Milton Friedman believes the Federal Reserve can afford to be
very generous with the money these days. The brilliant economist is right
Over the past 10 or 15 years, some supply-siders have ridiculed
Friedman's brand of monetarism. But they shouldn't have. In Friedman's
proven view, shifts in the money supply affect changes in national income
(as measured by the gross domestic product) and prices. While the speed at
which money changes hands is seldom exactly steady, the relationship between
money and GDP holds up over long periods of time -- and sometimes even
shorter periods of time.
Perhaps today's disappointing economic recovery and stock-market
decline can be traced to a recent growth slump in the money supply.
Here are some facts. The Fed provides the raw material (or cash)
to create the monetary base. The base, in turn, feeds or restrains the
growth of M2 -- a conventional measure of money that includes currency,
checking accounts, money-market funds and savings accounts. From the autumn
of 2000 to the autumn of 2001, this measure of money roughly doubled to 12
percent from 6 percent, as the Fed sent fresh cash into the economy. This
set the stage for economic recovery in 2002.
However, from the autumn of 2001 to the summer of 2002, M2
growth slipped all the way down to 4 percent. This nine-month decline in
money growth parallels the devastating stock-market plunge and raises big
questions about profits and the whole economic rebound.
The money slump has also released a new round of deflationary
pressures. As Friedman has written throughout his career, money matters for
prices as well as GDP. Inflation, or deflation, is a monetary phenomenon.
Prices of tradable goods have suffered as the Fed's money
spigots have closed. Yearly price declines have shown up in food (-2.4
percent), energy (-5.8 percent), gasoline (-3.6 percent), natural gas (-12
percent) and computers (-21.8 percent). And in the commodity sector,
crude-material prices have deflated by 4.2 percent -- so it's getting to a
point where monetary declines are coinciding with drops in commodity prices.
More broadly, price indexes for capital goods and consumer goods
have fallen 1.5 percent. Even the badly flawed consumer price index shows
the deflationary impact of slumping money growth, with computers,
televisions, software, cellular-phone services, toys, coffee, apparel and
camera equipment all deflating. In fact, nearly one third of the components
of the CPI are declining, according to economy.com. Only the service sector
has been immune from price drops, but this is largely because of government
Headline writers and talking heads will tell you that the Fed
remains accommodative to this economy because the fed funds interest rate
policy target remains at a four-decade low of 1.75 percent. But money flows
are much more important to the economy than the fed funds rate.
Yes, Alan Greenspan & Co. can control the funds rate, as well as
the money supply. But they can't control both at the same time. Therein lies
the single biggest conundrum for policymakers.
When economic activity slows, and consequently bank-reserve
demands come down, the Fed sells Treasury securities from its portfolio in
order to take cash out of the economy and stabilize the fed funds rate. So
while the Fed's target interest rate doesn't change -- tricking the headline
writers and talking heads -- the money supply is
ITAL) This appears to be the exact case today.
When the Fed takes cash out of the system, it shrinks the
reserve base and restrains bank deposits, loans and investments, creating a
credit crunch for small and large businesses. The Fed may think policy is
loose, but in fact policy as defined by money-supply trends is actually
getting tighter. There really is no other explanation for this year's
economic slowdown and price deflation.
More important than Iraq, or even a handful of corporate crooks,
is the slumping money supply. Investors have become increasingly fearful
that the outlook for profits gets worse without sufficient money to fuel the
economy and stabilize prices.
The greatest reform Alan Greenspan could make in his remaining
tenure at the Fed would be to downplay the interest-rate target and
re-emphasize the importance of money. Right after the Sept. 11 bombings, the
Fed did exactly that. "The Federal Reserve will continue to supply unusually
large volumes of liquidity to the financial markets," read the Fed's policy
statement of Sept. 17, 2001. "(We recognize) that the actual federal funds
rate may be below its target on occasion in these unusual circumstances."
Unfortunately, the Fed quickly returned to its old ways. By
stubbornly maintaining a fed funds rate of 1.75 percent instead of
fortifying the money supply, economic recovery hopes are fading. Until the
central bank comes to its senses, both the stock market and the economy will
continue to disappoint. Prices will continue to deflate. Business profits
will continue to disappear.
You say it can't happen here? That's what Japan said.
Commentators continue to warble on about oil, war, accounting fraud and all
the rest. But money is the key to where we are today. That's Milton