By Steve H. Hanke
Money matters — it’s a maxim of Prof. Milton Friedman that I repeat often in my columns, and to my students in class. Since the Northern Rock bank run of 2007 — the “opening shot” of the recent financial crisis — the money supply, broadly measured, in Poland and the rest of Europe has taken a beating. In the Euro-zone, money supply growth is anemic and becoming weaker, while private credit continues to contract. In Poland, the money supply has seen a recent slight recovery, but remains relatively weak. This is cause for concern, because the quantity of money and nominal gross domestic product are closely related.
When it comes to measuring the money supply, we must heed the words of Sir John Hicks, a Nobelist and high priest of economic theory: there is nothing more important than a balance sheet. These sentiments were recently echoed by my Parisian friend, former Governor of the Banque de France Jacques de Larosière, in his April 17th lecture at Sciences Po.
Components of the money supply appear on a bank’s balance sheet as liabilities. The money supply is simply the sum of the deposits and various other short-term liabilities of the financial sector. On every balance sheet, the sum total of assets must equal total liabilities. In consequence, the money supply (short-term liabilities) must have either an asset or longer-term liability counterpart on the balance sheet (see Figure 1).
Figure 1: The Balance Sheet of Monetary Financial Institutions
One of these counterparts is known as credit, and it includes various financial instruments such as private loans, mortgages, etc. Money and credit are often confused as synonyms, but they are not the same thing — credit is a counterpart to money. Any economist worth his salt should have the money supply on his dashboard. But, it is also important to look at what the financial sector is doing with these deposits — are they lending this money back out to the economy, and if so, to whom? There is one very important counterpart of the money supply that is particularly worth looking at — loans to private individuals and businesses, known as “private credit.”
In the Euro-zone, the growth rate of the money supply has historically moved in the same direction as private credit growth. Recently, however, this relationship has reversed. Despite a very modest rebound in the annual growth rate of the money supply (2.3 percent), growth in private credit has been contacting for over a year, indicating a severe credit crunch (see Figure 2).
Figure 2: Euro-zone Money Supply and Private Credit
How can Europe’s money supply (M3) be growing while private credit is shrinking? First, it is necessary to determine where on the asset side of the balance sheet this increase in the money supply (deposits) is going. As it turns out, a whopping 40.8 percent of the growth in M3 over the last year has gone to bank lending to governments.
In short, the money is going to government borrowing, and the restructuring of the liability side of bank balance sheets is modestly pumping up the Euro-zone money supply. Meanwhile, private credit remains in the doldrums.
And things are not much better in Poland, where annual growth in private credit and the money supply has been below its trend level for quite some time (see Figures 3 and 4) .
Figure 3: Poland Money Supply
Figure 4: Poland Private Credit
Following the collapse of Lehman Brothers in September 2008, private credit, in particular, took a beating (see Figure 5) – the annual trend growth rate dropped from 16.21 percent to 8.90 percent, leaving private credit currently well below its trend level.
Figure 5: Poland Money Supply and Private Credit
The main factor hampering broad money and private credit growth in the Euro-zone and the “Zloty-zone” alike is, not surprisingly, the government-created squeeze that has been put on banks as a result of the Basel III’s capital-asset ratio hikes. By requiring banks to hold more capital per dollar of risk assets (read: loans), the regulators have put a constraint on banks’ balance sheets, which limits their ability to lend (create private credit). In consequence, money supply and private credit growth has been slower than it would have otherwise been.
Even the International Monetary Fund (IMF) and the Paris-based Organization for Economic Cooperation and Development (OECD) quietly acknowledge that this will hamper GDP growth and raise lending rates. But, thus far, they have failed to fully assess the negative impact of raising capital requirements during an economic slump. The problem is that analysts at the IMF and OECD are not properly focused on private credit and the money supply. Indeed, when viewed in terms of money and private credit, the picture comes into sharp relief.
So, paradoxically, the drive to deleverage banks and to shrink their balance sheets, in the name of making them safer, destroys money balances and creates a credit crunch. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital-asset ratios. In the end, economic activity remains weak and unemployment continues to climb, which makes banks less safe.
Clearly, central bankers around the world have misdiagnosed the patient – a reread of Prof. Friedman on money, as well as Prof. Hicks and Mr. de Larosière on the importance of balance sheets, is much needed. Alas, the contradictory monetary policy mix – loose state money and tight credit – shows no sign of letting up anytime soon.
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