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January 14, 2011 pdf

The Money Supply and those (supposedly) Overworked Printing Presses

Christopher’s question…

What is the linkage between the money supply and the monetary base? I have heard repeatedly that the money supply is expanding and the printing presses are running overtime. If this is the case, how can that NOT be inflationary moving forward?

If we are not running the printing presses, then what is going on?

Let’s take a walk through the credit creation process…

Checkable deposits

1. Borrow request a loan from a depository institution (e.g. commercial bank)
2. If the loan is approved, the borrower is asked to sign a note payable, which details how the principal and interest is to be repaid to the bank.

This is a liability or a note payable to the borrower

Asset or a note receivable to the bank

What does the borrower get in return?

3. Bank issues a deposit slip to the borrower.

This increases the borrower’s checkable deposit equal to the amount of the loan.

This checkable deposit is an asset to the borrower, but a liability to the bank.

4. Credit is thus created by the bank in favor of the borrower – the M1 increases because checkable deposits are part of the M1 Monetary Aggregate (Money Stock).

It is clear that the bank has created both credit (the loan) and money (M1 – checkable deposit). We could also say that the bank has also created M1 money in checkable deposit form and lent it to the borrower. We could also say that the bank has monetized the borrower’s debt. The borrower’s debt, or note payable, is not M1 money. The bank’s liability – the checkable deposit, is M1 money. Therefore in this process of creating credit for the borrower, it has also created NEW M1 money. Yet another way of looking at this, is that the borrower and the bank swap debt or liabilities with each other and new money and credit are created. Note that the bank need not have the M1 money to lend it out: it simply creates a liability on itself.

Rarely does the bank lend currency money out. In almost all cases, the bank simply creates a checkable deposit liability on itself and gives title to that to the borrower. The borrower can ‘spend’ that money by means of check, debit card, or wire transfer. Spending this money really means conveying title of this checkable deposit to someone else.

Confusion often arises in the minds of most people because most of the time they go to a bank (depository in general…bank, credit union, etc.) and deposit currency or checks in their account. Obviously, that currency or check already existed – and we can think of it as ‘old money’. This type of deposit has been called ‘primary deposit’ in the past. When banks create new deposits (as explained in the loan transaction above), these newly created deposits are referred to as secondary deposits. These secondary deposits are the result of the borrower signing a note payable in favor of the bank. Since the vast majority of ‘new money’ is created by depositories, in the process of creating credit, NO PRINTING PRESSES ARE REQUIRED!

Where does the expression, RUNNING THE PRINTING PRESSES, come from?

In the 1860s, in order to partially finance the Civil War, the US government (the North – Union), actually printed United States Notes, often called ‘greenbacks’ and spent them. Up until the Civil War, state chartered banks also had paper money (currency) printed and would lend that paper money out when making a loan. By placing a heavy tax on this bank note (or paper money) issue, the Federal government ended this practice by state chartered banks.

In order to maintain their ability to maintain loans or credit, state-chartered banks aggressively promoted checking accounts. Federally-chartered national banks were given the power in the 1860s to issue bank notes or paper money. This power was eliminated in the 1930s. This left only the federal government with the legal ability to print paper money. At various times in the past, the US government would purchases silver and gold and on the basis of those purchases, would print silver and gold certificates. Such purchases were eventually eliminated and the silver and gold certificates were withdrawn from circulation.

With the passage of the Federal Reserve Act, the Federal Reserve System was empowered to issue paper money, called Federal Reserve Notes. At the present time, with very minor exceptions, the only paper money in circulation in the US are Federal Reserve Notes. All other forms of paper money no longer legally circulate with the exception of the United States Notes. They are so scarce that those remaining are in the hands of collectors.

The Fed does not issue paper money in the form of Federal Reserve Notes as part of the credit creation process. Rather, it stands ready to supply paper money in the form of Federal Reserve Notes to the public when they demand it. This issuance of Federal Reserve Notes to the public is channeled through the depository institutions. It is part of the depository institutions ‘cash in the vault’. As a practical matter, nearly 90% of all legitimate transactions in the US economy are facilitated by means of checkable deposits – NOT CURRENCY. In the illegitimate, or underground economy (estimated to be in the 10-20% range of the total economy), currency – or paper money, does virtually the facilitation of transactions. Much of that paper money stock (Federal Reserve Notes) serves as the currency of other nations whose citizens do not trust the currency of their respective countries.

It is, therefore a bad characterization to say that inflation is caused by RUNNING THE PRINTING PRESSES! On occasion, it could be said that hyperactivity by loan officers at depository institutions might cause acceleration in inflation.

How does the Fed controls this activity?

www.econnewsletter.com/dec032003

Again, more to follow…