by Emmanuel Martin

The “normalization” of monetary policy in the United States, which started with the first interest rate hike in December 2015, is in standby mode now. The unwinding of the Federal Reserve’s balance sheet after its formidable expansion since the 2008 crisis has been slowed down and interest rate hikes have been stalled. Fed Chairman Jerome Powell talks of a “patient” approach.

To many market-watchers, this could be a sign that the Fed does not even know what it is doing (as critics frequently charge). They are impatient to see a return to the clear rules that underpin long-term credibility and stability. For some monetarist economists, the focus on interest rates, rather than money supply and the negative impact of new banking regulations, unduly complicates things. Such economists see the policy normalization process as an opportunity for a paradigm shift toward better monetary and banking governance.

Follow the money

For monetarists, money is at the heart of economic dynamics. In that respect, monetary (money supply) policy takes precedence over fiscal (government spending and taxation) policy. The target is monetary stability. To some extent, monetarists oppose both free-market economists who insist on money “soundness” (rather than stability) and interventionist economists who do not mind an expansionary, inflationary monetary course. A monetarist criticism of the Fed’s monetary policy for the past three decades is that it had often been too loose, creating speculative bubbles and then too tight – constraining growth or recovery.

To prevent inflation, monetary policy should ensure that the growth of money supply in the economy is not too high compared to trend economic growth (which is different from inflation-targeting). To avoid recession, the money supply should not lag behind nominal gross domestic product (GDP) growth. The favored monetarist focus is thus money supply, rather than (actual or expected) interest rates and inflation rates. A monetarist economist such as Professor Steve Hanke links nominal GDP growth and aggregate demand growth to money supply expansion.

But which money supply? Traditional, narrow measures of monetary aggregates (M2), often used by central banks, might be leaving some money out. Today, some monetarists tend to use the broadest possible concept of money supply, which includes “quasi-money.” To make the measure as accurate as possible, quasi-money instruments are not given the same degree of “moneyness” but are weighted – less than notes or coins, for example, in the measure of money. The recent “Divisia M4” aggregate, based on such a method of not “simple-sum additions” is the monetarists’ preferred tool. It includes weighted measures of money-market funds, long-term deposits, commercial paperrepurchase agreements (repos), and Treasury bills.

Private and state money

This monetarist perspective has interesting consequences, notably when trying to understand the post-2008 crisis period. Indeed, other free-market economists feared depressed interest rates and Quantitative Easing (QE) policies would unleash inflation in the U.S. and Europe.

Regarding QE, the monetarist camp pointed out that central bank money is but a tiny fraction of money creation, the biggest chunk (between 70 and 90 percent depending on countries) of which comes from private banks (through credit) and non-bank private actors (through “repos,” commercial paper, etc.). During the economic slump, private money creation collapsed and QE monetary policies actually less than offset the fall – at least within the U.S.

Of course, QE also came with problems such as regime uncertainty and what Professor Larry White calls “preferential credit allocation,” susceptible not only to a simple lack of efficiency through credit misallocation, but also lobbying and cronyism.

Overall, the growth of money supply (state plus bank money) was low, despite QE – especially in 2010-12 and 2014-2016 for the U.S. Hence, there was sluggish economic growth due to a form of “credit crunch.” It was only between 2016 and mid-2018 that broad money supply in the U.S. finally fell in line with long-term economic growth, potentially explaining the country’s strong economic growth in 2018. For most of the postcrisis period, however, the monetary stance had been, according to monetarists, restrictive. How could this be?

Regulation and QE vs. recovery

Obviously, the 2008 crisis had a depressing effect on private money creation, as it brought fear and lack of confidence among economic actors. Less intuitively, though, zero-rate monetary policies themselves created a “zero-interest trap” – by shrinking banks’ incentives to lend to one another on the interbank market – and compressed banks’ profit margins. Interest paid on excess reserves at the Fed (to contain inflationary pressure) also contributed to a fall in the bank money supply. Worse still, this situation was compounded by stricter bank regulations that were supposed to improve the financial system. In 2010, Basel III banking regulations internationally and Dodd-Frank legislation in the U.S. had a tightening effect on private money. Banks’ ability to lend was constrained with toughened capital-asset requirement standards.

French economist Henri Lepage recently took the analysis further, beyond national boundaries. Since the 2000s, he argues, globalization has developed its own global wholesale money market, which uses safe assets (notably government bonds of developed countries) to securitize contracts. This translated into the production of “global money” (offshore dollars) – which is hard to track given the scarcity of statistics. New regulations and QE have had a negative impact on global money. QE absorbed vast quantities of safe assets, making them scarcer and increasing their price (and thus decreasing their rates). Global money thus decreased.

Price increases in safe assets (for collateral) add to the increased costs for banks and financial institutions. And new U.S. regulations to integrate global repo operations in capital-asset ratios and liquidity ratios of the few global “market makers” have given them the incentive to rein in their activities. As a result, the global money market is dysfunctional, which is not good news for growth.

The unintended consequence of the stricter rules is their pro-cyclical effect on the economy. For banks and non-bank actors, all this amounts to tight monetary policy. In the context of attempts to normalize monetary policy, especially the prospect of unwinding the Fed’s enormous balance sheet, a monetarist goal would be to ensure that private money can finally regain its place and compensate for the reduction in “state money.”

Such a process would require a serious paradigm shift. Banks need more freedom to respond to market needs. The current regulatory framework is too constraining.

Which ‘regulation?’

This raises the question of regulation. The banking system was already highly regulated from the top down before 2008. The first problem was that enforcing the regulations partly relied on experts from the banking profession – the regulators could be “captured” by the regulated. Then, because the regulations were so complex, banks would work around the spirit of the rules while respecting their letter. Third, the multiplicity of agencies created an incentive for banks to engage in regulatory arbitrage. Fourth, several government policies related to expanding home ownership (the American Dream Downpayment Assistance Act, the Community Reinvestment Act, the social-engineering missions of Fannie Mae and Freddie Mac) badly skewed the incentives of the entire system.

Another set of concerns relates to the new regulatory framework consisting of thousands of pages of rules: it is costlier but still shaky. Among the newly instituted rules are higher capital-asset ratios (Basel III). Beyond raising costs, these regulations imply that