The Delta Blues

What happened in 08

Was yesterday’s news.

What’s happening now

Is the delta blues.

I’m mystified by the emphasis some pundits are placing on totals while ignoring recent changes in those totals—the deltas. Even though most of the growth in the Fed’s balance sheet is almost two years old, some say its size is too big and must be shrunk. It’s the same with bank reserves and the money supply. Many say we have plenty of money out there and dangerously high levels of bank reserves. I say the markets and the economy have long since adjusted to those levels; it’s what’s happening to them now and recently that matters. It’s the delta stupid.

 Back in the day, I could quote you the change in real GDP for the past several quarters without trying hard. Yet, if someone had asked me the level of GDP, I would have had no idea. I remembered the last few months of changes in prices, industrial production, the money supply, and so on, but I, and most of my colleagues, couldn’t have recalled the absolute levels of these indices. Why not? Because the levels didn’t really matter to the state of the economy or policy. What mattered was how they were changing.

 I infer that Milton Friedman’s view of the proper level of bank reserves, Fed assets, and the like, was that they should all be whatever was necessary to achieve a moderate steady growth rate in the money supply. It was the growth or change in the money supply that mattered—not the levels.

When the FOMC decided recently to prevent major shrinkage in its portfolio from resulting from the run-off in mortgage-backed securities, that was not a decision to ease policy. It was a decision not to allow an automatic tightening of policy. It will become clear soon that it must do more and achieve whatever growth in its portfolio is necessary to keep the money supply growing, at least slowly.

 Referring to the high level of excess reserves being held by banks, many say “You can lead a horse to water, but you can’t make it drink.” If that’s true, the solution is not to take the water away. Add more water, and perhaps spike it with a little punch, until the horses start drinking. If monetary policy has not been sufficiently easy to promote faster growth, the solution is not to tighten policy but to make it easier.

 Remember the law of diminishing marginal utility in Econ 101? It says that additional units of something adds less to total satisfaction than previous units of the same thing added. While total satisfaction may rise with more, it will rise at a slower rate, and we will reallocate our holdings to substitute something with higher utils of satisfaction at the margin for something else providing fewer utils. We constantly reallocate, maximizing our satisfaction by having the marginal additions to satisfaction roughly the same for each portfolio item.

Holding money or cash is no exception. If we hold additional cash or banks hold additional cash reserves, total utility will rise, but marginal utility will likely fall. At some point the benefits of spending, investing or lending additional cash will outweigh the benefits of holding more of it. That calls for more money creation, not less. Eventually the horses will drink.

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