What is monetary and fiscal policy?

In this post we look at government monetary and fiscal policy and how that are related. Very interesting stuff when you follow the actions of governments (spending/taxes), and reserve banks (interest rates).

General Monetary Policy

The process by which central banks control 1) the supply of money, 2) the cost of money or interest rates, and 3) the availability of money. See 'What is money supply?'. Monetary policy can be expansionary which increases the supply of money in the economy (used to spur economic growth); or contractionary which does the reverse.

• Expansionary policy. Total money supply can be increased by printing more money (increasing M0), lowering the cost of money (interest rates) and making easier to 'borrow' it into existence, and by lowering reserve and capital requirements on banks (allowing them to lend more). The US Federal Reserve has added an additional measure allowing banks to swap risky assets (code for assets that have lost most/all of their value, but the banks can't afford to admit it) for quality US Treasuries. This impacts their balance sheet and thus capital ratios by being able to account for the assets differently.
  
• Contractionary policy. Reducing total money supply by printing less (or taking money out of circulation), raise the cost of money (interest rates), and raising reserve requirements.

Monetary Policy Targets

Governments control or direct different policy objectives with monetary policy. These include:

1. Inflation targeting. Targeting a CPI rate of change, say 2-3% yoy, through changes to the overnight interest rate.
   
2. Price level targeting. A specific CPI number, through changes to the overnight interest rate.
   
3. Monetary aggregates. Targeting a CPI rate of change, say 2-3% yoy, by changing money supply (M0).
4. Mixed policy. Targeting low (full) unemployment and low CPI change (low inflation).
5. Gold standard. Targeting low inflation as measured by gold price by changing the fixed gold - currency rate.

Difficulties arise in monetary policy due to globalisation. With globalisation investment capital, and commodity prices are free to move across borders resulting in exchange rate fluctuations, whilst monetary policy is nation dependent. As of July 2008, we have the following quick summaries of monetary policy:

• US. Expansionary - The Fed is stuck between inflation and a failing economy, as it has dual mandates of price stability (low inflation - stability in prices) and employment (sound economy).
• China. Contractionary - Rampant inflation is being addressed with high and rising interest rates and increasing bank reserve requirements. However money supply is increasing (M0) as the Yuan is pegged to the USD, requiring China money printing and sales to artifically depress the Yuan.
• EU. Contractionary - The EU Fed mandate is price stability (low inflation) and is raising interest rates to contract the EU economy in response to high CPI. The EU economy is believed to be close to stalling point.
• Australia. The Reserve Bank is raising interest rates to slow a booming economy (based on the resources sector & government spending). Mandate is inflation targeting with yoy CPI 2-3%.

Fiscal Policy

Fiscal policy relates entirely to government spending. Like monetary policy, fiscal policy can expansionary or contractionary. Fiscal policy is expansionary when government spending exceeds income (money added to the economy), and contractionary when taxes exceed spending (money taken from the economy).

Governments spend of things like social programs, military/police, healthcare and education, as well as infrastructure like roads, airports and ports. Government spending can be funded through:

1. Taxation. Or taxes, surcharges, fees, levies, co-contributions, fines and other language that means taxes.
2. Sale of assets. Such as airports, highways, power plants, radio spectrum.
3. Draw-down of previous surpluses.
4. Borrowing money from capital markets. By selling government bonds.

Are monetary policy and fiscal policy independent?

John Hussman summarises best though this is a more advanced concept (albeit in a US environment. Swap Federal Reserve for your local central bank, and Congress for your local Government).

There is a simple way to think about the relationship between fiscal policy (government spending, taxes) and monetary policy (money supply, interest rates). It is what economists call the Government Budget Constraint

Government Spending = Tax Revenues + Change in Bonds held by Public + Change in Bonds held by Federal Reserve

What this says is that there are literally only 3 ways to finance government spending.

1. Increase tax revenues. Note that this is not necessarily accomplished best by raising tax rates. Regardless of how high the government has set top tax rates, government revenues have consistently hovered between 19% and 19.5% of GDP. The high deficits of the recent past are due to growth in the government share of GDP from about 19% in the 1960's to nearly 23% currently. This growth has been due primarily to an increase in Social Services expenditures such as Medicaid and Social Security. The share of GDP allocated to infrastructure (highways, telecommunications) as well as basic research has actually declined.

2. Sell bonds to the public. This borrowing from the public is the primary means of financing the government deficit. Other things being equal, if the government issues more bonds, the price of those bonds tends to decline, meaning that interest rates tend to rise. This does not mean that a government deficit raises interest rates (there is no statistical evidence to support this notion). The true burden of government is not how much it borrows, but how much it spends. If the government decides to raise taxes rather than borrow from the bond market, it is true that investors will need to buy fewer bonds, but only because they also will have less to invest (due to the higher taxes, which almost always fall on those individuals with the highest savings rate). Raising taxes to cut the deficit therefore does nothing to increase the supply of funds available to other borrowers, and therefore nothing to reduce the level of interest rates. A cut in government spending does increase the supply of funds available to private borrowers. This is particularly true if the tax and regulatory environment is friendly to investment, which can then offset the cut in government spending without a decline in GDP.

3. Sell bonds to the Federal Reserve. This is another way of saying print money.

In short, the Federal Reserve is not nearly as independent as it may appear. The Fed has the choice of whether government liabilities take the form of bonds held by the public, or money held by the public. The Federal Reserve can alter the mix of government liabilities (bonds held by the public vs. money held by the public), but the total amount of these liabilities is determined by fiscal policy, not monetary policy. The Fed can affect whether excessive government spending results in tight bank credit or high inflation, but it cannot prevent both unless Congress controls the growth of government spending itself.

Global Money Supply

In this post we look at Global Money Supply (M0 to M3). For a primer look at 'What is money' and 'What is money supply, inflation?'. But first a massive hat tip to Mike Hewitt at DollarDaze.org for his 2008 Global Money Supply update.

First, a table showing global money supply by the top 25 nations. Note that China, Russia, India and Norway did not publish M3, so an average multiple on M1 was used to estimate that data.

There are two very interesting facts in this table. The first is that top 6 countries account for 80% of M3, and the top 9 for 90%. Second, note that the average M3:M1 multiple is 19.4. This means that there is nearly 20 times more money in circulation that the money 'officially' printed by the respective central banks. Welcome to fractional reserve banking. This is consistent with an average 5% reserve requirement. See 'What is reserve banking?' for more information.

The next table looks at money growth for the same 25 nations ranked according to M0 year on year (yoy) growth. The rows shaded green show the top 6 (top 80%) nations according to M3 from above.

What is interesting in this table are the different growth rates for different countries. Since M0 is central bank control money, this is the best indication of what nations are doing. As of July 2008, we see the US and Japan having very slow money expansion, where as developing nations and petro-nations have high money growth. The reason for this high money growth is that these nations seek to maintain currency parity with the US dollar. So as the US dollar falls (becomes worth less for domestic economic weakness), these nations must print and sell their currency to maintain parity.

This excessive money printing is responsible for inflation in these nations. Remember to quote 'inflation is always and everywhere a monetary phenomenon' and you'll sound like an economist!

One last point, M3 can be a misleading money growth indicator as it captures large sums of money in money market accounts and liquid assets. During turning points in the economy, risk-adverse investors may sell assets such as property and equities and place this money in M3 type accounts. Of course this doesn't change the amount of money, just it's composition.

More to follow!

Bonds, inflation and the economy

In 'What is net present value?' and 'What are bonds, treasuries and corporate debt?' we looked at bond basics and bond fundamentals. Here we look at more advanced types of bonds and how they are influenced by the economy and inflation.

Let's be clear about how bonds work. Bonds are purchased for the current value (CV) of their future cash flow values (FV). For short term bonds such as overnight, 13 weeks or 1 year instruments this isn't hard to calculate. But when you work with long bonds such as a 30 year bond you need to be highly accurate with one variable...the discount rate. To show consider a special type of bond called a zero coupon bond. This bond pays no annual interest, instead returning the nominal principal amount at a date in the future. Let's consider a 30 year $1 billion zero coupon bond, with a discount rate of 4.22% and 5.30%. How much would you pay for this particular bond?

CV = $1B/(1+0.0422)^30 = $212.4 million (or a 79% discount to nominal)
CV = $1B/(1+0.0530)^30 = $289.4 million (or a 71% discount to nominal)

So for a 1.08% difference in the discount rate, this bond gained or lost 8% or $77.0 million. If you think this is not likely, look at the chart below (www.yahoo.com). This shows the implied yield (discount rate) on a 30yr US treasury.
As you can see the market is uncertain about the discount assumptions to make for such a long period of time. To see how these discount rate uncertainties translate into bond prices, let's look at two long bond ETFs (Vanguard - TLV, and SPDR Lehman - TLO). As you can see bonds can be a volatile investment, particularly at the long end of the yield curve.
The level of bond yields (discount rates) at different timeframes tells you a lot about the economy. Consider the following chart from Mike 'Mish' Shedlock, one of my favourite bloggers.
Looking at the 3 and 5yr US treasuries, we can see how bond market traders in late 2000 switched from worrying about inflation (high discount rate) to worrying about a recession. This is because the bond discount rate is basically made up of the markets opinion about inflation and economic activity. Shown below is the 'yield curve' for July 2008. This shows the forward yield estimates (discount rate) for different treasuries at different timeframes. Click here to go to this site which also shows a dynamic yield curve corresponding to the S&P500 over the last 6 or so years. A great feature.
The bond punch line... finally.
The reason bonds are so important is that there are trillions of dollars in bonds outstanding. Bonds are used to fund government debt (huge for the US and EU), corporate debt (huge for financial companies) and private debt (home loans, credit card debt, student loans). The bond market is at the heart of the credit crisis because bond holder demand higher returns (interest rates) when inflation or uncertainty rises. This raises the cost of borrowing for EVERYONE and why the mandate of central banks is price stability which by default means low and steady bond yields.

Next the great moderation and peak-credit. Peak oil is an insect bite compared to peak-credit!

What is Fractional Reserve Banking?

Here we look at the history, function, operation and some criticisms of fractional reserve banking. This is important as most every nation has a FRB system in place.

History

In the middle ages goldsmiths would take deposits of gold/silver coins and issue 'goldsmiths notes' to depositers. Over time these notes became a trusted medium of exchange. Soon goldsmiths realised not everyone would want their gold at the same time and began to issue more 'goldsmith notes' in loans than they had in actual gold. Thus were born the first banks which paid interest to creditors (depositers of gold/silver) and received interest from a greater pool of debtors (people the bank loaned money to).

Function

The US Federal Reserve summarises FRB:
Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money... For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to create "money".

Money Creation

Modern banks start with money from the nations central bank (M0). From here the amount of commercial bank money created through loans depends on the reserve requirements of the bank. From the NY Fed:
If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000).

Control of Money Supply (and inflation?)

We see that the money supply is either central bank money (M0) or commercial bank money (M1-M3). We also know that inflation is 'always and everywhere a monetary phenomenon'. So how can central banks control money supply?

• Central bank money. Central banks can directly adjust their supply of money as they control the physical (notes/coin) and electronic creation of money.
• Commercial bank money. Central banks control this through regulation by changing the reserve requirements on banks. For example, a 10% reserve requirement enables $100 to become $1000. A 20% reserve requirement reduces that figure to $500. Capital ratio requirements also limit the types of loans banks can make (more low risk loans, fewer high risk loans).
  

Criticisms of Fractional Reserve Banking

There are two general criticisms of FRB. The first is that changes in money supply rely on the commercial bank lending process. When contracting money supply, this can be achieve easily as bank foreclose or withdraw credit in response to higher central bank imposed interest rates or reserve requirements. However, when seeking to expand money supply, the bank must have a willing borrower to borrow the new funds into existence. When the economy enters a down turn, borrows may not be willing to do this. Thus lowering interest rates and/or reserve requirements in a slow economy can be like 'pushing on a string'.

The second criticism is that increasing money supply artificially through money creation effectively lowers the cost of money (interest rates) through a simple supply demand mechanism (more money than goods). Alternatively, reducing money supply can create money shortages (for loans etc) which pushes up interest rates. Low interest rates can lead to over investment in unproductive assets (such as US housing from 2002-2006). High interest rates can lead to under investment in assets needed for current and future productive capacity.

Business cycle recessions are seen by Austrian School economics (more later) as necessary to liquidate unprofitable investments made due to artificially low interest rates. Once liquidated, capital is freed up for new investment in productive assets to take place.

What is Money Supply, Inflation?

In ‘What is Money Supply?’ we look at different types of money, where it comes from and what it means for the economy.

Money supply

Money supply (sometimes called money stock) is the total amount of money held by the non-bank public. When classifying money we generally separate categories as follows (note different countries do this differently):

• M0. All physical currency (notes & coin), as well as central bank accounts that can be exchanged for physical currency (see what is money)
• M1. M0 plus money in checking or current
• M2. M1 plus most savings accounts, money market accounts, and small term deposits (certificates of deposit).
• M3. M2 plus all other term deposits (CDs), institutional money-market funds, repurchase agreements and other large liquid assets.

The practice of fractional-reserve banking leads to large variations in money supply.

Fractional-reserve banking

Most nations use fractional-reserve banking. When banks give out loans in fractional-reserve banking a new type of non-M0 money is created (the M1-M3 components). Large differences in the different types of money exist based on bank margin requirements. The above image shows money supply for the US (www.dollardaze.org). FRB is covered in more details in a dedicated post.

Money and inflation

The money supply equation (MV=PQ) provides a useful framework for considering the link between money supply and inflation. Here:

• M is the total supply (M0 to M3) of a nation.
  
• V is the velocity of money measured as the number of times per year each dollar is spent.
  
• P is the average price of all goods and services sold during the year.
  
• Q is the quantity of all goods and services sold during the year.
  

We simply here that if money (M) is expanded through excessive fiat money printing, then the average prices of goods and services (P) will increase. Provided money velocity and the quantity of goods and services remains constant. The increases in prices (P) will be called inflationary and a nations reserve bank will look to target that figure to the 1-3% range depending on the country.

So what is inflation?

A simple definition is that it is 'rising prices'. But that is just the symptom. What is the cause of inflation? Inflation is believed to be caused by excess money supply (fiat money printing). This was famously acknowledged by Milton Friedman with 'inflation is always and everywhere a monetary phenomenon'.

It is also important to understand that inflation measures such as the consumer price index (CPI) are an overall economic indicator. Like all averages, CPI is made up of rising and falling components. Lets look at different components:

• Rising: Food, fuel, healthcare
• Steady: Housing costs*
  
• Falling: Consumer electronics, automobiles, clothing

How you perceive inflation depends on where you live and the type of purchases you make. Let's consider three different countries:

• Indonesia: majority of purchases are food/fuel related. Indonesian's are experiencing very high inflation:
• USA: mix of food/fuel/housing expenses. Food/fuel are rising, however costs of housing are falling (July 2008). If you are buying a house then you stand to benefit from a large price decline (deflation) in housing saving you potentially tens or hundreds of thousands. If you already have a house, you are seeing only rising prices for food/fuel which is inflationary.
• Australia: mix of food/fuel/housing expenses. Food/fuel are rising, but with its booming economy, rising interest rates (not falling like in the US) is making housing and rents more expensive! Inflation in Australia is over 4% and the populace knows it.

In 'What is fractional reserve banking' and 'How to benefit from inflation' we look in more detail at these issues.

Curious readers can find out more about money supply