Here is Jason Rave over at Macro Matters on “History’s Lessons”:
Continuing with the Monetary theme I’ve had going lately, following Lars Christensen’s post about “Free to Choose” I decided to re-read Friedman and Schwartz’s “A Monetary History of the United States”. I came across this gem again, just about as beautiful explanation of a recession I think there is. Because of the number of parallels the passage has with the current economic climate, I thought I would share the relevant text here. The passage is referencing the banking crisis of 1907 in the US.
I am very happy to have inspired Jason to read Monetary History. It is a true masterpiece and anybody interested in monetary history and theory should read it. Jason goes on to quote Friedman and Schwartz on the 1907 crisis:
“The business contraction from May 1907 to June 1908, though relatively brief, was extremely severe, involving a sharp drop in output and employment. Even the annual net national product figures show a fall of over 11 per cent in both constant and current prices from 1907 to 1908
From May 1907 on, the stock of money, seasonally adjusted, declined in every month until February 1908 – mildly until the panic, then sharply. From May to the end of September, the money stock fell by 2.5 per cent, from September to February by 5 per cent. Though mild, the decline before the panic is worth noting. It gives some evidence of unusually strong downward pressure, at least in the monetary field. Thanks to its strong upward trend, the stock of money typically rises during mild contractions, declining at most for an occasional month or two. There are only three subsequent contractions in which the estimated money stock in any month of the contraction was below its previous peak by a larger percentage than the 2.5 per cent decline from May to September 1907 alone.
…”The initial decline of about 2.5 per cent (from May to September 1907) reflected in part a decline in high-powered money by about 1 per cent…the rest of the initial decline reflected a fall in the ratio of deposits to reserves, as banks increased their high-powered money holdings by some 5 per cent despite the decline in total high-powered money…(also) although the absolute amount of both deposits and currency fell, deposits fell by 2 per cent, currency by 5 per cent.
The subsequent decline in the money stock from September 1907 to February 1908, on the other hand, has all the earmarks of an active scramble for liquidity on the part of both the public and the banks. The stock of high-powered money rose by 10 per cent over that five-month period, yet the money stock fell by 5 per cent. As in 1893 the public’s distrust if the banks…(was) reflected in the combination of a rise in currency in the hands of the public, this time by 11 per cent, and a decline in deposits, this time by 8 per cent. The two together produced a decline in the ratio of deposits to currency from 6.0 to 5.0. At the same time, the banks sought to improve their capacity to meet the demands of the public by raising their currency holdings… The result was a decline in the ratio of deposits to reserves from 8.2 to 7.0. Taken by itself, each of the changes in the deposit ratios would have produced a decline of 7-8 per cent in the stock of money and, together, of nearly 14 per cent. The actual decline was kept to 5 per cent only because of the accompanying 10 per cent rise in high-powered money”
Jason then draws a very interesting parallel:
The similarities in the process of deleveraging and the flight to liquidity between then and over 100 years later are striking. I think what’s more important to remember for the current crisis and policy response is what Friedman and Schwartz gone on to describe as the post crisis response of economic agents;
“The deposit-currency ratio rebounded rapidly and within less than a year seems to have resumed it’s earlier trend. The deposit-reserve ratio resumed its rate of rise after 1908 but at a lower level rather than at the level of the earlier trend… The experience of the panic apparently raised the liquidity preference of the commercial banks for a considerably longer period than it did that of their depositors. The same contrast in the behaviour of the two ratios is noticeable after the monetary crises of 1884 and again after the troubled period of 1980 to 1893. We shall see it occurs again after the panic of 1933.”
Given the fact that Euro zone M3 is currently growing at a below trend rate (see here), and given last night saw the third record high level of overnight deposits held with the ECB at EUR827.534 billion, I’d imagine a similar dual speed deposit ratio recovery is prevalent in the currency bloc as we speak (stay tuned for some statistical analysis of this). This has important implications for policy. That is, if depositors regain confidence in banks more rapidly than banks do in depositors and the economy, the problem is bottlenecks in the willingness to lend on the part of banks due to permanent increases in the demand for money. Thus the ECB and other central banks should be doing all they can to meet this demand, as I have argued here and here, and should continue to flood the market with cheap money until they do so (were they not constrained by inappropriate inflation targets).
Despite being written over 50 years ago about events over 100 years ago, Friedman and Schwartz’s economic documentation is still incredibly applicable to events occurring this very minute.
So what Jason basically conclude is that the ECB’s actions since December basically is what Friedman would have suggested. I of course fully agree that Friedman would have advocated increasing the money base to avoid a collapse in nominal spending. However, I would also stress that a key weakness in ECB’s policies is the lack of a clear statement of the real purpose of these operations. The ECB needs to be much more clear on it’s nominal target. In the dream world the ECB would formulate a clear NGDP level target, but we all know that that is never going to happen.