One of the hottest (if not the hottest) intra-Austrian debates today is between what is sometimes referred to as deflationists and inflationists/stagflationists. This is not a policy debate of course, as all Austrians is anti-inflation, but rather a debate about whether the current recession will be associated with deflation or inflation. Examples of deflationists are Frank Shostak, Mike Shedlock and Gary North while examples of stagflationists include me, Antony Mueller and Peter Schiff. The dispute is largely originated in a dispute over the definition of the money supply. I have already dealt with that issue extensively (see for example here, here and here ) so I will not repeat this here. Instead, I will focus on the appeal made by the deflationists to the development of the monetary base, which have been largely stagnant for the latest year.
The implicit or explicit argument from the deflationists appear to be that 1)The Fed controls the monetary base, so it is a good reflection of how tight its policy is 2) The monetary base determines the money supply, so the stagnant monetary base implies a stagnant money supply. Yet both of these assertions are simply wrong, at least given the current financial structure.I have actually once answered the monetary base argument before. At that time I pointed out that more than 90% of the monetary base is made up by what in monetary statistics is called currency in circulation, which is to say paper notes and metal coins held by the public. And I also pointed out that the amount of currency in circulation is determined by public preference for making payments using notes and coins versus making electronic transactions. In the U.S. this is also determined by demand in high inflation third world countries for using dollars as means of payments instead of local currencies. Most likely the stagnant amount of currency in circulation reflects the trend towards a cashless society as well as growing repatriation of previously exported dollar notes and coins due to the distrust of the dollar that the decline in its purchasing power has caused.
I also illustrated that point by pointing out that during the inflationary boom of the 1920s, the monetary base was stagnant. By contrast, the monetary base soared during the deflationary depression of the 1930s, as bank collapses caused people to prefer to hold money in the form of cash instead of deposit money.
However, I now realize that this response was unsatisfactory in one aspect. Namely, because my focus on the currency in circulation part of the monetary base seemed to imply that the other part of the monetary base, bank reserves, do in fact have the characteristics that the deflationists claim. That’s not what I meant, although now I realize that the post was written in a way which could reasonably be interpreted that way. And as I see Robert Murphy write a whole article focusing on bank reserves as a proxy for monetary conditions it is clear that the issue must be addressed. So I will now clarify: bank reserves are in today’s system basically irrelevant too, both as a proxy of Fed policy and of monetary conditions.
The reason is that there really isn’t any demand for bank reserves. To the contrary, banks do everything they can to minimize it because reserves inflict opportunity costs for them in the form of foregone interest income. In the past, banks still felt compelled to keep large reserves because of the risk of bank runs. But with the Fed providing unlimited quantities of liquidity in the case of unexpected increases in withdrawals, this is not an issue anymore. Today, the only thing preventing banks from reducing reserves to zero is formal reserve requirements and the need to have cash available for withdrawals from bank offices and ATMs. But with the banks moving away from deposits with reserve requirements such as demand deposits and instead finance its operations in for example Money Market Mutual Fund accounts (And using so called sweep operations the banks ensure that the level of demand deposits are always minimized even if customers deposit money there) that don’t have any reserve requirements the level of required reserves is declining in importance. And with the increasing use of electronic transactions, cash for customer withdrawals is also becoming less important and is at an absolute level very low. Because of this, bank reserves are increasingly disconnected from the level of money supply.
Indeed, if Robert Murphy had looked more closely at figure 1, he would have seen this point. Bank reserves in early 1990 were $60 billion as compared to $42 billion now. If bank reserves really had been a good proxy for the money supply, then that would have implied a cumulative monetary deflation of 30% during the latest 18 years. The Fed under Greenspan would, if bank reserves were really a good proxy of monetary conditions, have been the ultimate hard money institution, providing more deflationary conditions than a gold standard. Nor do the trends show any correlations with the housing bubble, as it started already in 2001 while the monetary base was flat until 2003. And after a brief upswing in 2003-04 it was basically flat after that. In other words, bank reserves have in today’s system nearly no correlation with monetary conditions.
But if the Fed performs open market operations, won’t that expand bank reserves? Well, no. While it may result in brief spikes, these spikes won’t last as the banks will lend out or invest the money the open market operations produce, either as bank loans or investments in securities. The reason why they are unlikely to keep the money more than a few days is the above mentioned fact that reserves represent opportunity costs and that it is more profitable for the banks to lend/invest. Contrary to what Murphy claimed, it is not the Fed that has moved away reserves from the systems, it is the banks themselves. If you doubt that, just check out the statistics for bank credit, which have soared in recent months.
Because the banks have the opportunity to lend/invest the money they get from the Fed and the incentive to do so, the Fed have almost no control over bank reserves. If they started to impose reserve requirements on all deposits, they could have controlled it, but as it is they don’t. Nor is it a reflection of credit conditions or monetary conditions as bank credit grows at double digit rates.
To summarize, the stagnant monetary base and bank reserves have absolutely nothing to do with interest rate policy, and is instead a reflection of the trend in the payment system to move away from currency in circulation and deposits with formal reserve requirements to deposits without reserve requirements, combined with the Fed’s promise to help all banks with unlimited quantities of liquidity if they need it. The deflationist claim that the Fed is not inflating is not only serious because it implies misleading investment advice, such as staying away from gold and buying treasuries. It is also damaging because it implies that Bernanke is actually mimicking market conditions (something which Murphy actually explicitly wrote in his article), thus effectively destroying all opposition to Bernanke’s inflationary policies. Unwittingly, the deflationists are thus serving Bernanke.
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this blog link — http://wallstreetexaminer.com/blogs/winter/?p=1079 — contains this posting “I would certainly say that a large fraction of M3 is indeed fictitious capital. Given the insane leverage in the banking system and inflated financial asset values, I don’t see why even most of this value could be considered “realâ€.
this mises article http://mises.org/daily/2302 — “Federal Reserve policies pump up the money supply creating the inflation. In the last decade, M3 has increased 120% and this monetary stimulus is reflected in the official inflation statistics.”
if the overall u.s. “money’ supply” denoted by m3 truly is expanding at a historically fast pace – meaning the ratios of the money supply (shifts between the different Ms) arent just changing in relation to each other — where does this “money” come from?
i have read here and elsewhere that M1 and the AMB is basically flat and has been for some months.
so if M3 is rapidly expanding what “money” items are contributing to its increase.
‘if’ (im not sure) portions of M3 are some kind of expanding swirls of credit, detatched from the monetary base, wouldnt these credit instruments still affect the flow of “realer money”?
cause direct price inflation, iow?
additionally, are the extra components of ‘M3′ affected more by government tax policy?
if say, taxes and govt fees increase in an area does this additional tax revenue make its way into what are mostly M3 items (an institutional time deposit?) thereby allowing money to enter various types accounts that can be inflated upon (iow, loans making their way into demand deposit accounts)?
whereas if taxes were lower ones pay, after expenses, would be kept under their mattres and spent at flea markets – and not making its way into govt structured accounts?
just wondering
scott_t:
M3 is larger than MZM – due mainly to the inclusion of time-deposits, which should not not be counted as money because they cannot be withdrawn at par on demand. The early termination penalty is high enough to deter anyone from investing in a CD without intending to go for the full term.
fusgerm:
A line of credit is money? No, that is a misconception. A line of credit is a right to borrow money on demand, usually for a predefined term. Instead of going into a bank to withdraw money from my savings account, I might ask my manager for a personal loan and walk out with the cash. But just because I have the ability to borrow on demand, with or without a line of credit, does not turn my potential borrowings into “money”.
If I had a line of credit with a zero interest rate, then indeed I could dispense with cash, as long as my purchases were within my credit limit. But, in reality, the rate of interest on overdrafts is discouragingly high.
It is true that many credit cards grant an “interest free” period for repayment. But, in reality, the merchant has to pay the interest when he accepts payment by credit card. Often he would give you a discount for paying cash, or if not then you could buy more cheaply from another merchant who would. TANSTAAFL!
You give a contrived example of a line of credit for which a time deposit acts as collateral. This is little different from a credit card which is paid off each month. The arrangement is viable only because you stipulate that the interest rate is the same on each. The reality that loan rates are higher than deposit rates limits the attraction of such schemes.
Interest-rates have an indirect influence on the demand for cash-holding. When rates are low, the attractiveness of lines of credit reduces the demand to hold cash. On the other hand, as rates rise, the increasing attractiveness of investing temporary surpluses of cash also reduces the demand to hold cash. The mere capacity to reduce the demand for holding cash is NOT sufficient to qualify something as money, or else all liquid assets would qualify.
if any case can be made that reserves don’t matter, I don’t think this is the correct time. Maybe it should be reserves don’t matter as much as you’d think they would. Recently, we have seen a huge growth on the balance sheet of the FED, bank reserves, and the monetary base. M1 has gone up considerably in this period, although not nearly as much as the FED’s balance sheet or reserves. I suspect these reserves will add to the money supply much more quickly in the coming years, once the economy turns around just a bit.
How I feel on money supply:
There are 2 distinct forms of money – circulatory and non-circulatory. Anything that can be converted into circulatory money on demand without risk of nominal loss should be called non-circulatory money. Cash and demand deposits are not necessarily circulatory. They can sit and wait, just like most savings deposits.
We often try to square the circle, saying money should be only that which is used in exchange for general goods. Well, if it can be used reliably, albeit indirectly, in such exchange, would this not be money too. Savings accounts turned to cash or checking deposits could be considered money.
Monetary stock measures really only tell us an estimate of total money supply and an estimate of circulating money. Generally, M1, M’ (see Mish’s page), and M(t) (see Nima’s link) are an estimate of circulatory money and are linked more closely to general price changes. M2, MZM, and to a lesser degree TMS are estimates of total money supply, which represent an upper bound on circulatory money.
M3 is combination of money and certain forms of credit, and I find it useless.
Strangely enough, this crisis has the appearance of the exact opposite. You’d figure in a crisis people would be cashing out to afford essentials. Yet the opposite seems to be occurring. Total money supply is growing sharply, while circulatory money is not. In fact, if people are holding onto their checking accounts and cash, even the narrow money supply figures are over-stating circulatory money. Prices are decreasing, conforming with Rothbard’s description of deflationary expectations, further fueling deflation.
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