U.S. Monetary Supply--the root of the Crash

U.S. Monetary Supply

The Concise Encyclopedia of Economics

Money Supply by Anna J. Schwartz, Economist at the National Bureau of Economic Research, New York.

http://www.econlib.org/library/Enc/MoneySupply.html

What Is the Money Supply?

The U.S. money supply comprises currency—dollar bills and coins issued by the Federal Reserve System and the U.S. Treasury—and various kinds of deposits held by the public at commercial banks and other depository institutions such as thrifts and credit unions. On June 30, 2004, the money supply, measured as the sum of currency and checking account deposits, totaled $1,333 billion. Including some types of savings deposits, the money supply totaled $6,275 billion. An even broader measure totaled $9,275 billion.

These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money.

The definition of money has varied. For centuries, physical commodities, most commonly silver or gold, served as money. Later, when paper money and checkable deposits were introduced, they were convertible into commodity money. The abandonment of convertibility of money into a commodity since August 15, 1971, when President Richard M. Nixon discontinued converting U.S. dollars into gold at $35 per ounce, has made the monies of the United States and other countries into fiat money—money that national monetary authorities have the power to issue without legal constraints.

What Determines the Money Supply?

Federal Reserve policy is the most important determinant of the money supply. The Federal Reserve affects the money supply by affecting its most important component, bank deposits.

Here is how it works. The Federal Reserve requires depository institutions (commercial banks and other financial institutions) to hold as reserves a fraction (typically 10%) of specified deposit liabilities. Depository institutions hold these reserves as cash in their vaults or Automatic Teller Machines (ATMs) and as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to depository institutions and changing the Federal Reserve discount rate on these loans and by open-market operations. The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the treasury security deposits the check in a bank, increasing the seller’s deposit. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells treasury securities: the purchaser’s deposits fall, and, in turn, the bank’s reserves fall.

If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits, until all excess reserves are used up.

If the required reserve ratio is 10 percent, then starting with new reserves of, say, $1,000, the most a bank can lend is $900, since it must keep $100 as reserves against the deposit it simultaneously sets up. When the borrower writes a check against this amount in his bank A, the payee deposits it in his bank B. Each new demand deposit that a bank receives creates an equal amount of new reserves. Bank B will now have additional reserves of $900, of which it must keep $90 in reserves, so it can lend out only $810. The total of new loans the banking system as a whole grants in this example will be ten times the initial amount of excess reserve, or $9,000: 900 + 810 + 729 + 656.1 + 590.5, and so on. {Thus the Federal Reserve is printing money which is fed into our banking system and dispersal through loans—consumer and commercial.[i]}

In a system with fractional reserve requirements, an increase in bank reserves can support a multiple expansion of deposits, and a decrease can result in a multiple contraction of deposits. The value of the multiplier depends on the required reserve ratio on deposits. A high required-reserve ratio lowers the value of the multiplier. A low required-reserve ratio raises the value of the multiplier.

In 2004, banks with a total of $7 million in checkable deposits were exempt from reserve requirements. Those with more than $7 million but less than $47.6 million in checkable deposits were required to keep 3 percent of such accounts as reserves, while those with checkable accounts amounting to $47.6 million or more were required to keep 10 percent. No reserves were required to be held against time deposits.

Even if there were no legal reserve requirements for banks, they would still maintain required clearing balances as reserves with the Federal Reserve, whose ability to control the volume of deposits would not be impaired. Banks would continue to keep reserves to enable them to clear debits arising from transactions with other banks, to obtain currency to meet depositors’ demands, and to avoid a deficit as a result of imbalances in clearings.

The currency component of the money supply, using the M2 definition of money, is far smaller than the deposit component. Currency includes both Federal Reserve notes and coins. The Board of Governors places an order with the U.S. Bureau of Engraving and Printing for Federal Reserve notes for all the Reserve Banks and then allocates the notes to each district Reserve Bank. Currently, the notes are no longer marked with the individual district seal. The Federal Reserve Banks typically hold the notes in their vaults until sold at face value to commercial banks, which pay private carriers to pick up the cash from their district Reserve Bank.

The Reserve Banks debit the commercial banks’ reserve accounts as payment for the notes their customers demand. When the demand for notes falls, the Reserve Banks accept a return flow of the notes from the commercial banks and credit their reserves.

The U.S. mints design and manufacture U.S. coins for distribution to Federal Reserve Banks. The Board of Governors places orders with the appropriate mints. The system buys coin at its face value by crediting the U.S. Treasury’s account at the Reserve Banks. The Federal Reserve System holds its coins in 190 coin terminals, which armored carrier companies own and operate. Commercial banks buy coins at face value from the Reserve Banks, which receive payment by debiting the commercial banks’ reserve accounts. The commercial banks pay the full costs of shipping the coin.

In a fractional reserve banking system, drains of currency from banks reduce their reserves, and unless the Federal Reserve provides adequate additional amounts of currency and reserves, a multiple contraction of deposits results, reducing the quantity of money. Currency and bank reserves added together equal the monetary base, sometimes known as high-powered money. The Federal Reserve has the power to control the issue of both components. By adjusting the levels of banks’ reserve balances, over several quarters it can achieve a desired rate of growth of deposits and of the money supply. When the public and the banks change the ratio of their currency and reserves.

If the Federal Reserve determines the magnitude of the money supply, what makes the nominal value of money in existence equal to the amount people want to hold? A change in interest rates is one way to make that correspondence happen. A fall in interest rates increases the amount of money people wish to hold, while a rise in interest rates decreases that amount. A change in prices is another way to make the money supply equal the amount demanded. When people hold more nominal dollars than they want, they spend them faster, causing prices to rise. These rising prices reduce the purchasing power of money until the amount people want equals the amount available. Conversely, when people hold less money than they want, they spend more slowly, causing prices to fall. As a result, the real value of money in existence just equals the amount people are willing to hold.

Changing Federal Reserve Techniques

The Federal Reserve’s techniques for achieving its desired level of reserves—both borrowed reserves that banks obtain at the discount window and non-borrowed reserves that it provides by open-market purchases—have changed significantly over time. At first, the Federal Reserve controlled the volume of reserves and of borrowing by member banks mainly by changing the discount rate. It did so on the theory that borrowed reserves made member banks reluctant to extend loans because their desire to repay their own indebtedness to the Federal Reserve as soon as possible was supposed to inhibit their willingness to accommodate borrowers. In the 1920s, when the Federal Reserve discovered that open-market operations also created reserves, changing nonborrowed reserves offered a more effective way to offset undesired changes in borrowing by member banks. In the 1950s, the Federal Reserve sought to control what are called free reserves, or excess reserves minus member bank borrowing.

The Fed has interpreted a rise in interest rates as tighter monetary policy and a fall as easier monetary policy. But interest rates are an imperfect indicator of monetary policy. If easy monetary policy is expected to cause inflation, lenders demand a higher interest rate to compensate for this inflation, and borrowers are willing to pay a higher rate because inflation reduces the value of the dollars they repay. Thus, an increase in expected inflation increases interest rates. Between 1977 and 1979, for example, U.S. monetary policy was easy and interest rates rose. Similarly, if tight monetary policy is expected to reduce inflation, interest rates could fall.

From 1979 to 1982, when Paul Volcker was chairman of the Federal Reserve, the Fed tried to control non-borrowed reserves to achieve its monetary target. The procedure produced large swings in both money growth and interest rates. Forcing non-borrowed reserves to decline when above target led borrowed reserves to rise because the Federal Reserve allowed banks access to the discount window when they sought this alternative source of reserves. Since then, the Federal Reserve has specified a narrow range for the federal funds rate, the interest rate on overnight loans from one bank to another, as the instrument to achieve its objectives. Although the Fed does not directly transact in the Fed funds market, when the Federal Reserve specifies a higher Fed funds rate, it makes this higher rate stick by reducing the reserves it provides the entire financial system. When it specifies a lower Fed funds rate, it makes this stick by providing increased reserves. The Fed funds market rate deviates minimally from the target rate. If the deviation is greater, that is a signal to the Fed that the reserves it has provided are not consistent with the funds rate it has announced. It will increase or reduce the reserves depending on the deviation.

The big change in Federal Reserve objectives under Alan Greenspan’s chairmanship was the acknowledgment that its key responsibility is to control inflation. The Federal Reserve adopted an implicit target for projected future inflation. Its success in meeting its target has gained it credibility. The target has become the public’s expected inflation rate.[ii]

History of the U.S. Money Supply

From the founding of the Federal Reserve in 1913 until the end of World War II, the money supply tended to grow at a higher rate than the growth of nominal GNP. This increase in the ratio of money supply to GNP shows an increase in the amount of money as a fraction of their income that people wanted to hold. From 1946 to 1980, nominal GNP tended to grow at a higher rate than the growth of the money supply, an indication that the public reduced its money balances relative to income. Until 1986, money balances grew relative to income; since then they have declined relative to income. Economists explain these movements by changes in price expectations, as well as by changes in interest rates that make money holding more or less expensive. If prices are expected to fall, the inducement to hold money balances rises since money will buy more if the expectations are realized; similarly, if interest rates fall, the cost of holding money balances rather than spending or investing them declines. If prices are expected to rise or interest rates rise, holding money rather than spending or investing it becomes more costly.

Since 1914 a sustained decline of the money supply has occurred during only three business cycle contractions, each of which was severe as judged by the decline in output and rise in unemployment: 1920–1921, 1929–1933, and 1937–1938. The severity of the economic decline in each of these cyclical downturns, it is widely accepted, was a consequence of the reduction in the quantity of money, particularly so for the downturn that began in 1929, when the quantity of money fell by an unprecedented one-third. There have been no sustained declines in the quantity of money in the past six decades.

The United States has experienced three major price inflations since 1914, and each has been preceded and accompanied by a corresponding increase in the rate of growth of the money supply: 1914–1920, 1939–1948, and 1967–1980. An acceleration of money growth in excess of real output growth has invariably produced inflation—in these episodes and in many earlier examples in the United States and elsewhere in the world.

Until the Federal Reserve adopted an implicit inflation target in the 1990s, the money supply tended to rise more rapidly during business cycle expansions than during business cycle contractions. The rate of rise tended to fall before the peak in business and to increase before the trough. Prices rose during expansions and fell during contractions. This pattern is currently not observed. Growth rates of money aggregates tend to be moderate and stable, although the Federal Reserve, like most central banks, now ignores money aggregates in its framework and practice. A possibly unintended result of its success in controlling inflation is that money aggregates have no predictive power with respect to prices.

The lesson that the history of money supply teaches is that to ignore the magnitude of money supply changes is to court monetary disorder. Time will tell whether the current monetary nirvana is enduring and a challenge to that lesson.

[i] The properly managed influx of funds through the banking system stimulates the economy and thus promotes prosperity. The removal of regulations on the dispersal of funds—as occurs under neoliberal policies—entails a speculative bubble. The loans are used to buy for example housing at inflated prices. A major contraction in the market entails defaults on the loans, which causes banks short on equity to fold.

[ii] The problem is that through funny bookkeeping much that is inflation isn’t counted. For example, changes in the cost of food, energy, and most manufactured goods, among other things are not used in determining the rate of inflation. The result of this is benefits tied to the rate of inflation are reduced, including salaries, social security payments, and return on bank deposits.

The fix isn’t money, there is too much debt to assets ratio in the U.S. and the financeers know it. Nor is it to increase the banks and expect them to loan it out again for to stimulate the economy. First most of the funds will be used to write down bad loans, and what little is left over will be held given how incredible high ristk now is. Reserve loans, for that won’t get the U.S. out of the tail spin, not for years. Given the dimensions of the decline in housing and the stock market too much money has been lost for a quick patch. Moreover, the imbalance of trade and the loss of jobs through outsourcing only exacerbate the problem. Add to this that millions are living off their credit cards, more debt which they won't be able to repay.

During the Great Depression, Germany was the worse. The ideal fix is to build up, as Hitler did, the manufacturing sector—put people to work making durable goods. Simply make distrubute housing and essentials for which we have sufficient capacity, then the collapse with ove 25% living in poverty will be reversed. Overturn the IMF's (globalizer's) plans by protecting markets with tariffs, and thereby assure that decent wages can be payed. Screw the special interests by developing mass transit and alternative energy sources, so that petro dollars won't bleed our country dry. Nationalize the health care system and end the 35% burden corprations impose. And turn the air waves over to the univeristy so as to assure accurate reporting, increase educational content, and end the corporate slant to content. These are the types of solutions which would make our country sound. And finally we must end the legalized bribery called campaign donations. How can our government supervise their donors? An independent government can supervise properly industry and financial institutions.

Adam Smith recommended lassie faire capitalism not because government supervision was inherently bad, but because intervention in a system of legalized bribery was worse than no intervention. Read of the Canadian solution, and of Adam Smith invisible hand at the bottom of http://skeptically.org/polrec/id11.html

Neoliberal free-market policies failing again. Under Reagan it was the S&L debacle, then it was the dot com and teach stock bubble and now the housing market collapse. Solution, raise the debt, drop and sell more T-bills, which is done through dropping the value of the U.S. dollar. In the first bout of Reaganomics the federal debt was doubled, in the second round (by the time Bush leaves it will be over $11 trillion) it will double again.

Hale “Bonddad” Sterwart in the Huffington Post at http://www.huffingtonpost.com/hale-stewart/lets-add-more-debt-to-the_b_114692.html

Posted 7/24/08

Let’s Add More Debt to the National Total

From a story talking about the housing bill in the Wall Street Journal on the mortgage bill Congress is passing “As a result of the bill, Congress will raise the national debt ceiling to $10.6 trillion from $9.8 trillion.” (See bottom of page for article). (In addition there is household which during the Bush reign has risen from $7.6 to $13.9 trillion, an increase of 82%.)

Let's just add more debt to the total, shall we? After all, we don't have enough debt. And we certainly wouldn't want to do anything that remotely resembles fiscal responsibility. That might send the wrong message to the markets about the US government's intentions.

Let's review. First, here is the yearly total of total US government debt outstanding at the end of each federal fiscal year.

09/30/2007 $9,007,653,372,262.48
09/30/2006 $8,506,973,899,215.23
09/30/2005 $7,932,709,661,723.50
09/30/2004 $7,379,052,696,330.32
09/30/2003 $6,783,231,062,743.62
09/30/2002 $6,228,235,965,597.16
09/30/2001 $5,807,463,412,200.06
09/30/2000 $5,674,178,209,886.86

Why are these figures important? Because they indicate there is a systemic problem with the US government's budgeting system. Since the end of fiscal year 2002, the federal government has added at least $500 billion dollars of net new debt per year every year. That indicates the budget has never even come close to being balanced over the last 7 years -- despite rampant claims to the contrary. "But Bonddad -- the national press says the budget deficit is small!" Right -- that's why we're borrowing all that money -- because we're balancing the books of the federal government. Anyone who is reporting the federal government's books are balanced should resign from the financial press right now because they have no idea what they are talking about. All this debt has resulted in $550 billion in write downs (see http://www.huffingtonpost.com/hale-stewart/from-one-disaster-to-anot_b_126442.html, Hale Stewart, 9/15/8).

But there are three deeper and far more important reasons why this continual raising of the debt ceiling is so incredibly dangerous.

The first is psychological. At the national level the federal government has continued to abdicate fiscal responsibility. The US went to war and didn't raise taxes to pay for it. The US increased domestic spending and didn't increase taxes to pay for it. Instead, we acted as though the debt didn't matter and that tax cuts pay for themselves. As a result we are left with an ever-increasing mountain of debt which we continue to kick down to road. {One kick is that the second biggest item—excluding SS which pays for itself in a separate tax—is the interest the U.S. pays on the debt—jk.} By not making tough choices now we make it easier to not make tough choices tomorrow.

The second reason is far more practical. As the debt load of the US has increased, the value of the dollar has dropped. Although the US economy was in an expansion* from November 2001, the value of the dollar continually dropped. Why?** An expanding economy should attract investment which in turn bids up its currency. Yet the dollar dropped. Some of the reason for this is interest rate policy which is an important determinant in currency valuation. However, the US -- which is the world's largest economy -- was seeing the value of its currency continue to decline. This has lead to inflationary pressures because commodities are priced in dollars. A drop in the value of the currency a good is priced in amounts to a de facto price increase in the good. In other words, one of the primary reasons for the spike in oil prices is the dollar's long-term drop in value. And we can thank fiscal irresponsibility as a primary reason for that.

The third reason why this development is important is it continues to push the national economic foundation closer to the edge. At some point all of this debt may cause very serious problems. Suppose that US creditors (bondholders) looked at the US' books and said, "I don't think you're going to be able to repay this loan I'm making to you. I need a higher interest rate as compensation for the risk I'm taking by lending you money." At that point, US interest rates increase. Imagine if that happened right now when the economy is at the beginning of a recession***. In other words, we're creating a situation that is rife with possible future problems. And some of these problems are serious -- as in they could lead to the financial system freezing from a random world event.

"But Bonddad. We've been doing business like this for almost 30 years and nothing bad has happened! It must be OK to do things things this way." Fine. Try smoking a pack a day for 30 years. You may not get cancer. But your chances of contracting it are a whole lot higher. That's why doctors will always advise you to quit.

Comments by JK

* * T-bills are sold to repay those that mature. The way to make them attractive to foreign markets is either to make the U.S. dollar cheaper (over 40 percent in 4 years against the Euro), or to have them pay a higher return through raising the percentage of dividends. But since bank loans, floating mortgages, etc. are tied to the T-bill rate this would effect negatively all sectors of the economy, thus the falling dollar.

** The economy hasn’t been expanding because the figures based upon this expansion do not account for the declining value of the dollar. Since the 1980’s various price inflations have been dropped from the calculation of inflation (including food, energy and consumer goods). Increases in manufacture goods prices is skipped (the logic is that they last longer). Adjust for the true value of the dollar, and our economy has been contracting.

*** We are in a recession: more flaky account. Adjust these figures for the actual rate of inflation.

By lying about the rate of inflation our government saves billions of dollars. For example the increase in social security payments is tied to the rate of inflation, as is government employee salaries. Most large corporations, and those with unions, give pay raises based on the rate of inflation. In the last two years the real rate of inflation (how much it costs to do everything you normally do) has gone up over 10% each year--jk.

The Feds must shore up the banks, if they fold they will suck we will be in another great depression. Don’t assume that our Neoliberal Republicans and the fellow-travelers Democrats are doing this to save your home from foreclosure. It is about saving their banking supporters.

Wall Street Journal page 1 store also at http://online.wsj.com/article/SB121681776929477089.html?mod=hps_us_whats_news