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28 July 2010

Fear Makes Money and Credit Scarce

Steve H. Hanke, professor of Applied Economics at The Johns Hopkins University and Senior Fellow of the Cato Institute, wrote an interesting article entitled Money Dominates.  He notes there is a controversy going on in which some in the government or among Obama's advisors favor more government stimulus and some want an end to very high rates of government spending and so are considered to be for "austerity."

The stimulus spenders include Prof. Paul Krugman, Prof. Lawrence Summers (Dir. of the National Economic Council), Prof. Christina Romer (Chair of the Council of Economic Advisers), and Treasury Sec. Tim Geithner.  The austerity side is represented by Obama Senior Advisor David Axelrod, White House Chief of Staff Rahm Emanuel, and Dr. Peter Orszag (Dir. of the Office of Management and Budget).  Germany and most of the other G20 countries are now favoring austerity.

The Keynesians believe government deficit spending will be stimulative whether the spending is done by printing money or by borrowing.  Monetarists, such as Milton Friedman was, hold that government spending is stimulative when it is done with printed money, but may not be stimulative if financed with borrowing.  Usually, government deficit spending is done with a combination of printed and borrowed money, so it is hard to test who is right.  However, the Japanese experience of the 1990s did separate the two sources of deficit spending with only borrowed money and the economy continued throughout to drag and sink.  The other example was from 1992 - 1997 in the U.S.  The deficit spending was based on printing money then and the economy expanded.

Hanke notes that Prof. Tim Congdon studied a 28-year period for the U.S. and found that the number of years that the economy behaved as the Keynesians claim it should was half the number of years in which it did not perform as they claim it should.  So, it is clear the Keynesians are wrong and the monetarists are at least less wrong.  In our present recessionary case, broad measures of money have fallen.  This is why the $862 billion stimulus of February 2009 was so ineffective.  This is why the U.S. and Europe are stuck with sub-normal growth rates and will remain so for some time.

The money supply situation is given in the following table:

Several measures of the money supply are given and these become broader and broader as one goes down the rows.  In August of 2008, before the recession in the U.S., the Federal Reserve deposits were $0.84 trillion, but in June of 2010, it had increased this greatly to $1.9 trillion, or by a factor of 2.25!  Yet, M2, the measure of money representing the traditional bank deposit liabilities was a mere $8.6 trillion, rather than the $17.6 trillion that would have been the case if the same M2 multiplier to the Federal Reserve deposits applied as had in August 2008.

At least the M2 value had increased, but as we go to wider and wider measures of the money and credit supply, we find that the measures have shrunk instead of grown!  The shadow bank liabilities are those of investment banks, private equity pools, mortgage finance companies, and structured investment vehicles.  They are down.  The international positions of banks holding U.S. dollars are also down.  Finally, over-the-counter derivatives are down in value.  Money and credit are in short supply.

What has caused this decrease in the effective money supply for doing business?  Fear and uncertainty.  When FDR said that all the American People had to fear was fear itself, he was being much less than honest.  Those who understood business and the economy had much justification for fearing FDR and his arbitrariness, his mad experiments, his general ignorance of economics and business, and his disdain for business.  So to do today's businessmen have good reason to fear Obama and his Democrat Congress and for the same reasons.  The bankers and financiers are especially frightened and uncertain in the face of the new regulatory legislation which actually tosses most of the regulations into the lap of the bureaucracies to formulate over the next few years.  It will be some time before the bankers and financiers have knowledge once again on how they may and may not act.  For a long while they will have difficulty calculating the return of investments and loans, so they are sitting on more of their money until they can figure out what the future holds for them.  This is the rational thing to do.  Meanwhile, the recovery will be, at best, at very slow growth rates and little hiring will be done.  This is the consequence of fear and uncertainty.

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