The world is running out of cash

The money supply is shrinking. That may well be the most ominous harbinger of continued economic slowdown. The supply measurement known as M3 or “broad money”—all the money there is on loan or in circulation—has been contracting at a rate of almost 10% annually in the US. The scary thing is, it should be going through the roof right now.

Since the beginning of the credit crunch, central banks have been printing money at an unprecedented rate, desperately adding liquidity to a financial system about to freeze up. M0, the narrowest measure (piquantly called “high powered money”) is the only part of the money supply utterly controlled by central banks and it has gone off the charts since September 2008. It is this discrepancy between the narrow and broad money supply that bodes very badly for the future.

Central banks control the money supply. That is one of the axioms of modern macroeconomics. Not with a printing press—currency is much too insignificant a proportion of the total money supply, the £20 note in your wallet trivial compared to the numbers on account in your bank). Instead, central banks create money by buying securities on the open market. Whenever they buy debt they inject money into the accounts of sellers (generally banks), which then have capital available to lend to deserving households and firms. These open market operations are the basic tool in the central bankers’ kit. By increasing deposits in member bank accounts, they stimulate lending and thus increase the money supply.

The magic of fractional reserve banking (a bank doesn’t have to hold all its deposits, it can lend most of them, because depositors rarely want their money back all at the same time) means that £1 introduced into the money supply by the central bank can engender up to £20 more. That is why so many economists were certain inflation would take off. Quantitative easing, the massive purchase of debt instruments, and the spectacular expansion of central bank balance sheets caused the narrow measures of the money supply to rise to unheard-of levels. The anomaly this time is that the rise in narrow money hasn’t engendered a rise in the broader money supply. That is because banks aren’t lending, they are hoarding.

Before he was the second most powerful man in the world, Ben Bernanke was a respected scholar of the Great Depression. His explanation of the spread of that calamity centered on the failure of bank intermediation. In the early 1930’s, as more and more banks failed, they took with them their particularised knowledge of their customers’ credit risk, which made lending riskier and thus less likely. It is again the unwillingness of banks to lend that may deepen the downturn.

Banks are frightened. They would rather keep cash in their account than lend it to entrepreneurs. Businessmen are frightened. Overcapacity, low demand, and the instability of credit make them prefer to keep cash on hand rather than invest and expand. Households are frightened. Rising unemployment and the overhang of debt from the boom make most of us want to pay off our debts rather than incur new ones. Our animal spirits do not bode well for recovery.

“Inflation is always and everywhere a monetary phenomenon.” So sayth Milton Freidman. John Maynard Keynes instead focused on entrepreneurs’ and banks’ expectations of the unknowable future. The rise of M0 and the fall of M3 suggest that from both a Monetarist and a Keynesian perspective, deflation is becoming likely. This makes Osborne’s deficit reducing measures even more pernicious.

Fasten your seat belts—it’s going to be a bumpy ride.