We've got a little problem in the economy. Tiny really. Nothing to worry about.
The government and the Federal Reserve are pumping money into the economy as fast as they can, yet the supply of money in the economy has started to fall -- and that, in turn, could endanger the entire economic recovery.
The Fed is buying mortgage-backed securities ($1.25 trillion) and debt from Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) ($200 billion), expanding its lending to banks by keeping interest rates close to zero and buying up U.S. Treasurys.
All that, according to the textbooks, should be flooding the economy with money. And that's exactly what you're supposed to do to get the economy running again and to avoid turning the Great Recession into a rerun of the Great Depression. (And if you need a reminder about a recovery going into reverse, try my soothing story on the recession of 1937.)
That's a lot of money running around
During the early stages of the financial crisis, those policy actions did exactly what they do in the textbooks. M2, the broadest measure of the money supply that the Fed still tracks, climbed from $7.36 trillion in October 2007 to $7.88 trillion a year later and to $8.39 trillion last June 22, according to the St. Louis Federal Reserve Bank.That's an additional $1 trillion to fund loans and credit card bills and plant expansions and state borrowing and . . . well, just about anything the economy needs.
And because each dollar of that extra trillion gets used over and over by the economy, the effect is even larger than that huge sum itself. What economists call the M2 multiplier has ranged between 8 and 12 for most of the period from 1959 to 2009. So that $1 trillion has the effect of an extra $8 trillion to $12 trillion in money racing around the economy.
Even in the huge $14 trillion-plus U.S. economy, that should be enough to jump-start economic activity and raise justifiable fears of runaway inflation.
In normal times, anyway. But the numbers coming out of the Federal Reserve say these aren't normal times.
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Multiplier takes a nose dive
Despite everything the Federal Reserve has done to pump money into the economy (and don't forget the $787 billion stimulus package passed by Congress), money supply as measured by M2 actually declined in the four weeks ending Sept. 14.And that's because what's called the velocity of money, the speed with which a dollar moves through the economy, has fallen.
That's not unexpected. During the Great Depression, the velocity of money fell 22%. In tough times, people from consumers to bankers sit on more money longer.
But this isn't good, folks. It's a problem big enough to jeopardize the recovery that the economy seems to be building.
Look at what's happened to M2 since it hit $8.39 trillion on June 22:
- By July 20, M2 had dropped to $8.34 trillion, down $50 billion.
- By Aug. 24, it was down to $8.28 trillion, down $110 billion.
- By Sept. 14, the latest data point from the St. Louis Fed, M2 recovered slightly to $8.30 trillion, still down $90 billion from June 22.
Economists who study this data use a four-week moving average to eliminate some of the week-to-week noise. At the worst point in the decline, the four weeks ending Aug. 24, M2 was dropping at an annualized rate of 12%. That's the kind of contraction you get in a financial panic. Not the kind of growth you want to see as you're trying to guide an economy to recovery.
Video: Banks working through their problems
And if you factor in the drop in the velocity of money and in the M2 multiplier, the situation is even worse. Remember, I told you that the normal multiplier from 1959 to 2009 was in the range of 8 to 12. But in the financial crisis, the M2 multiplier, according to the Federal Reserve, dropped close to 4. And it hasn't bounced back.
- Markman's view: Global money thaw becomes a torrent
So in the past few weeks, money supply has dropped at a rate fast enough to derail the recovery, and the velocity of money has remained stuck at the slow speed of a financial crisis.
The good news is that it's pretty clear what the problem is. The bad news is that it's not at all clear how to fix it.
The problem is that the banks still aren't lending. They're sitting on a huge proportion of all the money that the Fed is pumping into the economy, and because the money they're sitting on isn't moving, that's putting the brakes on the velocity of money.
Continued: What M2 actually measures
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