Central Banks’ Artillery Losing Momentum: The Failure Of Monetarism

ECB meetings

The graphics below show the failure of the Monetarist theory, in its simplest version MV=PT – rather flippantly brought closer to reality by changing PT for nominal GDP; so, MV = NGDP.

The failure, the lack of seriousness, is that T is not GDP, nor is M directly dependent on the Central Bank’s balance sheet. According to the theory, when the central bank’s balance sheet increases, it issues money which goes directly to the public. As can be seen from the graphics, this doesn’t work. And it doesn’t work because the bank are right in the middle of this. They create money by issuing loans. The graphics represent the amount of liquidity in circulation in the US and the Eurozone, divided by the volume of the Fed and the ECB’s balance sheet. If the theory was true, when the central bank’s balance sheet/cash issuances increase, the relationship M3/B should be, more or less, constant. But we can see it isn’t.

Money in circulation (M2 in the US, M3 in the Eurozone) is not created by the central bank, but by the private banks when they lend. These loans are the fundamental countepart of M2 and M3. Loans are converted into deposits which provide the liquidity for us to function. Since the crisis, we can see that there has been a sharp decrease in the potential for creating money.





Ergo, there is something missing in the MV = NGDP equation, something linked to credit. Something related to the demand for credit, which may be eliminated by the uncertainty, or something related to the offer on the part of the banks, which are suffering from the same syndrome. On the other hand, we know that there have been no problems with credit to the public sector, which has continued to expand. But because hardly anyone remotely considers that the US can default.

That is what was thought would happen to the euro in 2012, when there was the sovereign bond crisis: there was doubt over some countries’ capacity to collect enough taxes to pay their debts. But this was sorted by Draghi, who replaced the incompetent Trichet, who should be prosecuted (for raising rates twice in 2011, which was the detonator for the bond crisis). As soon as Draghi guaranteed that no creditor in euros would remain unpaid, he miraculously deflated the crisis and lowered risk premiums to normal levels, something which the government took credit for. A lie. In any event, the public sector is strong enough to increase credit and liquidity, something which inhibits the austerity theory. But we have talked enough about this.



About the Author

Miguel Navascués
Miguel Navascués has worked as an economist at the Bank of Spain for 30 years, and focuses on international and monetary economics. He blogs in Spanish at: http://http://www.miguelnavascues.com/