Money supply

In my post last Friday I highlighted how the Governor of the Reserve Bank had just been making up stuff, and apparently knowingly misleading Parliament, to distract from the Bank’s own responsibility for New Zealand’s current very high core inflation. There may well be a case to be made that central banks did about as well as could reasonably be expected over the last couple of years – “reasonably be expected” here set by reference to the general views at the time of other expert observers (none of whom, admittedly, had chosen to take on statutory responsibility for inflation) but simply making stuff up blaming the Moscow bogeyman helps no one, and detracts from any serious conversation about what went on with inflation – core and headline – and why. To put my own cards on the table, there are many reasons why Adrian Orr should not be reappointed, but the poor inflation outcomes are not the most important of those reasons (of course, a superlative performance on inflation might have covered over a multitude of other sins and shortcomings).

After Friday’s post, someone got in touch to point out that I had not mentioned one other episode in that FEC appearance which could also reasonably be described as “making stuff up” and misleading Parliament. Opposition members were asking questions that included that rather loaded phrase “printing money”, to which Orr responded – apparently in reference to the LSAP – that the Reserve Bank did not create money, that all they did was to lower bond yields, and that banks etc were the people who increased the money supply.

In normal circumstances, the Governor’s comment would not be far wrong. The “money supply” – deposits with financial intermediaries (those included in the Bank’s survey) held by “the public” (ie people and firms not themselves included in the survey) – mostly increases in the process of private sector credit creation. For example, each new mortgage to purchase a house results simultaneously in the creation of either a deposit or a reduction in another mortgage as the house seller deals with the proceeds of the sale. Monetary policy operates typically by adjusting interest rates to influence, among other things, the demand for credit.

Some of the Reserve Bank’s emergency crisis tools don’t have any direct effect on the money supply measures the Reserve Bank compiles and reports. The Funding for Lending programme – a crisis programme that bizarrely is still injecting cheap liquidity now – simply lends money to banks (against collateral). That transaction boosts settlement cash balances held by banks at the Reserve Bank, but those balances aren’t part of “money supply” measures (they are deposits held by one lot of surveyed institutions – banks – at another surveyed institution – the Reserve Bank).

The LSAP is different. If, for example, a pension fund had been holding government bonds and had then sold those bonds to the Reserve Bank. the pension fund would receive payment from the Reserve Bank in a form that adds to that pension fund’s deposits at a bank. Settlement cash balances increase in the process, but so does the money supply (the pension fund’s deposits count in the money supply just the same way that your deposits do). Had the Reserve Bank bought all those tens of billions of dollars of bonds from local banks, the transaction would have boosted only settlement cash and not the money supply measures. But it didn’t. There were plenty of sellers – the Reserve Bank was eagerly buying at the top of the market – and some were local banks, and others were not. And so when the Governor suggested to Parliament that the Bank’s bond-buying did not increase the money supply, he wasn’t really being strictly accurate.

If you are now drumming your fingers are thinking this is all very technical and not really to the point, then in some respects you are correct. We’ve heard a lot about “the money supply” in the last couple of years. Most of it isn’t very accurate, but in many respects the difference doesn’t matter very much. “Money supply” measures (the formal ones referred to above) have not mattered very much to central bankers for decades, and that has been so whether inflation was falling sharply and undershooting inflation targets, or (as at present) proving very troublesome on the high side. The general view has been that money supply measures have not contained consistently useful information about the outlook for inflation, over and above what is in other indicators.

That does not mean – to be clear – that inflation is anything other than a monetary phenomenon for which central banks (and their masters) are responsible. It also does not mean that in extreme circumstances, in which say the government/central bank is flinging huge amounts of money at households without any intention of paying for those handouts now or later through higher taxes, that straight-out government money creation will not be a problem, paving the way for something that could end in hyperinflation. It is simply that specific official measures of the money supply have not proved very useful as inflation forecasters. Decades ago we hoped they did – and money supply growth targets were the rage for a decade or more in some central banks – but they didn’t.

And perhaps you can begin to see why if we go back a couple of paragraphs to the LSAP purchases. If the Reserve Bank purchases bonds from you and me (or our Kiwisaver fund) that will add to the money suply measures the Reserve Bank compiles and reports. If the Reserve Bank instead buy bonds from banks who bank with the Reserve Bank, it won’t add to the money supply measures. Does anyone really suppose there are materially different macroeconomic implications from those two different scenarios? The Reserve Bank doesn’t (from all they have said and written about how they think the LSAP works) and – for what it may be worth – I agree with them. You could add a third scenario, in which the Bank buys a bond from a non-bank entity that itself had bought the bond on credit. In that case, even RB purchasing from a non-bank won’t add to the money supply measures, but will (presumably) reduce any credit aggregates that captured the initial loan.

It might all have been different decades ago when, for example, central banks paid no interest on settlement cash balances, sometimes (as in New Zealand) banks were forbidden from paying interest on short-term or transactions deposits, and where banks were subject to variable reserve asset ratios. That was the world I started work in, but none of that is true today. Money supply measures usually aren’t very enlightening about inflation prospects, and these days neither even is the level of settlement cash balances (since the Reserve Bank pays the full OCR on whatever balances have accumulated). Thus, the LSAP may have been a dumb idea (and a very expensive one so it proved), but not because it may or may not have boosted official measures of the money supply to some extent. The pension fund that sold a government bond and now has bank CD in its books instead is no better or worse off because one asset wasn’t in the money supply official measures and the other one is. Neither are its members.

What matters is (mostly) two things: first, level and structure of interest rates, and second whether or not more purchasing power is put in the hands of public. The LSAP purports to change the former – which it seems was probably what the Governor was trying to claim at FEC the other day – but does not, and does not purport to, change the latter directly.

(By contrast, when for example the government sharply ran down its cash balances at the Reserve Bank and paid out at short notice a huge level of wage subsidy payments, not only did those payments boost the money supply measures (in most cases) but they put more purchasing power in the hands of the private sector (households supported by those payments). That isn’t a comment about the merits or otherwise of the wage subsidy scheme – I thought it was mostly great, directly counteracting what would otherwise have been a huge loss of purchasing power – just a description of how things work technically).

What about some numbers and charts?

This is a chart of annual growth in the Reserve Bank broad money measure

Annual growth rates have fluctuated a lot. There was a surge in the annual growth rate in 2020 (and a 3.5 per cent lift in the month of March 2020 alone, presumably largely reflecting the wage subsidy payments) but (a) it proved shortlived, (b) the peak was still materially below peaks in the 90s and 00s, and c) core inflation in the mid 90s and mid-late 00s did not get near the current core inflation rates (depending on your measure somewhere between 5 and 7 per cent).

For those of you who remember studying money in your economics courses, here is a measure of the velocity of money (in this case, quarterly nominal GDP divided by the broad money stock at the end of each quarter.

This measure of the money supply has been been growing faster than nominal GDP pretty much every year since 1988 (mostly just reflecting the fact that regulatory restrictions on land use have inflated house prices to absurd levels, driving up both money and credit as shares of GDP). You can see a bit of noise in 2020 – the big initial increase in the money supply I mentioned earlier and the temporary sharp reduction in GDP – but two years on there is nothing now that looks unusual.

Here is a chart of the level of broad money, expressed in logs (which means that if the slope of the line is unchanged so is the percentage rate of growth in the underlying series).

Nothing particularly out of the ordinary in money supply developments (on this formal measure) over the last few years.

But for anyone out there who still wants to put some weight on this official measure of the broad money supply, here is the chart of quarterly percentage changes.

Eyeballing it, the most recent three quarters (to September this year) appear to have had the weakest growth since 2009. a period when nominal GDP growth and core inflation falling away sharply. Since I don’t put much weight on money supply measures, as offering anything much about the inflation outlook, I wouldn’t emphasise the comparison myself.

Inflation is primarily a monetary phenomenon, and a national phenomenon (that was why the exchange rate was floated, to make it so), and something for which central banks are responsible and should be accountable. Core inflation has been – and still is – at unacceptably high rates, as a result of choices and misunderstandings by our central bank (their misunderstandings were widely shared, among private sector economists and in other countries, but that does not change the responsibility even if it might mitigate the appropriate consequences for those central bank decision makers). Monetary policy choices matter, a lot. But official measures of the money supply don’t usually shed much additional light, and have not done so over the last couple of years.

Brash vs Gould vs Brash

Former UK Labour MP (and academic administrator) Bryan Gould, and former Reserve Bank Governor (and political leader) Don Brash have been engaged in a fairly robust exchange of views in the op-ed pages of the Herald.

Gould began it a couple of weeks ago with a column, initially prompted by some combination of the initiatives from both the Minister of Finance, and the Labour Party, that may lead to governance reforms at the Reserve Bank, and Sonny Bill Williams’ Islam-inspired objections to interest, and hence to sponsorship by the BNZ.   The politicians being not very radical at all, Gould pointed us to Williams.

Sonny Bill, however, has succeeded, if we are thoughtful enough to recognise it, in throwing a spotlight on the entire role of the banks in our economy and our society.

Gould’s specific concern?

It is the willingness, not to say keenness, of the banks to lend on mortgage that provides the virtually limitless purchasing power that is constantly bidding up the prices of homes in Auckland and, now, elsewhere.

It is the banks that are fuelling the housing unaffordability crisis, a crisis that is leaving families homeless and widening the gap between rich and poor.

Gould isn’t keen on operational autonomy for the Reserve Bank, whether on monetary policy or banking regulation, at all.

Why should the Government be able to hide behind the Governor of the Reserve Bank and duck responsibility for a policy of the greatest importance to so many Kiwis? Why should ministers not be held to account in Parliament and to the country for failing to deliver outcomes they were elected to deliver?

And actually, I have some sympathy with him on that.   Banking regulation should be administered by the Reserve Bank, but approved by the Minister of Finance or Parliament itself.

But Gould’s argument isn’t some abstract one about the optimal assignment of powers within the Reserve Bank Act.     His concern is that banks create credit, and in so doing create new deposits, as a profit-making business.

They lend you money that they themselves create out of nothing, through the stroke of a pen or, today, a computer entry.

The banks make their money, in other words, by charging interest on money that they themselves create. Not surprisingly, they are keen to lend as much as possible.

In fact, most businesses are keen to increase volume, at least for as long as they can make money on the marginal addition to their sales.   Supermarkets are typically keen on selling you more groceries, health food shops on selling you more health food, fashion outlets on selling you more clothes etc.  But Gould’s bugbear is banks (and, presumably, other lending institutions).   To read Gould, you’d think that banks crammed money down the throats of unwilling borrowers.  There doesn’t seem to be any role for demand in his story (let alone for the regulatory restrictions that artificially inflate urban land values).  Banks, as currently structured, don’t appear to serve any socially useful purpose.

As you might expect, Don Brash –  a former Governor, a former ANZ director, and currently chair of one of the small Chinese banks in New Zealand –  disagreed.   Writing of Gould he notes

He then goes on to blame this money creation for the housing affordability crisis which Auckland now finds itself in, and to attack the Government for washing its hands of this aspect of the housing crisis.

Mr Gould is not alone in peddling this nonsense, but that certainly doesn’t make it correct.

Don Brash isn’t disputing the rather obvious point that the banking system, in the course of lending, also create deposits.  As he says

The banking system does create money.

But at this point he rather veers away from the substance of the issue (Gould’s claim that bank credit creation at the root cause of the housing affordability problems – dismissed by Brash as “peddling this nonsense”) to make a correct, and useful, but in this context perhaps subsidiary, point.    What is more or less true of the system as a whole, just isn’t true for any individual bank.

If individual banks really could create money by “the stroke of a pen or a computer entry”, as Mr Gould contends, why do they bother paying interest on deposits, why do they borrow funds from parent banks overseas, why do they borrow funds in the international market, why do they need to hold some funds in government securities as a liquidity reserve, why do some banks occasionally run out of money when customers lose confidence in them?

….I now chair the small New Zealand subsidiary of the Industrial and Commercial Bank of China….. It would certainly make life very much easier if we could, “by the stroke of a pen or a computer entry”, simply create the money which we lend out to New Zealand borrowers. Unfortunately, we can’t.

Individual banks, and their managers and boards, have to worry (sometimes a lot) about the funding side of their balance sheets.  If Don Brash’s bank increases lending to New Zealand borrowers, that process will indeed create new deposits for the New Zealand banking system as a whole.  But there is no guarantee any of those deposits will come back to his bank.  In the immediate term,  if one bank increases lending more than other banks do, that will lead to a loss of liquidity from the lending bank.  In boom times, it might be easy to fund such rapid lending growth.  In times of crisis, funding can be almost everything.  I was heavily involved in these issues in the midst of the 2008/09 financial crisis, and recall banks telling us then that no matter what initiatives the government or the Reserve Bank took, they’d be reluctant to increase lending if they couldn’t count on secure on-market funding.  Their Boards just wouldn’t let them.

But in a way, Brash’s response didn’t actually deal with Gould’s point –  that for the banking system as a whole, deposits don’t usually constrain lending. Rather the two typically grow as part of a simultaneous process (with some exceptions about changes in the current account deficit etc).  If so, perhaps the credit creation process could be the root cause of the (housing) problem?

Gould returned to the fray in a column in yesterday’s Herald.   But, oddly, he doesn’t attempt to defend his view that banks are the cause of the housing problem.  Rather he tries to teach the former Governor to suck eggs, offering lay lessons in monetary economics, and suggesting that Brash doesn’t really know what he is talking about.

In fact, he first misrepresents what Brash said

…..I said the vast majority of new money in circulation is created by the banks “by the stroke of a pen”, and they then make their profits by charging interest on the money they create.

If this is “nonsense”, the “peddlers” include some very distinguished economists.

But, as you can see from the quotes above, Brash seems to be mostly using the “peddling nonsense” phrase to respond to the housing affordability argument.  Moreover, he explicitly states (see above) that the banking system creates money  (personally, I’d prefer he’d used “deposits” rather than “money”).

In fact, in the entire latest Gould column there is not a single mention of the housing issue.  Instead, there are extensive quotes from a very good –  but entirely conventional –  Bank of England Bulletin article from a few years ago on how the credit and deposit creation process actually works, and how that process is quite different from the very stylised approach that often lingers in elementary economics textbooks.     In fact, our Reserve Bank made many of the same points in an article in their Bulletin a few years earlier.  A (then) Reserve Bank senior manager was making these points in a speech 15 years ago.  But the Bank of England article is very good.    Then again, recall that the Bank of England runs things pretty much exactly the same way our Reserve Bank does.    There simply isn’t any stunning fresh insight in the BOE piece to up-end how best to think about monetary policy and banking regulation.

So when Gould quotes the BOE piece

They then go on to say, “Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money – the so-called ‘money multiplier’ approach…[but that] is not an accurate description of how money is created in reality.”

They go on. “Banks first decide how much to lend depending on the profitable lending opportunities available to them – which will, crucially, depend on the interest rate set… It is these lending decisions that determine how many bank deposits are created by the banking system.

Anyone who knows anything about this stuff is simply drumming their fingers, and going “yes, yes, tell us something we didn’t know”.   But do notice the mention of interest rates in that second paragraph.  The way central banks choose to manage the monetary system these days relies on adjusting an official interest rate, not on attempting to directly manage quantities (of base money, lending, deposits or whatever).   Demand for credit matters quite a lot, and the interest rate is a key rationing device.     When overall demand is weak at any given interest rate –  as has been the case for the last decade –  interest rates tend to fall, and official interest rates are typically cut.  Banks can’t just generate new demand out of thin air.

Gould concludes

But the capacity they [banks] have is hugely important. I concluded by asking whether it was wise to entrust such wide-ranging powers – so significant in their impact on the whole economy – to the banks, and then to arrange that the only person able to regulate that impact was himself a banker – the Governor of the Reserve Bank.

Reasonable people can differ on the extent to which banks should be regulated, and even on who should do the regulation (one should always cautious about the risk of capture, of bureaucrats/ministers by those they are supposed to be regulating).

But in his two articles put together, Gould has done nothing (at all) to substantiate his claim that banks are the prime (or even just a key) source of the housing affordability problems.    Simply describing the way in which credit and deposits are created, across the banking system as a whole, contributes little.

I would grant one point.  If banks could not create credit – in the process (simultaneously) allowing young generations to borrow from older ones – house price cycles would look rather different.  Perhaps house prices would be a little lower.  But the biggest change would probably be not in the level of house prices, but in who owned the houses.   Even more young people would be unable to purchase their own home, and more of those homes would be owned by those not constrained by access to credit (be it the evil “investors”, cashed-up foreigners, or institutional vehicles such as pension funds).  Systemic credit risks might be lower, but at what cost to individual families etc?  The fundamental factors that create (artificial) scarcity  –  land use restrictions running hard into rapidly rising population-fuelled demand –  wouldn’t have changed at all.

And for believers in the idea that the banking system is the source of the problem, it is often worth pointing them to the United States.    It has the same sort of banking system we do –  the banking system simulataneously creates loans and deposits –  and yet vast swathes of the country, including big cities often with quite rapid population growth, have had no problems with unaffordable house prices (as a resource on this, try this excellent interview with leading US housing academic Joseph Gyourko, which almost deserves its own post).  The private banking system isn’t the problem.  Land use and housing supply restrictions are.    The banking system certainly enables some people who would otherwise be squeezed out completely to purchase (in fact that is what it always did for first home buyers –  whether the “bank” was a private one, or the State Advances Corporation).  If house prices ever do fall back a long way, some borrowers might well regret having borrowed.   But in all sorts of areas of life, hindsight is like that. For now, they’ve made the best decisions they could for themselves, with the information they have,

Monetary reform ideas have a long tradition –  sometimes advocated by some pretty prominent economists (eg Laurence Kotlikoff, who came through New Zealand a few years ago).  Usually, there is (a lot) less there than the advocates make out.  Sometimes – as with Social Credit –  the analysis is simply misconceived, or even straight-out nutty.  I suspect Gould is in the former camp.  We could, if we wanted to, have a quite different system of monetary management.  I think we’d mostly be worse off if we did.  And since our system is the same system adopted now across virtually the entire world, the burden of proof should surely be on the advocates of change to demonstrate that the outcomes of their alternative visions would be demonstrably superior.  Gould hasn’t done that.  And it is no use simply going ‘but the 2008/09 crisis was so awful, anything has to be better’ without a great deal more supporting analysis, of the causes and consequences of those crisis episodes, than is on offer here.


Some idling on the money supply

I don’t find aggregate measures of the money supply particularly enlightening, and usually when I focus on the money and credit aggregates at all it is on the credit side of things.  In a floating exchange rate system, credit growth tends to result in money creation, rather than vice versa.  Whether it results just in money creation, or in some mix of money and offshore financing, depends largely what people do as a result of whatever gave rise to the credit creation.

Cross-country monetary aggregate comparisons are also fraught.  Different countries measure the money supply in different ways, and the importance of the types of institutions whose liabilities are captured in the money supply measures differ from one country to another (banks are much less important in the US than in most other advanced countries).

All that said, I put a chart of money supply growth since 2007 in my post yesterday.  I did so simply to respond to a not-overly-well-considered claim by Kirk Hope that New Zealand had not relied on monetary policy, or money supply growth in particular, to the same extent as the other large industrial countries he cited.

Then I noticed that a few people had looked at the chart and concluded that New Zealand had had wildly rapid growth in its broad money supply, one observing that

One reason house-price inflation took off: QE.NZ. We may not have had QE officially, but compared to “New Zealand has had the second fastest rate of money supply growth” of all major developed countries – around half of which was borrowed into existence to buy houses.

So I thought I should do a slightly better chart.  After all, countries with faster population growth should probably expect faster money supply growth (they need more), and it makes sense to look at these things in real terms –  after all, Japan has had deflation over that period and Turkey has had rather high inflation.

For what it is worth the OECD has broad money supply data for 19 countries (including the euro area as a whole) and I added in the German data I used in the post yesterday.  For those countries, I got population data from the IMF and inflation data from the OECD, and calculated real money supply growth per capita for those countries between 2007 (just before the recession) and 2015.

And here is the resulting chart

broad money

I’m not sure I’d want to take much from it.  On this measure, and despite having had larger cuts in interest rates than all (?) of these countries since 2007, we’ve had rather moderate real per capita money supply growth (although still ahead of the UK, Japan and the euro-area of the dreaded QE).  It has been faster than underlying productivity growth to be sure, but not dramatically so.

Bank balance sheets just haven’t been growing very rapidly (in real per capita terms) over that period.  And much of the credit (and money supply) growth, I would argue, is the endogenous response to higher house prices, rather than some independent factor pushing house prices up.  The interaction of planning restrictions and population pressure have pushed real house (+land)prices in our biggest city up sharply, and unsurprisingly people need to take out larger loans than previously to purchase houses.  When they take out such loans, the stock of credit rises, and so does the stock of deposits (the money supply).  If, in aggregate, people treat higher house prices as new wealth and consume more then over time money supply growth will tend to lag behind credit (their spending will flow into a current account deficit, funded typically by bank foreign borrowing).  If, on the other hand, people in aggregate treat higher house prices as an additional cost, undermining their sense of well-being, the effect could be the other way around.  But just because credit/money rises we shouldn’t necessarily think of banks as the driving force in the process –  more an accommodating one, mostly responding to other structural (and perhaps speculative) forces.