Tight money. Visibly tight

Based on my rough estimate, repayment of principal for household debt runs on average about 5 percent of outstanding household debt each year.

Let's say the number is 5 percent for domestic nonfinancial debt in general.

Let's also say we don't borrow money to pay down our debt. So then we must be using transaction money for those payments. M1 money. M1 is the money we receive as paychecks. Pocket money. Checking account money, if anyone still pays by check. The money we use to buy all the output in GDP, except when we buy on credit. 

 

Paying down debt destroys money. So let's look at the quantity of M1 money after we subtract the 5 percent of domestic nonfinancial debt we pay off each year, and look at what's left in M1 as a percent of GDP:

M1 (less 5% of Domestic Nonfinancial Debt) as Percent of GDP

As you can see, transaction money was so tight between 2000 and 2010 that the repayment of 5 percent of the principal would have drawn M1 down to a number below zero. If you want an explanation for the cause of the financial crisis and Great Recession, this is all that you need.

Transaction money is the money we spend. Too much of it causes inflation. But not enough of it is a problem, too. And it is probably safe to say that every recession shown on the graph was caused by a decline in the quantity of M1 money. For the 2001 recession and the "great recession" of 2009, it is undeniable.

I stopped the graph in 2019 because the Federal Reserve redefined savings to be part of transaction money in 2020, adding some $12 trillion to M1 overnight. The FRED graph of M1 shows it. I see this change, and all of the increase since 2010, as an admission by the Fed that they let M1 get much too low, apparently without realizing it. Yeah, they watch interest rates like hawks watch mice, but the quantity of money is another matter.

You remember what Friedman said, right? No, not the "always and everywhere" thing. This:

There is strong evidence that a monetary crisis involving a substantial decline in the quantity of money is a necessary and sufficient condition for a major depression.

The quote is from Chapter 2, on page 48 in my copy of Money Mischief. Look it up in yours.

 

The moral of the story: In a tight-money world, excessive reliance on credit is ultimately self-defeating.

And, no: Counting savings as part of M1 money does not solve the problem.