Research Reports

AMERICAN INSTITUTE for ECONOMIC RESEARCH www.aier.org Vol. LXXIX, No. 11, June 18, 2012

The Changing Nature of Money Once upon a time, current policy would have yielded stronger growth and more inflation. by Steven R. Cunningham, PhD, Director of Research and Education

he same financial and techno- and inconvenience: savings accounts, in different accounts moves through Tlogical innovations that have money market accounts, and CDs. the economy in different ways. But contributed so much to our lives help M1 and M2 are the most commonly more about that later. explain why monetary policy stimu- discussed aggregates. During the inflationary environ- lus hasn’t been working, and why the When interest rates and infla- ment of the 1970s and early 1980s, broad-based price inflation everyone tion are low, as they are now, many the opportunity cost of holding is expecting hasn’t arrived yet. people hold all of their money in money in non-interest-bearing For more than three years, gross checking accounts. They aren’t accounts rose. Over time, as much domestic product has struggled to giving up much interest for the as possible, people moved into sav- maintain a growth rate in the 2-3 convenience, and they need interest ings accounts and CDs. Limited by percent range, and inflation has re- income less to offset inflation. When Regulation Q, created in 1933, banks mained surprisingly tame. Sustained interest rates or inflation rise, many paid no more than 5.25 percent in- expansionary monetary policy by people will move money from the terest on savings. Savings and loans the Federal Reserve over the same checking accounts in M1 to the sav- paid no more than 5.5 percent. period should have yielded stronger ings accounts and CDs, which are Eventually, inflation exceeded short-term GDP growth followed only in M2. Because M2 includes these amounts, and depositors by inflation. But it didn’t. M1, M1 changes, but M2 does not. sought higher returns. In the late To understand why requires a This matters because money held 1970s, the quest for interest prompt- deeper look at the phenomenon we call money. Innovation has changed Chart 1: Velocity of M1 money and the way it functions in Velocity of M1 money stock (M1V) 11.0 the economy. quarterly, seasonally adjusted Money has many attributes that 10.0

are inseparable. It is a collection of 9.0 assets; it is a medium of exchange; it changes hands. 8.0 Economists have created an array of definitions for money as a collec- 7.0 tion of assets. M1 measures narrowly Pre-1981 Trend → 6.0 defined assets that can be used di- rectly for transactions and bear little 5.0 or no interest (cash and checking 4.0 accounts, for example). Broader ag- gregates, M2 to M4, include interest- 3.0 bearing assets that can be converted 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 into transactions money at some cost Source: Federal Reserve

Inside this report In countries from Canada to Kenya, digital currencies and mobile payment systems are making transactions faster and more convenient. A virtual currency, Bitcoin, crosses national lines and is testing the viability of money that is backed by nothing. These high-tech alternatives to cash and cards are paving the way to the future. See back page. Also A few simple precautions can help summer travelers avoid rental frauds and hotel hackers. See Ask the Expert, page 3. Research Reports, June 18, 2012

Chart 2: Velocity of M2 linked directly to bank accounts, al- Velocity of M2 money stock (M2V) lowing individuals to sell securities quarterly, seasonally adjusted 2.2 and deposit the proceeds instantly into M2 accounts. Money changes 2.1 hands more quickly, but also shifts

2.0 between aggregates instantly. As it’s become more difficult to say 1.9 which aggregate funds belong to, it’s Pre-1994 Trend ↓ also become harder to gauge how mon- 1.8 ey works as a medium of exchange. Monetary policy creates incen- 1.7 tives for people to change their de- mand for goods and services, which 1.6 affects prices. The incentives operate along specific channels that econo- 1.5 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 mists call transmission mechanisms. Quarterly The channels have changed. If we Source: Federal Reserve know less about how money oper- ates in the economy, we certainly ed people to move out of M2 entirely ters even less predictable, since late know less about the impact of policy and into what was then a fairly new 2008 the Fed has been paying inter- or money supply changes. financial instrument: money market est on bank reserves, which reduces Behavioral shifts and financial accounts in brokerage houses. the payoff on bank sweeps. All innovation have weakened the Depositors’ actions ultimately led to this makes it harder to know how interest rate channel. All else equal, the repeal of Reg Q in 1986. But the sweeps distort our understanding of an increase in the money supply flow of dollars, driven by the quest the economy. usually lowers interest rates, making for interest, continues to this day. In the early 1990s, world events it cheaper to finance large purchases. In January 1994, the Federal Re- created another monetary shock. The This stimulates demand and is ulti- serve began retail sweep programs fall of the Soviet Union and the de- mately inflationary. In the 21st cen- that increased the movement of mocratization and marketization of tury, credit card interest rates often money among accounts that had dif- Eastern block nations led to hyperin- exceed 20 percent, and people still ferent impacts on the economy. flation in these countries and distrust use them. Firms, for their part, are The new Fed rule allows banks of their currencies. The solution for no longer so reliant on bank financ- to transfer balances from (M1) many was to turn to U.S. currency. ing. They have a wider selection of household transactions accounts Many dollars created during the pe- securities and derivatives than ever into (non-M1 M2) savings accounts, riod did not remain in the U.S. and before to turn to. which are subject to different reserve were not part of the domestic money Another key transmission requirements. As needed, the funds supply, skewing the data. mechanism, the liquidity channel, automatically shift back into transac- By making money easier to has been altered by the easy money tions accounts. The banking innova- move around, technology has fur- of the Greenspan Federal Reserve. tion allows depositors to earn higher ther confused matters. As money Today, with a money-supply expan- rates of return than they would moves more quickly among ag- sion of about $2.3 trillion since the otherwise. It also allows banks to gregates that behave differently, it end of 2007, we are still in such an reduce reserves, which, until recently, has become harder to predict how economy. The presence of so much did not earn interest for them. funds will impact growth, employ- cash has substantially reduced the Because the movements between ment, and inflation. effects of changes in available cash M1 transactions accounts and M2 In 2012, individuals can transfer balances in individual accounts and interest-bearing accounts affect bank funds in and out of M1 or interest- reserves in bank-owned accounts. reserve requirements, they affect bearing M2 accounts with a The speed at which money bank lending. This, in turn, affects smartphone app. But it doesn’t stop changes hands is called velocity. economic activity and employment. there. Banking services available That’s changed, too, from posting a The problem for economists, via ATMs, telephones, hand-held fairly steady rate of change to erratic policy makers, and the rest of us is computing devices, and comput- growth that makes predictions more that banks are not required to report ers make it easy to move money unreliable than ever. on sweeps. The amount of funds between M2 and broader aggre- The U.S. economy is producing involved is unknown. Making mat- gates. Brokerage accounts are often about $15.4 trillion per year in goods

2 Research Reports, June 18, 2012

and services, while the total amount As shown in Chart 2 on page 2, of money readily available for trans- velocity growth of M2 is also becom- ASK THE EXPERT actions (M1) is about $2.2 trillion. To ing more erratic. M2 velocity has been buy $15.4 trillion of goods and ser- much more stable than M1 velocity Summer Scams vices with $2.2 trillion dollars, each over the last 50 years or so, which is dollar has to be spent seven times. one reason why the Federal Reserve cam artists never go on vacation— Accordingly, we say that the velocity switched to using this aggregate when Sand some are looking for ways to of circulation, or simply velocity, of formulating policy. But M2 velocity is profit from yours. But there are steps you M1 is currently seven. (There is a moving a lot more money. The insta- can take to protect yourself. different velocity for each measure bility of this “more stable” aggregate is A lot of legitimate websites, including of money—M2 has its own, which is also confounding a clear understand- Craigslist, allow users to advertise vaca- different from M1’s.) ing of the economy. If money moves faster, it takes less Technology may be the dominant tion homes for rent. But a website cannot of it to stimulate activity and less of it factor in the decline in M2 velocity guarantee that a posting is authentic. raise prices. The money-GDP-price over the last 10 years or so. The Don’t be deceived by pictures of vaca- level relationship is summarized in a most recent downward trend has tion rentals. Scammers can easily copy bit of monetary arithmetic called “the left us with the lowest M2 velocity photographs from other advertisements. equation of exchange.” It works like of the past 50 years. It takes a big- If the person renting the property this. In percentage terms: money sup- ger change in M2 to have the same ply growth + velocity growth = real impact on nominal GDP than any asks you to wire deposit money, don’t GDP growth + inflation rate. time since the 1950s. This is one rea- do it. Scammers prefer to have money Chart 1 on page 1 shows that in son why the Fed’s stimulus efforts, wired because the transaction can’t be the 1960s and 1970s, the velocity of which pumped billions of dollars canceled, unlike payments by check and M1 grew at a steady rate of about into the economy, may have had credit card. 2.5-3.5 percent per year. This made such a lackluster effect on growth Contacting the tax assessor’s office in the arithmetic easy. For a given level and unemployment. of GDP growth, with velocity grow- More changes in the nature of the city where the property is located can ing at a constant rate, an increase in money could be around the corner. help confirm that an online vacation rental the money supply growth rate has to The monetary and fiscal crises in is the real deal. Check to make sure that the result in an increase in nominal GDP. Europe could lead to additional person renting a property actually owns it. Chart 1 also shows that after 1981 shocks to the monetary aggregates, Then track down the owner’s home phone or 1982, changes in velocity became as could further innovations in the number to learn if it’s a match with the erratic. Velocity summarizes the financial system. In such an environ- financial and payments system in a ment, monetary policy is as much art number you’ve been given. single number. The Fed conducts as science, and the effects of policy It’s also a good idea to Google the policy in the context of this system. may continue to be unpredictable. property address and the word “scam.” If the system is changing, then Uncertainty about the potential If the scammer has used the same trick velocity is changing, and Fed policy for inflation tops the list of conse- before, there’s a strong chance someone will yield unpredictable results. quences during these changing and has posted a warning. One source of change has been uncertain times. If the inflationary financial innovation. For example, impact of monetary policy will be Finally, the FBI has warned people the introduction of interest-bearing potentially less predictable, then in- about identity thieves hacking into hotel checking accounts in M1—another flation rates will be more volatile. For Internet connections to create pop-up outcome of the quest for higher in- individuals and businesses alike, this windows that tout fake software updates. terest of the 1980s—ultimately made volatility heightens economic peril. If you click on the links, you will down- more money immediately available Inflation is damaging enough load malware. Do all your updates before for transactions. In effect, this means to individuals and firms. But if that the velocity of M1 changed people know how much inflation you travel, and only update directly from because M1 changed. The Fed re- to expect and when it will come, the software company’s website. defined M1 in the early 1980s. Un- they can do something about it. —Steven J.J. Weisman is a lawyer and fortunately, a one-time re-definition Inflation that a person cannot pre- author. His website is www.scamicide.com. can’t fix continuing change. dict is far more dangerous. To submit questions for future columns, e-mail [email protected]. For guidance on specific situations, consult your lawyer or financial advisor. Read more articles about money at aier.org

3 Research Reports, June 18, 2012

Got Cash? Not for Long. Electronic currency will change the way we all do business, and the future is just around the corner. by Sarah Todd, Editor

n the digital age, hard cash is are the medium for M-Pesa. Many stead, Bitcoin users collectively own Ibecoming more exotic. Bills and people in these countries do not and manage the currency. Finally, coins make up just 7 percent of the have bank accounts or easy access Bitcoin is not backed by a physical money in circulation in the U.S. A to financial institutions. The digital asset such as gold or by any central poll released this May by the Ras- financial service, which is jointly bank. The currency maintains value mussen Report confirms Americans’ owned by Vodafone and Kenya’s only so long as enough people agree dwindling reliance on physical cur- Safaricom, lets users transfer and that it does. rency: 43 percent have gone a full receive funds through text messages. These properties make Bitcoin week without paying for anything In Kenya, 73 percent of adults use risky. The currency can easily with cash or coins. mobile money. lose value, and it has. It plunged Countries from Sweden to To transfer funds, people go to from a peak value of nearly $33 in Kenya are charting new frontiers an M-Pesa outlet that loads money June 2011 to a low of about $2 in in the digital economy, using text onto their phones. They then pay November. Today, Bitcoin is on the messages, smart phone apps, and bills, make purchases, or give money mend—but at about a $6 value, it’s virtual money for transactions. to others by sending a text message. nowhere near its former heights. These technologies offer a glimpse The recipient of the text brings the Digital currency can make of coming changes in the way the phone to the nearest M-Pesa vendor monetary transactions faster, more world conducts business. to collect cash. convenient, and more accessible. But Sweden is en route at present, cyber-security to a cash-free economy: Countries from Sweden to Kenya are chart- and privacy features still Physical currency makes ing new frontiers, using text messages, need to be improved. up just 3 percent of the And as digital payment money in circulation. smart phone apps, and virtual money. methods and currencies Most Swedish pubs do not become more popular, accept cash. A growing number of Closer to the U.S., Canada an- they will destabilize the average businesses and banks are following nounced plans in April to introduce rate at which money is exchanged. suit, according to a March report MintChip, a digital currency for Economists use that rate to predict from the Associated Press. transactions under $10. the impact of monetary policies. Sweden is also ahead of the curve MintChip will store Canadian This might not have an immediate on mobile payments. Many Swedish dollars in phones, tablets, and other consequence for ordinary people citizens purchase public bus tickets devices. Like physical cash, it is a paying daily bills. But in the long- via text messages. This summer, completely anonymous currency. It term transition to a largely digital the country’s four major banks also does not require a third party economy, uncertainty about policy will launch Swish, an app that lets to authorize or process transac- could mean rockier ride for all of us. mobile phone users transfer money tions, so money will change hands to one another electronically. And directly between users. Prototypes PayPal is currently testing mobile for MintChip apps will be an- gold corner payments in Stockholm that let nounced in September. people purchase goods at two major A different kind of digital cur- 1,900 $1,613.50 stores by swiping their phones over rency, Bitcoin, can be bought and 1,800 checkout scanners. sold in 15 world currencies, includ- Mobile payment options are well- ing U.S. dollars. 1,700 suited to Sweden’s high-tech popu- Bitcoin has three important 1,600 lace. The country has a ratio of 116.05 features. Bitcoins exist only online, 1,500 mobile phones per 100 residents, although they can be exchanged compared to the U.S. ratio of 89.86 for hard currencies. The system is 1,400 mobile phones per 100 residents. decentralized: No authority—either 1,300 In Kenya, Tanzania, South Afri- a central bank or a corporation— Jun-2011 Oct-2011 Jan-2012 May-2012 ca, and Afghanistan, mobile phones guarantees the currency’s value. In- Price of gold, June 14, 2012, London PM fix.

4 Research Reports (ISSN 0034–5407) (USPS 311–190) is published twice a month (except for combined issues in January and August) at Great Barrington, Massachusetts 01230 by American Institute for Economic Research, a nonprofit, scientific, educational, and charitable or ganization. Periodical postage paid at Great Barrington, Massachusetts and additional offices. Donate now at aier.org. POSTMASTER: Send address changes toResearch Reports, American Institute for Economic Research, Great Barrington, Massachusetts 01230.