Banking and the Money Supply I: Sources of Inflation

In order to determine whether we face a future of mass inflation or a deflationary spiral, we need to understand exactly what these terms mean, by what mechanisms they occur, and how the consequences of inflation and deflation play themselves out in the broader economy. Last time, we knocked the first one out when we looked at two possible ways to describe inflation and concluded that the expansion of the money supply was more useful than descriptions of price movements. Conversely, deflation is best defined as a contraction in the money supply. We also briefly touched on the effects that expansion of the money supply has on the economy, and even society at large. We will now examine just how the money supply is influenced by America's central bank, the Federal Reserve (FED), and the banking system it serves. Once we are finished, we should have a general idea of the "rules of the game" and the laws that govern the creation and destruction of money under the present banking regime. Warning! I have been told by many sources, some of which I consider reputable, that I haven't a clue what I'm talking about when I discuss fractional reserve accounting. Occasionally I have been told that goes for pretty much everything else, too, whacko, so why not shut the heck up. That may be the case. I might get a few things wrong. I am, after all, an amateur. But I try not to let snide remarks and piddling considerations of fact prevent me from making a fool of myself. If you want the story straight from the horse's mouth, check out "Modern Money Mechanics," a self-indicting document put out by the Federal Reserve Bank of Chicago some years ago. Inflation You have probably heard the charge of government "printing money" from many sources. You may have heard the charge refuted by stating that all money is "debt based," and since debts must be repaid, money is therefore not printed and that this system is therefore "fair." The reality is that the new money created by the banking system is generally not "printed" -- printed and coined money are called currency to distinguish them from the broader concept of money, which may have no physical existence at all except as entries on an accountant's books. It is debt based, but this is not to say that "it eventually gets repaid" or somehow isn't real. Money is created through accounting practices used by the banking system. I hope that sounds as irrational to you as it does to me. After all, how can it be called "accounting" when the result of doing it is an increase in the thing we are supposed to be "counting?" When I count things, I usually wind up with the same quantity at the end as when I started, though sometimes things get hairy when I run out of fingers and toes. But banks don't; they usually manage to come up with more, at least right up until the point that they fail and start taking money from taxpayers. Wouldn't it be more honest, you might ask, to call it something else, like maybe "multiplying?" Or, some more judgmental types might suggest, "lying" or "fraud?" But as we will see, honesty is really beside the point here. We are talking about America's financial system! Boring as it may seem, to understand inflation and deflation we will have to understand at least a little bit about how banks do their accounting. But I promise, it isn't that bad. You'll make it. The inflationary accounting trick that results in changes to the money supply comes from two primary sources: fractional reserve banking and asset purchases/lending by the FED. Neither is really that hard to understand. Well, not "understand," since it doesn't actually make any sense. It's just the way things are done, that's all, and if you want to know what's going on, you'll just have to get used to it. Fractional Reserve Banking and the FED You probably heard about how the practice of fractional reserve banking multiplies the supply of money in your high school economics class. For most young people, this seems a little strange, but hey, more money is better, right? And it says so in an actual textbook. On economics, no less. It is not until we reach adulthood that we recognize that most statements appearing in textbooks are either lies, blasphemy, or incoherent nonsense. Luckily, like most of those other bothersome fact thingys that inflict themselves on us while we're at school, it probably went in one ear and out the other without really sticking anywhere in between. But since that is the subject of today's post, for most of us we'll need to go over it one more time. Reserves Most such discussions start out with "when you go to your bank and deposit $1000 in your bank account..." But I'm not going to start there, because that's not where money starts. If money started with you, you probably wouldn't go to work every day. You'd probably sit at home and exude money. I would. But here in the US of A, most private parties that make a habit of exuding money wind up in prison on charges of counterfeiting. There's only room for money exuder in the US, and that is the FED. As we'll see, money starts with the FED. So in talking about fractional reserve accounting, I'm going to start with "reserves," which is a deposit of money sitting in a bank that is initially provided by the FED. The FED produces reserves by buying assets and lending money. In banking, buying assets vs. lending money is usually a distinction without a difference. Banks usually buy "debt instruments," like bonds and mortgage notes. So, they are buying a contract that stipulates that the holder of the contract is entitled to regular payments with the return of principle plus interest over time. Just like a loan extended by the bank. Either way, money it transferred out of the bank to somewhere else, and some party owes the bank money. When the FED buys an asset or extends a loan to another bank, it assumes ownership of the asset/loan obligation and credits the seller/borrower with money that never existed before. The FED creates money when it buys assets. Simple as that. The FED is taken to be able to issue an endless supply of money, so that it can buy as many assets or as few as it likes, regardless of price, and extend loans of any quantity whatsoever. The money issued is considered a liability of the FED balanced by the asset it purchased, which becomes part of the FED's balance sheet. Our money units are called Federal Reserve Notes (FRN) because they constitute liability claims against the assets held by the FED. Theoretically, anyway. Try enforcing your pathetic little "claim." It keeps track of such purchases with neat little 2-column charts called "T" accounts that look something like this: Looks nice, doesn't it? Clean, tidy and "balanced." Neat little charts produced by highly educated, meticulous people in spiffy suits have the uncanny ability to create the air of legitimacy, don't they? I mean, look at the balance. These people are smart! And so meticulous! Brings a certain German political movement to mind... Legitimate or not, money is created out of thin air, ex-nihilo, from nothing, by this process. This ex-nihilo money is called the "monetary base." It is also sometimes called "high-powered money" because it has yet to be multiplied by the fractional reserve system. Fractional Reserve Banking The money which the FED spent to buy the asset from the private seller enters the banking system as new "reserves" in the seller's deposit account with his bank. A fraction of these new reserves must be kept "on reserve" while the remainder may be lent out. Thus begins the process of fractional reserve banking. At this time, the legally required fraction is 10%, but banks are not required to lend up to this amount. Usually, they do not. Whatever fraction is left over above the 10% that is not lent is termed "excess reserves." Like the FED, banks use the same neat little T-account charts to keep track of their own pilfering shenanigans. A bank which has lent out money up to its reserve requirement would have a T-account that looked something like this: Remember: virtually all money is held in some bank account, somewhere. Though it is conceivable that the borrower is walking down the street with a large roll of currency in his pocket, it isn't likely. The money lent out to the borrower will more likely wind up in another bank account as soon as the borrower spends it on whatever it is he borrowed the money to buy. This is indicated by the T-account above. Notice that the money deposits fall in the liability columns. Deposits are considered a liability with the bank and do not disappear when money is lent out. The entity holding the deposit account is still considered to have money on deposit with the bank. It may withdraw and spend this money at any time, and the bank simply has to come up with the money for transfer. Both the money lent out and the deposit held at the bank are considered and accounted as money at the same time. Lending up to the required minimum reserves increases the money supply by 90% of the initial reserves. I don't care what neat little chart some bankster wants to show me, this accounting is not legitimate. It is not accounting when the money supply increases as a result of a transaction. It is fraud. Further, the money which has been lent out is spent by the borrower and winds up in the deposit account of the seller in another bank as new reserves exactly as before. From there it can be lent out to yet another party and held as a deposit simultaneously, getting counted twice, exactly as before. If this continues up to the theoretical limit, which it rarely does, the initial asset purchased by the FED will result in 10X the purchase price in circulating money. You'd think this system would strike any sane, reasonably intelligent person as stupid. But that's how we do things. Most of us go along with it without giving it a second thought. What could possibly go wrong? Notice the difference between bank lending and lending you might do on your own. Suppose you buy a bond from a corporation that needs to borrow money. You give your money to the corporation, and they give you the bond with a promise to pay you back over time. No money is created or destroyed by this process, whether you get paid back or not. It simply changes hands. Purchases and loans by banks are unique in this regard. Why they are afforded such privileged status, I do not understand. But that is the system. Monetary Statistics: AMB, M1 and M2 The "money supply" can be monitored by a variety of monetary statistics which are available for free at the website of the Federal Reserve Bank of St. Louis. You may ask, "Why are there several measures? Isn't there only one supply of money?" Yes, there is. But in another of those zany aspects of the world of economics, economists cannot even come to an agreement on what money actually is. You might have guessed as much considering the type of accounting they permit right under their noses. I do not want to go into any boring details trying to define money. Most of us have a basic understanding of it as the thing we use as the universal exchange medium for other goods. For the absolute best, most readable, concise introduction of money I have ever read, see Mises on Money, a free mini e-book hosted by LRC. Here, I will stick to the basic gist of the monetary statistics I think are most useful. The Adjusted Monetary Base (AMB) is simply the supply of money put into circulation as the result of the accumulated transactions of the FED. This is the "high-powered" money supply which enters the banking system as the result of FED asset purchases, before multiplication by the fractional reserve process. M1 and M2 are two different descriptions of the money supply which are produced by adding up money in circulation. The principal difference between them is that M1 does not contain money held in "time deposits," a.k.a. savings accounts and CD's, since this is not considered as "available" for spending as is money held in "demand deposits," a.k.a. checking accounts. These money statistics do include the results of fractional reserve multiplication. MULT is the M1 multiplier. It is equal to M1/AMB. It is an expression of the effect that fractional reserve multiplication has on the monetary base to produce the circulating money supply. Now that we've dealt with the principle sources of money and monetary inflation, and have had a look at how to describe these quantities, it is time to consider the sources of deflation. But I'll leave that for next time... ------- Cross-posted at Eternity Road