Sitting on a String

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very strange is going on. It has been going on since August. The
U.S. money supply is shrinking.

the charts published by the Federal Reserve Bank of St. Louis.
The St. Louis FED has been diligent for decades in making available
charts and tables regarding the money supply, as well as other
key statistics. I trust the long-term consistency of this information.

If you will
see for yourself what is going on, you will be able to understand
this report with less confusion, meaning your confusion will stay
even with mine. I assure you, what the graphs reveal has confused
me. But I think it’s better for all concerned if we see the evidence
before we start speculating about causes.

take a look at MZM
, "money of zero maturity." This
indicator I regard as the most relevant monetary indicator, because
it is closest to the characteristic feature of money: instant
spendability. Here, the decline is most prominent.

This is not
a minor downward blip. This is a full-scale decline. It has been
going on for six months. The free market, through its innumerable
transactions, is shrinking the money supply.

look at M-2
. This is a traditional indicator. I have followed
it intermittently for three decades. The monetarist school of
economics, once led by Milton Friedman, used to pay more attention
to M-2, which includes time deposits (savings accounts), than
to M-1 (currency plus checking accounts), although I don’t know
if this is still true of most monetarists. This statistic tells
the same story, but less radically.

Third, look
at the adjusted
monetary base
. This monetary component is the one that the
Federal Reserve System controls. It reveals the FED’s holdings
of assets, mainly U.S. government debt certificates. The monetary
base is what Friedman has called high-powered money. This base
supplies the reserves that the commercial banking system uses
to create loans, and hence money. Here, things are less clear.
Notice that the graph peaked in late October. It had gyrated after
late August. As you can see, the general trend was upward until
November. Then, it stabilized through December, and has now started

What is going
on? If the monetary base is stable, at least peak to peak, but
MZM and M2 are falling, what is causing the disconnect between
FED monetary policy and the market’s use of monetary reserves?

One answer
is the
rise in the supply of currency
, i.e., pieces of paper with
dead politicians’ pictures on them. There was a steady upward
move until late July. Then the rate of increase itself increased.

When currency
increases, the ability of the banking system to increase the number
of loans decreases. When a depositor goes to his bank and withdraws
currency, the bank can no longer use his money to make loans.
When he pulls out currency and refuses to deposit it in another
bank, the banking system cannot make new loans. The fractional
reserve money-expansion process reverses, imploding the money
supply by multiples of the face value of the currency withdrawn.
The banks must call in old loans. When the currency supply rises
faster than the increase of the monetary base, banks cannot increase
the money they lend by the same percentage increase as the monetary

Since August,
the monetary base has stayed almost constant. The currency component
of the money supply has increased. So far, this tells us that
the non-currency components of the money supply must have fallen.
So, I went looking for other statistics that would verify what
the logic of money tells us. I did not have to go far. This chart
tells us: the public is pulling currency out of the banking system
by cashing in (i.e., cashing out) its small
time deposits

While no
one is using the terminology, we may be witnessing a bank run.
This is not a panic-driven bank run, like something out of the
Great Depression. This is a steady bank run that is motivated
by something other than fear.


When the
Federal Reserve Board decided in 2001 to fight the recession and
then fight the after-effects of 9-11, it pumped money into the
economy. Its answer to recession was monetary inflation. This
is the FED’s usual response.

The combination,
a rising money supply and falling demand for commercial loans,
produced the sharpest decline in the federal funds rate in my
lifetime. The federal funds rate is the rate at which commercial
banks lend money to each other overnight, in order for lending
banks that have temporarily overshot their legal reserve limit
to maintain legal reserves for their loans. The fed funds rate
has remained in the 1% range for almost two years.

As the interest
rate on savings accounts has fallen, small, risk-averse savers
have been hit hard. Someone with $100,000 in a savings account
in 2000 was earning $2,000 to $3,000 a year. For the last two
years, he has earned under $1,000 a year, maybe as little as $600.
Last May, one survey
the following: the typical saver was losing money!’s
spring 2003 survey of passbook and statement savings interest
rates shows that interest rates are continuing to plummet. Once
again, rates have reached an all-time low since
began tracking these rates in 1987.

The national
average interest rate for passbook accounts is 0.60 percent.
That’s down from 0.80 percent last fall and 0.87 a year ago.
Passbook accounts, in which customers track their deposits and
withdrawals in a little book, are fairly rare.

passbook accounts have paid less than the more modern statement
savings account. But in this survey, the results are equally
dismal. The national average for statement savings accounts
is 0.60 percent, down from 0.82 last fall and 0.92 a year ago.

If you
put $500 in a savings account and left it there for a year,
you’d get $3 interest, since the rate and the yield are the
same. If you were in the 27 percent tax bracket, that $3 would
be whittled down to $2.19. Subtract 3 percent for inflation
and you have about $487 in buying power.

That was
May. By October, the
national average for banks was under 0.4%

In July,
the rise in currency and the decline in time deposits accelerated.
It is understandable why. People who held time deposits were being
paid so little for their thrift — negative, after taxes and price
inflation — that they might as well pull their money out of the

A person
who has currency can buy and sell without leaving a paper trail.
He can pocket any profits. He has his money close at hand.

Someone else
can send money to relatives abroad. I heard recently that Mexicans
sent $14 billion to relatives last year. Most of that money, I
suspect, was in currency. I also imagine that more than $14 billion
was sent. Immigrants send money home. The paper dollar serves
as a second currency in third world nations.

The FED decided
to stimulate the economy in 2001 by pumping in new money. Lo and
behold, this policy is now backfiring. It has produced such low
rates of investment return for savers that they are pulling currency
out of the banks. This has created an anomaly: a fall in the money
supply, or at least a fall in the various money supply statistics.

There may
be better explanations out there for the anomaly of a falling
money supply, however defined, despite a stable monetary base.
What amazes me is that there is so little discussion today in
the financial press about the existence of this anomaly, let alone
its implications for financial markets.


This phrase
has been used to describe central bank policy in a time of recession.
The central bank increases the monetary base, but commercial banks
don’t respond by lending to the public. They buy government bonds
instead. The problem is, this phrase has not generally been applied
to an economy that is in a recovery phase. It is always applied
to an economy in a recession.

The FED today
is not pushing on a string. It is sitting on the string. It is
not pumping in new money. It is pulling reserves out of the system,
though so slowly that this may be a statistical blip. But the
money supply is falling, according to standard measures. Yet
prices continue to rise, although in the low 2% per annum range
(median cpi).

The economy
seems to be recovering. The stock market is up. Gold is up. The
euro is up. The dollar is down internationally. Yet from the statistics,
we learn that the FED is not inflating, the money supply is falling,
and prices are rising, but only mildly.

Thus, all
of the major forecasting systems seem to be stymied. There is
no pattern that makes sense, according to the economic models
that I am familiar with.

I see this
as a warning. Be suspicious these days of anyone who has a quick
explanation. You now have seen the charts. The charts at present
do not seem to conform to any theoretical framework of economic
explanation that I see in newsletters or the financial press.

writers must exude confidence in their systems, but this confidence
ought to be related at least loosely to the basics of monetary
policy. It is better to point out the anomalies than to conceal
them for the sake of preserving an illusion of confidence.

Money is
not the whole story, but it is a large component of any financial
story. What we are seeing is Federal Reserve policy — monetary
stability — that is being thwarted by individual decision-makers
beyond the Beltway and beyond the New York financial district.
The FED isn’t pushing or pulling on the monetary string, but depositors
are making decisions to pull out currency. There may be other
factors in the decline of the money supply, but the currency component’s
direction is the most obvious: upward. This produces a downward
move in time deposits.

There is
another plausible explanation, one suggested to me by Joe Cobb.
People may be switching from time deposits (0% reserve) to checking
accounts (10% reserve), thereby shrinking both M-2 and MZM, but
not M-1. Seasonally adjusted, M-1 is falling, but not seasonally
adjusted, it is up slightly. This would suggest the public’s loss
of faith in saving at today’s rates, but not a run into currency.
But there is this limiting factor at work: the advent of “sweeps,”
in which customers’ money in checking accounts (10% reserve) are
moved overnight to savings accounts (0% reserve), and then moved
back into checking accounts the next day, has reduced
to 30%
the number of banks bound by reserve requirements.
Perhaps Alan Greenspan will offer his opinion on this the next
time he testifies to Congress. This assumes, of course, that some
elected official bothers to ask him.

One thing
is clear: the FED is pursuing a stable money policy with the main
tool that it has: the monetary base. All discussion of the U.S.
economy today should begin here.


What we are
seeing is a fall in the dollar internationally that is not based
on the FED’s pushing on the string by pumping in new money. Right
now, FED policy looks neutral. But the fall in the money supply
is not neutral.

The rise
in gold’s price is not taking place as an inflation hedge. It
is taking place parallel to the decline of the dollar against
the euro. There is something more fundamental going on here than
traditional inflation hedging, or so it seems to me. There is
a move against the dollar that is not based on fear of inflation.
I think we are seeing the beginning of a shift away from the dollar
as the world’s primary reserve currency. What has prevailed since
1940 is beginning to change.

I am cogitating
on this. Who knows? I may come up with an answer and win the Nobel
Prize in economics. The question is: Will the Nobel Committee
pay me in dollars or euros? I’m hoping for euros.

15, 2004

North [send him mail]
is the author of Mises
on Money
. Visit
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