Miguel Navascués | The Fed is continuing to buy assets and issue money to chosen subjects (for the first time not just the banks), as can be seen in the graph of acquired assets net of depreciation, with a year-on-year variation (purchases made so far are more than double those made in 2008). However, the speed of money circulation (i.e., GDP/M2), shows a decline to levels never seen before: each unit of money in circulation moves just $1.4 of GDP. Or, in other words, more and more money is needed to move the same amount of GDP.
The speed of circulation is derived from Friedman’s identity: MV = PT, where M is the money in circulation, V is its speed, T is the number of transactions made over a period, and P is the price of each one. As this is impossible to calculate, P*T is replaced by the nominal GDP. It is no longer an entity, it is an equation.
So following on from that, V = nominal GDP/ M, and it measures (ideally) how much of each unit of production is exchanged for each unit of money paid. The larger it is, the faster the money circulates and the more economic activity there is for each monetary unit. In other words, V is telling us whether people want to spend more or less on offered goods. Therefore the fall in V means that there is more and more accumulation of liquidity and less spending, which obviously goes against the intentions of the Fed. By the way, the downward trend in V since the Great Recession of 2008 explains why there have been no outbreaks of inflation in this long period of monetary expansion: this is because there has been a high degree of stockpiling or demand for liquidity by the public, and little confidence in risky spending, either on consumer (especially durable) goods or, more importantly, capital goods.
This is no more than a speculative reflection on the low speed of money in circulation with respect to GDP. In fact, money has been diverted in a very large degree towards financial operations. Whatsmore, this has been encouraged by the companies themselves. Instead of investing in capital goods, they have resorted to buying back their own shares. These buy backs take advantage of abundant and cheap liquidity to maintain the value of their company and reward their executives by revaluing their bonuses. This policy makes sense for each company individually, but as a whole it translates into weak real investment.
That has been the great weakness of the quantitavity easing policy, which has been diverted from the real economy to the financial economy. This has not translated into large investments, but rather into buybacks and other forms of speculation. It remains to be seen whether the stock market is capable of sustaining its current level or, as the contraction deepens, reaches new lows. The second quarter will be crucial in both directions, to measure the depth of the disaster for GDP and the unemployment rate, and to see the stock market’s response.
What the Fed wants is the opposite to happen. For the money injected to become an increase in circulation speed and nominal GDP, and even increase inflation a little more (as it has reiterated several times). Will it succeed on this second occasion, or will we have to think of other types of instruments?
What we have seen since the new expansionary policy started is that the Fed has achieved some initial successes, such as bending back certain interest margins which were reaching dangerous levels. For example, Baa private bonds, which had reached a spread of 5 pp over the Fed Funds rate, have been withdrawn due to the effect of greater liquidity.
As well as inflation expectations, which are plummeting to zero, they have risen to almost 0.5-1%.
The question is how far is the Fed capable of going? I repeat it has put twice as much into circulation as in the 2008 crisis. What is becoming clear is that it is going to have to do more, ensuring that the money “stays” in (and circulates through) the real economy. The Fed has said it is ready for anything and is credible. Except for those political voices which, as always, question this type of policy from the government benches.
And of course, the ECB*, which has not done even a part of what the Federal Reserve has, should think about putting a stop to the remote control on credit guarantees which are not working at the moment (it is the banks that decide to give credit). It needs to realise it will have to absorb more debt from the member states, as their indebtedness is going to increase by at least a further 20%. And the most effective thing right now for Spain, given the nature of this government, would be an offer of money aimed at private individuals, namely Helicopter Money, which is difficult for the government to interfere with.
For example, is the Fed saving the Helicopter Money for later (it has not ruled it out)? This is the only option that would ensure the money will not be diverted to the market from the financial circuit and will remain in the really productive economy.
By the way, this is an operation that requires the collaboration of the government, which is difficult in Europe, since this does not exist. The real Helicopter Money – not the metaphor used by Friedman- consists in the government sending or charging to the citizens’ bank account an amount of money during the time of the crisis. So the latter feel they have a higher income that they can manage, knowing that the scheme’s limit is the end of the crisis. The government finances itself by issuing debt that it places with the Fed (The latter cannot contact every citizen and give them a cheque).
I think the Fed is ready for anything. And if what it has done so far is not enough, it will draw on more firepower until the risks of depression and deflation dissipate. (If there are no political obstacles.)
(*) it has not been possible to obtain a series of velocity of circulation for the euro, except for dates going back a long time.