Sitting on a String

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

Consider 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.

First, 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.

Second, 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 down.

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 base.

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 reported 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.

Traditionally, 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 bank.

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.

Newsletter 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.

January 15, 2004

Gary North [send him mail] is the author of Mises on Money. Visit For a free subscription to Gary North’s newsletter on gold, click here.

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