Will banks help kill the recovery? By Jim Jubak MSN Money 10-02-2009

Will banks help kill the recovery?
Despite the Fed's efforts to flood the economy with cash, the broadest measure of the money supply is declining because most of the new money is just sitting in vaults.
By Jim Jubak
MSN Money
October 02, 2009

We've got a little problem in the economy. Tiny really. Nothing to worry about.

The government and the Federal Reserve are pumping money into the economy as fast as they can, yet the supply of money in the economy has started to fall -- and that, in turn, could endanger the entire economic recovery.

The Fed is buying mortgage-backed securities ($1.25 trillion) and debt from Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) ($200 billion), expanding its lending to banks by keeping interest rates close to zero and buying up U.S. Treasurys.

All that, according to the textbooks, should be flooding the economy with money. And that's exactly what you're supposed to do to get the economy running again and to avoid turning the Great Recession into a rerun of the Great Depression. (And if you need a reminder about a recovery going into reverse, try my soothing story on the recession of 1937.)

That's a lot of money running around
During the early stages of the financial crisis, those policy actions did exactly what they do in the textbooks. M2, the broadest measure of the money supply that the Fed still tracks, climbed from $7.36 trillion in October 2007 to $7.88 trillion a year later and to $8.39 trillion last June 22, according to the St. Louis Federal Reserve Bank.

That's an additional $1 trillion to fund loans and credit card bills and plant expansions and state borrowing and . . . well, just about anything the economy needs.

And because each dollar of that extra trillion gets used over and over by the economy, the effect is even larger than that huge sum itself. What economists call the M2 multiplier has ranged between 8 and 12 for most of the period from 1959 to 2009. So that $1 trillion has the effect of an extra $8 trillion to $12 trillion in money racing around the economy.

Even in the huge $14 trillion-plus U.S. economy, that should be enough to jump-start economic activity and raise justifiable fears of runaway inflation.

In normal times, anyway. But the numbers coming out of the Federal Reserve say these aren't normal times.