Myths About The Monetary Base And Bank Reserves
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.
Comments (53)
"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."
Are money disappearing from monetary base as a result of bank loans or investments in securities? Where? If public holds less cash - where do they go?
Published: April 5, 2008 12:56 PM
Happy to see someone else also believing bank reserves no longer relevant. In addition to total required reserves declining 34% from $62 bil. in 1988 to $41 bil. now, reserves actually held at the Fed dropped nearly 80% over same period (from $38b to $8b) -- with balance being held as vault cash ($24b and $33b, respectively).
Yes, Fed trades govies to influence funds rate. But Fed's "bought outright" holdings of Treasuries are actually required as collateral for issuance of FR notes. During last 20 years, as required reserves declined by that $21b, The Fed's Treas. holdings increased by more than $500b, as did the amount of FR notes outstanding. Clearly, the Fed does not buy (sell) Treasuries in order to increase (decrease) bank reserves and the money supply.
Moreover, the causal direction, over time, is primarily global demand for US currency (would love to see 50-year time series of that portion of US currency held outside US; latest Fed est I saw was > 60%) being willingly satisfied by Fed -- thereby necessitating corresponding increases in Fed's Treas. holdings as collateral for growth in FR notes outstanding.
Published: April 5, 2008 2:12 PM
The reason Austrians are divided about money and bank reserves is that both camps are wrong. The Fed issues paper money that is backed by the fed's assets. Private banks issue checking account dollars that are backed by the private bank's assets, but denominated in the paper dollars issued by the fed. When the fed issues another $100 of paper, the fed gets a $100 bond, so the fed's assets rise in step with its liabilities and the value of the dollar is unaffected. When Wells Fargo issues 100 checking account dollars, they get assets worth $100 in exchange, so there is no effect on either wells fargo dollars or fed dollars. But if the fed lost assets, then its paper dollars would fall. Then the wells fargo dollars, being claims to fed dollars, would lose value as well. On the other hand, if wells fargo lost assets, then wells fargo dollars would fall, while fed dollars would be unaffected.
Published: April 5, 2008 2:31 PM
I wouldn't consider myself a deflationista or an inflationista. However, historically, when real monetary base is negative, there is an increased probability of recession. It is of little importance to me as an investor whether the consequence is inflation or deflation since my investment strategy will move me where the resulting best returns so long as I can still predict the recession. For example, if there is deflation, then you would expect that the dollar would gain value relative to gold and I would be more inclined to stay out of commodities, vice versa for inflation. For bonds it would be a decision about whether to invest in T-Bonds or TIPS. Right now, I would be in both since they both have been performing well.
I do have one problem with your argument though. First, I should note that I follow real monetary base, not a figure unadjusted to inflation. I have substantial evidence that since the 1960s the 18month change in that figure has been strongly correlated with recessions. Second, that figure hit a peak in March of 2006, not in 2004, and had increased by roughly 25% since the last recession (where it was flat).
Most importantly, your argument hinges on the opinion money market operations and sweeps have reduced reserves and have increased credit. I should note that Shostak does not include sweeps in his definition of the money supply though Mish includes it in his MPrime figure (which he prefers to monetary base). I'm pretty sure that banks cannot loan out of money market accounts (though they may be able to out of sweeps which can justify their inclusion in a money supply figure, but it would only have an influence on the present recession, the explosion in that figure is recent and the data is released late which makes it harder to make investment decisions on) which means that it is unlikely that credit is expanded with their use. Since my primary concern is to investigate when the central banks stops expanding credit to help identify business cycles, I would consider them unimportant. Also, the figure you used was including loans and investments which of course will go up since Glass-Steigel was passed. Banks are making more investments than ever. No one denies that, but the question is how does that expand the money supply and increase credit? Does a slowing of that figure indicate a slowing of credit expansion and serve as an indicator of recession? I didn't do the statistical analysis, but it looks like it never stops going up. My concern is the expansion of credit and when that spigot gets turned off.
No one thinks that bank reserves are the only indication of the expansion of credit, but historically monetary base adjusted for inflation has served very well. My primary concern with this measures is when to get out of the investments that have performed well due to the boom (yes I try to take advantage of the Fed's credit cycle). In this case, my recession figures (I describe their creation at the site above) helped me see the decline in stocks and REITs, where the money had been flowing into. If commodities are going up because of an increase an inflation, I will invest in them. If bonds are going up due to lower interest rates or a possibility of deflation, I will invest in them. People should be flexible about what happens. 35% bonds, 20% commodities, and the rest in cash and if either go under their 200 day average, get out. That's the best investment strategy right now.
Published: April 5, 2008 2:37 PM
Savings deposits are not to be included in the money supply. The same applies to money market funds. Neither of them is accepted as a medium of payment.
Please read:
http://nimamahdjour.blogspot.com/2008/03/money-supply-watch.html
Rothbards arguments in favor of including savings deposts are completely spurious. Please let me know if you need me to explain why,
@Mike Sproul: I did not receive any reply regarding my last comments on another article. The real bills doctrine is completely mistaken in its approach. Any paper money issuing authority HAS to purchase assets or goods in order to 'back' its monetary base. You are pretending there is an option to issue money without backing it with anything. Please let me know if you need me to explain the details again.
Best regards,
Nima
Published: April 5, 2008 4:20 PM
@Victor Agroskin:
"Are money disappearing from monetary base as a result of bank loans or investments in securities? Where? If public holds less cash - where do they go?"
No. In the case of investments, money is simply transferred from the buyer's checking account to the sellers account. The money supply doesn't change.
If the bank makes a loan it credits money on the borrower's checking account and in fact new money is created.
Best,
Nima
Published: April 5, 2008 4:29 PM
"Any paper money issuing authority HAS to purchase assets or goods in order to 'back' its monetary base. You are pretending there is an option to issue money without backing it with anything."
Any money-issuer can print money and give it away. If they choose this option they get no backing for the new money and inflation results. When the money-issuer does get equal-valued assets, then its assets rise in step with its liabilities and the money holds its value.
Published: April 5, 2008 4:36 PM
every savings account i have ever had let me withdraw money whenever i wanted. i think one may have had a cap on the numer of withdrawls..after that there was some kind of service charge. the savings acount i have now has an atm card attached to it and i can withdraw cash like any other deposit account.
why shouldnt this be part of the money supply
Published: April 5, 2008 5:46 PM
Mr. Marks,
That's also why you use Monetary Base ADJUSTED for changes in required reserves.
-Kizner Fervor
Published: April 5, 2008 7:31 PM
to mises.org / mark thornton:
couldn't you just release the formula of the true money supply as a footnote to the mises money aggregates graph, referring those interested in the subtleties to the shostak and salerno pieces?
otherwise it could get confusing - nima has got his own tms (see blog).
will the real tms please stand up!
Published: April 6, 2008 3:11 AM
I am confused. Please post Mises definition and let's start over again.
Published: April 6, 2008 5:05 AM
Three quick responses:
(1) I hope SK does not take me to be one of the "deflationists." I think gold prices might soar in 2008-2009.
(2) Yes there is a downward trend in bank reserves from 1990 to the present, but superimposed on that there is quite clearly the textbook mechanism of open market operations. I've looked again at Figure 1 in my article that SK criticized, and it still jumps out at me. When the Fed lowers the target, reserves go up, and vice versa.
(3) SK claiming that the monetary base was flat through 2003 is simply false. I have a forthcoming mises.org article to show this specifically, but look here if you don't take my word for it.
Published: April 6, 2008 3:14 PM
One point of clarification: In the FRED graph to which I link in the post above, I've displayed it as annual percentage change. So don't misread that and think the monetary base fell in 2003. No, from 2001 - 2003 the annual growth rate was around 10%, and then by 2003 it fell down to 5% growth.
Is that "flat"?
Published: April 6, 2008 3:21 PM
It seems to me that the day people will actually want their cash in paper instead of computer entries, the Fed will simply buy treasuries and print cash on demand. In that situation the monetary base will rise rapidly to match true money supply. The monetary base is simply true money supply less ready-to-be-printed money and therefore irrelevant. Did I miss something here?
Published: April 6, 2008 5:32 PM
@Mike Sproul: You are advancing the same arguments which I already refuted in the other blog post you were commenting on.
Please let me know if you forgot what I wrote there.
Published: April 7, 2008 4:15 AM
LA:
>>I am confused. Please post Mises definition and let's start over again.
From Human Action:
Under the gold standard the dollar and the pound sterling were merely names for a definite weight of gold ... We may call such a sort of money commodity money.
A second sort of money is credit money. Credit money evolved out of the use of money-substitutes. It was customary to use claims, payable on demand and absolutely secure, as substitutes for the sum of money to which they gave a claim.
Fiat money is a money consisting of mere tokens which can neither be employed for any industrial purposes nor convey a claim against anybody.
...
Claims to a definite amount of money, payable and redeemable on demand, against a debtor about whose solvency and willingness to pay there does not prevail the slightest doubt, render to the individual all the services money can render, provided that all parties with whom he could possibly transact business are perfectly familiar with these essential qualities of the claims concerned: daily maturity as well as undoubted solvency and willingness to pay on the part of the debtor. We may call such claims money substitutes, as they can fully replace money in an individual’s or a firm’s cash holding... A money-substitute can be embodied either in a banknote or in a demand deposit with a bank subject to check (“checkbook money” or deposit currency), provided the bank is prepared to exchange the note or the deposit daily free of charge against money proper.
----------------------
My conclusion? All zero-maturity deposits are "money-substitutes" as von Mises defined it, and therefore should be included in the broader definition of money.
Rothbard's inclusion of savings accounts in money was consistent with Mises' definition. And so is Karlsson's inclusion of MMMFs.
Shostak excluded MMMFs on the grounds that the deposit was backed 100% by money-market certificates. And he excluded savings accounts, in direct contradiction to Rothbard 1978, on the technical grounds that the bank could formally delay withdrawal for 30 days. In reality, I wonder if Frank was misled by the same misconception as Mike Sproul - the idea that bank-deposits which are 100% backed by some asset are non-inflationary. In that case we might as well exclude demand-deposits on the grounds that all fiduciary media are backed by loans to the banks' customers.
Published: April 7, 2008 4:52 AM
The only difference I can see between gold/silver coins versus paper money is that coinage is essentially collateral money, if the meaning behind the money in a particular society goes belly up you're still holding something valuable in exchange for the good and/or services you rendered before.
Published: April 7, 2008 5:15 AM
I don't think the question "what is money" can ever be answered in technical terms and be done with it.
Money is the most marketable, liquid commodity and demand to hold money arises from exactly that.
This means anything that can be viewed by a person as liquid, easily marketable, can be money.
If banking system in general lets you withdraw from your savings before time is due, and if people know this then money in savings accounts is money. If savings accounts were operated with strict contracts that had severe penalties then it would cease to be money.
I think even the most of the gold in the world, excluding industrial but including jewelry, is money because holders think in case there is an emergency gold can be exchanges for almost anything.
Also in some underdeveloped regions of the world regular commodities like animals and grain can be viewed as money and should be considered regarding the money supply of that region.
In short what makes something money is peoples subjective valuations and since it changes from person person, from culture to culture and from time to time, there is no way to calculate the real money supply just as there is no way to calculate a general price level.
Of course big parts of the money supply can be calculated but even then people find so many derivatives people will need to redefine the money supply constantly.
Published: April 7, 2008 7:00 AM
"SK claiming that the monetary base was flat through 2003 is simply false. I have a forthcoming mises.org article to show this specifically, but look here if you don't take my word for it."
What I saw in that graph was that since 2002 the monetary base has been growing at a decreasing rate. So, if you use this number as a proxy for money supply growth it would imply that inflation - both cosumer price and asset price levels, should have been increasing at a decreasing rate during this period. But this was during the period that the housing bubble was growing, commodities were in the process of tripling in value and even the highly manipulated government CPI numbers were accelerating.
That same graph would have implied that the 90's were a time to buy commodities, which I suppose would be right if you were willing to wait a couple of years. Of course if you bought them in 2002 you wouldn't have missed much.
Something doesn't equate here. Either all of the signs of money supply inflation were a mirage or the monetary base is a poor measure of the money supply. You can't come to both conclusions simultaneously.
If somebody had given me a crystal ball in 2001 that could tell me the monetary base and nothing else, what would my investment choices have been if I were operating under the theory that the monetary base and M1 were sound measures of the money supply?
I definitely wouldn't have bought gold, housing or commodities, in fact if I was a daring sort I would have shorted all of those things. I would have been buying dollars and fixed income securities. And I would have lost my ass.
Published: April 7, 2008 7:03 AM
I agree with Ktibuk. The monetarist and Austrian attempt to measure the money supply is about as heroically misguided as the Keynesian attempt to measure inflation. Think about all the firms that use their shares as currency to pay employees or buy other firms. How would one include these shares in a tally of the medium of exchange? How would one differentiate normal shares meant for investment from those intended as currency? In twenty years we'll be up to M20 in this money classification game.
One of the themes I am getting from the recent Shostak/Murphy/Karlsson commmentary is that the basis for the Austrian's traditional critique of the Fed printing press is waning, or needs some patching up. After all, if the Fed has been tightening Austrians should be clapping Bernanke on the back for his prudence.
All three try to explain the oddity by showing how deflation (ie tightening) is not something being created by the Fed, but is something that is happening to the Fed. For instance, Shostak says that the slowing economy is causing people to hold less money in their stock of cash. Karlsson shows how institutional changes in monetary conditions are leading to a secular drop in the demand for cash and Fed reserves. The Fed's ability to increase the money supply in Karlsson's piece is non-existent since private banks have skirted the rules and accept deposits that require no reserves.
These arguments are interesting in that the traditional Austrian tropes of "the Fed gunning the printing press" and “flooding the economy with cash” have less meaning. Instead, monetary conditions, in particular money demand, seem to be dictating Fed policy. Deflation is happening to the Fed, as opposed to the Fed causing deflation, and likewise for inflation. Language such as printing, pumping, flooding etc. become inaccurate. Instead, the economy might be said to “draw” from or “push back” money to the Fed according to their whim and not the Fed's. If the Fed's growing irrelevancy is true, how should the Austrian critique adapt and what sorts of institutions deserve its attention?
Anyways, it's a great series of articles on a similiar subject.
Published: April 7, 2008 12:07 PM
more junk economics from the 29 yr old Swede...
have none of you read any Austrian economics?
Here:
Inflation > Malinvestment > ruins capital structure > deflation as banks refuse to make loans and borrowers refuse to borrow. See, for example Japan.
http://www.thelongwaveanalyst.ca/pdf/V5_1.pdf
Published: April 7, 2008 12:27 PM
"M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds."......"M2 was approximately $6.8 trillion and largely consisted of savings deposits." (summer of 2006)
http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html
can someone explain how the savings account works? the saving accounts i have had all allowed access to my money any time i wished which is why it seems odd to me that there is as much discussion about whether savings accounts should be included in any money supply definition.
additionally, are savings account deposits subject to fractional reserve requirements? meaning, do most banks only keep a fraction of the indicated balance of a savings account?
from the same link..."In March 2006, the Federal Reserve Board of Governors ceased publication of the M3 monetary aggregate. M3 did not appear to convey any additional information about economic activity"
this link - http://www.kitco.com/ind/Turk/turk_mar262006.html --
"12-mos from Feb 05 to Feb 06 --
M1 +0.4% M2 +4.7% M3 +8.0%
if this information is correct would low growth in M1 mean that money formerly destined for M1 type accounts is finding its way in to the extra M2 and M3 components instead? if thats the case, that would seem economically relevant.
if not the Federal Reserve, where does the 'money' that rapidly expands M2 and the formerly reported M3 come from?
the expansion of these things for instance - "most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000)" -and- "all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements."
wouldnt the lent out funds from a (what appears to be increasing balances in a) CD (in the form of a check) most likely make their way into demand deposits of some type? and thus be inflated upon?
Published: April 7, 2008 1:54 PM
Nima: If I read American financial regulation correct, then people with money in saving deposits and money market accounts can withdraw their money immediately at will through ATMs or even in most cases debit cards up to 6 times a month. That certainly makes the money deposited there still available as money, unless you've been sloppy enough to have already used that possibility 6 times a particular month. But that is probably unusual in most cases.
RPM: I didn't say the monetary base was flat, I said bank reserves was flat. That is two very different things because, as previously mentioned, more than 90% of the monetary base consist of currency in circulation.
Nathan: Do you have any valid factual arguments, or are invalid hints that my age or nationality somehow makes my arguments false all that you can produce? In that case, if personal attacks is all that you can produce, you might as well not say anything at all.
Published: April 7, 2008 2:54 PM
Nima: If I read American financial regulation correct, then people with money in saving deposits and money market accounts can withdraw their money immediately at will through ATMs or even in most cases debit cards up to 6 times a month. That certainly makes the money deposited there still available as money, unless you've been sloppy enough to have already used that possibility 6 times a particular month. But that is probably unusual in most cases.
RPM: I didn't say the monetary base was flat, I said bank reserves was flat. That is two very different things because, as previously mentioned, more than 90% of the monetary base consist of currency in circulation.
Nathan: Do you have any valid factual arguments, or are invalid hints that my age or nationality somehow makes my arguments false all that you can produce? In that case, if personal attacks is all that you can produce, you might as well not say anything at all.
Published: April 7, 2008 2:56 PM
Stefan:
No, you said monetary base, but in context I now agree that you just mistyped:
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.
Published: April 7, 2008 3:30 PM
Nathan, why the ad hominem attacks? Of what relevance is either Mr Karlsson's age or ethnicity?
Published: April 7, 2008 6:15 PM
nathan says:
"Inflation > Malinvestment > ruins capital structure > deflation as banks refuse to make loans and borrowers refuse to borrow. See, for example Japan."
thanks for the blurb on the kondriateff wave, but your example of japan doesn't hold water. japan didn't experience deflation, only falling cpi. in fact, it would have been far preferable to hold cash yen than gold for the 1990's, and many japanese did just that. japanese bank shareholders copped it in the neck, but not their depositors, so no 1929-33. banks were able to access almost free money, which they invested in us treasuries (carry trade) at favourable yields. in this way they were able to repair damaged balance sheets over time without necessarily loaning to clients.
i don't think you'll get much argument from the austrian camp about the severity of the unfolding recession, here we're arguing about whether commodities are going to hell in a handbasket, as per your theory, or whether the central banks are successful in their vigorous and creative inflationary measures.
and yes, it is galling that karlsson is so able and smart for such tender years. i too, am quite envious, but pleased to note that he does make the odd grammatical error in english. i never make any mistakes in swedish.
Published: April 8, 2008 11:20 AM
Inquisitor, I should hope it's fairly obvious. Taken to the extreme, would you put your eggs in the basket of an "Austrian economist" who lived in Fiji and was 17 years old? How can he possibly know what it's like to live in the land of the Fed when he doesn't even watch American TV? I would argue that economics is about evaluating the world around us as much as it is about reading books that were published 60 years ago.
Newson, the Long Wave Analyst has been called "an historical materpiece" by David Tice of prudentbear.com - an Austrian economist who is also a deflationist. It's a shame so many people on this site focus on ethical and theoretical issues instead of talking about Mr Market.
PS - other deflationists / perma-bears, gold bulls are James Grant and Richard Duncan, but I concede they are nothing compared to Karlsson. lol...
Published: April 8, 2008 1:57 PM
That alone will not suffice to dispose of his argument. It is merely an instance of the genetic fallacy.
Published: April 8, 2008 5:27 PM
nathan mayer says:
"It's a shame so many people on this site focus on ethical and theoretical issues instead of talking about Mr Market."
ok, so following your kondriateff theory, you would have gone long gold to weather the japanese recession, and lost money. mr market not happy!
here's a chart of gold in yen -
http://bp1.blogger.com/_wxWoeht5I6o/RdA_xwZ4niI/AAAAAAAAAAM/mwbaUd-ebMc/s1600-h/gold_yen-long.png take a look at how badly gold performed in yen during the post-bubble decade from 1990 to 2000. if you can't decide whether inflation or deflation is going to happen, you can't possibly hope to align your portfolio correctly.
Published: April 8, 2008 8:17 PM
"That alone will not suffice to dispose of his argument. It is merely an instance of the genetic fallacy."
It was neither alone nor my main point.
"ok, so following your kondriateff theory, you would have gone long gold to weather the japanese recession, and lost money. mr market not happy!"
I don't follow Kondratieff religiously but I find him interesting, especially since he cites Richebacher, Sutton, Russell, Tice, Grant, Prechter Weiss etc.
According to your chart, a Jap would actually be ahead in gold since their bear market began in 1989. A little better than holding real estate or Jap banks, right?
"There is a superficial commonality. There is such a thing as pushing on string. What Keynes describes, however, he does not explain. Only the Austrian cycle theory can do that. A good example can be found in the Asian crisis. Paul Krugman says that Japan fell into a liquidity trap. Why? He doesn't know. He just describes it as an unfortunate state of mind adopted by the citizens, one that can only be cured by printing money.
But there is no need to resort to psychological explanations for why the Japanese are reluctant to borrow. It is clear that the pool of funding was unable to support the level of investment that had been subsidized by excess credit creation, averaging 9 percent per year prior to the crisis. When the central bank raised interest rates, the bubble burst and all the misallocation-which is to say the robbery-was revealed.
How do you recover from a crisis? The Japanese government continues to inflate and spend money. This is incredibly wrongheaded. To create more money is merely to replicate the error that brought about the problem in the first place. And yet, virtually every economist, from Keynesian to monetarist, recommends this disastrous path as the way out of recessions. The only path to recovery is to allow the bad investments to wash out of the economic structure and allow the pool of funding to be replenished."`
http://mises.org/journals/aen/shostak.asp
Published: April 8, 2008 9:26 PM
nathan mayer says:
"According to your chart, a Jap would actually be ahead in gold since their bear market began in 1989. A little better than holding real estate or Jap banks, right?
i don't know where the comment on buying jap banks or real estate came from. to refresh your memory, here's what i actually said:
"it would have been far preferable to hold cash yen than gold for the 1990's, and many japanese did just that"
look at the gold chart in yen and you'll see whether you bought gold at the top of the nikkei share-bubble in 1989, or one year later, makes no difference whatsoever. you would have been better off with yen stuffed under the mattress. this, despite what prechter, weiss, tice or the beach boys may say.
Published: April 9, 2008 1:25 AM
to nathan meyer:
"I don't follow Kondratieff religiously but I find him interesting, especially since he cites Richebacher, Sutton, Russell, Tice, Grant, Prechter Weiss etc."
just for the record, Nikolai Dmitriyevich Kondratiev (russian spelling) was executed during stalin's reign in 1938.
i don't think he'd be doing any citing of prechter & (who's alive and well) & co, but we know what you mean.
Published: April 9, 2008 2:17 AM
It couldn't possibly even serve as an additional consideration... it is wholly extraneous. If Mr Karlsson were, for instance, a teenager with no background in economics, it might've made sense.
Published: April 9, 2008 7:05 AM
Nathan: "more junk economics from the 29 yr old Swede...
How can he possibly know what it's like to live in the land of the Fed when he doesn't even watch American TV?"
In 1912 a 31 yr old Austrian wrote a radical treatise on the "Theory of Money and Credit". His arguments were as iconoclastic and powerful as those of the 29 yr old Swede.
But of course Mises couldn't have written anything of relevance to America, since he didn't have the benefit of watching American TV...
Published: April 10, 2008 1:25 AM
It is pretty shocking that Austrians cannot decide whether savings accounts and MMMF accounts are money or not, and hence cannot decide whether we are currently experiencing inflation or deflation!
Karlsson has done a superb job of clarifying the definition of the money supply. I want to approach it from a different tack, rather than quibbling about how often you have to go to a bank to pick up your cash holding.
von Mises distinguished between money and money-substitutes. By "money" he designated what we now call the monetary base - i.e. currency in circulation and bank reserves. And by "money-substitute" he designated a "claim to a definite amount of money, payable and redeemable on demand, against a debtor about whose solvency and willingness to pay there does not prevail the slightest doubt ... provided the bank is prepared to exchange the note or the deposit daily free of charge against money proper."
If we keep this distinction in mind, then we will not make the mistake of double-counting. A money-substitute is a CLAIM to money. Why would we ever want to lump together CLAIMS to money with money itself?
There is only one reason: banks have a privileged legal status, conferred in the US at least since the Fed was founded in 1913, and in the UK at least since the bank of England was established in 1694. Banks have a statutory right to create claims which they do not have sufficient reserves to honor. (In the old days banks went broke when they ran out of gold, but these days if there is a bank-run then the central bank or treasury replenishes most lost deposits by either printing more money or fleecing taxpayers.)
Because bank-claims cannot all be honored simultaneously, incompatible claims have to be counted twice in the money-supply. The only question to answer is: has the bank granted someone a right to spend money on demand which the bank is already using? If it has then the money is simultaneously spent AND satisfying a demand for cash-holding, and therefore should be counted twice.
This is consistent with Karlsson's brilliant riposte to Justin Rietz, regarding Joe's withdrawal of money from his MMMF account:
(link)
"Before the transaction both Joe and [others] had the right to spend the money at a time of their choosing, meaning in effect that both parties had the money. But after the transaction Joe will lose the right to use it - since he has spent the money - while [others] will keep the right."
It is no answer to say that the bank will cash in its investment in an MMMF or credit instruments when the depositor withdraws his money. Not only has the bank's investment already changed the structure of prices by bidding up the price of those securities, but it has hit the structure of prices with a doubly whammy by satisfying at the same time the depositor's demand for cash holding. It is no different if a depositor withdraws money from his demand deposit, and then the bank chooses to sell down the investments (i.e. loans to customers) which it had made with the money in order to satisfy its reserve- or capital-requirements.
By the same reasoning, MZM should also include all lines of credit extended by a bank, since they too grant a claim to money from the bank on demand. They too reduce the beneficiary's demand for cash-holding. The only difference is that, when exercised, they give rise to a loan incurring interest, rather than to a reduced deposit earning interest. Examples are the undrawn balance on a home equity account, demand-deposit overdraft, or bank credit-card. (Credit from a non-bank credit-card is included indirectly via the card-company's line of credit with its own bank.)
What if a non-bank also accepts deposits, invests them, and offers redemption at a guaranteed price on demand? Is that not also a form of credit expansion? Perhaps, but we may disregard it because free unprivileged banking constrains credit expansion to very narrow bounds, as von Mises reiterated.
Are statistics for credit-limits available? It would be ironic if the money supply were in fact contracting due to reductions in home-equity and the associated lines of credit.
Published: April 10, 2008 1:31 AM
fusgerm says:
"By the same reasoning, MZM should also include all lines of credit extended by a bank, since they too grant a claim to money from the bank on demand. They too reduce the beneficiary's demand for cash-holding. The only difference is that, when exercised, they give rise to a loan incurring interest, rather than to a reduced deposit earning interest. Examples are the undrawn balance on a home equity account, demand-deposit overdraft, or bank credit-card. (Credit from a non-bank credit-card is included indirectly via the card-company's line of credit with its own bank.)"
very interesting. are you alone in this belief? i cannot remember any treatment of unused credit facilities by any of the usual suspects.
Published: April 10, 2008 4:22 AM
newson:
Economists have generally baulked at classifying undrawn loan balances as money. But suppose they are excluded. And suppose that an innovative bank, in a drive to minimize its reserves, offers to replace customers' demand deposits with an overdraft facility secured by a one-month CD. The customer's deposits are all made into the CD, while his payments are all made out of his overdraft. Each month his overdraft is automatically paid off in full by the maturing CD, and the balance of the CD is rolled over for another month.
To protect its collateral, we may also suppose that the bank does not permit early termination of the CD even at a penalty-rate. That will not inconvenience a customer since he already has access to his funds through the overdraft.
Now, a time-deposit which is not eligible for early termination is not money by any reckoning. It is not money because it does not confer a right to withdrawal on demand. Even Rothbard 1978 included a CD as money only if it were eligible for early termination, and then he included it only at the discounted penalty rate.
Where, then, is the customer's money? If it does NOT consist in the undrawn balance of the overdraft, then it does not exist at all. If all banks did this then Shostak's definition of money would consist of little more than money in circulation.
This is an unrealistic scenario for several reasons. But I think that it is already taking place to a large extent using different instruments, e.g. when consumers dispense with a demand-deposit and simply pay off their credit card each month (plus a handful of additional payments) from a money-market account. To exclude bank lines of credit is to vastly understate the true money supply.
Published: April 10, 2008 4:36 PM
"This is an unrealistic scenario for several reasons."
are they to numerous to mention here?
Published: April 10, 2008 5:48 PM
scott t: "are they too numerous to mention here?"
1. The bank would have to set its overdraft interest rate no higher than the CD interest rate, to attract customers into the arrangement in the first place. But that's not implausible for an overdraft secured by a CD.
2. It wouldn't work well for a business-account which makes large numbers of staggered deposits and withdrawals. In that case, both its CD-balance and its overdraft-balance might climb to astronomical figures in one month. The pair of accounts would really have to be offset on a daily basis, but then the two accounts are effectively one.
3. Regulatory issues. E.g. the overdraft, although fully secured by a time-deposit, would still not (I think) be deemed risk-free under the regulations governing capital requirements. If that is so then capital requirements would constrain overdraft-growth.
The particular scenario (overdrafts secured by time-deposts) was not aimed at realism, at least not on a large scale, but as a thought-experiment to discredit any definition of money which excludes undrawn lines of credit,
Published: April 10, 2008 7:08 PM
Susana: Lines of credit are money? You've got to be kidding. I've got Visa and Amex credit cards, and both have got much higher credit limits than I'd ever want to use. And I'd never borrow money either at their rip-off interest rates. And still the companies send me letters inviting me to accept an increase in credit limit.
If you do get a letter like that, don't say yes unless you really expect to use it. When I applied for a home loan they asked me what the credit limit was on my credit cards. They said that reduced the maximum credit they could authorize, since they had to take into account the credit I already had.
Bottom line: Anyone can have a line of credit at some crazy rate. It doesn't mean you'll ever use it.
Published: April 11, 2008 7:31 PM
That's a good point, Susana, though somewhat at odds with the advice which you give.
We are talking about a committment by a bank to honor a claim for money on demand.
If you are using your credit card as a charge card, paid off in full within the interest-free period, then you are getting free credit. I take it that you agree that your credit card is a money-substitute in that context.
But even if you had to pay daily interest on your credit card balance, you might still want to use it in an emergency. The fact that you have access to it in an emergency means that you do not have to keep so much money at call in the bank. You might prefer to invest your surplus cash in T-bills or a CD, since the credit card still serves to satisfy an emergency demand for cash.
If you consider the interest-rate excessive then you can sell your T-bills or CD pay off your card-balance early. The interest-rate is not particularly important, if you can pay off or refinance the debt when you have the leisure to do so. But your card is what makes it reasonable to reduce your cash-balance in favour of short-term liquid investments in the first place. Your card has satisfed your persistent demand for cash holding without requiring you to maintain such a high cash-balance. And it has done so to the extent of your available credit.
Bottom line: your line of credit is a money-substitute, even if you don't use it for long afterwards as a loan-substitute.
Published: April 11, 2008 9:45 PM
fusgerm says:
"Are statistics for credit-limits available? It would be ironic if the money supply were in fact contracting due to reductions in home-equity and the associated lines of credit."
here's karlsson's take on the above - https://www.blogger.com/comment.g?blogID=14390234&postID=833301952146361117
Published: April 12, 2008 7:53 AM
Thanks Newson
It would be nice to clarify just which lines of credit are included in MZM and the extent of those which are not.
Googling turns up very little.
It seems that banks keep lines of credit off their balance sheet as far as they can to minimize their capital requirements. You'd think they'd be recorded as current liabilities.
Thus "Standby lines of credit are recorded by banks as an off-balance sheet exposure, and under Basel I do not attract a regulatory capital charge if the term to maturity is less than one year, which is normally the case."
One site stated that unused credit on credit cards was excluded on the grounds that the limit could be dropped at any time by the card-issuer. (This pretext sounds as unlikely as a 30-day delay on savings withdrawals.)
http://www.auburn.edu/~johnspm/gloss/money_stock:
"There are a number of still broader definitions of the money stock ("M3," "M4," "L," etc.) that go on to add in such only slightly less liquid money-like assets as checkable money market mutual funds, larger denomination bank certificates of deposit, credit card credit limits, pre-approved lines of credit, and so on."
http://sci.tech-archive.net/Archive/sci.econ/2006-01/msg00309.html:
"An important shortcoming of the Fed's definition is that it ignores lines of credit which can be exercised at the pleasure of borrower. Firms often hold substantial lines of credit on their banks, which they can use at a moment's notice. Likewise consumers have lines of credit with their credit cards that are just as useful for purchases as checking accounts or the currency in their wallets.
...
In effect, the money supply is substantially larger and less measurable than the Fed's definition."
Published: April 13, 2008 9:21 AM
I think you are overlooking something basic. Money is an asset. A line of credit is not. If you think that it is, then try listing it as an asset when you are applying for a loan. It actually makes it harder to get a loan, not easier --as I mentioned above.
Another thing-- If there is a bank run then the Fed steps in to supply a bank with cash. You could say that every bank has a line of credit with the Fed. What's going to happen to your money supply if you include that line of credit in it? Blow it sky high, that's what.
Published: April 14, 2008 5:09 PM
A line of credit is an asset. Its value to you is the amount of money that it saves you from having to raise cash. For example, it may save you from having to liquidate stocks when the market is low. It gives you the capacity to earn extra interest in a time-deposit rather than in an at-call account. If you are a business then it saves you from having to dump inventory below cost during seasonal shortfalls in cash-flow. If you pay off your credit-card balance monthly then it is worth at least as much to you as the free interest on your balance.
I agree that this is hard to quantify; perhaps that is why it might be kept off balance-sheet.
Although the undrawn balance is an asset of indefinite value, the drawn balance is of course a liability (a loan in fact) of a very precise value.
As to your other point, I like your analogy of a line to credit to the Fed. A bank's balance sheet consists of a constellation of assets and liabilities with varying dates of maturity. A housing loan is an asset which might not fully mature for over 20 years. A business loan is an asset which might not mature for a few years. Short-term treasuries and MMMF shares are assets which are redeemable within a few days. Many liabilities, however, are due at call. That is the case for all deposits except for term deposits. The bank would be insolvent without an implied line of credit to the Fed. It would simply not have enough working capital to accomodate a bank-run.
If MZM is broken down bank by bank, then it is a measure of each bank's working capital. It measures how much money the Fed would need to inject into the bank if there were a run on it, assuming that the bank did not sell assets to raise cash. MZM measures the bank's implied line of credit to the Fed.
Actually, that is not quite true. The bank's reserves should be DEDUCTED from MZM for it to be true, since if there is a run on the bank then the bank can rely on a combination of Fed credit and its own reserves. And on reflection, I think that bank reserves SHOULD be deducted from MZM, rather than simply omitted altogether, since a bank contributes to the money supply only to the extent that it does not have 100% reserves. If it kept 100% reserves then its MZM component would be nil, and if all banks arranged their affairs in the same way - i.e. so that maturing assets and maturing liabilities were in sync - then we could neglect bank-deposits from the money supply.
In short, lines of credit should be added to MZM if they are not already included in it, and bank reserves should be deducted. Then MZM (excluding currency in circulation) is a measure of the banks' working capital, and is equal to the sum of the banks' implied lines of credit to the Fed.
Published: April 14, 2008 8:31 PM
To get back to the theme of this blog, regarding the monetary base and bank reserves, I accept Karlsson's reasoning, though I wonder if bank credit might have been swollen by the exercise of off-balance-sheet lines of credit. A credit squeeze might still generate a one-off surge in bank credit as existing lines of credit are drawn on.
Moreover, it seems that the New York Fed also agrees with Karlsson:
In practice, the connection between reserve requirements and money creation is weak. Reserve requirements apply only to transaction accounts, which are components of M1. Deposits which are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, a bank can always borrow any shortfall in reserves from the federal funds market. Consequently, reserve requirements currently play a relatively limited role in money creation in the US.
http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html
Published: April 14, 2008 8:56 PM
Susana:
"Money is an asset. A line of credit is not."
Paper dollars issued by the fed are the fed's liability, but they are an asset to whoever has them in their wallet. Checking account dollars created with a line of credit are the liability of the bank that issued them, and they become an asset to whoever they are paid to.
A more interesting question is "What effect do the different kinds of dollars have on the price of groceries?" The answer is that neither has any effect, as long as the fed's dollars are adequately backed by the fed's assets, and the private bank's dollars are adequately backed by the private bank's assets.
Published: April 15, 2008 12:00 PM
Mike: "Paper dollars issued by the fed are the fed's liability..."
And what exactly is the Fed's liability, or that of a bank? Here's how Wikipedia defines liabilities: "In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future."
Under the gold standard, banks had a liability to exchange a specific amount of gold upon demand for its paper dollars. Under our fiat system, what liability do banks have? None. They have no assets to transfer to a consumer who doesn't want to use their paper money. Calling money a liability is just an accounting convenience. They have to call it something and accounting has no category for toilet paper.
Published: April 15, 2008 1:23 PM
Sproul:
Checking account dollars created with a line of credit are the liability of the bank that issued them, and they become an asset to whoever they are paid to.
The issue was not over the dollars created with the line of credit but with the undrawn balance of the line of credit itself.
That aside, I think that this "implied" line of credit that present day private banks have to the Fed is the explanation of the rampant inflation of recent decades.
You would say that the private bank's dollars will have no effect on prices (assuming adequate backing), because if there is a bank run then the private bank can simply sell assets if its reserves are insufficient on their own.
The problem is that bank-runs tend to occur in a market like the present one, in which a bank's loan-book will sell at a poor price due to the credit scare. The market for loan-books is highly limited, and at the moment the banks are eyeing each other suspiciously.
That implies that a bank will survive a run today only by relying on its line of credit to the Fed, which in turn implies that the Fed's dollars are committed to back the private bank's dollars. This circularity is the flaw in your elegant equations: not only is the value of the private bank's dollars dependent on the Fed's dollars, but the Fed's dollars are in practice hamstrung by the private bank's dollars.
I agree that under free banking there is no issue. The central bank, even if it still exists, can simply tell the commercial bank to drop dead. In that context a private bank will behave responsibly - it will align its maturing liabilities more closely to its maturing assets so that it is never forced to dump most of its loan-book on a hostile market.
Published: April 15, 2008 4:38 PM
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 “real”.
this mises article http://www.mises.org/story/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?
Published: April 18, 2008 4:13 PM
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
Published: April 18, 2008 5:05 PM
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.
Published: April 28, 2008 11:25 PM