The document discusses the sluggish economic recovery in the US despite massive monetary expansion by the Federal Reserve. It provides the following key points: 1) Most of the money from quantitative easing programs has remained as excess reserves held by banks at the Federal Reserve rather than flowing into the real economy or increasing bank lending. 2) Money supply has grown but credit growth and velocity of money remain low, restraining economic growth. 3) Investment remains subdued due increased uncertainty from issues like the ongoing Eurozone crisis. 4) Infrastructure investment is proposed as an alternative driver of growth and employment given the lagging housing sector recovery.

1. 83S. Nayak, The Global Financial Crisis: Genesis, Policy Response and Road Ahead,
DOI 10.1007/978-81-322-0798-6_4, © Springer India 2013
Rising output and rising incomes will suffer a setback sooner or later if the quantity of
money is rigidly fixed. Some people seem to infer from this (Quantity Theory of Money)
that output and income can be raised by increasing the quantity of money. But this is like
trying to get fat by buying a larger belt. In the United States today your belt is plenty big
enough for your belly. It is a most misleading thing to stress the quantity of money, which
is only a limiting factor, rather than the volume of expenditure, which is the operative
factor.
John Maynard Keynes, An Open Letter to President Roosevelt, The New York Times,
December 31, 1933.
Monetary Mechanics
Since the outbreak of the crisis in September 2008, the Fed has finished two rounds
of quantitative expansion and launched the QE 3 in September 2012. It has added
$1.9 trillion to money supply over 3 years and will inject $400 billion more over a
year. Money supply, M2, has gone up from $7.4 trillion in January 2008 to $10
trillion in August 2012, i.e., by 35% over four and half years and average annual
growth of 7.8%. Over the earlier decade 1998–2008, the M2 grew from $4.4 to $7.4
trillion, at the average annual growth of 7%. The roaring 1990s saw M2 rising from
$3.2 to $4.6 trillion, a lower average annual growth of 4.4%.
In spite of such mammoth monetary expansion and near-zero interest rates, the
economy has not responded with the buoyancy which it should have. To understand
this sluggish response, one must go into the monetary mechanics and ascertain how
QEs have percolated down into the different channels in the monetary structure of
the economy to influence vital economic parameters such as investment, consump-
tion, output, and employment. From the viewpoint of the monetary aggregates and
policy, the issue has been examined in economic literature and experience from the
Keynesian as well as Friedmanian angles. Although the Friedman’s analysis of
direct effect of money supply on output and employment in normal times known as
monetarism became prominent in 1970s, it lost its relevance later. Since 1980s,
Chapter 4
Why Is the Economy Not Taking-Off?

2. 84 4 Why Is the Economy Not Taking-Off?
interest rate emerged as more important tool of monetary impact, and Keynes’analysis
via interest rate again became preeminent. Further, in times of recession, the
Keynesian perception is more relevant and dominates in understanding of the
influence of monetary measures. Apart from this macro angle of money supply and
economy, it is essential to also examine microstructure of money supply. Money
supply is defined in many ways and gauged by different measures. To understand
the impact of money supply on macroeconomic parameters, one must first ascertain
the impact of monetary expansion on different components or constituents of money.
Money can be most narrowly defined as currency in circulation and as widely
defined to include not only demand, savings, and time deposits of banks but also
deposits of nonbanking financial institutions, money market funds. Another impor-
tant component of money is credit. Expansion in money supply without credit
growth is like pumping the air into leaking balloon.
Where is the money going? The money is still sitting tight in the Fed in the form
of excess reserves of banks with the Fed. The bank lending has not increased as
desired. The monetary base is getting bloated, but money supply is not growing fast.
What has grown is the demand deposits of banks and excess reserves of banks with
the Fed. Table 4.1 shows the growth in different components of money since 1990
over the last more than two decades.
If we see currency M1 and M2 since the crisis, we find that growth has been more
in M1 than in M2. Compared to the growth of M1 of 2.5% in 2000–2008, the
growth since the crisis in 2008–2012 has been record as 16.7%. The growth is in
demand deposits of banks and excess reserves of banks with the Fed which have
gone up from mere $1.6 billion in 2008 to a record figure $1,477 billion in 2012
(Fig. 4.1). Out of the QEs of $1.9 trillion, $1.48 billion is with the Fed as reserves
of banks. Money is yet to move into the productive channels of the economy. The
credit growth has not gained momentum. Bank credit before the crisis in 2008 had
reached the high of $9.5 trillion. This level was crossed in February 2012 indicating
the slow growth in credit demand as well as delivery. The commercial paper (CP)
issues are worst affected because of the fear of holding securities. The CPs outstanding
Table 4.1 Dynamics of money
C M1 M2 M2−M1 Ex Rs Vm2 Vm1
% % % %
(In $ billion)
1990 223 798 3,163 2,365 1 1.8 7.1
2000 524 (13.5) 1,140 (4.2) 4,633 (4.6) 3,493 (4.8) 2 2 8.9
2008 757 (5.5) 1,370 (2.5) 7,451 (7.6) 6,081 (9.2) 1.6 1.8 10
2012 1,060 (8.9) 2,400 (16.7) 10,123 (8) 7,723 (6) 1,477 1.6 6.9
Data Source: FRED, Economic Research, Federal Reserve Bank of St. Louis
C=currency in circulation, M1=C+demand deposits, M2=M1+savings and small time deposits
M2−M1=savings and small time deposits
Ex Rs=excess reserves of banks with the Federal Reserve
Vm1=nominal GDP/M1, Vm2=nominal GDP/M2

3. 85Monetary Mechanics
came down after the crisis from $2.2 trillion in 2007 to a low of $916 billion in
2012. It has yet to reach its precrisis level. M2–M1, which show the savings and
small time deposits of banks, have grown at 6% in 2008–2012 compared to 9.2% in
2000–2008. The growth in money supply is totally concentrated in the excess
reserves of banks with the Fed. Unless it percolates down to credit growth and into
more commercial paper, the recovery will be sluggish.
The velocity of money is still at record lows. The velocity of money, M2, is the
ratio of GDP to M2. It shows how many times money, $ in form of M2, moves in a
year to create GDP. During the 1990s, the Vm2 went up from 1.8 to a high of 2.1
before the dot-com crisis (Fig. 4.2). It dropped sharply after the crisis and to the
level below 1.6, the lowest since 1965. Vm1 has shown more dramatic drop from 10
in 2008 to 6.9 in 2012. The velocity money is yet to move up even after more than
3 years of antirecession fiscal and monetary nutrition.
Never in the history has the Fed given the lending support to the banking industry
to the extent it has done after the crisis. The banking industry has never approached
the Fed for major financial support. Until 2008, all the banking crises which the econ-
omy faced were managed by the government deposit insurance corporation, through
mergers and acquisitions in the industry and government support to the extent of $153
billion. There was hardly any Fed support in the crisis. In postdepression history, the
Fed has been managing money supply and its cost, but was never a large financier to
the banking industry $1.5 trillion in 2009 and to $2.5 trillion in September 2012 con-
stituting 25% of money supply, M2. Huge monetary expansion has yet to translate
into credit and accelerate the production cycle and promote growth.
Fig. 4.1 Excess reserves of depository institutions (Excresns). Shaded areas indicate US reces-
sions. 2012 research.stiouisfed.org (Source: Board of Governors of the Federal Reserve System)

4. 86 4 Why Is the Economy Not Taking-Off?
Sluggish Investment
One of the main reasons why the economy still to gain vigorous growth momentum
and employment is not growing at the rate it should have is that investment has not
picked up except in few consumer-oriented sectors not on the considerations of
profitability but because sheer uncertainty of the overhang of Euro crisis which still
needs to be resolved (Fig. 4.3). Until the Euro crisis comes to its logical and
financially viable solution, the investment climate in the USA is likely to be some-
what lackluster. While the ECB, Germany, and IMF have to be large contributors in
the financial involvement, China, Japan, and OPEC also need to give assistance to
avoid the backlash of Eurozone recession on their economies. The USA has its own
fiscal cliff to manage and can hardly afford to extend any finance. It can extend sup-
port in kind by exporting goods, including agricultural products, and swapping them
against the Eurozone’s holdings of US government securities.
The corporate America has been resilient and shown healthy growth. The sec-
toral and corporate changes are a part of the economic changes and capitalistic
system. That is what capitalistic system does to corporate on its knees. The indus-
trial or sectoral changes follow the technological progress and pull of consumer
demand. The market rules and capitalism are ruthless. Market-driven capitalism
does not spare the lax, nonresponsive, incompetent, and inefficient corporate for
long. The economic Darwinism is the driving force of optimal capitalism. The
declining and dying sectors suffer and wither. The rising and growing sectors per-
form and attract capital. In this constantly changing industrial and service sector
space, the proactive, perceptive, dynamic, and financially efficient corporates overtake
the ones which are not.Yet, the overall results of the corporate sector give the sense
Fig. 4.2 Velocity of M2 money stock (M2V). Shaded areas indicate US recessions. 2012 research.
stiouisfed.org (Source: Federal Reserve Bank of St. Louis)

5. 87Infrastructure: The Growth Driver
of where the economy is moving. In this context, the corporate performance has
shown progress. The post-tax profits of corporate (Fig. 4.4) are growing. Under the
impact of the decline in GDP in 2009, the corporate profits had shown a sharp dip.
The revival of the economy in 2010 has added buoyancy to the corporate perfor-
mance. Record-low interest rates and record rise in government expenditure have
rejuvenated the corporate America. The stock market has gone up with Dow show-
ing the rise from 10,000 to 13,000, 30% rise. Yet, the corporate America has not
been unrolling its capital expenditure program. This is reflected in the record cash
pile up by companies and record liquidity status of banks. The nonfinancial corpora-
tions held cash of $1.24 trillion at the end of 2011. Apple, Microsoft, Cisco, Google,
and Pfizer held 22% of the total. Nearly 57% of American corporate cash was held
abroad.1
Until this cash moves in the economic cycle from the current financial
cycle, the economy would not take sustainable spin for growth.
Infrastructure: The Growth Driver
The housing and real estate sector has been the driver of the US economy. One of
the major handicaps of the current recovery is that the crisis was the result of the
borrower’s payment defaults in the housing sector that not only led to the collapse
1
Moody’s Investor Service, March 14, 2012.
Fig. 4.3 Gross private domestic investment (GPDI). Shaded areas indicate US recessions. 2012
research.stlouisfed.org (Source: U.S. Department of Commerce: Bureau of Economic Analysis)

6. 88 4 Why Is the Economy Not Taking-Off?
in housing prices, but the avalanche of foreclosures created a huge overhang of
stock of housing units. This overhang of houses has hampered the new construction
activity which can attract fresh investment and generate employment. The backlog
of housing stock is so large that there is less scope for new house construction
except in areas and towns where the earlier boom had not reached or could not
reach. Until this unsold housing stock is reduced sharply, new housing construction
would not begin in a big way to give boost to employment and growth in the econ-
omy. The housing sales plummeted from the peak of housing boom at 1.28 million
units to an all time low 323,000 in 2010. The new home sales have to pick up to
600,000 units to generate investment and employment in this sector.
Since the housing and real estate sector will continue a laggard and fail to be the
driver of growth for a few more years to come, the other sectors have to take the lead
to be the engine of growth. While the service and technology sectors comprising
several industries offer the right potential in the light of the demand pulls as well as
supply and endowment factors, the sector which is in urgent need of refurbishment
and offers large employment potential is the infrastructure. Instead of leaving it
entirely to the forces of markets, there is a need in the current environment to engage
in public–private partnership in this sector. This unorthodox venture could act as the
sustainable accelerator of growth in the current uncertain environment.
One of the major reasons for slow growth in employment is that over the years,
the employment intensity of government expenditure has gone down due to the techno-
logical change as well as the shift in the composition of government expenditure.
In early stage of capitalist development, government expenditure on infrastructure
Fig. 4.4 Corporate profit after tax (CP). Shaded areas indicate US recessions. 2012 research.
stlouisfed.org (Source: U.S. Department of Commerce: Bureau of Economic Analysis)

7. 89Infrastructure: The Growth Driver
was relatively large contributing to fast growth in employment. Although the
infrastructure is not in short supply as it was in the early days of industrialization,
a large stock of infrastructure is in need of refurbishment and modernization. Now
is the opportune time to allocate resources in this sector which will yield quick
results in employment generation.