Money Doesn’t Pour Into Markets

One often reads people talking about how investors poured lots of money into stocks, bonds, houses, gold, or some other asset.  Sometimes this fact is used to explain a big run-up in asset prices.  “The money had to go somewhere, didn’t it.”  This view is wrong, but it’s wrong in interesting ways, which reveal a lot about how people think about macroeconomics:

1.  First of all, at the most basic level it’s obviously wrong to talk about money literally “going into” markets.  If you visit Wall Street as a tourist and ask to see the big pot of money that people have invested in the stock market, they’ll give you a quizzical look.  Money goes through markets.  (Especially money created by the Fed; the monetary base.)

2.  Most sensible people who talk about money pouring into markets don’t mean it literally.  But even if the phrase is used figuratively, it is still wrong.  Indeed, let’s think about what people might mean by money pouring into a market.  Perhaps they mean that people are making lots of purchases.  Money is a medium of exchange, so lots of money is being used to facilitate stock purchases.  And it is true that on days when stock prices rise by an unusual amount, transactions volume of often higher than normal.  Unfortunately, that’s even more true of stock price crashes, which are often associated by an enormous volume of trading.  The famous stock market crash of 1987 was associated with record-breaking volume, but I don’t recall people saying investors poured money into the stock market that day.

3.  I have the same problem with people who talk about money being “saved.”  At the individual level that’s true, but my decision to hold on to more dollars means someone else is holding on to less dollars.  If we (collectively) increase our real holdings of base money, that is contractionary for NGDP.  But suppose we save in some other way.  If I buy a financial asset, someone else sells me the asset.  Suppose I buy a used house.  I pull $200,000 out of the bank (dissaving) and buy a house worth $200,000 (saving).  The seller gives up a $200,000 house (dissaving), and puts the $200,000 received by selling the house in the bank (saving.)  It’s never going to net out to any aggregate increase in saving unless new capital is built.  Now do the same example with a new house.  I pull $200,000 out and buy a new house.  Same as before.  The man who builds the house gets $200,000, so he actually increases his new saving by $200,000.  Aggregate saving in the economy goes up by $200,000.  What’s different is that the new house didn’t exist before being built, hence total wealth rises by $200,000.  Following the money is completely unhelpful for thinking about national saving, all that matters is whether new capital goods have been produced.

4.  Others point to the money created by the Fed, often called the monetary base.  Prior to mid-2008, this was composed of non-interest-bearing cash plus n0n-interest-bearing reserves.  Some argue that an easy money policy in the 2000s tended to boost real estate prices.  But why would this be true?  One possibility is that the Fed put lots of reserves into the banking system, and these reserves were somehow “lent out” for new home purchases.  In fact, roughly 95% of all new base money created in the years leading up to until mid-2008 was currency that went into people’s wallets, not new bank reserves.  This is even true in the short run.  Monthly increases in the base are overwhelmingly currency, with just a little bit of extra bank reserves (until late-2008.)  So it’s hard to see how this new “money” could have been pouring into the housing markets.  Money doesn’t have to “go somewhere,” 95% of it stays in wallets (prior to 2008).

5.  Others argue that the Fed held interest rates to very low levels.  But how did they do this?  Interest rates are set by the markets, not the Fed.  They can influence interest rates by injecting money into the economy, but if money was very easy shouldn’t we have observed a very rapid growth in NGDP?  Or at least a big increase in bank reserves, if you prefer that metric?  How do we know that rates weren’t low simply because the supply of credit schedule shifted right faster than the demand for credit schedule?  Why assume monetary policy is involved at all?

6.  Prior to 2008, the amount of new money created by the Fed is typically trivial, compared to the size of the economy.  And it was usually injected by buying T-securities, which is a huge and liquid market.  Thus it’s hard for me to see how the so-called Cantillon effects were important.  On a typical day the Chinese would buy more Treasury debt than the Fed.  If the Fed had bought German and Japanese debt instead of T-securities, then the holders of those securities would switch over and buy the T-securities the Fed was no longer buying.  The net effects would be tiny.

7.  Monetary policy can have a big effect on asset prices, but the effect has little to do with what assets the Fed is buying (until 2008, after that the purchases were so massive it might have marginally shifted interest rate spreads.)  My hunch is that if the Fed had bought index stock funds during 2002-06 instead of T-securities, the impact on asset prices would have been roughly the same.  If there was an impact, it was because monetary injections can raise expected future NGDP, and higher expected future NGDP can lead to an increase in the current prices of stocks, commodities, real estate, gold, art, etc.  But this doesn’t occur because money is a medium of exchange.  Suppose an auction house was silly enough to demand payment for multi-million dollar paintings in shares of Apple stock.  That might add 1% to the normal transactions cost for a wealthy investor buying a Van Gogh, but wouldn’t dramatically affect the price of the $100 million painting.  If the price of Van Gogh’s was soaring because an easy money policy was quickly raising future expected NGDP, those paintings would soar in value even if not paid for with money.  (Whether money raises NGDP via its medium of exchange role is a tougher question, where even market monetarists are split.)

8.  If wages and prices were 100% flexible then money would have almost no real effects.  Because wages and prices are sticky, money does have real effects on output and real asset prices.  But not because money “pours into” particular asset markets, rather because more money raises NGDP, and this raises real output (if wages and prices are sticky), which raises real asset prices.

Money matters, but not for the reason most people believe.

Saving matters, but not for the reason most people believe.

Money and saving affect the business cycle (if at all), by affecting either M or V.

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