Savings(M2-M1) vs Consumer Credit

Savings(M2-M1) vs Consumer Credit*

The question of whether the currency is “over inflated” arose out of an article on the WSJ.

Inflation is typically considered as price inflation.  The hypothesis is that monetary inflation leads to price inflation.  In considering the purpose of money, I concluded that some level of inflation is required and that it should be as little as possible.  As little as possible is as close to zero as possible.  On a monthly basis, price inflation does drop below zero.  The concern is that, should it fall below zero for to long, deflation can occur.  As little as possible is, then, more of an empirical issue.  Examination of the CPI suggest that it has been held lower since 2005 than it was from 2000 through 2005.  So, at least in examining price inflation through 2010, it appears that it is as low as possible.

The concern, though, is that of monetary inflation.  And the reason for concern is that monetary inflation is considered to lead to price inflation.  This concern comes out of the quantity of money model.  I presented this model in a previous post, “Mitt Romney Part II“.  According to this model, an increase in the money supply leads to an increase in prices given that the velocity of money remains constant.  Formally, this is expressed as MV=PQ.  M is the quantity of money.  V is the velocity.  P is the general price level and Q is “an index of the real value of final expenditures.”

This model and it’s formal expression deserves considerable attention.  As a starting point for economic models, it is important.  What the model doesn’t immediately point out is that is also necessitates that wages must also increase with the increase in the money supply.  If the money supply doubles then wages also double.  Of course, if wages double, then buying power remains constant.  As such, while there is price inflation, there is equivalently wage inflation.  So, while nominal prices increase, real prices do not.

What is also doesn’t consider is that the money supply is separated into a number of different types of money.  Two of them are M1 and M2.  The specific definitions of M1 and M2 are available on Wikipedia.  The money measures include MB, M1, M2, M3, and MzM.  M1, M2 and MzM are the most readily available.  M1 is basically cash while M2 is cash plus savings.  It is interesting, then to look at M1 and M2.  And, what we are most interested in is M1 per capita, that is per person.  After all, it is the amount of money per person that is important.  As population grows, the economy needs more money per person.  And, of course, as the price of goods does increase, we are really interested in M1 and M2 adjusted for inflation.  What we get, from [M1]/{[CPI]*[POP]} and [M2]/{[CPI]*[POP]} is a value that represents the number of baskets of goods per person.

The graph is shown below.

If I have, in fact, interpreted M1 and M2 properly, what we have is a very interesting trend.  While both values to vary about the trend lines, they follow linear trends.  These are, of course, general measures.  They are the average for the entire economy, that is everyone.  M1, being available cash for spending on stuff, indicates that the standard of living has remained somewhat constant since 1959.  On the other hand, when we add saving and time deposits of less than $100,000 as well as money market deposits for individuals, we get a different picture.  It suggests that “someone” has been saving money. This “savings”, the difference between M1 and M2, on a per capita basis is shown below and is in real dollars.

Returning to Mitt Romney’s statement, we find that M1 is not inflated.  We do see that M2 has continued to inflate since 1960. What “over-inflated” means, is ill defined.  At least, in terms of price inflation, it is meaningless.  And, if M2 should produce some sort of issue, it is not an issue that has occurred recently.  And, being that M2 is M1 plus savings, it may be more fruitful to consider just that portion of M2 that is “inflated”.  This is shown below.

Rather, what Romney is refering to is likely to be the inflation of the monetary base.  The monetary base includes all of the reserve accounts.  With higher reserves, banks can lend more.  The purpose for the Fed inflating the monetary base is to allow M1 and M2 to increase as a result of lending.  Examination of the monetary base has inflated by some 2000%.

This increase seems to have manifested as an increase in M1 and M2, especially (M2-M1), seen as the bump at the very left end of the plot.  It is suggested that the banks are not lending, even though they have the reserves.  The concern is that the 208% increase in reserves will suddenly be unleashed in lending at a later date.   I will examine this in another post.


This examination of M2-M1 led me in an alternative direction.   What is somewhat bothersome is that, over this same period of time, consumer debt has increased.    Consumer debt has increase almost exponentially and is shown.

While the average individual has been accumulating debt, savings has continued to increase.  It  makes little sense that the rational consumer would both save at some minimal interest rate while simultaneously carrying credit card debt (revolving) at high interest rate.  It may be so, and is worthy of exploration.

There are a couple of ways to look at consumer debt, including the monthly change. The monthly change is the amount that is added each month and amounts to the additional spending on top of M1.  This will be examined later.

Another way of looking at it shown below.  To get consumer debt and savings on the same basis, both are adjusted for inflation and on a per capita basis.  For the sake of getting them on the same graph, savings is divided by three.  It is, for the most part, about three times the level of consumer debt.  The result is as shown.

This is a fifty year time span.  As the Fed interacts with the economy on a monthly basis, this is a span of 600 opportunities for interaction.  As individuals interact with the economy on a daily basis, even hourly, this is a span of more than 18000 individual interaction.  There is something obviously similar between the two curves.  There is also something obviously different.  Neither can be ignored.  They are, no doubt, connected in some manner.

This is, of course, not surprising.  A fundamental relationship in macro economics is that investment = savings.  Still, the relationship as shown isn’t exact.  And, I have yet to show that this data is, in fact, what the theoretical relationship represents.

Aside from the factor of 1/3, introduced to get the two curves side by side, there are other apparent relationships.  These deserves some exploration, a detailed exploration that will be tabled for later.  There is some general points to be made.  One simple reason that the macro theory isn’t an exact match to the data is that, as with all economic theories, is that it is a simplification.  Macro and micro theory attempts to illuminate the major effects while ignoring the “noise”.  This is, in fact, how all science works.  Even physics principles are oversimplifications that ignore “noise”.  Another may be that the savings here is all of it, as measured by the money supply. The investment is in terms of only consumer credit.

We have to be careful in terms of our perception of causality.  We are looking at macro measures.  They may be linked at very fine levels of a dollar here and a dollar there, but at a macro level we only find them connected.    In all, there is feedback in the system that leaves us unable to directly determine causality or even if movement at one point of the curve is for the same reason as movement at another point.

That the level of revolving credit follows the measure of savings is highly suggestive.  The savings loaned out as consumer credit card debt is a form of investment, at least from the point of view of the person making the loans.

I am going out on a limb, making this point here;  While cash income and expenditures on basic goods and services has remained flat since 1960, the money supply in terms of savings has increased.  This increase in reflected in the availability of funds for the purpose of loans on revolving credit.  The savings, though, is not reflected in the savings of the average consumer or middle class. (or so I’ve heard)  It is going somewhere, just not to the middle class.  Rather, the middle class has continued to borrow, on revolving credit.

I still remain unconvinced regarding Romney saying that “Bernanke has dangerously over-inflated the currency.”  There is no doubt that bank reserves have been increased by 200%.  But this does not lead directly to the interpretation or conclusion that our currency is over-inflated.  I am looking forward to determining what effect we might expect from these reserves in the future.  But, it is my understanding that the Fed also controls the reserve requirements.   Alone, the increase in reserves indicates only that the reserves have been increased.  There are mechanism in today’s economy that are keeping lending and borrowing low and whatever these are, they represent a different mechanism that has been typical for some three or more decades.  And, all that is necessary, should lending and borrowing suddenly increase, is for the Fed to increase reserve requirements.   Romney’s statement remains nothing more than a guess.


[1]  I should point out that the money multiplier effect suggests that (M2-M1) may, in fact, “double count” funds. Simplified, if I am to understand it correctly, it goes like this;  Bob borrows $10,000 from Bank of Alpha and purchases a car from Tim’s Auto.  Tim puts this in his savings, giving Bank of Alpha $9,000 to loan with a 10% reserve requirement.  Bob borrows $9,000 and buys a car from Tim’s Auto.  Tim then puts this in his account.  Now Bob borrows $8,100 and buys another car which results in another $8,100 in Tim’s account.  The result is that Tim’s account now has $10k + $9k + $8.1k = $17.1K.  Of course, Bob owes $17.1k.  So, in the balance of things, while one measure of money is $17.1k, the difference between savings minus debt is, in fact, zero.



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