Distributed Economics

Central banks  are charged with regulating the money supply. Regulating not in the sense of rules, and laws, although they do form part of the framework it operates in. Regulating in the sense of controlling the quantity of. This is from the leaflet,  Modern Money Mechanics, published by the Federal Reserve Bank of Chicago in 1968, and last revised in June 1992:

From the standpoint of money creation, however, the essential point is that the reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net changes in them are largely determined by actions of the Federal Reserve System. Thus, the Federal Reserve, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences banks’ decisions with respect to their assets and deposits.

Bank’s assets are for the most part their loans.

The  commercial banking fractional reserve system introduces a rather strange money particle/loan anti-particle recursive relationship between some, but not all, of the loans in the monetary system.  This isn’t true for loans made to companies that borrow money through the bond market for example. They borrow money by selling an IOU, as does the Government when it borrows money using treasury certificates.  It’s only within the commercial banking system that money takes on this strange duality, and can expand and contract with the extension and default of loans.

What am i trying to say there. If a loan goes bad in the corporate bond market, then the company goes bankrupt, and my ownership of that bond gets me into the queue of creditors for a claim of assets and not much else. There are no money supply implications. The money i gave the company in return for a bond, is out there somewhere with whoever the company gave it to in return for goods, services, or a passport for tax free exile.  If a bank loan based on my bank deposit defaults however, I still have my deposit. But there is a deposit out there somewhere that should really disappear. That the current implementation doesn’t allow this to occur is one of the stresses on the system.

The bigger problem though, is that since there isn’t a fixed quantity of money within the commercial banking system, it depends after all on how much lending they’re allowed to do, it’s critically important to scrutinise what’s happening within the system quite carefully.  For example, if an expansion of credit is occurring, is it because the system is expanding within it’s allowed limits, or has it found a a way to circumvent them?

The Federal Reserve seems to believe that by controlling the money supply, it also controls the loan or credit supply.  It controls the money supply, by requiring the banks to hold a small portion of their total deposits either in physical bank notes, or on deposit with the federal reserve bank. Let’s look at money supply regulation first.

Leaving aside the banking system’s day to day liquidity issues in terms of satisfying customer’s demands for access to the funds in their deposits, it is arguably the case that it doesn’t matter how much the banks keep in reserve, or how much of that is on deposit at the central bank, as long as it is a fixed portion of the local bank’s reserves.

As long as some known fraction of the money represented in deposits is required to be held at the Federal Reserve (or in bank notes and coins), then the Federal Reserve can calculate what the total money supply is simply by multiplying. It can set what level it thinks is appropriate for that total, and adjust the reserve amount appropriately, or it can inject money to increase it, again by the known percentage that is anchored by the reserve. The only difference from that simplistic perspective, between a 1% and 10% requirement is how much you have to multiply by to get the total money supply. This is the textbook presentation of the reserve based system.

The statistics on commercial bank reserves, and the Monetary Base for the United States of America, are reported in Report H3 by the Federal Reserve. The Monetary Base is the simplest statistic on the quantity of money in the system, and is defined as the total  of commercial bank reserves held at the Federal Reserve, plus the total of printed/coined currency. To wit:

As you can see, things start to get a little funky on the right hand side there when the Federal Reserve starts trying to resolve the 2008 credit crisis. Let’s look at things before that happens though. This graph is showing the totals for all physical currency and the reserves. It is the reserves that are supposed to be regulating the money supply, “through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities”. So all other quantities of money, within the fractional reserve system, should be derivable as some multiple of the reserve. (This incidentally, is i suspect where the Rothbard fallacy may originate. Individual banks lend a fraction of their deposits, however the federal reserve regulates their deposits, as a multiple of the reserve.)

Which unfortunately is not what is being shown in the chart above. Then again, what relationship should the total quantity of physical currency have, to the bank reserves? Physical currency isn’t controlled any more, in terms of a fixed relationship to reserves, rather it’s printed as needed. Even so, it’s reasonable to expect that that need would in some sense reflect a somewhat consistent percentage of the total quantity of money – which is essentially physical currency plus the sum total of all bank accounts. So the chart seems to show that the federal reserve is successfully keeping bank’s reserves constant, but either there has been a consistently growing demand for physical notes over bank accounts in the last four decades, or something else is going on.

The consistently growing demand for physical banknotes theory isn’t entirely discountable as it happens. The US dollar is accepted world wide, and a significant amount of physical cash is held outside the USA. That can be deduced simply from the large amounts that were found during and after the invasion of Iraq.

Digging a little deeper. M1 is the base measure of the actual money supply, and includes physical currency, demand deposits and other checkable deposits. Demand deposits are all bank deposits which allow immediate access, rather than savings accounts and similar, which require deposits to remain for a specified period of time. Looking at the historical data on the components of M1, from the Federal Reserve’s H6. Table 4, and please note the y-axis on this chart is in $ billions, whereas for the other two it is $ millions:

Interestingly, demand and checkable deposits do look like they are holding approximately stable in the last couple of decades at least. In fact they’re holding stable at roughly 10 times the reserves held by the central bank. So, the reserve requirement does appear to be successfully regulating the quantity of money held in demand and chequeing accounts. These in other words appear to be the Net Transaction Accounts, for which the banks are required to keep 10% either on deposit with the federal reserve, or present as physical cash in the bank vaults. So why then, is physical cash going up so much? After all, if the Federal Reserve is actually printing physical cash to increase the Money Supply, then the deposits wouldn’t be staying relatively constant, but would in fact be increasing to match.

Or in other words. Is physical cash being printed in order to increase the money supply, or is physical cash being printed because the money supply is increasing?  One last chart.

This chart shows the Total Reserve, the Monetary Base, M1, and the Total Liabilities of the US Commercial Banks from the H8 data series, table b1152a. Total Liabilities, is the sum of all the money deposited at the Banks by their customers, plus loans from other Banks. That table starts in 1973, and yes those are the right units.

What is the money supply? Is it just the checking accounts most people use for day to day cash, the Net Transaction accounts? Does it include savings as well? Physical cash in Iraq and elsewhere? There are economic arguments for and against counting each of those in fact, that’s why there are the different measures, Monetary base, M1, M2 and before it was discontinued M3.

If the money supply is just the amount held in Net Transaction Accounts, then the Federal Reserve is regulating it successfully. But that’s the only thing that is being regulated. Physical cash is clearly expanding, but that’s nothing besides the total amount of cash represented by deposits with commercial banks. The electronic money supply, the money that is represented as electronic 0’s and 1’s in a computer database somewhere is clearly growing exponentially. And has been for some time.

One definition of the money supply that isn’t explitly reported, but would seem to be fairly important in a fractional reserve system, would be the amount of money that the banks can lend a fraction of. As you might guess from the above chart, it certainly isn’t the amount held in Net Transaction Accounts.

So just as this post attempted to dissect the deposit side of the fractional reserve money/loan dichotomy in the context of the larger system, next time, we’ll look at the loan supply.

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