Cash is getting more important as bank deposits become less important
Cullen Roche has a new post that makes the following inaccurate claim:
The system we reside in today is not one designed around central bank reserves and cash. In fact, central bank reserves and cash are playing an increasingly less important role in the economy as time goes on. Reserve requirements are no longer necessary in well managed banking systems, cash is becoming a less common form of money and the importance of inside money (bank money or deposits) has become increasingly evident to the economy as the credit crisis proved.
In fact, both cash held by the public and bank reserves are a larger share of GDP than in 1929. For reserves, that’s partly because of the crisis. But currency as a share of GDP was higher in 2007 than 1929, so it’s not just about liquidity traps. As the role of cash has increased, bank deposits have become steadily less important with both DDs and TDs shrinking as a share of GDP.
Update 9/14/13: Mark Sadowski showed that my bank deposits statement isn’t accurate. There is a long term downward trend in bank deposits as a share of GDP, but recently there has been a sharp uptick, presumably due to the zero interest rates on alternative assets such as T-bills.
Roche contends that economists put too much emphasis on the base. But he overlooks the fact that the base provides a nominal anchor, a numeraire, without which it’s impossible to model the price level or NGDP. And that would still be true even if the base were just 0.00001% of GDP, which it might be in a future all electronic money regime.
While I’m nitpicking other bloggers, let me comment on this post by Ryan Avent:
And he [Tyler Cowen] asks why high-growth countries seem to have high rates of inflation. Looking at the chart we see that low-inflation economies are developed, for the most part, while high-inflation economies fall into the emerging-market category. That dovetails nicely with what we’d expect based on the Balassa-Samuelson theory. It points out that rich countries have higher price levels than poor ones. Productivity in the tradable sector sets wage rates across the economy; wages rise with productivity, and since producers of traded goods hire workers from the national labour pool producers of non-traded goods and services must raise their wages to compete for workers. Non-traded goods and services are therefore very expensive in rich countries and cheap in poor ones.
That implies that an economy experiencing rapid productivity growth in its tradable sector””because it is catching up to the rich world, say””will have a high rate of inflation relative to rich economies. Put simply, convergence of its price level with the price level in more developed countries necessitates a higher rate of inflation.
This is false; it necessitates a rising real exchange rate. But that can be achieved either through higher inflation or higher nominal exchange rates. Germany and Japan chose to raise their nominal exchange rates when they were growing faster than the US.
PS. Yes, lots of US currency is held out of the country, but that has no bearing on my argument. It’s all about the medium of account, not the MOE.
HT: lxdr1f7, Saturos
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13. September 2013 at 07:26
Scott, I don’t understand your point of view. If the Fed printed $1T tomorrow and locked it in a safe that couldn’t be opened for 1000 years it would literally have zero impact on the price level. That’s proof that it’s entirely possible for reserves to be meaningless (not saying they always are).
13. September 2013 at 07:47
effem, If they did that there’d be no change in the monetary base. Fed holdings of cash don’t count.
13. September 2013 at 08:07
“This is false; it necessitates a rising real exchange rate. But that can be achieved either through higher inflation or higher nominal exchange rates.”
High inflation in Argentina isn’t causing the real exchange rate to rise.
13. September 2013 at 10:23
Nick Rowe chimes in:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/09/moe-vs-moa.html
“I used to think that whoever controlled production of the Medium of Account controlled the price level. Now I think that’s wrong. Unless the Medium of Account is also the Medium of Exchange.” – N. Rowe
13. September 2013 at 10:42
Scott,
Empirically speaking I think Cullen is correct or at least “more right”. Any relation between money and NGDP requires money to be broadly defined to include bank deposits. You’ve said yourself the base isn’t a good indicator, and it’s relation with NGDP has become less reliable since 1929. (Even though currency held by the public has increased, which I find quite surprising).
Secondly, “Without which [base money] it’s impossible to model NGDP”, why is it?
13. September 2013 at 11:46
Scott,
Cullen Roche responds:
“Scott’s claims that bank deposits have become less important is categorically wrong. And I think this trend is only going to become increasingly magnified with time as technology evolves and banks and online payment systems become more advanced. In other words, the future of money is digital, not physical. And those theorizing about a physical world in a digital age will be left in the dust.”
http://pragcap.com/the-future-of-money-is-digital-not-physical
13. September 2013 at 12:04
E money is the future? That’s a laugh. All the commercial banks were about to die, vaporizing their emoney deposits after LEH.
Emoney is a derivative of physical cash, and just as ephemeral, and subordinated to the $600 trillion with of derivative contracts outstanding.
Such faith so soon. Almost unseemly.
13. September 2013 at 12:33
lxdr, I don’t follow. What is your point?
Chris, You completely missed the point. It has nothing to do with whether the base is a good indicator. It isn’t, but neither is M1, M2, M3, etc. The base is important because NGDP is measured in dollar terms. So the market for dollars has a huge role in the determination of NGDP.
Mark, I agree that the future of money is digital. If he thinks that fact somehow weakens my argument then he obviously doesn’t follow the argument. And notice that in that quotation he does not present any data refuting my claim that bank deposits are a shrinking share of GDP and currency is an increasing share of GDP. Facts are facts.
13. September 2013 at 12:56
JP Koning on MOA vs MOE (again!):
“Separating the functions of money””the case of Medieval coinage”
13. September 2013 at 13:39
Thanks for your reply. I agree, the market for dollars is very important. But why there is this insistance to call only the monetary base “dollars” is beyond me.
And just to query this “currency is a greater proportion of gdp relative to 1929, and deposits are less” argument. Perhaps black market currency distorts the numbers, also consider the rise of the shadow banking system as perhaps lowering deposits:gdp. Maybe deposits are still a large proportion, theyre just called money market mutual funds or w.e.
13. September 2013 at 15:22
Scott:
Part of the shrinking ration of checkable deposits to NGDP is due to measurement issues.
The banks report the transactions account balances after they sweep the funds out of them into something that has no reserve requirement. The customer, however, always has the funds available to cover checks or electronic payments. Sometimes the banks move the funds to places that are reported in a broader measure of the quantity of money. However, banks were sweeping funds to overnight repurchase agreements and those weren’t measured in any quantity of money.
MZM is probably the best, but it includes my savings account balance, which is not checkable. But my bank isn’t sweeping my checking account balance into my savings account.
13. September 2013 at 15:50
What’s the ratio of domestic, circulating U.S. currency to U.S. GDP?
13. September 2013 at 19:13
I couldn’t agree more! In a world of dimensionless numbers defining the units has a lot of power.
http://informationtransfereconomics.blogspot.com/2013/07/all-your-base.html
14. September 2013 at 02:26
Ok here’s a question to try and help me understand your way of thinking. How would you think about “The Corset” – a 1970s british banking policy you may be familiar which was used to stem excessive demand. Banks had their balance sheet size restricted, thereby restricting growth of banks’ contribution to the money supply but not of the monetary base.
How would you understand this in the Supply and Demand for monetary base determines NGDP framework?
14. September 2013 at 03:22
There’s actually far more base money (reserves+cash in circulation) in existence at present than bank demand deposits.
14. September 2013 at 05:59
Chris, we tried something similar in the late 70s. It was our government’s last, desperate attempt to avoid hiking interest rates. It led to a recession (or at least, the 1980″”not 81, which was caused by the aforesaid higher interest rates, but the downturn in ’80″”was blamed in Fed meeting minutes for tanking the economy in, if I recall correctly, late 1979 and early 1980).
Anyway, efficacy aside, Market monetarists (and certainly Scott Sumner) do seem to understand the effect of money supply restrictions (capital and reserve requirements, along with more explicit credit controls) on the money supply. From what I can tell, their position is that so long as the government doesn’t *change* such restrictions, they don’t affect the relationship between supply/demand for base money and NGDP.
I don’t really agree, though of course I’m a policy wonk, not a macroeconomist. From what I can tell, the private financial system *seems* to always find ways around restrictions on expanding the money supply, which is why modern central banks came to rely on interest rates to restrain credit (in many cases going as far as removing reserve requirements entirely).
The New Zealand central bank has a good paper on this (which I unfortunately can’t seem to find at the moment).
14. September 2013 at 06:05
Chris, Yes, black markets explain much of currency demand, but why use the term “distorts?” Demand for currency is demand for currency.
Bill, Good point.
Joe, Probably only 1% to 2% of GDP, but that has no bearing on my argument. What matters is the demand for currency, not what it’s being used for.
Thanks Jason.
Chris, I am not familiar with that policy, but if it reduced NGDP but not the base, then is must have increased demand for base money. Demand for base money tends to rise when banking is disrupted for any reason.
14. September 2013 at 09:00
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14. September 2013 at 11:27
hmmh… to Joe’s point, hundred dollar bills circulating in the black market in Asia are not relevant with respect to US economic activity or price level or interest rates in the US.
14. September 2013 at 11:33
as of 1996, more than half of US currency by value circulates abroad.
http://www.federalreserve.gov/pubs/bulletin/1996/1096lead.pdf
yet, I believe they are included in estimates of the monetary base, such as the currency in circulation on the H.6 release.
15. September 2013 at 07:16
druce, Of course they are relevant, just as the decision of scared depositors to put currency under their beds in the 1930s had a big effect on the US economy.
17. March 2017 at 06:14
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