The truth about money, inflation and deflation, part II

The scenario described in part I was not altogether attractive to the banks, who although they could loan out receipts for gold coins they did not have, thus creating money and charging interest on that money, they still faced the downside when deleveraging hit, and their prosperity could turn to ruin.  This led first to the creation of the Federal Reserve and other central banks, then to the elimination of the right of the depositor to withdraw the gold coins backing the money.  Gold still played a role in international exchange for a while, but that too was eliminated by Nixon, and there has been no link between money and gold since.  Now the money was issued by the central bank, and that was the backing for all loans.  Most people lose the ability to follow at this point, but just substitute the gold coins in the earlier scenario with Federal Reserve Notes (FRN), or their electronic equivalents, excess reserves held by banks at the Fed.  What used to be receipts for gold was now just receipts from central banks.  The same principles still hold, but there are a few points unique to Fiat money that could not hold when a scarce commodity was the backing for money. 

Banks today make loans from their reserves of FRN or excess reserves, and still create money in making loans, inflating the effective money supply.  Because banks are required to keep minimum reserves, the amount of money they can create is limited as a multiple of the amount of FRNs they have.  There are two relevant measures that track these amounts:  The Fed Balance sheet, or adjusted monetary base, measuring the total FRNs and excess reserves in existence, and M1, which is a measure of credit in the economy as created by banks.  The correspondence between M1 and total credit is not perfect, and additional measures to track effective money supply have been devised, including M2, M3, and MZM.  But M1 is the best measure for price inflation, and behaves as a good proxy for credit (again, acknowledging that it is not strictly a measure of credit).

The Fed’s balance sheet represents the number of FRNs or excess reserves the central bank has created in order to pay for assets the bank has acquired.  In principle, the two halves of the balance sheet should be equal, and at least in theory, the Fed could shrink the balance sheet at will by selling the assets it has acquired, and in the process reclaiming the FRNs it had previously issued.  When this has credibility, then it gives the market confidence in the currency, since shrinking of the balance sheet would severely curtail M1, and deflation would ensue.  In practice, the Fed used to buy Treasury bills in exchange for FRNs, and constantly roll over the short-term bills for new ones, maintaining its balance sheet on short-term US government debt, which again added to the credibility of the central bank, since in theory, it could in short order bring the balance sheet down over one maturity cycle of US government debt, only a matter of months.  It should not be overlooked here that the amount of money in the economy was therefore limited by the amount of US government debt.  This is the biggest difference to take place over the past 100 years:  Money used to be backed by precious metals, where it is now backed by debt.  In 2001, Alan Greenspan gave a speech warning of the surpluses being run at that time reducing Federal debt to “an irreducible minimum”, and how it would have negative impacts.  He couched his words as he always did, but that was giving him reasons for panic:  He would have lost control of the money supply without Federal debt, and in fact the FRNs that had purchased that debt would be returned to the Fed, shrinking the monetary base or forcing it to purchase private assets to keep FRNs in circulation.  Greenspan no doubt saw the troubles it would cause if the Fed held corporate bonds or even stocks, distorting markets and inviting corruption into the decisions of which bonds and stocks would be held.  Further, it would pose problems if the Fed had to sell stocks, depressing their prices, and with corporate bonds, terms of maturity would be greatly longer, and there were risks of default, impairing their ability if called-upon to re-absorb the FRNs, to uphold the credibility of the Fed.   If the markets could doubt the ability of the Fed to stop monetary inflation, it was thought that the risk of inflation would cause what was then coined as an increase in “inflation expectations”.  It was about the power of the Fed to shrink the monetary base, something they rarely if ever actually did, but the threat of which was their major weapon.  Greenspan was heard, and government quickly put an end to those surpluses, one might say with ever-greater efficiency.

But the Fed’s balance sheet is not the principal regulator of prices; that role belongs to M1.  Yet the Fed only controls the balance sheet, or the monetary base.  M1 is a good measure of the amount of money effectively at work in the economy.  I’ll stay away from the formal definition for now, but for monetary base to become M1, banks need to make loans, and in the process create money.  The relationship between monetary base and M1 is called the money multiplier, which is a measure of the amount of leverage at work in the effective money supply.  The money multiplier is highly negative right now (more in part III). 

When the Fed tightens monetary policy, which usually manifests in slowing the rate at which the Fed acquires new T-bills rather than actually selling them, this makes FRNs scarce, causing increased competition between banks to acquire them, and hence higher prices for them in the form of interest rates.  But interest rates are just the measure, the real quantity is the supply of FRNs.  With those limiting, banks are not able to make new loans and still maintain their minimum reserves, which shrinks the number of loans outstanding, and M1 shrinks as a result.  The monetary base usually does not shrink much.  Paul Volcker shrank the monetary base very slightly over 3 months, and interest rates rocketed.  It has not been done since then.  When the Fed loosens, it increases the availability of money by buying more T-bills, which increases the supply of FRNs, and therefore the reserves against which banks can make loans.  But it does not force the banks to make loans, still a voluntary activity, which is why loosening is often referred to as “pushing on a string”. 

In part III, today’s picture.

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About krakondack

An arrogant know-it-all who presumes to lecture qualified public officials, and other authority figures, on their errors and shortcomings.
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