Wednesday, March 17, 2010

Fed and the Money Supply: Details

A thoughtful consideration of my articles on how the Fed works to expand bank credit, the Fed’s massive expansion of Member Reserve Deposits, and the steady decline in bank loans could easily result in some head scratching. My explanation of expanding bank credit (similar to what you find in Meltdown by Thomas Woods) would lead you to think that bank lending would be going crazy now, with the reserves built up to such a massive amount. There are, however, other factors at work in the process that I did not include in my discussion. I thought that my explanation of the Fed’s basic activities was long, complex, and convoluted enough without adding many other things in as well. I should also say that the degree of complexity is not really apparent until something like the present situation occurs.

What other factors? Well, there are basic banking practices, bank profitability, bank capital and loss reserve needs, and other regulators. This last factor is not minor. The banks have a galaxy of people looking over their shoulders. These regulators insist, and have the power to insist, that the banks follow certain “risk” and accounting standards. It isn’t that everyone of these standards are necessarily bad, but that the application can be arbitrary and outside of context. The standards change constantly, especially in their detail, which sometimes makes what the bank was doing in accordance with the regs yesterday, but today, that practice is wrong and subject to penalty. How this is working out in today’s circumstance is explained in this Forbes article. The author is an administration cheerleader, but he inadvertently gives you a very good idea of what is happening.

Most basic in considering a bank’s standard method of operating is that it is a business, with shareholders, employees, balance sheets, and standard operating practices that have been developed over centuries. Banks are in business to make a profit. Sound banking, to the extent that it can be found amid all of the nonsense required of banks today, also includes of many of the practices that any business needs to follow if it is to be profitable.

In addition, especially within today’s funny-money environment and the uncertainty of future of changes in regulation and government activity, a bank has to protect itself (think of the uncertainty BO’s TARP Tax created). The bank has several different accounts of its own that it maintains for financial protection. It has a capital account, what you could also call equity. The bank’s capital is reduced if it operates at a loss or if other assets are lost. The bank also has a loan-loss reserve, which is an account of cash that the bank keeps to cover bad loans and the failure of other assets, e.g., mortgage backed securities. During the financial crisis, many banks saw significant shrinkage in these two accounts. In order to restore the health of a bank, these two accounts have to be built back up. Banks cannot and will not expand their loans again until they have a healthy capital account (which would be a certain ratio to its obligations) and loss-loan reserve (also a certain ratio to outstanding and new loans). In the normal course of events, these accounts would be increased by either by going to the capital market or by retaining profits. The capital market is not functioning well right now, especially for banks, and profits are hard to come by. Sensible banking is standing in the way of the government’s (read BO and the Fed) demands for increased loans.

One might suggest that a bank could take some of the excess reserves that the Fed has given the bank and put that in either of these important accounts. But it can’t. There is no legitimate accounting method to do so. It is exactly the same problem for someone who wants to take stolen money or drug profits and put into a business. There is no way to account for it.

A bank can take money the Fed has created and placed in a bank’s “reserves”, but there is only one use that it can put that “money” toward: loans. When I wrote that a bank with an increased reserve could then make loans, I was implying a practice that is not the norm. I am not aware of any restriction preventing a bank from just expanding its loan portfolio when its reserves have been expanded, assuming that the capital and loan-loss reserves are sufficient. It may be that the accounting techniques available do not support that approach. For whatever reason, banks tend to take a different approach.

What happens is that the bank will take excess funds out of their Fed account, presumably a percentage that leaves the required deposit in their Fed account. This “money” (in quotes because it is stuff that the Fed created) the bank then loans.

The process probably goes like this. The Fed has selected a target interest rate below market for the Federal Funds/discount rate. To maintain that low rate, the Fed will be buying Federal bonds from institutions. When the bank presents the check for the purchase of the bonds to the Fed, the Fed puts the funds into the “reserve” account of that bank at the Fed. The bank now has more funds in their “reserve” account than they need for the demand deposits held by the bank. If a “qualified” loan applicant is available (qualified in quotes because low interest rates distorts, undercuts the real criteria needed to make loans, i.e., a market interest rate), the bank takes the “money” out of the reserve account, leaving at least sufficient funds to cover its reserve requirement, and loans the “money” to the applicant. And thus the money in circulation has been expanded. The funds loaned are used to pay bills related to the purpose of the loan, which means that the “money” shows up in other banks’ demand deposits, which those banks use as they use any money. They adjust their Fed reserve account to reflect the increase in demand deposits, and loan out a portion in new loans. After this process continues through its natural course of movement from bank account to bank account, the ultimate increase in the money supply comes close to equaling the reserve ratio. Today, large city banks are required to have 10% of their demand deposits in their Fed accounts (currently, they can count cash in their own vault as part of the “reserve”). Thus, an increase in the “reserves” of $1B can see an increase in the money supply of $10B.

As much as the Fed and, today, BO, would like to see an automatic process whereby the Fed can force up the money supply, just by increasing the Member’s deposits, as we see above, there are some countervailing forces. How long those forces will remain in effect is the current question.

It is also the case that as much as the Fed wants banks to begin lending again, it doesn’t want them to be lending as much as the current massively, over-funded Member’s accounts would allow. Currently, there is over $1T in excess reserves. That is more than any historical period by a factor of close to 100,000! Even the Fed, which normally ignores the actual pumping of money, is concerned about the amount of reserves currently sitting there.

But what is the Fed to do? Bank loans are actually still declining. Interest rates, according to mainstream economics, have to remain low to stimulate the economy. As soon as the Fed starts withdrawing the excess reserves, interest rates will start up, especially long-term rates, and all kinds of unwanted consequences will result, including increased interest expenses in an already bloated federal budget. BO will start yelling at the Fed and the Congress will start “investigating”! Also, the stock market will dive, (the dollar might actually strengthen, who knows?) housing purchases will decline as mortgage rates go up, and the economy will tend to slow. If it weren’t that we are all living in the middle of this circus, it would be fun to watch.

As of yesterday, the Fed again reassured everyone that interest rates will remain low. Aren’t they nice?


  1. I've been reading von Mises's theory of Money, and he has convinced me that the Quantity Theory of Money is a weak conceptualization. It works fine in simple times, when the main thing changing is the money-supply. However, it does not work well around turning points.

    To explain his theory briefly, he says that one has to think of money using Demand and supply analysis, just like one does for other goods, even though he acknowledges that money is a category that is quite different of many purposes of analysis.

    Now, try to picture a demand and supply curve for money. The Y-axis would have to be an inverse of some price-index (i.e. the price of money, expressed in terms of goods).

    Now, imagine that the supply curve moves outward to the right (i.e. supply of money expands). We will then get more money in circulation and a lesser "price" for money, in terms of goods it can buy. This is the situation that the Quantity Theories try to capture.

    However, when one has a panic, one also gets the demand curve moving out to the right (expanded demand for money), because lots of people -- and particularly lots of businesses want to hold cash. Demand does not shift just because of fear. Like any other demand, the demand for money depends (at the margin) on the attractiveness of substitutes. When rates on a 1-year CD are near-zero, it might result in someone (at the margin) holding some money which they might have placed in a CD.

    I have yet to read up on von Mises's theory of Credit and on how it integrates with his theory of money, but i suspect a demand and supply analysis might work in the context of loan markets too.

    Right now, demand for loans are likely to be very low. Though there are anecdotal stories of people wanting to start business, and not getting loans, i suspect that is not the norm. I suspect that -- given current conditions -- the trend is toward people "mending their balance sheets" by paying up more loans than are newly taken out.

  2. Rational Theorist, thank you for your comment.

    What I have heard bankers say is that there are few qualified loan applicants. By qualified, they mean potential borrowers who meet their tightened lending standards. Some people make a big deal out of the "carry trede", where banks borrow from the Fed at near zero, and buy short-term Treasuries at 1-2%. I don't think it is that big a deal, especially in the long run. So, right now bank loans are continuing to fall. Some are waiting for a bust in the commercial real estate market because existing projects won't be able to roll their loans over. It could happen.

    As long as unemployment remains high, BO continues to drain savings out of the economy with increased federal debt, and both the banking and business community are concerned about the uncertainty of what is going to happen next, I don't think we need worry about inflation. Our falling standard of living will be enough to worry about.

    I agree with you about the monetarists. But, don't think too generally about money in the entire economy. More important is the entry point for inflation. The past twenty years have demonstrated that we can have massive increases in the money supply, see modest general price increases, while narrow asset sectors have hyperinflation, piles of dollars pile up overseas, and narrow sectors in the economy have large, continuous price inflation (medicine and higher education).

    I do expect slightly more price inflation since BO's programs and expansion of the federal payroll put money directly into the consumer economy.