Extraordinary Demand to Hold Cash—The Mystery Persists
By Robert Higgs • Wednesday October 24, 2012 2:16 PM PDT • 11 Comments
Since the fall of 2008, the Federal Reserve System has pumped an almost incomprehensibly large amount of reserves into the commercial banking system—about $1.4 trillion.
In normal circumstances, this action would have given rise to hyperinflation. Of course, not only has no hyperinflation occurred, but scarcely any inflation at all has occurred, and policy makers seem to have lost more sleep in worrying about deflation than about inflation.
By this time, everyone knows that the hyperinflation did not occur primarily because the banks simply held onto the bloated reserve balances, rather than using them to extend new loans and make new investments. Whereas it used to be the case that increased reserves fairly quickly translated into increased money supply, in the past five years the money supply has increased only moderately and, in certain spells, hardly at all. Additional bank reserves, as such, are not available to the public for making expenditures; hence they have not provided fuel for the spending that would have driven prices up more or less across the board.
However, the money supply has increased somewhat. Indeed, by historical standards, its increase in the past five years—about 38 percent for the M2 measure of money—has been fairly brisk.
Yet this increase failed to give rise to accelerated price inflation in large part because the public has chosen to increase the amount of cash it holds, rather than spends. In technical economic jargon, the money stock’s velocity of circulation has fallen substantially—by about 18 percent in the past five years.
The bulk of this decline occurred in 2008, when the financial debacle drove many individuals and firms to flee to the seemingly safest financial asset available amid the tempest of uncertainty—cash. After the winter of 2009, the velocity of monetary circulation rose somewhat, but during the past two years, it has resumed its decline. It now stands at the lowest level recorded in more than fifty years.
People ordinarily do not add to their cash balances (relative to their income) unless they believe that alternative assets will have lower risk-adjusted yields than cash. Because cash has a nominal yield of zero, the only way that holding it can have a positive real yield is if its purchasing power increases—that is, if people expect price deflation. Perhaps in the present situation, they have not so much expected deflation as they have considered the risks associated with alternative assets to be too great to compensate for their greater expected nominal yield.
I do not claim to have the One True Solution to the puzzle of why the velocity of monetary circulation has fallen so far and, more puzzling to me, why it has not rebounded more from the collapse it experienced during 2008. We live, it seems, in a time of extraordinary apprehensions about the future. Financial, economic, and regime uncertainties abound. Although some people enjoy remarking that fiat money is “just paper” and hence “essentially worthless,” the public in general has viewed it in recent years as valuable, indeed, so much so that they have greatly increased their demand to hold it, and they continue to maintain and even to increase this extraordinary demand for the asset with a zero nominal yield.
Tags: Bailouts, Economics, Federal Reserve, Government subsidies, Inflation, Money and Banking 
I don’t understand the mystery. Individuals, families, and businesses are worried about the economy. They are reducing indebtedness and increasing their liquid assets. Some are investing in the stock market, but it’s too risky for many. Bond interest rates are so low that they cannot overcome the losses that would occur if one has to sell early. So, people are putting money into savings accounts.
MingoV | Oct 24, 2012 | Reply
There is not only uncertainty about the future, there is uncertainty about the present and even the past! Uncertainty about events past: Can these large cash balances not just be assets against which to balance baked-in but not recognized losses in all sorts of malinvestments? Uncertainty about the present: why not hold a liquidity cushion because you can’t quite trust the mark to market of even your liquid portfolio of assets to refelct a liquidation value the second you (and the rest) think you have spotted the unwind of liquidity?
MG | Oct 24, 2012 | Reply
According to John Williams at ShadowStats.com,the real inflation rate over the last 4 years has been over 20% or well over 5% per year. Although the Federal Reserve Bank’s and the U.S. Government’s official inflation stats are often manipulated with bogus methodology and hedonics,this inflation rate if calculated like it was 30 years ago would show its true levels. It is obvious to any casual purchaser of fuel products: Gasoline,heating oil and natural gas or for anyone who buys anything at the local grocery store that retail prices have risen considerably. Not only have prices increased but the downsizing of packaging without a subsequent lowering of prices has indicated the shrinking purchasing power of the dollar. For example a 1 pound container of coffee is now 10.5 oz.or a 1/2 gallon of ice cream is now a quart and a half and so forth. Of course,many of the banks are holding their TARP money,in order to justify their balance sheets and at the same time receiving a quarter percent interest from the Federal Reserve. In other words we have zombie banks. Once the 17 plus trillion dollars worldwide that was created out of thin air is either lent out or hits the streets inflation should rocket up from its present,but under reported level,to the moon. In the end,its the average Middle Class citizen who hasn’t had a real increase in wages in almost 40 years plus the poor,the elderly who watch the purchasing power of their savings eroded plus Bond holders and savers who get screwed. In the 5000 plus years of nations and economics paper fiat currency has always failed and led to civil unrest,revolution and despotism. Only Gold and Silver,which is real money,has worked in the long run. Always.
libertarian jerry | Oct 24, 2012 | Reply
The decreasing velocity of money is a direct result of the increase in excess reserves.
Businesses and households that could rely on credit for exigent purchases must now have cash on hand for those purchases.
JoshINHB | Oct 27, 2012 | Reply
Gov’t policies for 2013 are unknown and we’re preparing for the worst. Major asset fluctuations are coming. Some may be corrections. Is anybody else waiting for a big collapse in the stock market or the price of gold or more cities to declare bankruptcy?
The stock market used to be a leading economic indicator. Now, I’m not sure what it is but it sure seems to depend on a man named Bernanke.
Interest rates? What are those?
Paul Hoffmann | Oct 29, 2012 | Reply
My cost of living for the basics of life has increased dramatically the last 3 yrs.
The cost of fresh meat in San Antonio is about double what it used to be 3 years ago. All food is much higher. City water is much more expensive, as is city electricity and city trash and cable and internet service. Oh and health insurance is way up. Gasoline?
Paul Hoffmann | Oct 29, 2012 | Reply
The entire issue of money supply and bank reserves is simply a numbers game. It makes banks look better on paper, at the taxpayer’s expense. The biggest difference between 1930 and today is that citizens of today can no longer hold gold. The only thing the vast majority can hold is cash: the prospect of holding wealth in the form of tangible real estate is beyond the means of the vast majority, and the high holding costs and taxation are a deterrent to many who can. At the micro level, a dollar does not go as far today as 10 years ago: re re basket prices. At the macro level, the USD value has fallen much more than 5% per year: re price of gold and oil, and exchange rates to other currencies. Both levels represent a decrease in value, which is likely more real than nominal.
al | Nov 7, 2012 | Reply