Monday, November 24, 2008

Where's the Money?

Milton Friedman once wrote:

Inflation is always and everywhere a monetary phenomenon.
—Milton Friedman, A Monetary History of the United States 1867-1960 (1963)

The Austrian school also believes that inflation is solely caused by Fed easing. The problem is this graph of the money supply and recent reports of deflation.

If the money supply has skyrocketed in an unprecedented fashion, how can inflation be falling? The only answer is cash is being hoarded. This harkens back to my cash bubble theory.

Where is it being hoarded? By banks at the Federal Reserve. Below is a chart of the deposits banks have at the Federal Reserve above what they are required. It is difficult to see the numbers earlier in the year, which is because they are so small. In the range of $42-45 Billion. The total deposits they have on hand have surged by $600 Billion. This account for 75% of the increase in the money supply. Data here.

My guess is that for many banks holding the cash is better than lending it. If they have to write down the value of the loan right after they lend it out, they will lose money and be in a worse financial position. So they hold cash.

The question now becomes, what happens once asset markets level hit bottom. Holding cash will no longer be desirable. As money starts to come out the incentives to lend will grow rapidly. Will the currency bubble burst with a huge jump in inflation? I'll be checking these data sources every day, to let you.

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