Harvard University’s economics faculty tends to pat itself on the back as a benign influence on American public life. It sees itself as the main intellectual conduit by which Keynesian ideas were imported from Cambridge, England, to become respectable and eventually orthodox in Washington economic policy-making. Since the 1950s its leading members have also been dismissive about money and banking, and denied the ability of monetary policy to affect demand, output and employment.
In 1970, Paul Samuelson – a Nobel prize-winner, also famous for a celebrated textbook – alleged that Milton Friedman’s and Anna Jacobson Schwartz’s 1963 work A Monetary History of the USA was light on theory and left the transmission mechanism from money to the economy ‘a black box’. Since A Monetary History of the USA was the book that persuaded many sceptics that ‘money mattered’, Samuelson’s allegations would have been devastating if only they have been proved correct (which they haven’t been). Ben Bernanke, the Chairman of the US Federal Reserve, is another prominent economist educated at Harvard and the nearby Massachusetts Institute of Technology. In 1995, Bernanke repeated Samuelson’s charge. A joint article with Mark Gertler in The Journal of Economic Perspectives was called ‘Inside the black box: the credit channel of monetary policy transmission.’ Nowhere did the article refer to – or even show a glimmer of understanding about – the standard condition of monetary equilibrium in macroeconomics, namely that national income is determined (i.e., in equilibrium) only when the demand to hold money balances is equal to the quantity of money created by the banking system. It would simplify, but not grossly misrepresent, the Bernanke and Gertler article as saying that money had no role in determining anything.
Bernanke is an eclectic economist, who by all accounts is both very bright and open to ideas. His politics are Republican and he supports free-market capitalism. Nevertheless, that Harvard education is a big handicap in understanding the interaction of money and the economy. The discussion in Friedman’s and Schwartz’s A Monetary History is – almost entirely – about a broadly-defined measure of money. Bernanke has said that he learned much from the Friedman and Schwartz book. This should be taken with a pinch of salt, as Bernanke’s true views about Friedman and Schwartz are probably similar to Samuelson’s. In his own writings, Bernanke does mention money sometimes, but it is invariably the the narrow M1 measure which focuses on the coins and notes in circulation and checkable deposits. Further, M1 is seen as a multiple of the monetary base, in accordance with textbook and classroom instruction. (Bernanke’s life has been dominated by textbooks, classrooms and journal articles. He apparently never considered any career other than an academic one, and had hardly any day-to-day contact with business and finance until his appointment to the Federal Reserve in 2002). So Bernanke does not believe that broad money (on either the M2 or M3 measures which include bank deposits and money market funds) needs to be tracked closely.
However, even the M2 measure is seriously defective, because it does not include deposits with a value above $100,000. Since most corporate and financial sector deposits are worth more than $100,000, the money balances of large US corporations are not now followed by the Federal Reserve at all. Only M3 now includes a significant quantity of bank deposits in the hands of large companies and financial institutions, but the Fed does not prepare the data and does not regard them as of any interest.
Given the welter of conflicting views on the different money aggregates, it would be reassuring if the aggregates all grew at more or less the same rate. But they don’t, in either the long run or the short. Friedman repeated time and again that stable growth of the quantity of money is a condition of wider macroeconomic stability, noting in his very last seminar presentation (in 2006, at the age of 94) that the reduced volatility in money growth in the 15 to 20 years before 2006 had a causal bearing on the benign, very stable period of the Great Moderation. (He was in fact talking about M2, which for most of his career was his favourite money concept. But M2 nowadays excludes all big corporate money holdings and cannot, in my view, be regarded as a satisfactory money measure anymore). Under Bernanke’s chairmanship, the annual change in broad money has varied from +15% in late 2007/early 2008 to -5% at present. This movement from +15% to -5% has occurred in little more than two years.
The impact of the M3 slump on the economy has been mitigated by the drop in interest rates to virtually zero, while the Keynesians might also want to highlight the advantages (as they see it) of the unprecedentedly large fiscal boost that has been engineered by the Obama administration. Nevertheless, the fall in M3 has two obvious messages for Fed policy-makers. First, something has gone wrong. Secondly, something ought to be done about it. If banks are not planning in the next few quarters to expand their balance sheets (i.e., in their normal business with private sector customers) and hence broad money, the state should become involved. Deliberate money creation can be conducted on a large scale by means of ‘Quantitative Easing’. Unfortunately, Bernanke’s Fed appears not to understand the case for action represented by M3’s performance. This is very worrying for financial markets.
It is certainly alarming that Bernanke and his Fed colleagues are far from clear about the transmission mechanism from money to the economy and indeed regard it as ‘a black box.’ And because they don’t understand what is going on, it is very unlikely that the US will adopt a British-style policy of Quantitative Easing (i.e., geared to a broadly-defined quantity of money). But Britain’s QE experiment had a simple and persuasive rationale: that large purchases of government securities by the state (either by the central bank or the government) from the non-bank private sector create new money balances when they are financed from the commercial banks and that each 1% addition to the quantity of money, broadly defined, implies (more or less) a 1% increase in the equilibrium nominal values of income and wealth. The probability has to be that US broad money will continue to go sideways and that macroeconomic outcomes will disappoint.
Tim Congdon is the founder of International Monetary Research Ltd.