Saturday, 19 July 2008

Yes, the money supply really is still growing quickly

Earlier this week, the Bank of England produced their regular money supply data. It showed that despite the credit crunch, the UK is still creating huge amounts of liquidity. In the year up to June, the money supply increased by 11.5 percent.

There is one principle that showed never be forgotten; inflation is always and everywhere a monetary phenomenon. In this form, the principle was coined by Milton Friedman. However, even the Romans and Greeks understood it. Emperors and city-states knew that reducing the amount of precious metal in new coins invariably lead to increasing prices.

It is no different today. During the last couple of years, the UK has seen extraordinary monetary growth, and as sure as night follows day, we are seeing inflation pick up and accelerate.

Yet, there are still some who think that the disruption in world financial markets will lead to a sudden collapse and uncontrollable collapse of monetary aggregates, leading to a 1930s debt deflation. Well, it hasn't happened yet.

The Bank of England has several measures of the money supply. M4 is perhaps the most popular measure. Basically, M4 covers notes and coins, current accounts and savings deposits that can be quickly converted into spendable cash.

Since M4 measures money, it follows that someone has to be actually holding this cash. The Bank of England conveniently breaks this data down into three groups; households, non-financial corporations, and other financial corporations. So what has been happening to the money holdings of these three groups.

The deflationist case rests on the smallest component of the money supply; non-financial corporations (NFCs) holdings of M4. It is true that the growth rate has slowed considerably over the last 12 months. A closer examination of the data suggests that NFC holdings have been quite erratic. It has fallen sharply during the most turbulent months of the credit crunch. When things quieten down, the growth rate resumes. In fact, more recently, NFC holdings of money has begun to grow again.

Now lets look at my favourite measure of money - household holdings of M4. Since inflation is essentially a process where there is too much money is chasing too few goods, household holdings of money is a very good guide to inflationary pressures. It has been growing at around 8-10 percent a year. In fact, in the last couple of months, the rate has picked up slightly.

The final component of the money supply is the most mysterious; holdings of other financial institutions. This category has grown at a shocking rate in the last 3-4 years, sometimes at around 30 percent a year. Although the growth rate has dropped slightly, it is still increasing at an extremely rapid rate.

What are other financial institutions? They are non-deposit-taking bank-like institutions. They have become increasingly important as banks have tried to evade regulatory capital requirements and move their lending activities off-balance sheet. This OFIs hold large deposits in regular banks. However, the counterpart to these deposits are found on the balance sheets of OFIs as lending. Make no mistake, the M4 holdings of OFIs is real money. Somewhere in the economy it creates demand, leading to the familiar problem of "too much money chasing too few goods".

So, the data is fairly clear. The money supply continues to grow at a inflationary rate. The decline of M4 holdings by NFCs suggests that firms might be a little short of cash, however households continue to have large amounts of it, and this wil cause inflation.

When the data suggests otherwise, and money supply growth starts to decline, I will think otherwise. Despite the credit crunch, which is for the most part a housing market credit crunch, the data screams inflation. Only higher interest rates will prevent it from rising further.


Slim said...

Interesting post

tom said...

Good post Alice, but there's something you need to know about M4 - it doesn't measure the shadow banking system! The murky world of SIVs, CDOs, Hedge Funds etc were never included in the M4 figures as there is no data for them. Now this, of course, meant that M4 was understated for many years. But it also means that M4 is now likely very much overstated. Billions are being destroyed on an almost daily basis in the shadow banking system. Merrill Lynch's writedowns last week will likely have actually added to M4, because as these banks are forced to bring these mysterious entities, SIVs and such, back onto their balance sheet, they suddenly become in-scope for M4 calculation, despite the fact that the action has in fact destroyed huge amounts of money overall. So the current turmoil is very much distorting the M4 numbers. This is a fairly widely accepted view now, and one of the main planks of the deflation thesis.

Anonymous said...

My two pence worth:

Could the sentiment of those who are presently saving carefully, even fearfullly, for a rainy day be a key here?

I expect many who are not actually having problems paying their mortgages are none the less raising the amount of "rainy day" money they keep in deposit accounts - spread around several banks and building societies - in anticipation of rising energy costs and possible employment problems in the near to medium term.

Such behaviour may account for the rise in the M4 Household component over the last six months; such money may not be quickly committed to purchases unless expectations turn positive again.

Especially with "equity" in housing dropping rapidly many will be feeling less rich and spending cautiously; with the fall-off in final salary pensions and declining stock market, many will be thinking easily accessible nest-eggs in several deposit accounts will be important for retirement and both anticipated and unanticipated nearer term financial needs.

If unemployment soon spreads out of the building and financial sectors, these people will remain cautious about spending, perhaps even long term. Many will be in their forties and fifties and keenly concerned that losing their jobs may mean in effect early retirement on their accumulated savings.

The Household M4 component may be seeing a last upward flip because of this kind of behaviour.

If unemployment starts to rise, consumer demand may fall rapidly despite the careful money management of the moderately well off.

In a few years these may become spenders again,
especially those nurturing the hope of a last move up in the housing market if they can maintain their own financial position while the housing market drops.

But if by that time there has been a big rise in unemployment, the upward pressure of the top third ("haves") on prices may be balanced or negated by the desperation of the middle third, struggling with the combined weight of housing and energy costs, and the poverty of the poorest third – the "have-nots".

B. in C.

Thai said...

You really have a wonderful' blog. Even though I am a yankee living in America, your blog's wisdom keep you on my daily RSS feeds.

Yet as one of your daily readers for many months now, I am still not convinced by these numbers and tend to agree more with Tom. Remember, % change is not the same as absolute size. The overall effect from big positive changes in a small number can still be diluted out by negative changes in a much larger number it is being added to.

What is the absolute size of the off balance sheet numbers now coming back onto the books? What is the absolute size of household M4?

Remember, the SIV's, etc.. of the Shadow Banking System is money that is already out there (i.e. WAS created in the past) and is simply unaccounted for in the current money supply numbers. We deflationisstas simply feel the size of that shadow money is much larger in size and shrinking faster than any cash the central banks can otherwise pump into the system or that households might be 'freeing up'.

In this regard, Mish has been a little more convincing than have you.

However, should you or Mish or someone else give me more absolute data vs. % change data, I could be convinced either way.

Rick said...

Thanks for the data, these are show exactly what I had suspected was happening.

I guess figures in coming months will show a huge rise in credit card debt.

Woody Finch said...

Interesting stuff.

I think the overall money supply figures are confusing - some up, some down, some unchanged. During a financial crisis these things can look very weird (cf Japan in the 1990s when any connection between money supply and inflation completely broke down).

But neither can I see how on this basis one explains previous 'low' rates of inflation during the massive monetary growth over the past 10 years. Where did all that money go? Is the 'credit crunch' just imaginary?

For a contrarian view see my latest post at

Anonymous said...

You can't really separate the various categories out and use them as percentage increases of themselves, and expect to wring much meaning out of them.

In fact the whole concept of M4 aka "wide money" is in trouble because it is basically credit, and we have *no* idea how much credit is in the system.

So chose which bits of credit matter, which don't matter, and hope the bits that matter you have figures for.

The deflationary argument is that all credit matters, it's in danger of collapsing, and even the credit you do have figures for (i.e. derivatives) are too big to keep inflated in a collapse.

Anonymous said...

Umm.... Surely the M4 data, which counts bank deposits, implicitly assumes that the banks do indeed have that money available.
As we know from Northern Rock and various banks in the US, this money is not available and many financial institutions are insolvent.
The amount of money the banks have to honour deposits is shrinking rapidly. In so far that M4 is based in denial of bank insolvency the figure is meaningless.
The money supply is not there, because the money supply has shrunk, people don't want or can't get credit, and debtors cannot repay their debts (and by doing so honour the M4 figures).
False accounting standards for banks can't change that.

Anonymous said...

[b]Anon. wrote:[/b]

[i]I expect many who are not actually having problems paying their mortgages are none the less raising [color=darkred]the amount of "rainy day" money they keep in deposit accounts[/color] - spread around several banks and building societies - in anticipation of rising energy costs and possible employment problems in the near to medium term.[/i]

... and even in cash.

A colleague of mine has drawn out £10,000 in fifties and buried it in a local forest until it's clear that we are not going to have an Agentina situation in which all the banks close their doors.

Anonymous said...

Anon. wrote:

I expect many who are not actually having problems paying their mortgages are none the less raising the amount of "rainy day" money they keep in deposit accounts - spread around several banks and building societies - in anticipation of rising energy costs and possible employment problems in the near to medium term.

... and even in cash.

A colleague of mine has drawn out £10,000 in fifties and buried it in a local forest until it's clear that we are not going to have an Agentina situation in which all the banks close their doors.

aSteve said...

All riveting stuff (as usual) though, I think Tom's point is absolutely crucial.

An awful lot is said about M4... and I don't really understand what is in M4 and what is not. Until 2006 a lot was said about M0 - then the data series ended abruptly with the "Reform of Sterling Markets".

I've recently become interested in M1, M2 and M3 - which are less discussed metrics... though metrics which seem extremely relevant and little discussed by the media.

I think that understanding the nature of these 5 statistics is key to establishing a clear understanding of what is going on.

BTW - AFAIK, M1 is contracting... M1, as I understand it, is (basically) money in current accounts.

Woody Finch said...

Even if you're a dyed in the wool monetarist you need to think about what's happening to velocity as much as the supply of money (clue: it's falling sharply).

peterthepainter said...

yo.Alice. great post and my wot a ace discussion yougot goin here! I have seen comments on blogs and in msm papers and the level of nous here is way higher(tighter more focussed). looks like i am not the only one out here who wants to know "is they is or is they aint no money?"
and i'm not even here i'm on beach!

Alice Cook said...

Woody finch,

"basic inflation identity":

%P = %M + %V - %Y

Inflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), minus the rate of output growth (%Y).

Velocity tends to be quite stable in the long run.

BTW, output is slowing, other things being equal, this means more inflation.


Woody Finch said...

Alice, thanks for the lesson ;)
Your evidence on velocity is?

Alice Cook said...


The question comes down to whether one can estimate a stable demand for money equation. After all, velocity is intimately connected to the demand for money.

While there have been short periods of instability, it is also true that there are long periods when a stable demand for money equation can be estimated.

There are two sources of velocity instability, financial innovation, and some short run fluctuations due to the business cycle. However, the relationship between inflation and money is a medium term thing, and these fluctuations are quite predictable. BTW, the financial innovations effect means that people tend to economize on their money holdings and is therefore quite a well understood phenomenon.

As for more direct evidence, I find granger causality tests are fairly convincing. The fact that money Granger causes inflation suggests to me that velocity is reasonable stable.

But let me ask you a question. What do you think happens to inflation when a central bank doubles the money supply? Do you really think that changes in velocity absorbs the inflationary impact?


alice cook said...


I meant to add....

With a 10 percent annual increase, the money supply doubles every 8 years.


Peter said...

Allowing nominal prices to surge offsets the impact of house price deflation, and hides the impact on wealth. This happened back in the mid 70s. But your analysis is excellent and shows that even John Major has got it right on inflation. But house price inflation has been crazy, see this post:

Tom said...

Good Job! :)

Peter said...

The only asset guaranteed to beat inflation is a precious metal, see: