It’s the Economy, Stupid (part 3)
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Part 3:
Money Supply 101 a.k.a. How to Kick-Start an Economy *If you think of an early agrarian society, the recipe for economic success is simple: Times of plenty are used to store excess grain and other foodstuffs which may then be used for seed stock and consumed during times of hardship.
Take the threat of starvation out of the equation and behavior changes dramatically. In modern industrial societies, when things are going well, consumers expect the trend will continue and respond by saving sparingly, spending freely, taking risks and increasing debt. During times of hardship or perceived hardship, consumers pay off debts, cut back on spending and risk, and save more. Governments behave similarly during periods of economic growth by spending freely and creating budgets based on recent tax revenues. During hard times, however, governments are not constrained by budgets and may, and often do, spend freely.
Hang with me, here…
Today, the United States and most of Europe are in a recession. The majority of consumers have responded by, you guessed it, spending less, paying off debts, and not taking on new obligations – not exactly an economist’s recipe to spend one’s way out of a recession. Normally, governments would respond by reducing interest rates, increasing government spending and perhaps providing a small financial stimulus package. In an otherwise normal economy with a healthy financial sector, the lower interest rates would stimulate the economy by increasing loans to companies and consumers, but today’s financial sector is anything but healthy. Banks are sitting on cash reserves, while loans to businesses and consumers have dropped dramatically.
That is what makes the current recession different. During the Great Depression, economists believed if you increase the money supply by 25%, spending will increase by roughly 25%. They did not understand that actual money supply equals static money supply times the yearly turnover. Let’s say it’s pre-depression 1928, the money supply totals $10 billion, and average buck is spent (turned over) 4.5 times. Roughly speaking, the real supply of money equals $45 billion.
Now, let’s fast-forward to 1932. The Federal Reserve has been printing money like mad, and let’s say the static money supply has increased by a whopping 100% in 4 years to $20 billion. Imagine the government’s dismay as the depression continues to worsen. What they did not realize was the turnover of money had decreased from, say, 4.5 to 2 times annually so, in effect, the real money supply had contracted from $45 billion to $40 billion.
We are certainly not in a depression, but apply this scenario to current economic conditions and it fits rather nicely. Banks have cash but aren’t loaning, customers aren’t spending, and posts on the Where’s George website are down 20% because turnover is down by a fifth. Because the Fed has not begun printing more money, the real money supply and spending are down a cool 20%.
Let’s say it is now February 1, 2009, and economic conditions have not improved. Since calling Ben Bernanke of the Federal Reserve and requesting he increase the money supply 20% by the end of the month is not a viable option, a more likely scenario would be for now President Obama to push through a one-time stimulus package that equals roughly 20% of the average household’s annual income, which amounts to about $10k per head of household and $5k per individual filer. A month or two later, the checks are in the mail.
Consumers get their fat checks, bank deposits swell, spending increases almost immediately, perceptions improve, employers hire, borrowers pry out their wallets and begin lending money, the sun shines, birds sing, and the patient is stabilized – for the moment.
