Weak Money Supply May Hinder Recovery
The BCCI scandal and the woes of major American insurance companies are raising the prospect of a renewed “flight to quality” in the financial system--and with it, a new tightening of credit.
By themselves, the BCCI and insurance debacles are so far minor shocks to the system. But they come at a time when the economy is struggling to pull out of recession and when the margin for error is razor thin. A lot can go wrong, and Murphy’s Law is as relevant as ever.
So one of the loudest debates on Wall Street and in Washington now centers on the adequacy of the economy’s safety cushion: the amount of money sloshing around in the system and whether it’s enough to protect the recovery from unforeseen shocks as well as to guarantee renewed growth.
Some experts argue that M2--a Federal Reserve tally of the money in such readily accessible places as consumers’ checking accounts, savings accounts and money market mutual funds--has grown far too slowly in recent months. Money has to flow to keep the economy moving, and a growing chorus of analysts fears that the money supply’s weakness is signaling trouble.
The issue has precipitated a verbal boxing match between President Bush’s chief economic adviser, Michael Boskin, and the Federal Reserve officials who essentially control the money supply:
* Boskin, backed by some veteran economists, argues that the Fed may have to cut short-term interest rates further, and soon, to make cheaper credit more available to consumers and businesses and thus encourage money growth. In theory, that would prompt more spending (houses, cars, etc.), keeping the economy on the recovery road.
* Many Fed officials, meanwhile, believe that the 2.5 percentage-point drop in short-term rates that they engineered between October and April was enough to assure a healthy economic recovery. The money supply trend is a fluke, they say; just give the economy time, and you’ll see.
Tuesday, Fed Vice Chairman David Mullins restated the Fed’s case, essentially dismissing Boskin’s concerns about money growth and the need for new interest rate cuts. “We’ve gone through the bottom” of the recession, Mullins told Reuters news service, adding that “the path we’re on looks adequate to allow the economy to grow.”
Robert Marks, president of SOM Economics in New York, is one who disagrees. “What the Fed has tried to do (since October) and what has happened are two different things,” he contends. “They’re trying to put money into the economy, but it’s not happening.”
The Fed’s own statistics show that M2 has grown at a 3.4% annual rate over the past seven months, to about $3.39 trillion now. That is near the bottom of the 2.5% to 6.5% range the Fed set for the money supply, despite the sharp decline in short-term interest rates that’s occurred.
Jerry Jordan, economist at First Interstate Bancorp in Los Angeles, believes that the 3.4% growth figure isn’t enough to turn the economy’s anemic second-quarter expansion into a bona fide recovery. “I’m scared stiff about it,” he says.
If the Fed has been pumping-up the financial system, why isn’t it reflected in faster money growth? One major drag on the system has been banks’ reluctance to make new loans, which translates into a reluctance to bid for savings deposits. Many bankers have been severely chastened by the losses they have so far suffered on all kinds of corporate, consumer and real estate loans. Their regulators have demanded that lenders be cautious. And even banks that would like to lend more are constrained by the need to bolster their own capital first.
Among large California banks, there was a significant contraction of loans in key categories in the first half of ‘91, as the chart shows.
Nationwide, Marks notes that annualized growth of a broad measure of corporate and household borrowing has fallen below 6% this year, to the lowest level since 1960.
Fed officials, however, believe that the more significant reasons for the lack of money growth are technical in nature, not a sign that there is too little credit available (and/or too little demand for it) to boost the economy:
* The ongoing shrinkage of the loss-ridden S&L; industry through liquidations removes many of those S&L; deposit dollars from M2.
* When individuals and corporations move cash out of checking or savings accounts and into longer-term investments--such as bonds--M2 drops. Money in bonds isn’t reflected in M2. And because more investors have been leaving low-paying short-term bank CDs in favor of higher-yielding bonds in recent months, the flight has been a significant drag on the money supply.
Marks, Jordan and other economists don’t doubt that money supply growth has been hurt by those technical factors. But that doesn’t change their basic premise: Short-term money such as that in M2 accounts has to be available to fund an economic recovery, and there isn’t enough of it, these Fed critics say.
The Fed’s great concern is that, if it cuts interest rates any further, it risks fueling too fast an economic rebound and a new inflationary spiral. Money makes the economy grow, but too much money causes demand to outrun production, and that leads to rising prices for goods and services.
But the experts who favor another Fed rate cut, and thus faster money growth, believe the greater risk now isn’t inflation, but rather a “double dip” recession: A new downturn in the fall, after the recent attempt at a recovery.
The BCCI scandal, the insurance companies’ turmoil and other financial shocks that have yet to surface (but undoubtedly will) pose too large a risk to the economy when credit remains tight and the money supply remains so thin, the Fed’s critics say.
“The risk of a double-dip is very high now--I’d say greater than 50%,” warns Lacy Hunt, chief economist of Hongkong Bank in New York.
