Austrian Money Supply A Brief Excursion Into Monetary Theory

Transcription

1 Austrian Money Supply A Brief Excursion Into Monetary Theory With regard to the money supply, it is worth taking a look at a few specific facets of Austrian monetary theory and the money supply measures that Austrian School economists prefer to use instead of the 'official' monetary aggregates such as M2. After all, Ludwig von Mises, the doyen of the Austrian School, first came to the world's attention in 1912 as a noted monetary theorist. Among the great achievements of Mises' 1912 work The Theory of Money and Credit ( Die Theorie des Geldes und der Umlaufsmittel ) was Mises' realization which error precisely led to the failure of the British Currency School theorists in the 19 th century. The Currency School successfully pushed through the implementation of the Peel Act in 1844, which was designed to end boom-bust cycles by strictly limiting the issuance of bank notes. Unless bank notes were backed by specie, they could no longer be issued. Essentially this put an end to a fraudulent practice that bankers had engaged in for centuries (namely, of issuing more banknotes masquerading as receipts for bullion than they had bullion in their vaults). However, contrary to the Currency School's expectations, boom-bust cycles did not end. Mises was the one who finally explained why this was so. He did so by furnishing a proper definition of money. According to Rothbard (in his essay Austrian Definitions of the Supply of Money ), Mises' definition of money can be summarized as follows: Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods on the market. Armed with this definition, Mises pointed out that the Currency School theorists had overlooked a major component of the money supply in the broader sense. Regardless of whether the standard money in use are fiat money bank notes or gold coins, fractionally reserved banks create additional fiduciary media in the form of deposit money from thin air whenever they extend credit. In the absence of a central bank backstop as it exists in a modern fiat money system, these additional claims can of course never be paid back, unless all debtors extinguish their debts. Hence the term fiduciary media for such money claims that are not actually backed by standard money, as they depend on the depositors' trusting that they will get paid. Excepted from this are of course so-called mutuum contracts, whereby the bank for instance acts as a pure credit intermediary by lending out money it has in turn received in the form of time deposits, or money it has received by issuing bonds, or when it simply uses its own capital to make loans. These activities do not increase the money supply. However, fractionally reserved loans made from demand deposits do create additional means of payment in the form of fiduciary media, and as long as

2 such unbacked deposit money claims to standard money exist, they can indeed be used for the final payment for goods and services on the market. They are therefore money. However, many official measures of the money supply contain significant components that are not money according to the above definition, but rather represent credit instruments. As an example, consider retail money market funds that are a large component of M2 in the US. These are not money, but shares (or units ) in investment trusts that have to be liquidated before they can be employed for payment. The fact that credit cards are often linked to such retail money fund deposits does not alter this fact. Since money market funds lend the money they receive to third parties by buying their commercial paper or t-bills, they are clearly extending credit and one double-counts by including them in the money supply. Similarly, travelers' checks should not be included in the money supply, as they too involve an intervening sales transaction before they actually become money again. On the other hand, savings accounts in the US are included in the broad Austrian money supply measure TMS-2, as they are in fact available on demand. There is a legal point that ostensibly argues against this, as US banks are in theory able to delay payment of a savings account by 30 days (this is in the fine print). In practice, no bank will ever enforce this right, as it would have the regulators knocking at its doors the very next morning, not to mention that it would have a bank run on its hands within a few hours. In the subjective evaluation of depositors, money in savings accounts is definitely available on demand, and it is this assessment that is important in determining the moneyness of these deposits. However, it still makes sense to also construct a narrow money supply measure TMS-1 for the US for analytical purposes (due to the simple reason that normally, money in savings accounts is not used as often in exchange as money held in demand deposits). There are also number of items that are included in the Austrian money supply measures, which are not contained in the 'official' monetary aggregates. Among these are so-called 'sweeps', which are contained in TMS-1 (these are demand deposits that are masquerading as money market deposit accounts or MMDAs - in order to escape minimum reserve requirements), or the Fed's 'memorandum items' such as demand deposits owed to foreign official institutions and banks or the government's deposits (the 'general account') with the Fed. Why is all of this important? One reason is that it is of course important to correctly define money. Even though modern-day money is a 'credit money', one must still be able to differentiate between money and credit. If you lend $100 to your neighbor, then credit in the economy has increased by $100 but obviously, the money supply has not. If the bank lends your neighbor $100, it is a good bet that the money supply will have increased as well.

3 The broad US money supply TMS-2 by legal categorization, chart by Michael Pollaro of Forbes. One reason why it is important to use the Austrian money supply figures in analysis is that the official numbers can occasionally give wrong signals due to one of their credit components diverging and signaling either too little or too much money supply growth. This doesn't happen very often, but it does occasionally happen at important inflection points. As a further aside, it is simpler to construct money TMS for the euro area, as euro area savings deposits are indeed time deposits. Therefore, one can simply add up currency and overnight deposits to arrive at the total. The Role of Bank Reserves Ever since central banks have begun with 'quantitative easing' (colloquially known as 'money printing'), people have wondered about the role so-called 'excess bank reserves' play. To begin with, there seems to be quite a bit of misunderstanding. When the ECB engaged in its LTROs, the financial press everywhere wrote something along the lines of but this hasn't made any difference...the banks have immediately deposited the money with the ECB again. This mainly shows that most people simply do not understand how the cartelized and central-bank backstopped fractionally reserved banking system actually works. Just as currency is a liability of the central bank, so are the required and excess reserves the commercial banks hold with it. Naturally, when the central bank buys assets with money it has created from thin air, there must be something that increases on the liabilities side of its balance

4 sheet in parallel with the increase on the assets side. That something are bank reserves. Simply put, bank reserves are the cash assets of banks. Just as you and me deposit money with banks, so the commercial banks deposit money with the central bank. They can at any time demand that these excess reserves are exchanged for standard money, i.e. central bank issued banknotes. Currency and bank reserves together form the so-called monetary base. However, while currency is considered part of the money supply, bank reserves are not. This is because they are 'outside of the economy' as long as they remain deposited with the central bank. However, new credit and deposits can be pyramided atop them according to the minimum reserve ratio, which in the euro area for instance amounts to merely 1 percent. So in theory, the banks could create 100 in new deposits for every 1 in bank reserves they hold at the central bank. It is when such new deposits are created, or when reserves are withdrawn because for instance bank depositors are withdrawing cash, that these reserves will directly or indirectly show up in the money supply. We will briefly explain how, in the course of quantitative easing operations, both excess bank reserves and under certain circumstances also new deposit money, come into existence. We use the Fed and the US banking system in this example, but the process is in essence the same in all fiat money systems. The monetary base consists of currency in circulation and bank reserves (which in turn consists of 'required' and 'excess reserves'). Bank reserves are in essence demand deposits of commercial banks deposited at the Federal Reserve. Required reserves (also known as minimum reserves) are those reserves that are legally required as backing for the demand deposits belonging to customers of commercial banks. In a fully loaned up fractionally reserved banking system with e.g. a 10% legal reserve requirement, every $1 in reserves will support $10 in customer deposits. Thus the term high-powered money for base money, as it serves as the means of pyramiding an enormous money supply on top of it. The central bank has the monopoly on issuing currency, so if a customer withdraws cash from a demand deposit, the bank in turn has to obtain the banknotes by drawing down its reserves account with the central bank (leaving aside that banks keep a certain amount of vault cash on hand, which for analytical purposes is treated as the equivalent of bank reserves). The bigger the amount of reserves (at a given reserve requirement), the bigger the amount of loans and deposits that can be supported, thus a withdrawal of cash has a reverse leverage' effect on the system, while a cash deposit has the opposite effect. The Federal Reserve tends to keep an eye on the demand for cash however, and actively works against the deleveraging effect created by large withdrawal demands. The biggest factor in influencing the level of bank reserves are the Fed's open

5 market operations. Let us say the Fed buys an asset worth $1,000 from someone (the Fed can basically buy any asset it wants, but in practice it mostly buys US agency and treasury securities). This would create a deposit of $1,000 in favor of said someone, who deposits a check drawn on the Fed with his bank. The bank in turn deposits this check with the Fed. Considering the totality of this transaction we arrive at the following: the Fed has increased its assets by $1,000, a demand deposit of $1,000 was created at a commercial bank, but crucially, after the bank deposits the Fed's check, bank reserves have also increased by $1,000. These reserves can once again be used to leverage the amount of outstanding loans and deposits according to legal reserve requirements (subtracting the minimum reserve that must be kept with the Fed for the newly created $1,000 in deposit money). By contrast, if the Fed buys securities not from a third party (like e.g. a large fund management company), but directly from a bank that is part of the Federal Reserve System, only new bank reserves will be created, but no additional deposit money. This is so because it is now the bank that gets the Fed's check, and deposits it on its own behalf with the Fed. However, as in the example above, new loans can in theory be pyramided atop these new reserves, in practice in almost unlimited fashion. The crucial thing to keep in mind here is that a big amount of bank reserves is not really needed to grow the money supply considerably. Banks were able to support $5.3 trillion in money TMS-2 outstanding in late 2007 with a very small amount of minimum reserves of $60 billion. Sweeps have made this possible, as they allow the banks to pretend that the bulk of their demand deposits are really savings accounts (so-called MMDAs, see above). Since the 2008 crisis, banks are no longer expanding the money supply on their own, or do so only reluctantly (credit demand has wilted as well). Thus the Fed is now actively inflating. It is giving the banks the means to theoretically increase the money supply by a huge amount, but more important is the fact that in the course of its monetization activities, the Fed creates a lot of deposit money directly. As the above chart shows, the broad US money supply TMS-2 has grown from $5.3 trillion in early 2008 to $9.3 trillion today (as of December 2012). This is a massive inflation of the money supply. However, as excess bank reserves amount to nearly $1.6 trillion as well, the cover of currently outstanding deposit money has risen markedly, which means that the banks could easily create another $10 trillion or even $20 trillion or more in new deposit money. This is not to say that it is very likely that they will do so but it would be theoretically possible. There exists thus in addition to the enormous money supply inflation that has already taken place, the tinder for a whole lot more.