caused the Depression. But arguably the Depression could have been prevented if the Fed had done more — if it had expanded the monetary base faster and done more to rescue banks in trouble. So here we are, facing a new crisis reminiscent of the 1930s. And this time the Fed has been spectacularly aggressive about expanding the monetary base.

Paul graphs the monetary base, which increased by 72 percent from September 10 to November 19 of this year. We should also note that the money supply – whether measured by M1 or by MZM – has increased by less than 1 percent. Over the same period, this has been a very substantial increase in bank reserves. Much of what the Fed has been doing has been to accommodate this increase in bank reserves so as to avoid a fall in the money supply.


Steve Roth said...

Friedman/Schwartz's basic assertion was that if the Fed had loosened heavily in '29, the depression would have been a recession ending in '31.

Notice that in fact, money supply stayed flat until '32. By then deflation had taken hold, making monetary policy largely ineffective. So it required massive deficit spending (WWII) to break the dragon's back.

This is not to defend them; as far as I'm concerned they *caused* the great depression. ;-) But the tight-money-early assertion seems well-founded.

The irony, of course, is that the tight-money policy resulted from the very "creative destruction" fundamentalist free-market belief system for which Friedman Schwartz are the leading cheerleaders and evangelists.

See? It was all their fault.

TheTrucker said...

If you give rich people more money then they are richer. That is all that happens. Trickle down does not work.

If you want rich people to invest you do not do it by giving them across the board breaks or by creating money and stuffing it into banks. That may rescue the banks (hence the rich people), but it doesn't do anything else. So long as the rich can remain rich by sucking on the interest from government debt or by financial trickery there will be no real investment.

If you want the holders of money to invest or to loan to people that will invest then you must threaten the value of hoarded money by creating more money and making very sure that this money gets to people who will spend it. You must purposefully cause inflation. Because only when you threaten the value of savings do you cause people to invest. It is the fear of being less rich or of somehow being poor that makes the holders of money actually take the risks associated with real investing.

The secret to causing true capital development is to control fiscal policy in such a way as to make rich people less rich unless they use their economic power to do what is in the common good as well as their own good.

In the 50's the rich paid a tax rate in the 90% range if they simply sucked on T-Bills. The real return to risk free savings were negative because of the progressive tax rates. The return to people saving to get a down payment on a home or for their retirement was positive. The Kennedy tax cuts followed by the insane WOP and Vietnam War caused inflation. And it has been hell to pay ever since.

Monetary policy is to blunt an instrument to deal with the economy. Paul Volcker destroyed the economy to "get" the inflation monster. Ronald Reagan then took advantage of the blasted rubble to create the myth that tax cutting and free markets were the golden fleece. We actually need the carrot and stick controls that can only be had through intelligent fiscal policy. This will require that Republicans never again gain control of the government. It will also require that the "schools of economics" be revised to teach REAL economics as opposed to "the use of calculus to make financial drivel look like economics". The phrase "opportunity cost" is an oxygen moron.

Peter Dorman said...


One point: the increase in excess bank reserves is not just an autonomous phenomenon to which the Fed must adjust; it is actually being encouraged by the Fed's new interest rate policy. I admit that at first I thought this was a good thing -- the Fed is becoming the "real" bank that we need at this moment -- but now I recognize that this way of financing asset expansion is at the expense of other banks being "real".

TheTrucker said...

Peter Dorman,

Are you saying that the Fed is encouraging banks to hoard money at the Fed as opposed to lending?

I understand the money multiplier stuff but do not believe the banking system actually works that way.

Excess reserves are created from slack lending but I also do not think that the banks are withholding credit out of fear and risk aversion at this point. I know that is the current story line but I ain't buying,

There are no borrowers. There are no borrowers because everyone is rolled up behind a log and nobody is taking any chances. No one wants to borrow because they are afraid of deflation. They are afraid that the Republicans will be able to stop fiscal stimulus.

Lets see what happens when the Congress meets for the lame duck session. If they let the auto industry shut down you will see the deflation monster on a rampage. And we need a stimulus NOW and more in January. Nobody is going to borrow any money in this climate but people that should not be borrowing.

Peter Dorman said...


Particularly in light of your moniker, you should take a look at Nocera. This is typical of a lot of reporting; I see no reason to doubt it. As for the Fed, yes they are encouraging excess reserves: they want the banks to lend to them.