The key chart
12-month cumulative flows (EUR bn) presented in a stylised consolidated balance sheet format (Source: ECB; CMMP)
Starting with three things about the nature of money:
- Money has taken various forms over time (gold, silver etc) but comes largely in two main forms today – cash and (electronic) bank deposits
- Money held electronically in the form of bank deposits represents 85% of total money in the euro area. Physical holdings in the form of bank notes and/or cash represent less than 10%
- Money is “created” primarily when banks make loans, and also when governments spend (hence concepts such as the “money multiplier” and “loanable funds theory” are redundant today)
Next, three things about how money is measured:
- Money is typically measured in the form of “monetary aggregates”, derived from the liabilities side of the consolidated balance sheet of monetary financial institutions (see key chart above). It is then classified according to its liquidity or degree of “moneyness” e.g. narrow money (M1, the most liquid), intermediate money (M2), and then broad money (M3), in the case of the euro area
- The calculation of money supply involves adding these components together – in essence, the sum of currency in circulation plus the outstanding amount of financial instruments that have a high degree of moneyness. The simplest way to think about money, therefore, is as the short-term liabilities of the banking sector (note that longer-term liabilities are excluded from the definition of broad money as they considered portfolio instruments rather than as a means of transacting)
M3 = M1 (currency plus overnight deposits) plus M2-M1 (other ST deposits) plus M3-M2 (marketable instruments)
- Money can also be calculated and understood by re-arranging the so-called “counterparts of money”, i.e. all items other than money on both sides of the consolidated balance sheet. Hence M3 in the euro area can also be calculated as:
M3 = credit to EA residents + net external assets – longer term liabilities + other counterparts
Finally, what are the three key messages from current trends in EA monetary aggregates?
- The headline YoY decline in broad money in August 2023 (-1.3% YoY) reflects an on-going arbitrage in favour of the highest remunerated deposits (and also bank securities outside M3) rather than a lack of confidence in the region’s banks. The very slow/limited pass through of higher policy rates to the rates offered on overnight deposits is the key reason here and is a unique feature of the current tightening cycle. While cumulative 12-month flows into other ST deposits (€855bn) and marketable securities (€154bn) have been insufficient to compensate fully for the outflows of currency and overnight deposits (€1,226bn) they also need to be considered together with the flows into longer term bank liabilities (€298bn).
- Financing flows to the private sector, while positive, are slowing very sharply. Cumulative monthly flows of credit to the private sector fell from €813bn in the 12 months to August 2022 to only €85bn in the 12 months to August 2023. Within this the respective flows of bank loans fell from €782bn to only €16bn.
- This pace of adjustment in financing flows highlights the rising risk of policy errors from the ECB, which lacks a playbook for the most aggressive period of monetary tightening in its history.
Please note that the summary comments and chart above are abstracts from more detailed analysis that is available separately.