It is erroneous to think that the financial problems of 2007–2008 were because there was an aggregate shortage of money. For example, financial writer Janet Daly wrongly writes “…From central banks which will have to print gigantic amounts of money to replace all the money that simply disappeared in the bad debt that bankrupted the banks in the first place.”
This contains both an important factual error and several important conceptual errors. If the problems of the financial systems are to be understood, these basic errors need to be swept away and replaced by a more accurate understanding of what occurred and what governments and central banks did thereafter.
What are the facts about money supply in those years? The euro area M1 was as follows (all data are in billions):
June 2005, 3256.1; June 2006, 3561.2; June 2007, 3794.5; June 2008, 3855.2.
There is absolutely no sign of any shortage in these data.
The U.S. M1 was:
June 2005, 1395.9; June 2006, 1381.7; June, 2007, 1358.6; June, 2008, 1400.0.
These data show stability in the M1 money supply.
The Austrian true money supply of the U.S. was:
June 2005, 4953.8; June 2006, 5044.3; June 2007, 5243.2; June 2008, 5473.8.
These data show growth in the U.S. money supply.
It is true that, starting in September of 2008, the FED responded to the stresses being experienced by certain financial institutions by creating large amounts of money. By June of 2009, the true money supply was 6149.9, and that was an increase of 12.4 percent in one year. But that increase was not because there had been an aggregate shortage of money in the system. As we have just seen, there never was such a shortage.
What happened was that certain specific financial institutions experienced losses in value of assets that they held. Financing sources then withheld financing from these banks and investment banks — but the money they withdrew and/or withheld went elsewhere in the system. Certain institutions became insolvent and could not meet their obligations.
The correct steps to have taken would have involved writing off bad claims, writing down assets, capital infusions, liquidations, and reorganizations. Instead, the government and the central banks responded with bailouts, supplying money, loans, and taxpayer-financed subsidies. Institutions that should have failed were kept alive. Managements that should have been terminated were kept in place to receive bigger bonuses. Layoffs that should have occurred were delayed or never happened. The general shrinkage in the size of the financial industry that should have occurred didn’t.
There was no general or aggregate liquidity problem in the sense of not enough available means of payment (money). The problem of certain major institutions was insolvency, and this manifested in their specific liquidity problems. They specifically could not get liquid funds to keep going. They could not get money to operate because funds-suppliers recognized that their asset values and cash flows required to service their debts were insufficient.
The central bank did not have to replace “money that simply disappeared” because such money never disappeared in the first place, as the data clearly show. A drop in asset values caused a flight out of securities of certain institutions, but the money had to go somewhere. If funding was denied Lehman Brothers, it did not go under a mattress. It went elsewhere.
The central bank did not have to respond by dramatically creating money and/or making loans on assets of questionable worth. It and other authorities could have decided to reorganize the system around accurate asset values with enhanced capital. Lenders to failed financial institutions could have been required by reorganization/bankruptcy procedures to accept equity in place of debt.
The problem is certainly not that the banks were bankrupted, as Daly writes. The problem is that they were not taken through bankruptcies or bankruptcy-like reorganizations. The problem is that these same institutions are still with us without significant reform having occurred.
Furthermore, the central bank and the government, by doing the wrong things, now have significantly worsened their own balance sheets, and this has enhanced the odds of hyperinflation and/or default.
