Friday, August 24, 2012

Hanke's Prescription for Tight Money

In a forthcoming article in Globe Asia, Steve Hanke argues that, contrary to popular belief, the money supply in the U.S. is tight and that this is keeping the economy from growing. He reaches this conclusion in his article, Money: West vs. East, by looking at the combined liabilities of the central bank and the banking system. He says many economists make the mistake of focusing on the former and ignoring the latter. What's key is that the state money supply is dwarfed by the bank money supply.

Sure enough, state money has almost tripled since the collapse of Lehman Brothers in 2008. This is because the Federal Reserve has flooded the economy with dollars. At the same time, however, bank money has contracted thanks largely to new regulations and increased capital requirements. Indeed, Hanke shows that the bank money supply, which makes up more than 90% of the total supply, has shrunk almost 10% since the Lehman crisis.

Hanke's best solution is to relieve the banking sector of some of the onerous regulations imposed since 2008. He recognizes, however, that this can't happen quickly enough. Therefore, he prescribes a more immediate remedy. He says the government should borrow short-term money from the commercial banks and use the proceeds to purchase long-dated government bonds from the public. In effect, the government's net debt obligations remain the same, but the average duration of its debt decreases. When the government buys debt from the public, that money gets deposited into banks. As a result, this action increases the money supply without increasing net government debt.

This all sounds a bit like quantitative easing, but Hanke argues it is very different. With QE, the purchased bonds land on the Fed's balance sheet. They don't disappear. With his recommendation, the bonds are purchased directly by the government and are simply canceled out.

With interest rates so low, perhaps it would be better for the government to borrow long term from the banks and use the proceeds to buy back short-term bonds. Duration will rise, which does not seem like a good thing at first--unless, of course, you expect interest rates to rise in future periods. An outcome that appears quite likely.