Friday, March 18, 2011

The Metric You Should Be Watching But Aren't

I recently made the case that money demand remains elevated and continues to be a drag on the economy.  The  flow of funds data for 2010:Q4 supports this conclusion.  This data shows that the share of nonfinancial private sector assets in liquid form remains relatively high.  Households and firms continue to hold significantly more liquid assets than they did prior to the recession.  The good news is that it the share of liquid assets  dropped slightly in Q4. Presumably, the share of liquid assets continued to decline in early 2011 though recent global events may change that.

Using the Flow of Funds data, the figure below shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are highly liquid ones (i.e. cash, checking accounts, saving and time deposits, and money market funds) as of 2010:Q4.  The figure also shows M3 velocity.

Other than the 1995-1999 period, there appears to be a strong negative relationship between these two series. The reason is obvious:  the greater the demand for liquid assets the greater the fall in spending and money velocity.  If we take the year-on-year growth rate of these two series, exclude the  1995:Q1-1999:Q4 period, and throw them into a scatterplot we see this indeed is a strong relationship*:

This liquid share seems to provide a good indicator of whether there remains an excess money demand problem that is preventing a robust recovery.  This, then, is the metric you should be watching but aren't.  Until it falls further we can expect nominal spending to remain sluggish.

*The full sample period has a R2 of 42%.


  1. DB, I still think you are looking at the shadows on the wall, not looking at the "real" factors.

    Recently I came across this quote from Nobel economist, William Vickrey from the 1990s which I hope you dont mind me posting here (its a bit long, but I think of great help in understanding what has gone wrong):
    Current reality: The time is long gone, however, when even the lowest interest rates manageable by capital markets can stimulate enough profit-motivated net capital formation to absorb and recycle into income over any extended period the savings that individuals will wish to put aside out of a prosperity level of disposable personal income. Trends in technology, demand patterns, and demographics have created a gap between the amounts for which the private sector can find profitable investment in productive facilities and the increasingly large amounts individuals will attempt to accumulate for retirement and other purposes. This gap has become far too large for monetary or capital market adjustments to close.

    On the one hand the prevalence of capital saving innovation, found in extreme form in the telecommunications and electronics industries, high rates of obsolescence and depreciation, causing a sharp decline in the value of old capital that must be made good out of new gross investment before any net increase in the aggregate market value of capital can be registered, together with shifts from heavy to light industry to services, have sharply limited the ability of the private sector to find profitable placement for new capital funds. Over the past fifty years the ratio of the market value of private capital to GDP has remained, in the U.S., fairly constant in the neighborhood of 25 months.

    On the other hand, aspirations for asset holdings to finance longer retirements at higher living standards have increased sharply. At the same time the increased concentration of the distribution of income has increased the share of those with a high propensity to save for other purposes, such as the acquisition of chips with which to play high stakes financial games, the building of industrial empires, the acquisition of managerial or political clout, the establishment of a dynasty, or the endowment of a philanthropy. This has further contributed to a rising trend in the demand of individuals for assets, relative to GDP.

  2. It seems to me then we should put money, however crudely done, into the hands of people who will spend it.

    Perhaps a national lottery that pays out double what it takes in? But you have to buy ticket of no more than $50, and the max payout per ticket is $200?

    Seriously, I would dump currency at night on street corners in modest neighborhoods.

    Is it possible we will do a Japan, as we cannot construct a way to get spending going? Even when there are obvious ways (such as I just mentioned) but they are not politically palatable?

  3. Housing prices are still falling. CalculatedRisk just headlined a piece on 18% of Florida homes being vacant. Banks have returned to paying dividends and buying back stock--but have not returned to mark-to-market accounting.

    Financial firms would not appear to be a reliable source of liquidity, so why should non-financial firms hold fewer liquid assets? Unless you are TBTF, like GE maybe, it's a risky game to play.

  4. David -

    How can you just blithely throw away the 20 1995-9 data points that don't fit your pre-concieved idea?

    With R^2 at the border of weak correlation as it is, I don't think you're making much of a case.

    Except for the 17 points in the tail, you have a cluster around 0,0. Yes, your best fit line looks good there and has a slant, but you're talking about a very small effect for most of the data set.

    I agree that there is an excess money demand. Corporations are sitting on it like brooding hens, and people can't get enough because their homes are under water, fuel and bread are expensive, and U6 is 16%.

    Which is why we need fiscal policy. It puts people to work.

    OTOH, thank you for the 50-year graph!


  5. Why does velocity seem to decline, post 1995? Velocity is measured as GDP/M3. But money is not just used to by new goods, which are covered by GDP, but also to buy existing goods, like stocks and existing houses.

    Imagine a situation were demand for existing goods increases and their price - the price of stocks, in this case - goes up. (M3+sales of existing goods)/M3 might stay equal but GDP/M3 might fall.

    The same thing did not happen during the housing bubble as this increase was financed by new money, i.c. (sub prime) mortgages.

    The (GDP + sales of secondhand cars + sales of houses + sales of stocks)/(M3 + new mortgages) metric might be the one to watch.

    Merijn Knibbe

  6. Very good, indeed. I use this useful indicator in Sapain to measure the demand of money, and it fit very well.

  7. ecb,
    Fallacy #7.
    I've been posting a lot of what Vickery had to say back in 96'. The guy was prescient. Too bad he's not with us any longer.

  8. nanute, I agree. Reading that 15 fallacies is quite extraordinary. How Vickrey was able to see so much so early is remarkable.

  9. Financial firms would not appear to be a reliable source of liquidity, so why should non-financial firms hold fewer liquid assets? Unless you are TBTF, like GE maybe, it's a risky game to play.