Gene Epstein (Barron's) on "Endogenous Money"

[Greg Nowell <GN842@xxxxxxxxxxxxxxxxx>]

What Alan Greenspan Might Have Said Is a Lot
                  More Revealing Than What He Did Say


                By Gene Epstein


                  Among all the candid statements Fed
Chairman Alan Greenspan made last
                  week before the Senate Banking
Committee, he might have added another
                  that's long overdue.

                  "From now on, Senators," he might
have said, "I'm going to abandon all
                  pretense that the U.S. central bank
pursues that colossal misnomer known as
                  'monetary policy.' You'll notice that
in my formal remarks, I didn't even
                  mention the monetary aggregates, and
you haven't bothered to ask me about
                  them.

                  "Indeed, if you had, I would have
referred you to the following sentence in the
                  report we just submitted to you: 'The
[Federal Open Market] Committee still
                  has little confidence that money
growth within any particular range selected for
                  the year would be associated with the
economic performance it expected or
                  desired.' That's why we're not at all
embarrassed that the monetary
                  aggregates grew faster than our
official targets in both '98 and '99, and why
                  we're not bothering to raise the
targets for 2000.



                  "In fact, long before I took this
job, our central bank gave up on trying to
                  influence money growth directly. So
those targets are just a bow to a bygone
                  tradition -- all talk, with no action
intended.

                  "As for what kind of policy we do
pursue, economist Louis Crandall of the
                  New York-based consulting firm
Wrightson Associates has proposed we dub
                  it the 'financial conditions policy,'
which would be a step in the right direction.
                  But in the interests of brevity,
'financial policy' might do even better."

                  That refreshing statement might begin
to clear the air about the role money
                  plays in this economy.

                  People often ask: If Milton Friedman
is right in saying that inflation is always
                  and everywhere a monetary phenomenon,
why worry about the effect on
                  inflation of real forces like tight
labor markets or the price of oil or rising
                  demand from the wealth effect?

                  Answer: Because when those forces
start pushing on wages and prices, the
                  money follows.

                  You might even say that, in this
crazy world, an expanding money supply
                  doesn't cause higher prices; it's
higher prices that cause the money supply to
                  expand.

                  By fixing a price on overnight credit
through targeting the fed-funds rate, the
                  central bank powerfully influences
those real forces. But when it comes to the
                  actual process of money creation, the
Fed's role is completely passive:
                  Whatever amount of money the system
needs, it gets.

                  Take one typical way a new demand
deposit, otherwise known as a checking
                  account, comes into being. A firm
goes to its bank seeking to borrow $1
                  million. So the bank opens up a line
of credit for that amount in the form of a
                  checking account and voila, $1
million worth of new money has been created.
                  The bank's balance sheet shows that
it has just acquired an asset of a $1
                  million loan and a liability of a $1
million checking account.

                  But doesn't the bank have to have
some backing for that sum? Yes, eventually
                  it does. Since reserve requirements
are currently 10%, it has to carry a
                  reserve of $100,000. But if it
somehow can't come up with the cash, then the
                  Fed steps in to fill the gap. By
purchasing Treasury bills, it pumps an extra
                  $100,000 into the banking system,
thereby expanding the monetary base.
                  And assuming the cash doesn't get
deposited with our bank directly, then it
                  simply borrows those reserves from
another bank at the overnight fed-funds
                  rate.

                  Unlimited Supply

                  Now, of course, by raising the
fedfunds rate, the Federal Reserve can make it
                  more costly for the bank to borrow
that sum. So the bank might charge a
                  higher rate of interest on the $1
million loan -- and the firm that wanted to
                  borrow the money might decide to back
off. In that sense, then, the Fed does
                  directly influence the "price" of
money. But at any given prices, the supply is
                  unlimited.

                  Which brings us back to the real
factors that help determine the demand for
                  money. If wages are rising rapidly
because labor is scarce, then consumption
                  will soar -- and firms will be
induced to borrow more, thereby boosting
                  money demand. And if equity prices
are high, then investors might decide to
                  finance additional consumption by
taking out margin loans, thereby converting
                  some of their unrealized capital
gains to cash.

                  But even this story is far too neat,
since it conjures up a misleading vision of all
                  credit transactions somehow falling
into the net we call "money."

                  As Crandall notes, when Chase
Manhattan finances auto loans by issuing
                  certificates of deposit, that boosts
the category of money called M-2. But
                  when General Motors Acceptance Corp.
finances its auto loans by issuing
                  commercial paper, the effect is quite
different, since none of the conventional
                  money aggregates happen to include
that liability. Similarly, if banks choose to
                  borrow from overseas depositors, the
domestic money supply is also left
                  untouched.

                  And the point is, if some credit
transactions do increase the money supply,
                  while others don't, and if the mix
between the two keeps changing, then the
                  pursuit of a "monetary policy" is a
fool's game. And as for trying to redefine
                  "money" in order to track it all,
even the monetarists have abandoned that
                  idea. In this ever-changing economy,
any new definition will soon become no
                  better than the ones that are
currently in use.

                  Even defining what we mean by the
stuff that's directly exchangeable for
                  goods and services is a bit elusive.
By convention, M-1 consists of currency,
                  checking accounts and traveler's
checks. That used to exhaust all liquidity, but
                  not anymore.

                  Consumers can also pay bills by
writing checks against their retail
                  money-market funds, which are part of
M-2. And if need be, they'll draw
                  cash out of their savings deposit and
bust their CD before it matures, both of
                  which are also part of M-2.

                  (Then there's M-3, which includes
M-2, plus jumbo CDs, institutional
                  money-market funds, eurodollars and
RPs.)

                  But none of these M's include that
new coin of the realm, stock options,
                  which help pay for the cost of labor.
And as for near-money, shares of stock
                  and the equity in a home surely
qualify, since in both cases, a piece of their
                  value can quickly be converted into
cash through tax-deductible loans.

                  In any case, market participants can
swoop in and out of the standard M's
                  pretty much at will.

                  Since M-2 includes M-1, and M-3
covers M-2, the chart on this page shows
                  seasonal patterns in M-1, in M-2 less
M-1, and M-3 less M-2. Notice that
                  M-3 less M-2 dips in the spring
months and then builds going into the winter.
                  Both M-1 and M-2 less M-1 spike in
April as taxpayers assemble the money
                  to pay Uncle Sam.

                  M-1 declines toward summer as the
financial markets slow down and then
                  surges going into December in honor
of the holidays. (Especially this past
                  December, since banks were
accumulating cash as a precaution for Y2K.)

                  And through it all, the Fed acts as
facilitator, satisfying the needs of all and
                  sundry, while Greenspan & Co. are
free to busy themselves with more
                  important matters.

--
Gregory P. Nowell
Associate Professor
Department of Political Science, Milne 100
State University of New York
135 Western Ave.
Albany, New York 12222

Fax 518-442-5298