How People are using their Money

It is instructive to take a closer look at how people seem to be handling their money. Obviously, people are not spending much, although the Federal Reserve sure cannot be faulted for not trying to jump start consumer and business spending. The monetary base, the sum of all bank reserves and money that can serve as bank reserves has gone from a year-over-year rate of increase of about one percent at the end of 2007, to a 101%, year-over-year, rate of increase at the end of 2008, to a 102%, year-over-year, rate of increase through the third quarter of 2009.

The unwillingness of banks to lend and/or the unwillingness of people to borrow shows up in how fast this base money turns over in the economy, that is, in the velocity of use of this base money. Whereas, velocity was increasing by about 4% through 2007, it declined by 101% in 2008, and was declining at a 104% rate through the third quarter of 2009.

The consequence of this was a build-up in excess reserves in the banking system. For a current review of this result see the column of Peter Eavis, “The U. S. Economy’s $1 Trillion Question”, in the Wall Street Journal (http://online.wsj.com/article/SB20001424052748703300504574565991276510968.html#mod=todays_us_money_and_investing).
If we look at broader measures of the money stock, we see similar results, but with some interesting shifts between money stock measures. The year-over-year rate of growth in the M1 measure of the money stock was roughly flat through the end of 2007, about 16% at the end of 2008, and approximately 19% through the third quarter of 2009. The turn-over, or, velocity, of the M1 money stock increased by about 5% in the earlier period, but fell by 16% through the year of 2008 and by 20% through the first three quarters of 2009.

The M2 measure of the money stock grew at a 6% year-over-year rate of increase in 2007, a 10% growth in 2008 and an 8% rise through the first three quarters of 2009. The velocity of the M2 money stock was roughly constant in 2007, but fell at annual rates of about 10% in both 2008 and through the first three quarters of 2009.

The difference in the performance of the M1 and M2 money stock measures tell of something very interesting in terms of how people are handling their money, but, it does not tell us much about how banks are lending because all measures of bank lending have been declining throughout the summer and fall months of 2009.

First of all, people have demanded more and more currency, a symbol of not only a move to security, but also an indication that people are paying for more of the things that they are buying with cash. The year-over-year rate of increase in currency outside of the banks was relatively flat through all of 2007 and through August 2008. In September 2008, however, the currency component of the money stock began to increase and was rising in the range of 10% to 11% by the end of 2008 through the September of 2009.
The other interesting thing about the growth of the M1 measure of the money stock was the rise in demand deposits at commercial banks. These are primarily “transactions” balances and serve much the same purpose as currency, reflecting the need to keep funds available for cash purposes. Also, people seem to feel more secure with funds in checking accounts than in other forms of bank accounts.

Demand deposits at commercial banks were actually decreasing all through 2007 and through the summer of 2008. In September 2008, the year-over-year the growth rate dramatically turned positive (16%) and then rose to a 54% rate of increase by December of that year. Demand deposits continued to grow at a 30% to 40% annual rate through most of 2009, falling off to about a 20% rate of increase in September and October 2009.

The interesting thing about this movement is where it is coming from. Primarily the movement into currency and demand deposits is coming from thrift institutions and retail money funds. The growth in savings deposits and small time deposits at thrift institutions turned negative in 2008, although the latter actually started to decline in late 2007. Since October 2008, the year-over-year rate of change of savings deposits at thrift institutions decline in the 7% to 9% range and the rate of decline in small time deposits at thrift institutions was in the teens for most of late 2008 before reaching 20% in the fall of 2009.

The biggest turnaround came in retail money funds. In late 2007 and through July 2008, the year-over-year rate of growth of money in retail money funds was in the 25% range. However, by the end of 2008, the increase was less than 10% and in March 2009, money was actually leaving these funds! In September 2009, the year-over-year rate of decline in these funds was over 16% and dropped further to -22% in October.

The bottom line of all this activity is that people have moved a massive amount of funds from time and savings accounts to demand deposits and currency. They have also moved massive amounts of funds from thrift institutions and retail money funds into commercial banks. There appear to be two main motives for this movement. The first is for people to have access to their funds for spending and to avoid the use of credit, if possible. The second is for people to feel that their funds are safer.

The consequences of this movement of funds are that the growth rate of the M1 money stock rapidly accelerated while the rate of increase of the M2 money stock only increased modestly. In recent weeks, however, the growth rates of both measures of the money stock have been slowing. Hopefully, this is a sign that fewer and fewer people are moving their funds into assets for use in transactions.

The next thing we need to look for in this area is a movement out of these “transaction” assets and back into time and savings accounts. It may take several more months for this to happen. When this movement begins we can gain greater confidence that people are feeling better about their financial circumstances and that the economy is, in fact, recovering.

Just a little aside on regulatory issues: A suggestion for restructuring the banking industry and its regulatory agencies would be to completely eliminate thrift institutions and the regulatory agencies overseeing thrift institutions and allow those thrifts that now exist the choice of either becoming a commercial bank or becoming a credit union.