Monday, January 4, 2010


Mankiw's Baseless Arguments

My article at Mises today is a bit long, but only because it has everything: Sarcastic quips about Greg Mankiw's logic, a discussion of M0 versus M1 and M2, and a fun story about a real estate developer (Shady Slick) who is ruined by a bureaucrat. I would have put in a love triangle but the editors cut me off.

Seriously, I had an epiphany about the deflationist camp's arguments concerning bank balance sheets and the money supply. Here's the kicker for that part of the article:
Now here's where the deflationists go wrong: I think many of them assume that somehow the money supply must have shrunk in the economy because of Slick's default on his loan. But that's not true.

The checking accounts of the union contractors, shingle manufacturers, and so forth still have (collectively) the $900,000 that Slick originally spent on their products and services. Thus, even though the total value of outstanding loans dropped by $990,000 because of Acme's write-down, the total value of checking or demand deposits didn't drop at all. This is true, even though it took a loan to originally push up the total value of demand deposits. (In contrast, if Slick had paid off his debt rather than defaulting, and then Acme didn't extend new loans, it is true that the money supply [M1] would have shrunk by $900,000.)

As I said before, I'm not trying to make an empirical case for what is currently happening in the US economy. I'm just pointing out that some of the glib deflationist arguments are incomplete. People who are expecting the money supply to collapse are overlooking some serious gaps in their argument.

DR. Murphy,

According to your example, M1 increases the minute the new owner of the Fed's check is deposited. But why then has M1 not risen to the same extent as M0?

If I understand your explanation correctly, the increase in excess reserve also corresponds to a new demand deposit, thus, in should increase M1 by the same amount as M0. Where am I going wrong on this?
If it were truly no big deal, then why is the Fed going to such drastic measures to contain it? The Fed paying interest on overnight funds at 25 bps is now turning into bank-only CDs for terms up to a year. Who would ever have thought we would see such a day?

The Fed having created the monetary monster, now wants to kill it off without any collateal damage to the economy. Good luck with that.

Also, if it were truly no big deal, then why would the Fed announce it plans to curtail its securities purchases in March to prop up the housing asset bubble?

I'm not certain, but I think because a lot of the Fed's purchases came right from banks. So if the Fed wrote a check for $1 million in order to buy a MBS from a commercial bank, then nobody's checking account went up by $1 million. The bank's "checking account" at the Fed goes up by $1 million, but that is counted as reserves, which are not part of M1.

Like I said in the article, I'm not saying my little story is a metaphor for what happened in the US system in reality, I'm just showing that the standard line of "loans down, therefore money down" isn't necessarily true.
Dr. Murphy,

Thanks for clearing that up.
Read your article on the Mises Institute and came here to see any comments. Please clarify your rationale about the following: "In contrast, if Slick had paid off his debt rather than defaulting, and then Acme didn't extend new loans, it is true that the money supply [M1] would have shrunk by $900,000." You say paying off the loan reduces money supply, if it is not lent out. Agreed, Slick needs to take money out of other uses to pay off the loan.

However, if Slick defaults and the bank is out the loan plus interest then the bank's equity supporting other loans is reduced. If the bank is fully loaned against that equity at 10 to 1 capital ratio then they will have to pull back loans x 10 to be in the same positon before the default. Fed regulations require 4% Tier 1 Capital and 8% Tier 2 Capital which makes an even bigger multiplier on the way down in the event of default. I guess they get back the 10% required reserves from the Fed since the loan is no longer outstanding, but the bank has taken a huge hit. It must reduce lending by much more than the default, thereby reducing the money supply. Bad/defaulted loans are the essence of the deflation argument.
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