The Global Financial Crisis is Not Over!

Steve Keens, one of the very few economists to predict the Global Financial Crisis in advance, has published on his blog a paper that he recently submitted to the 2010 Australian Conference of Economists. As usual, his research is exemplary, and his ideas are very clearly explained.

The paper is technical but can be understood by anyone with an introductory knowledge of economics, provided that they understand the basic differences between the various measures of money supply in the economy--M0, M1, M2, and M3. M0 measures the amount of actual, physical currency (paper dollars and coins) in circulation and in bank vaults. But, as we all know, only a very small portion of our "money" can be found at any time in the form of physical cash and coin. The vast majority resides in the form of simple bookkeeping entries--e.g., credits to our bank accounts. To account for this, economist calculate M1 which includes both paper currency and coin as well as demand deposits (checking accounts) at banks or similar institutions. Thus, M1 is a "broader" measure of money supply than M0. But, not all money is held in cash and checking accounts. Some is held in less liquid vehicles like savings accounts and CD's, so-called "time deposits". M2 thus includes all the components of M1 but also includes savings accounts, CD's and other time deposits. Finally, M3 includes everything that M2 does, plus even less liquid forms of money.

The key point to understand is that the Federal Reserve has almost direct control over M0, but significantly less influence over M1 and very little influence over the much larger M2 and M3. The Fed can create money but it can't control what happens to that money once it leaves its hands, and it's this latter factor that most influences M1, M2 and M3.

With this in mind, here are a few choice quotes from Mr. Keen's paper analogizing the situation in the 1930's to today:

Since M1 (and more expansive definitions of the money supply) is determined by the actions of the private financial system as well as the Federal Reserve, the public and private money creation systems were working in opposing directions in the 1930s. For the first eight years, the private sector’s reductions in credit overwhelmed the public sector’s attempts to expand the money supply. By mid-1938, when the USA’s private debt to GDP ratio had fallen to 140 percent of GDP (from its deflation-enhanced peak of 238 percent in 1932), substantial increases in M0 were able to expand the aggregate money supply and increase economic activity by enough to cause unemployment to fall.

This interpretation brings us to the debt-driven analysis of the Bezemer-Fullbrook Group, applied in this instance to the Great Depression. From this perspective, both the boom of the 1920s and the slump of the Great Depression were caused by changing levels of debt in an economy that had become fundamentally speculative in nature. Rising debt used to finance speculation during the 1920s made that decade “The Roaring Twenties”, while private sector deleveraging when the speculative bubble burst caused a collapse in aggregate demand that ushered in the Great Depression in the 1930's.
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As is well known, a major topic in mainstream macroeconomic debate was explaining the sources of “The Great Moderation” (Bernanke (2004); see also Davis and Kahn (2008) and Gali and Gambetti (2009)). Now the focusing is on explaining—and hopefully escaping from—”The Great Recession” that followed it. From the point of view of the Bezemer-Fullbrook Group, these two events have the same cause, as did the Roaring Twenties and the Great Depression before them: a debt-driven speculative boom, followed by a deleveraging-driven downturn. As an aside, there is no doubt that Ben Bernanke is applying the lessons he took from the Great Depression in his attempts to avoid a second such crisis. Figure 10 shows the annual rate of change of M0, M1, M2 and M3 (which the Fed stopped recording in 2006) over the two decades since 1990. Growth in M0 is off the scale from late 2008 until early 2010, as the Federal Reserve more than doubled the level of base money (the average annual rate of growth of M0 over this period exceeded 100%). However, as during the Great Depression, broader measures of the money supply are failing to respond as dramatically. While there has been growth in M1, it has been one sixth that of M0 (and measured M0 now exceeds M1); M2′s growth never exceeded 10 percent and is now close to zero; it is likely that growth in the now unrecorded M3 is either anemic or negative.

Indeed, though the Fed no longer reports M3, private economists still track it and its growth is indeed negative. A recent article the UK Telegraph reports the following:

The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.

So long as M3 is contracting, deflation, rather than inflation, is the concern. I only wish more "mainstream" economists understood this.