I've noted the conspicuous drop in money supply in several earlier posts. As of last week, M2 money supply (seasonally adjusted) was down $40 billion (about 0.6%) since July 7th. M3 money supply is down $72 billion (about 0.8%) over the same period. MZM is down $87 billion (about 1.3%) over the same period. This is compared to 2003 before July 7th, where M2 rose $297 billion, M3 rose $383 billion, and MZM rose $311 billion over the six month period. Much of the growth was between April and June, when these money stocks were growing at annual rates in the high teens.
In theory, a drop in money supply should influence lending activity and thus economic activity. This is why money supply growth is often viewed as a leading indicator. But it is dangerous to draw hypotheses from data. Commercial and industrial loans from banks reporting weekly data fell $25 billion from 12/25/02 to 7/2/03 and $27 billion from 7/2 to 12/3. In a similar vein, real estate loans at commercial banks rose $139 billion for the first six months of 2003, and $69 billion over the next five months. The economy grew 2.1% in the third quarter. Consumer credit grew $47 billion from December 2003 to June 2004, and $36 billion from June to the present. It does not look like the drop in money growth has had any significant effect on growth or lending activity, except perhaps modestly on real estate lending.
What seems to have happened is that the amount of money going into M2 and M3 has slowed relative to the money coming out. Think of what happens when people purchase, refinance, or extract an equity loan from their home. The money will probably end up in a short term money account like a money market fund at a commercial bank. As the homeowner figures out what to do with those funds, it may end up as an automobile, in a mutual fund, as a down payment on an investment property, a luxury cruise, home improvements or whatnot, and it is no longer counted in M2. So while refinancing is increasing, the growth rate of money going in is faster than money coming out, when the refinancing boom slows down, the process reverses itself. Institutional money funds, also big parts of M2 and M3, are used as collateral for loans, so while huge amounts of real estate lending is going on, those firms will hold larger amounds of IMFs, and when lending slows, they will require smaller amounts. Seeming to back this up is data on total time deposits at all depository institutions, which grew $402 billion, or more than 10%, from December to June, and have been flat (up $35 billion) since.
So the screeching halt of money supply growth has not caused a screeching halt in lending activity. That's good in that sense. But the lending data and the current level of interest rates don't suggest any pickup in lending either, especially consumer and industrial lending, which we would expect to sustain investment spending and economic growth over the long term.
Where it has benefited companies is in lending spreads. With less funds required to sustain real estate lending, there is more capital left to be allocated to junk and higher yielding bonds. With CD rates at multi-decade lows, the demand for higher-yielding assets has also increased. In return, as demand has lowered higher-yielding borrowing rates, it has led to a flurry of corporate refinancing at lower borrowing costs, with lower interest payments reducing the need for cost cutting and job cuts to increase profits.
Is this process sustainable? Probably not. Junk bonds and stocks are priced for a continually improving economy. If we're lucky, we'll get half the growth of the third quarter, and half again of that in the first quarter of 2004. Christmas sales have not been encouraging, state and local finances are still strained, and employment gains have been meager. There have been glimmers of hope, such as the latest industrial production data, but these improvements in the monthly data have yet to show any staying power and are far from levels where they would lead to more hiring. Overall, expectations are very high relative to what I think this economy is going to provide.
The key imbalance developing is between business profits, which have improved tremendously, and consumer saving, which has deteriorated badly. This is the part of money supply that is most worrying. While savings in the GDP definition has increased, thanks to the tax cut, demand deposits at commercial banks have dropped $16 billion, or about 5%, while consumer credit has increased $36 billion. True savings should equal the net inflow into net worth. Even if we have more of our income left after expenses, if we draw down our checking accounts and run up our credit card bills, we can hardly call that savings. The tax cut has masked a crunch on consumer finances, caused by cuts in state and local government spending, job losses, increases in insurance and energy costs, and above all the reduction in the amount of home equity we can extract to maintain spending above what our incomes can provide.
Like most imbalances, the one between household savings and profits will rectify itself over time. Either savings will rise relative to profits (a big hiring spurt occurring without any increase in spending or profits), or profits will fall relative to savings. You can choose yourself which one you think is more likely. I've already done so. If the result of that adjustment means another increase in yield spreads, a number of riskier companies could quickly find themselves financial trouble, and the economy will quickly find itself in peril with little juice left in the policy gas tank. Extreme nervousness dead ahead.
I'm sure I'm as guilty as any economist/blogger in "administering corporal punishment to the deceased equine quadruped". While I developed a visceral hatred of math and arcane economic theory during a brief fling with an Economics PhD program, it's still very tempting to cover every assumption behind any economic conclusion just to "prove" I know what the hell I'm writing about. Economists in general are somewhat insecure because while the theory of economics has developed over the last 100 years, the actual economy is pretty much the same animal. Proving yourself to Brad DeLong requires a completely different style and organization than writing like Paul Krugman. The worst part comes when you disagree with Krugman yet need to write a coherent narrative. You can begin to attack his assumptions, start bringing in the economic jargon, and quickly become wholly unintelligible. Or you can keep it simple and morph into a 10-year old boy who can only say "Krugman sucks".
Which is why Brad DeLong laments that a two-hour lecture on the economic conclusions of a Ph.D-level paper quickly becomes a two-hour lecture on mathematics and modeling theory. He wants to explain the paper, but is worried that the students won't get it without explaining the math, so instead of losing two hours at the end answering background questions he blows it all at the beginning recapping theory. It's also why when Robert Kuttner criticizes Krugman on variety of issues he talks about where nothing can be done, it can quickly devolve into a discussion that means little to anyone. The discussion quickly devolves into long standing bitch sessions between differing schools of thought (e.g. Keynesians versus Austrians) and isn't about the economy anymore. Anyway, I'd thoroughly recommend crawling through a number of these links to see the various opinions on the subject. They're all quite good, except for him.
While some analysts are surprised by this, it was only a matter of time before consumers would run out of tax cut cash to spend. I think with third quarter GDP so fantastic, expectations were a little too high and mediocre growth looks much worse in comparison. From the reports I've seen, retail sales will still be up from last year, but 2-4% growth is not the blowout retailers were hoping for.
The Wal-mart article mentions that gift certificate sales are up significantly this year. I know from personal experience that we're once again going this route. Post 9/11, it's been far too much of a pain to lug presents cross-country to the family. While this would bode well for first quarter sales if it is a trend (retailers count certificates as sales when they're spent), if retailers have too much inventory then they will lose any profits discounting what they don't sell.
Tell me something I don't know. My November gas bill was more than double the October bill. Natural gas is not terribly fungible because the infrastructure is not as extensive as with oil - pipelines are regional rather than national. It certainly does set up the same conditions for manipulation as existed in California. Fortunately industrial users are complaining, so Orrin Hatch is leading an investigation. You can bet your sweet bippy that if it was just consumers, we'd be SOL.