Money, Where’s the Money?

According to the author of the article, Steve Hanke, governments have been focusing on whether fiscal authority or more fiscal stimulus is the right strategy to contain the crisis. However, Hanke believes that the government leaders should be focusing on the money supply.

by Steve Hanke
Real Clear Markets

Since September 2007, when the British Government and the Bank of England bungled the Northern Rock affair, one government after another has sent in the boy scouts in an attempt to douse what has become an international economic wildfire. Their efforts haven’t worked. Indeed, they have often made matters worse – much worse – and the fire remains uncontained.

Heads of state continue to rush from one meeting to the next. Worryingly, they (and the army of pundits that follow them) continue to focus most of their rhetoric on whether fiscal austerity or more fiscal stimulus is the right strategy to contain the crisis and turn things around. Instead, they should be focusing on the money supply. As history shows us, money and monetary policy trumps fiscal policy.

When the monetary and fiscal policies move in opposite directions, the economy will follow the direction taken by monetary (not fiscal) policy. For doubters, just consider Japan and the United States in the 1990s. The Japanese government engaged in a massive fiscal stimulus program, while the Bank of Japan embraced a super-tight monetary policy. In consequence, Japan suffered under deflationary pressures and experienced a lost decade of economic growth.

In the U.S., the 1990s were marked by a strong boom. The Fed was accommodative and President Clinton was the most austere president in the post-World War II era. President Clinton chopped 3.9 percentage points off federal government expenditures as a percent of GDP. No other modern U.S. President has even come close to Clinton’s record.

Since the crisis commenced in the early fall of 2007, most countries have applied huge doses of fiscal stimulus, and – with the exceptions of China, Japan, and Germany – taken contractionary “monetary” stances. How could this be? After all, central banks around the world have turned on the money pumps. Isn’t that simulative? Well, yes, it is.

But, central banks only produce what Lord Keynes referred to in 1930 as “state money”. And state money (also known as base or high-powered money) is a rather small portion of the total “money” in an economy. Even after the Fed more than tripled the supply of state money in the wake of the Lehman Brothers collapse in 2008, state money in the U.S. still accounts for only 15% of the total money in the economy.

This is the case because the commercial banking system creates most of the money in the economy by creating bank deposits. Accordingly, at present, 85% of the total money supply in the U.S. has been created by the banking system. In a wrongheaded attempt to make banks safe in the middle of a slump, politicians and regulators have mounted an international campaign to force banks to recapitalize and to increase their capital-asset ratios.

The regulators are very proud of their progress. For example, the European Banking Authority issued a preliminary report on 11 July 2012 in which it congratulated itself for forcing banks in Europe to raise $115.6 billion in capital since December 2011 and for boosting their capital- asset ratios.

But, these bank capitalization mandates, when applied in the middle of a slump, are misguided and dangerous. They have forced banks to deleverage on a massive scale. In consequence, the privately produced portion of the money supply has contracted in most countries. And since this private part of the money supply is so much larger than that accounted for by state money, the net result has been a tight monetary reality in most countries – with the exception of China, Japan, and Germany. This explains why we are witnessing so many credit crunches at the same time central banks are pouring out liquidity.

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