Monday, August 15, 2011

Monetary Illusions

In Deflationary Monetary Policy, I argued that quantitative easing (QE) is not money printing and would therefore not lead to a sustainable increase in inflation. While that piece focused on the Federal Reserve’s expectation of maintaining zero percent interest rates, further explanation on the illusion of money printing is necessary. This concept will become far clearer once the distinction between money and money substitutes is proven.

Ludwig von Mises presented the foundations of monetary theory in his seminal work, The Theory of Money and Credit, nearly 100 years ago. Although his insights regarding inflation, deflation and exchange rates are equally enlightening, discussion of those topics will have to wait for another day. Understanding the actual effects of quantitative easing on the money supply first requires an understanding of Mises’ theory on the banking system.

Mises states that “the business of banking falls into two distinct branches: the negotiation of credit through the loan of other people's money and the granting of credit through the issue of fiduciary media, that is, notes and bank balances that are not covered by money. (p.146)” Further explanation of this latter branch of banking will help eliminate monetary illusions. To better display Mises’ concepts, some simple examples are necessary.

The first branch of banking is fairly straight forward. Person A deposits $100 in Standard Bank (fictional name). Standard Bank holds $5 as cash reserves and loans $95 to Person B to grow crops. In this situation, Standard Bank is merely acting as an intermediary between two parties and earning a small profit for bringing the two parties together. At the end of the loan period, Person B repays the principal amount plus interest to Standard Bank (hopefully having earned a small profit on selling crops). Standard Bank pays Person A interest on the deposit. The total cash (money) in the system started with $100 and ends with $100 plus interest (a return on capital).

Now consider the same situation above, but with a twist. After Standard Bank loans $95 to Person B, another loan of $100 is made to Person C. There is now a $100 deposit liability, $5 in reserves and $195 in loans. An obvious question that arises is, where did the extra $100 come from? Before answering this question, it’s imperative to consider the banking system in a larger economy.

Imagine an economy with one thousand people. On any given day, a number of people deposit funds, request loans or withdraw funds from various banks. Standard Bank currently holds $100,000 in deposits. On typical days, Standard Bank receives $1,000 in new deposits and withdrawal requests for $500. Since the bank can easily cover withdrawals on most days, Standard Bank is only required to maintain cash reserves of 5 percent. Out of $100,000 in deposits, the bank must only retain $5,000 in cash on hand. The other $95,000 can be lent out or invested at the bank’s choosing. Up until this point, the situation has not deviated from the initial example.

Once the bank has lent or invested the other $95,000, one might assume the bank can no longer make loans. This view happens to be incorrect, as a bank’s ability to make loans is not operationally constrained by its amount of capital. Standard Bank can still grant credit through issue of fiduciary media. Previously this form of loan might have included physical letters of credit or bank notes. In today’s electronic world, these credits may simply show up as numbers on a computer. Regardless, let us continue with the simulation.

Standard Bank, having already lent $95,000, provides new loans for another $100,000. These loans are not covered by money but still represent a current liability of the bank. A good question at this juncture is, why would anyone except this form of credit? The answer stems from confidence. As discussed earlier, most banks typically receive deposits in excess of withdrawal requests on any given day. Therefore, under common circumstances, customer repayment is practically guaranteed. As long as loans are invested productively, the bank also gets repaid in time. Confidence in the continuation of this pattern allows uncovered credit, or money substitutes, to be treated as money.

What happens if confidence in the bank is lost? Extending this concept to its natural limit will conclusively display the difference between money and money substitutes. Standard Bank starts the day with $100,000 in deposits, of which only $5,000 is being held in cash reserves. The other $95,000 has been loaned and another $100,000 of credit granted. This $195,000 in loans and credit has already been used in purchasing goods.

During the day rumors questioning the financial soundness of the bank begin to circulate. Customers holding deposits and merchants holding bank credit become nervous about the consequences of the bank’s potential bankruptcy. All claims holders rush to the bank and attempt to withdraw their money. At this point it becomes clear that the bank cannot repay all of the claims. Even if the bank sells its assets, the total equity of $100,000 will only cover half of the bank’s liabilities. Unfortunately for those remaining depositors and holders of credit, Standard Bank is bankrupt and the outstanding liabilities are worthless. The $100,000 of credit granted in fiduciary media has been entirely wiped out.

This example began with individuals depositing $100,000 in the bank and ended with an equal amount being returned, though not necessarily to the same individuals. In the interim, Standard Bank allowed the “granting of credit through the issue of fiduciary media” for another $100,000. Although $200,000 may have been circulating through the economy at various times, half remained “not covered by money.” This uncovered portion is best described as money substitutes.

Although this example ignores some details including the accrual of interest or potential losses on assets, the underlying concept is constant. All banks, including the Federal Reserve, have the ability to grant credit apart from any current capital. Confidence in the system allows individuals, corporations and governments to accept these money substitutes as forms of payment. However, as should be abundantly clear, if all parties were to request physical money in return, only a portion could actually be repaid.

In theory, banks could extend unlimited credit if confidence in the system was never questioned. History suggests this outcome is unlikely, as vast increases in fiduciary media will sow the seeds that create growing fear about the bank’s ability to repay. While extension of credit in this form can create temporary inflation, the extension of credit is actually a dilution of claims on real money. Without an increase in the real money supply (by the Treasury), the extension of credit and inflation will ultimately resolve itself through default and deflation.

Through quantitative easing the Federal Reserve Bank created fiduciary media, but not real money. Although the normal extension of credit through fiduciary media can create temporary inflation, the next post will further explain why quantitative easing is less effective in this task. Understanding the difference between money and money substitutes is critical to recognizing the effects of inflation versus deflation, appreciation versus depreciation of exchange values, and fiscal versus monetary policy. Monetary illusions have resulted in frequently poor allocation of resources and capital. Hopefully clearer recognition about the theory of money will lead to better policies, better investments and a better economy.

No comments:

Post a Comment