The Professors Were Wrong
Macroeconomic 101 teaches us that Central Banks can control the money supply and hence the economy. They can buy and sell treasury bonds; they can lift commercial banks' reserve margins; they can move interest rates. Indeed, there is an elegant formula depicting how Central Banks can control money supply and hence inflation: Price x Quantity (GDP) = Supply of Money x Speed of Money.
Unfortunately, the control and the formulae are far from perfect. This was shown in the tremendous growth and subsequent decline of money supply in the US before and after the GFC. This is now been replayed in China. In all of these cases, Central Banks find their policy tools have at best a temporary influence on the supply of money.
The root cause is that Central Bank's control mechanisms do not cover all types of money.
Central Banks' control over Common Understanding of Money
Going back to basics, what are money?
Rudimentary view of money are physical coins and cash.
More evolved view of money include deposits and lendings through expansion of banks' balance sheets.
Another level up we include investment grade fixed-income securities such as treasuries, bonds and asset-backed securities. These are created via expansion of balance sheets of institutions other than banks.
Central banks (or an affiliated central agency) can directly control the physical money. They can also control the banks' balance sheets pretty effectively. Finally, they can control to an extent the treasury bonds on the market through open market operations.
The control breaks down there. Central banks can only influence the amount of other fixed-income securities in the market by setting a theoretical price floor (the zero-risk cash rate). However, the actual price of such securities fluctuate depending on market sentiments (as reflected by changes in margin spread). Central banks have no mechanism of addressing the spread.
Therefore in times of optimism, soaring demand drives up price (lower spread) and leads to flooding of money in the form of bloated balance sheets stuffed with fixed-income securities. Money supply grows rampantly out of control. In times of pessimism, price drops (higher spread) and leads to an exodus of money as people dump securities (or alternatively they become illiquid as they lose credibility). Money supply dwindles significantly.
Money which Central Banks have No Control
There is another category of money which central banks usually does not measure and certainly have no control over. That is credit between non-financial institutions.
For example, my prepayments to my hairdresser is a form of credit. I have effectively advanced her a loan, with which she can invest to expand her hairdressing business. One company's account receivable is basically a portfolio of loans to other companies. The debtor company is effectively financing the working capital of creditor companies.
This pool of money is not controlled by the cash rate (since their usage does not usually involve interest). Nor is it affected directly by banks' reserve margin, since banks are involved in their creation. Hence central banks do not have effective means of moderating them.
To make matters worse, this fourth form of money is very pro-cyclical. It expands when people and companies trust each others' credit-worthiness, i.e. when economy is booming, optimism is high and everyone's rolling in cash. It can be choked off when companies start doubting each other, i.e. when economy is slowing, everyone's worried about being paid, which in turn affects their ability to pay themselves.
Implication: Central Banks have limited potency
Without going into the numbers, we can at least conclude that central banks are far from being able to control all of the money supply. There are at least 2 types of money they are impotent over.
This article is not arguing the theory behind Monetarism - counter-cyclical control of money supply can moderate economic cycles. It is raising questions about if our institutions can do what Monetarists want them to do - can they actually control the money supply?
This pool of money is not controlled by the cash rate (since their usage does not usually involve interest). Nor is it affected directly by banks' reserve margin, since banks are involved in their creation. Hence central banks do not have effective means of moderating them.
To make matters worse, this fourth form of money is very pro-cyclical. It expands when people and companies trust each others' credit-worthiness, i.e. when economy is booming, optimism is high and everyone's rolling in cash. It can be choked off when companies start doubting each other, i.e. when economy is slowing, everyone's worried about being paid, which in turn affects their ability to pay themselves.
Implication: Central Banks have limited potency
Without going into the numbers, we can at least conclude that central banks are far from being able to control all of the money supply. There are at least 2 types of money they are impotent over.
This article is not arguing the theory behind Monetarism - counter-cyclical control of money supply can moderate economic cycles. It is raising questions about if our institutions can do what Monetarists want them to do - can they actually control the money supply?
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