Money supply

Many argue that the excess liquidity was one of the reasons for the international financial crisis. Moreover, it happened mostly due to the emerging economies’ actions. Let’s discuss this assumption on China’s example.

It has been already discussed that extensive inflow of investment into the U.S. economy was a possible reason for a crisis. Some argue that this was because of a “global saving glut”, which states that current account surplus in emerging economies was caused by increased savings in China and other developing countries. But if this phenomenon is observed from the other side, one can notice that the reason for money inflow to the U.S. might have been the monetary policy of emerging countries’ governments, which carried out the practice of increasing money supply in their economies.

One issue to consider is a comparatively high ratio of broad money M₂ (currency in circulation plus demand and time deposits) to GDP. China is well above the global average on this measure, while a somewhat similar economy in Brazil is well below. Nearly all of the countries that have higher M₂/GDP ratios than China are in Europe, but these countires are out of the scope of this discussion. More importantly, the ratio for China has been rising steadily in the recent years. The U.S. is the only one to benchmark, but it is an instructive one. In 1998, China’s M₂ was 70 percent smaller than in the U.S. In 2009, it was 35% percent larger.³ The following chart shows this discrepancy:

Let’s also not forget that China maintained an artificially weak currency to make Chinese goods relatively cheaper for foreign countries to purchase (thus stay competitive in its exports), thereby keeping its vast workforce occupied and encouraging exports to the U.S. One byproduct was a large accumulation of U.S. dollars by the Chinese government, which were then invested in the U.S. government securities and those of Fannie Mae and Freddie Mac, providing additional funds for lending that contributed to the housing bubble. This was so because, firsly, Chinese Yuan was tied to the dollar, and secondly, the U.S. was considered to be the “safe haven”.

If we consider the M0 supply in emerging countries economies, we definitely notice a steady upward trend in the period of 2000-2009⁴:

What can we derive from those graphs? The fact that in these economies the volume of money supply has been increasing, and to remain competitive in exporting, countries had to invest abroad, and the U.S. securities had been chosen as a safe and long-term investments place.

We suggest that the traditional equation CA=S-I can be rewritten as CA=(S + money supply)-I, which clearly signifies the fact that money supply growth can also be a reason for the excessive inflows of investments into the U.S. economy. This is why we suggest that such significant current account imbalances were as well caused by the increase of money supply in the developing economies, not only by the increase in savings.