First, a brief recall of the basics of monetary economics which deals with the relation between paper money and real economy. Milton Friedman theorised on monetary economics, won Nobel recognition. The Economist (2006) celebrated Friedman as possibly “the most influential economist” of the 20th century and the Econ Journal Watch survey (2011) ranked him next only to John Maynard Keynes.
Keynes’s thesis was that monetary policy should make money cheap to promote investment and consumption. Friedman differed from Keynes and theorised that money should play a neutral role.
His theory has proved good text for all times even as Keynes is good sub-text for abnormal contexts like credit-starved recessions. Friedman’s foundational logic is that inflation is ever and everywhere related to money supply.
Seeing a close nexus between prices and money supply, Friedman theorised that when prices rise, money supply should reduce and when prices fall, money supply should increase. Friedman also ruled that money supply should be strictly tailored to nominal growth in GDP. More. He was clear that genuine savings alone, not inflated credit money, should fund investments.
The US overcame its hyper inflation mess of the early 1980s by applying Friedman’s thesis. It restricted money supply to growth and successfully controlled inflation.
From then Friedman became the US Fed’s idol. Even recently (April 2011) in its paper called “Friedman’s monetary economics in practice”, the Fed defended Friedman against Paul Krugman who had criticised Friedman in his article titled “Who was Milton Friedman?”
Yet, by the 1990s, when the US increasingly began driving its growth through phoney credit money, the US Fed sent its idol to the archives. In July 2000, the Fed stopped setting target ranges for money supply growth. From June 2006, it ceased giving money supply data. In July 2008, it confessed that, in the past two decades, the relationship between money supply growth and growth of the US economy had broken down.
Recently, in May 2013, asking “What is the money supply? Is it important?” the Fed finally explained. First, as over some periods, measures of the money supply had shown a close relationship with nominal GDP and price levels, “some economists — Milton Friedman being the most famous example — had argued” that money supply determines the level of prices and inflation in the long run.
Second, the Fed had, at times, used measures of the money supply as an important guide in its monetary policy.
Third, in recent decades, as the relationship of money supply, GDP growth and inflation in the US had been quite unstable, the Fed had concluded that the importance of money supply as a guide for US monetary policy had diminished over time. This was a clear epitaph for Friedman's monetarism.
Burying the teachings
By when did the Fed, which idolised Friedman, bury his teachings? The answer lies in Fed’s words — “in recent decades” — pointing to the 1990s when phoney monies had become intense and invasive. Read on.
Post the 1980s, the US intensely globalised the dollar and actively created credit money for its survival and growth ( Business Line , June 13, 2013). Credit surpassed GDP several times over. In 1980, nominal GDP of the US was $3.7 trillion against which US bank credit stood at $4.5 trillion.
By 2010, nominal GDP rose to $14.3 trillion, but bank credit long-jumped to $51 trillion. In the three decades from 1980 to 2010, US GDP rose 3.8 times, but bank credit, 10.4 times. From 1970 to 2012, total US debt rose 51 times, external debt 160 times, federal debt 42 times, but GDP only 15 times — showing the total disconnect between real economy and credit money.
The picture of the money tsunami is incomplete without looking at shadow banking. According to the Financial Stability Board (2012) unregulated shadow banking in the US grew to $23 trillion in 2011 — meaning that much additional money got generated outside banks.
This is about 35 per cent of the US’ financial assets of $66 trillion – of which the banks’ share is far less, just 22 per cent! On top of this is the $244 trillion derivatives as of 2011. Yet, despite this financial tsunami, in 1980-2010, the US consumer price index moved up from 82 to 218 — up only 1.6 times.
During 1990-2000 inflation rose by 35 per cent but credit money more than doubled, to 81 per cent. During 2000-2010, inflation rose by 23 per cent, butcredit money went up by 83 per cent – some three-and-a-half times inflation.
How did the US manage to create so much phoney credit money and yet beat inflation — and defeat monetary economics?
For five unique, US-specific reasons, the US Fed claim that the relationship between money supply, nominal GDP, and inflation has broken down seems right.
One, the US has de-territorialised some $7.8 trillion in liquid cash and securities, held by other countries as forex reserves. Obviously, the dollars created in the US but circulating outside would not create inflation in the US.
Two, because of the consumption driven growth and huge imports, the US current account deficit of $9.2 trillion, which caused that much outflow of dollars, ensured that the US credit money explosion spilled out. This process also brought cheap Chinese goods into the US and moderated inflation.
Three, by the US maintaining and increasing the demand for dollars in trillions through reciprocal dollar recycling contracts, the US dollar, instead of falling, rose three times (see Business Line , July 11, 2013) again helping the US to tame inflation.
Four, the economic theories expounded by modern economists have led the US (and the world) to believe that while commodity price rise is inflation, asset price rise constituted prosperity and wealth, thus justifying credit-induced asset price rise as promoting prosperity. This perverse logic led to the creation of phoney financial wealth unrelated to real wealth, namely nominal GDP.
According to McKinsey Global Institute, the ratio of GDP to financial assets, which was almost equal at 10:12 in 1980, doubled to 22:43 in 1990, multiplied three times at 32:93 in 2000 and peaked to three-and-a-half times at 55:196 in 2007!
And five, to fuel growth essentially by asset price rise, the US Fed cut down the short-term interest to less than one per cent to entice households to borrow at cheap rates against the credit-fuelled fake appreciation of homes and stocks.
According to a 2001-2006 study co-authored by Alan Greenspan, the then Fed chief himself, US households borrowed $3.2 trillion against the fake appreciation in home values — for consumption. Lending against fake house values led to the sub-prime crisis.
The strategy behind US success in creating and deploying phoney credit monies without inflation was the globalisation of the dollar and the dollarisation of the world.
A cluster of reasons, including US lifestyle based on leveraged consumption financed by phoney credit in trillions, importing goods, and running current account deficit in trillions, contractually recycling back to the US at cheap interest the trillions dollars sent out, and investing borrowed trillions outside the US for higher returns, have made all this happen.
The phoney credits invested in stocks outside the US in 2002 fetched, by 2007, 52 per cent more than did investment in US stocks. While a dollar invested in foreign markets in 2002 returned $2.90 by the end of 2007, a dollar invested in the US market during the same period yielded only $1.90. Because of this, the net global equity position of the US shot up from a measly $40 million in 2002 to $3 trillion by 2007 (Gian Maria Milesi-Ferretti, International Monetary Fund).
Now, understand why the US campaigns for FDI into India. The phoney credit money is used to import cheap, borrow back cheap, and invest outside for high returns.
An unwary world was slowly drawn into the dollar recycling game without realising that trade, which was traditionally bilateral (between countries), has been made multilateral with the unilateral dollar as the arbiter.
In modern financial economics, phoney credit and liquidity substitute for both savings and capital. Greenspan, who discarded Friedman’s monetary discipline and adopted ‘neo-financial’ economics, became known as the ‘god of money’, because he created and inducted fake credit monies into the economy without inflation.
By recycling the phoney credit monies it has created and sent out, investing outside the US and earning huge returns, the US has escaped Friedman’s effect. It’s a model no other country can offer. After the 2008 financial crisis, Greenspan confessed that his belief in financial markets had been proved wrong. Modern economics has perverted monetary economics and created and globalised trillions of dollars of phoney money — with which the world cannot survive for long and without which it does not know the next step.
QED : The US has co-opted the world into holding the tiger's tail, with neither knowing how to let go of it!
(The author is a commentator on political and economic affairs, and a corporate advisor.)