A quick example on base money and money supply

A lot of people have a hard time understanding why base money growth (i.e. Fed printing) doesn’t necessarily lead to money supply growth. I’ve been beating this drum for a few years now, and I get the question a lot. So here’s a quick, non-technical answer:

Say base money is 10% of the money supply (close enough for illustrative purposes). Then, if the 90% portion is contracting because banks aren’t lending and consumers are deleveraging, it doesn’t take much contraction for this to more than offset almost any increase in the 10% (base money) portion. This is the basic concept.

Reality is a bit more complex because pre-crisis, much of the growth in credit came from the “shadow banks”, which were outside of the existing regulatory framework and weren’t part of the fractional reserve banking system. They financed their lending through the repo market. The shadow banking system has delevered/is delevering as well. In short, the increase in base money would have to offset both the reduction/contraction in bank lending and the reduction/contraction in the shadow banking system for there to be overall growth in the money supply.

So, even though the money supply of the banking system has returned to modest growth, the broader point is that there is no one-to-one correspondence between base money and the broader money supply. You can get rapid growth in the money supply when there is no base money growth (which happened pre-crisis), and you can get contraction in the overall money supply when base money is growing rapidly (which happened post-crisis). 

The main determinant, therefore, is really risk appetite: do banks and shadow banks want to lend and do others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?  These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around–in large part because of what Econ 101 taught us about the primacy of price and rational actors. 

If you want to know what is happening in the money supply, look to the lending portions of the economy, not base money, to get the real story. Don’t let the shrill cries of the inflationistas throw you off course.