Given that I am regarded as a monetarist, and that I blame the 2007-09 recession on tight money, you might think it strange that I’ve never really discussed what happened to the money supply at the beginning of the recession. I notice that some commenters simply assume that the problem was an increased demand for money, produced by the financial crisis. After all, you’d expect an increased demand for liquidity during a banking crisis. And some money supply indicators rose sharply during 2008-09.
But this is not the case. It turns out that in an accounting sense the problem was a lack of supply of money during the early stages of the recession. During the period from 2003 to 2006 (when the housing bubble peaked), the monetary base rose at a fairly brisk and steady rate of about 5% a year. Then, beginning in early 2006, the growth rate slowed sharply. Indeed the base only rose by about 2.4% between early 2006 and May 2008 (1% per year), with the slowest growth occurring in late 2007 and early 2008, just as the recession was beginning:
So it wasn’t just errors of omission.
Why haven’t I emphasized this fact? Because I don’t think the base is a reliable indicator of the stance of monetary policy. It soared in late 2008, yet money actually got much tighter.
I don’t think the distinction between errors of omission and errors of commission is meaningful in the realm of monetary policy. Using my ship captain analogy, the captain’s equally at fault if he steers the ship on to a reef, or if he falls asleep and the wind blows the ship on to the reef.
But others do make that distinction, so I thought it might be useful to point out that by this criterion the Fed was to blame, and indeed committed errors of commission. The nominal recession was initially triggered by less growth in the supply of money, not more demand. Indeed it’s surprising that NGDP growth did not slow down even more rapidly during 2006-08.
After mid-2008 the surging demand for base money did become the main problem, and was caused by near-zero interest rates and IOR. That raises the question of whether there are any reliable money supply indicators.
William Barnett has a new book out which discusses the use of various divisia indices of money. These indices are analogous to the consumer price index, i.e. they don’t weight all types of money equally. I would encourage knowledgeable grad students to take a look at this link, and see what you think. The approach is certainly theoretically superior to simple sum indices, and one of the M4 indices shows a sharp drop in growth during late 2008 and early 2009. I don’t feel I know enough about the various indices to have an informed opinion, but it’s a topic I’d like to discuss in the comment section. When I get a better understanding of the pros and cons of this approach, I hope to do more posts. I’m especially interested in the intuition behind the sharp drop in M4 growth during late 2008.
PS. Michael Belongia and Josh Hendrickson, both at the University of Mississippi, are also heavily involved in the divisia index project.