Managing the money supply is like slicing pizza

By DAVID MOON, Moon Capital Management, LLC
April 7, 2013

In the past five years, the money supply has increased somewhere from 38 to 80 percent, depending on how you define money supply. We know this is important, otherwise analysts and commentators wouldn’t remind us every day.

What is the money supply and why is it important? Or is it even important?

Economists tell us there are a number of different types of money. The most narrow definition of money is something economists call M0. It is the sum of all of the cash in your pocket and the change in the sofa cushions. If you combine checking accounts to the currency in circulation you get M1. The next category of money, M2, includes savings and money market fund balances.

If you add large institutional money market funds and jumbo CDs to M2, you get M3. (The money supply is a bit like the Rocky movie series.)

There are also M4 and MZM definitions of money, but you get the general idea.

The Federal Reserve creates money through the private banking system. When the Fed buys Treasury securities in the open market, it does so by crediting the selling bank’s account the cost of the bonds. Until credited to the selling bank, that money did not previously exist.

The selling banks can then lend a multiple of that money. That is, a bank can receive $1 million in electronic sales proceeds from the Fed then use that million dollars to originate $9 or $10 million in loans.

Voila! Money is created.

The Federal Reserve is assigned the role of managing the money supply, with the mandate of maximizing employment and stabilizing inflation. Additionally, the Fed uses monetary policy to pursue moderate long-term interest rates – whatever “moderate” means these days.

In contrast to its previous position, the Fed now says that inflation and GDP are not correlated with the money supply and its importance as a guide for the conduct of monetary policy has diminished over time.

Monetary policy is the management of the money supply. So, according to the Fed, the money supply has become a less useful tool for managing the money supply.

Call me naïve, but that doesn’t pass the smell test.

This prima facie nonsense is based on something called the velocity of money, or how frequently each M changes hands. More velocity results in more inflation, irrespective of the total amount of money in the system.

Think of the US economy like a pizza. If the pizza increases in size and isn’t cut into more slices, each piece of pizza has more cheese and pepperoni. But if the Papa John’s guy cuts the same size pizza into more slices - that is, prints more pizza slices – each slice becomes worth less, even if we don’t notice it when we begin eating.

Eventually we realize the slice is smaller. And if we’re buying pizza by the slice, we eventually figure out that a $4 piece of pizza is more expensive than a $4 piece of pizza used to be.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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