Using the Monetary Base as a Recessionary Indicator

"The reason why there is inflation is because the money supply is increasing"

I've heard that argument so many times over the years I decided to look at the data. So I began keying in the increase in money supply using the AMBNS data series at the St Louis Fed when I saw this problem:

Yep, the monetary base seems to have gone into overdrive since the Global Financial Crisis hit. The problem was, though, that in a credit crisis banks and financial institutions tend to sit on their money. I then discovered the EXCRESNS data series at the St Louis Fed, which measures excess reserves:

Yes well that graph is certainly frightening and pretty much confirms that the financial crisis we are experiencing is the worst since the great depression. Yet despite the fact that the Fed has been madly pumping money into the economy and increasing the monetary base (M0), "depository institutions" (ie banks, mainly) have sat on a lot of that money. In other words, a lot of the increase in money supply has been countered by a resistance to lend. Yet there is obviously a way to more accurately measure the net amount of money in the monetary base by removing the excess reserves from the monetary base figure. So to come up with the "Net Monetary Base", we get the M0 figure ("AMBNS") and take away the excess reserve figure ("EXCRESNS"). So I punched up the data into my spreadsheet and this is what I have come up with for the past 20 years:

Well there we have it. A line going up. Woo hoo OSO you've done some great work there.

But it's not the actual amount of money we're interested in so much as the annual increase. So here's the year on year increase in Net M0, with recession bars thrown in:

Now THAT looks more interesting doesn't it? In fact the most obvious question I had when I first made this graph was "What is that spike in the money supply in the middle of the graph?" According to the Federal Reserve Bank of New York:

A variety of factors continue to complicate the relationship between money supply growth and U.S. macroeconomic performance. For example, the amount of currency in circulation rose rapidly in late 1999, as fears of Y2K-related problems led people to build up their holdings of the most liquid form of money...

Interesting stuff. Yet there also seems to be another factor at play here, namely the fact that recessions seem to be associated with monetary bases that are only growing slowly. Let's look at the same graph for 1970-1990:

Oh well so much for that theory I suppose. Look those four recessions in the 1970s and early 1980s - obviously the money supply was increasing before and after these recessions. If we connect the above graph with the 1990-2010 one we'll even see that while the increase in the money supply drops in the late 1980s, it is still increasing when the early 1990s recession hits. So it appears as though the experience of a contracting money supply causing a recession is only applicable to the last two recessions. Or is it?

We need to remember that inflation is something which needs to be factored in here. While inflation can be caused by an increase in the monetary base, it can also result from an increase in money velocity as well as supply constraints. In theory, if the money supply is increasing (or decreasing) at a faster rate than inflation (or deflation), then it means that goods and services are getting "cheaper" in relation to the total money supply; conversely, if the money supply is increasing (or decreasing) at a slower rate than inflation (or deflation), then it means that goods and services are getting more "expensive" in relation to the total money supply.

So let's put that in some graphs - the spread between annual growth in the net money supply and annual inflation, for 1960-1970, 1970-1990 and 1990-2010:

Bingo! Suddenly it all makes sense. Recessions occur whenever the spread between the Net Monetary Base and Inflation is negative. A negative result implies that inflation is greater than the increase in the money supply, which means that a real deterioration in purchasing power occurs. It is thus a reliable recessionary indicator going back to at least 1960.

Of course one of the characteristics of this indicator is that while negative results imply a recession, the actual recession may or may not be directly associated with that period:

• The 1973-74 recession starts almost immediately the spread goes negative (it was the direct result of the 1973 oil crisis, which was a supply shock).
• By contrast, the 1980 and 1982 recessions start after a long negative spread period.
  
• The early 90s recession is also different in that it started after the spread returns to positive.
  
• The GFC recession started after multiple dips into negative territory and continued for some time even when the positive spread exceeded 1000 basis points.
  

Obviously if we keep a close eye on this spread, we can determine whether the economy is in danger of recession. At the present time (using data from November 2010), the spread is 426.61, which is healthily in positive territory. In fact, here's a graph of the last 36 months:

This shows that it was touch and go in the first half of 2010 as the spread neared zero but remained positive, but that things have improved somewhat since then.

To create this graph yourself you can download the following data from the St Louis Fed and use it in a spreadsheet:

• AMBNS (The Monetary Base)
• EXCRESNS (Excess Reserves)
• CPIAUCSL (Inflation Index)
• NBER recession cycles
  

The equation is simple:

1. AMBNS minus EXCRESNS = Net Monetary Base
2. Place the results of the Net Monetary Base and CPIAUCSL side by side in the spreadsheet
3. Use the spreadsheet to determine the year on year percentage growth of both the Net Monetary Base and CPIAUCSL
4. Take the year on year result for the Net Monetary Base and minus the year on year inflation result to discover the spread
5. Add recession bars from NBER data
   

Here is how the page in my spreadsheet looks with this data.

Update: 2011-01-08
Graphs showing each decade can be found here.

Iceland vs Ireland: Which is worse?

Much has been said recently about the contrasting fortunes of Ireland and Iceland. In 2008, both nations were seriously affected by the global financial crisis with both economies declining substantially. Recent commentators, most notably Paul Krugman, have argued that Iceland's response to the crisis has had a better outcome than Ireland's. Iceland, with its own currency, allowed the Krona to depreciate substantially - a process which caused an inflationary bout. Ireland, on the other hand, is part of the Eurozone and while capital flight has been felt in the Irish bond market, the Irish economy has not undergone a currency depreciation - a process which has caused a bout of deflation.

So in order to discover which nation has had a worse economic experience, I have mined some data at official sites. For Irish GDP data, I downloaded the latest Quarterly National Accounts; for Icelandic GDP, I looked up data at Statistics Iceland. In order to ensure harmony between the two datasets (and thus ensure apples are being compared to apples) I cross checked the data with the latest Eurostat GDP release. Then, via a spreadsheet, I have created an Index comparing the economies of the two nations. Here is that index:

As you can see the current situation is hardly good for either nation. According to this index, Ireland's economy has shrunk by 13.4% since 2007 Q4, while Iceland's has shrunk by 11.7%. The advantage that Iceland has over Ireland in terms of GDP is quite small. Moreover, Ireland's economy has been in trouble longer than Iceland's - it wasn't until 2008 Q4 that Iceland's troubles really began while Ireland's had begun 12 months previously.

Nevertheless, one important indicator shows a huge difference between the two: unemployment. The latest figures from The Economist show that Ireland's unemployment is currently 13.6%, while Iceland's unemployment is 7.5%. Another important indicator is the budget balance. The Economist tells us that Ireland's budget balance is -37% of GDP, while Iceland's is only -7.7%. While both nations have serious problems, these figures seem to show that Ireland's is far worse.

Of course one of the reasons why Iceland and Ireland are so different in their experience of the economic crisis is the one that Krugman likes to champion: devaluation. Iceland has allowed the Krona to devalue while the Irish are "stuck" with the Euro. Yet this argument assumes that exchange rate variations don't really matter - at least over the medium to long term. It is obvious, though, that Iceland's GDP has reduced in value in comparison to the Eurozone simply because of the Krona's devaluation. When we factor in the devaluation of the Krona when comparing the two nations, the difference is much starker:

The data for the Krona's performance against the Euro can be found here. I averaged out the monthly mid-range figures for each quarter. For example the Euro-Krona exchange rate for 2007 Q4 was 88.7466926667 while for 2008 Q1 it was 101.325026. I then assigned an index of 100 for the 2007 Q4 and used the math in the spreadsheet to multiply each quarter's decline in currency to the GDP figures.

According to this graph, Iceland's GDP, as measured in Euro, has declined by a whopping 52.1% since 2007 Q4, which is due to a combination of economic decline and currency devaluation. While Iceland's unemployment rate may be lower than Ireland's, holders of the Krona (ie the citizens, businesses and government of Iceland) have had their wealth taken away... not by taxes, not by spending cuts, not by austerity measures, but by the foreign exchange market.

Ireland has a number of choices, none of them good. One choice is to default on debt. Another choice is to take money away from households and businesses in the form of spending cuts and/or tax increases. Iceland, by contrast, has had these choices forced upon them by the currency devaluation. If Ireland had the choice of default, Iceland has already done this as international creditors have lost out on their investment. If Ireland has the choice to take money away from households and businesses, Iceland has already had this done as the purchasing power of the Krona has been essentially halved.

The Iceland/Ireland battle is an interesting one because it lines up different views of economics: Iceland is favoured by Krugman and those who believe in using inflation as a means to reduce real debt; Ireland is favoured by Europhiles and those who believe that currency devaluations and inflation damage economies; Iceland is favoured by those who are not too concerned about sovereign debt default; Ireland is favoured by those who believe that debt should be paid back, especially sovereign debt; Iceland is favoured by those who believe that the Eurozone and its "one size fits all" monetary policy is doomed to failure; Ireland is favoured by those who see inherent advantages in having a common currency and monetary policy which ensures that the currency retains its value; Iceland is favoured by those who believe that monetary policy should be used by central banks to help grow the economy when needed; Ireland is favoured by those who believe that price stability should be a central bank's sole concern, and that fiscal policy should be used by governments to grow the economy when needed.

My bet, of course, is with Ireland - the Eurozone recovery, led by Germany, will create a demand for Irish goods and services, grow the Irish economy and reduce Irish unemployment. Nevertheless it will be fascinating to see how these two nations perform as years go by.