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Steve Saville: Bank Reserves and Inflation

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August 25, 2009 – Comments (7)

Yet another must-read article by Steve Saville. It dispels the "standard economics textbook" notion of the fixed money multipler (which he had discussed months ago in this article). These particular paragraphs are great:

Our view, which will undoubtedly be considered sacrilegious in some quarters, is that the level of reserves within the banking system is not central to the inflation/deflation issue. We will explain why in a moment, but first we'll present charts that clearly illustrate the lack of any relationship between bank reserves and monetary inflation.

The main reason that the money supply could grow to such an extent in the face of declining reserves is that US regulatory changes implemented during the early 1990s effectively removed the requirement for banks to hold reserves (they must hold reserves for "demand deposits", but through the process known as "sweeping" they are able to get around this requirement). To put it another way, any amount of bank reserves can now support any amount of bank deposits. This, in a nutshell, is why it makes no sense to agonise over what will happen to today's unusually large quantity of bank reserves as if the inflation/deflation issue hinged on the result. It is also why, in TSI commentaries over the years, we have only ever mentioned the "money multiplier" taught in economics courses to point out that it no longer exists in any meaningful way.

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Bank Reserves and Inflation -- http://dollardaze.org/blog/?post_id=00688
by Steve Saville
August 24, 2009

   
Recent arguments between deflationists (those who are forecasting deflation) and inflationists (those who are forecasting inflation) often boil down to opposing views about what will happen to the huge quantity of reserves that the Fed has supplied to the US banking industry over the past year. The inflationists claim that these reserves will, in the not-too-distant future, support a massive increase in the money supply via the famous "money multiplier" (for every additional dollar of reserves, the banking industry can supposedly create an additional 10 dollars of deposits). The deflationists, on the other hand, claim that this won't happen because the banking industry's collective balance sheet is now so grossly impaired that there will be no meaningful expansion in the total volume of bank lending for a long time to come. And in any case (according to the deflationists), even if the banks did want to lend there is now a dearth of credit-worthy borrowers to lend to. There is also a third group, that we'll call the 'just-rightists', who believe that the Fed has done a wonderful job of staving off deflation, and will, at the appropriate time in the future, remove the excess bank reserves before an inflation problem arises.

Our view, which will undoubtedly be considered sacrilegious in some quarters, is that the level of reserves within the banking system is not central to the inflation/deflation issue. We will explain why in a moment, but first we'll present charts that clearly illustrate the lack of any relationship between bank reserves and monetary inflation.

The first of the following charts shows the upward trend in True Money Supply (TMS) between January of 1990 and August of 2008. Specifically, it shows that TMS rose from $1,725B in Jan-1990 to $5,444B in Aug-2008 -- a percentage gain of 215% over the period in question. The second chart shows that the total quantity of bank reserves FELL from $63B to $45B over the same period. Taken together, the charts show that a 215% rise in total money supply was accompanied by a 28% decline in bank reserves. (By the way, TMS does not include bank reserves. It comprises currency in circulation plus demand deposits plus savings deposits).

The main reason that the money supply could grow to such an extent in the face of declining reserves is that US regulatory changes implemented during the early 1990s effectively removed the requirement for banks to hold reserves (they must hold reserves for "demand deposits", but through the process known as "sweeping" they are able to get around this requirement). To put it another way, any amount of bank reserves can now support any amount of bank deposits. This, in a nutshell, is why it makes no sense to agonise over what will happen to today's unusually large quantity of bank reserves as if the inflation/deflation issue hinged on the result. It is also why, in TSI commentaries over the years, we have only ever mentioned the "money multiplier" taught in economics courses to point out that it no longer exists in any meaningful way.

Given the above, why do so many analysts believe that bank reserves determine total money supply via a 10:1 (or some other) "money multiplier"? The answer, we guess, is that this was the way the monetary world worked once upon a time. The rules have changed, but old habits -- like assuming that the Fed prompts an increase in the economy-wide supply of money by boosting bank reserves -- die hard. The Fed does exert considerable influence over the money supply, but it does so by distorting interest rates and by simply being there (the Fed's existence enables the private banks and the government to do things they would not otherwise dare to do or be able to do).

With regard to the inflation/deflation issue, we think the smart deflationists (those who define deflation in terms of money supply, not prices) are right about most things. In particular, they are probably right that the banking industry won't contribute significantly to growth in the economy-wide supplies of money and credit over the years ahead, almost regardless of what happens to bank reserves. However, we think their overarching conclusion is wrong.

They are wrong, in our opinion, because they are failing to account for the fact that during prolonged periods of economic weakness the primary engine of inflation will be the government, not the banking establishment. The government, using the tool known as the central bank, can borrow a virtually unlimited* amount of new money into existence. For its part, the central bank can help things along through not only monetising (buying with money created out of nothing) whatever amount of government debt is not absorbed by other investors, but also through lending new money directly into the economy.

The past year has yielded solid evidence in support of our view that the inflationary efforts of the government will overwhelm the deflationary effects of private sector de-leveraging. For example, US bank lending has been stagnant since August of last year, and yet the economy-wide supply of credit has continued to expand and TMS is up by around 13%. The inflation is being driven primarily by a dramatic increase in government borrowing and secondarily by the Fed's** implementation of programs that bypass the commercial banks and inject new money directly into the economy.

In conclusion, while there is certainly a risk that the banking system's massive infusion of reserves will eventually contribute to the overall inflation problem, our inflation forecast in no way depends on such an eventuality. Over the past decade we have consistently maintained that if/when private banks and private borrowers became unwilling or unable to expand their respective balance sheets and debt burdens, the government would take control and borrow into existence whatever amount of new money was needed to perpetuate the inflation. There is no good reason for us to step away from this forecast now because the evidence of the past year strongly supports it.

    *The bond and currency markets impose the only practical limitation, in that monetary inflation will become counterproductive (from the government's perspective) once bond yields begin to rocket upward and/or the currency's foreign exchange value begins to tank. As long as the bond and currency markets remain cooperative, the government will effectively have carte blanche on the monetary inflation front.

    **Like the balance sheets of the private banks, the Fed's balance sheet is grossly impaired. However, although the Fed's shareholders are private banks (every bank operating within the US technically has an ownership stake in the Fed), the Fed does not operate under the same constraints as the private banks. If there was ever any doubt about this it should have been removed over the past year by the Fed's demonstrable willingness to obliterate its own balance sheet for the sake of adding money and credit to the economy. In effect, the Fed operates in similar fashion to a branch of the federal government. When a branch of the federal government gets into trouble it is often allocated more resources and more power.

7 Comments – Post Your Own

#1) On August 25, 2009 at 12:35 PM, 4everlost (29.40) wrote:

"The bond and currency markets impose the only practical limitation, in that monetary inflation will become counterproductive (from the government's perspective) once bond yields begin to rocket upward and/or the currency's foreign exchange value begins to tank."

If only we could figure out when that will be...

Another great find, binve!  Rec #1 from me.

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#2) On August 25, 2009 at 1:13 PM, cthomas1017 (91.36) wrote:

Ditto.  +!

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#3) On August 25, 2009 at 1:43 PM, StopLaughing (< 20) wrote:

If I understand Saville he is saying that deficits do matter and that fisical policy is more important than monetary policy as far as inflation is concerned.

He may have a point in that 2/3s of the money supply is controlled by non US sources. China may have more control over our money supply than Bernanke.

Saville is suggesting that Obama and Congress have more control over the money supply than Bernanke.

Saville is saying the fed controls inflation by adjusting interest rates. However, that basically turns Money theory into a type of Keynsianism.

The ability of the Fed to control long term interest rates in the longer run is quite limited.

There has to be more going on here than Saville is focusing on. Further, if the reserves do not control money supply then the Fed really does not have much control over money supply.

Distorting the interest rates is very imprecise and subject to a lot of unforseen consequences.

I would like to see some other opinions before I buy into Saville's primary arguments.

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#4) On August 25, 2009 at 2:29 PM, russiangambit (29.45) wrote:

FED has 2 mandates - keep unemployement low and keep inflation low. It looks like it is failing at both. Why? Because FED took on 3rd mandate - save our "banking" system. As Saville says, FED gives loans to the abnks and takes on as collateral all kind of junk, that is currently on it s secret balance sheet. That has never been done before.

Actually, it is a job of the Tresury to stabilize the banking system and provide the loans, with the approval of Congress. By going to FED, they bypass the Congress approval and keep everything secret. So, we have little idea just exactly how much money was given to the banks to plug-in their holes in return for their toxic assets.

However, since banks are using these loans to stay solvent and not lending the money, how is that inflationary.

As for what FED is doing, I am not sure it is even legal.

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#5) On August 25, 2009 at 3:34 PM, kstarich (30.57) wrote:

Binve - Great post!

I am so tired of the propaganda machine touting the Fed's role as setting the prime rate and controlling inflation, They should be exposed for their fractionalized banking policies and FOMC.  This is where the real crime is!

The Fed's days are numbered, 71 days to go.

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#6) On August 25, 2009 at 3:56 PM, binv271828 (< 20) wrote:

4everlost, cthomas1017, Thanks I appreciate that!

StopLaughing, You first 5 points are very valid and I agree with them.

There has to be more going on here than Saville is focusing on. Further, if the reserves do not control money supply then the Fed really does not have much control over money supply.

First .... (annoyed sigh). I give you one article that is focused on one idea and you think that Saville's analysis is not big enough? Dude, have you read any of the other dozens of articles of Saville that I have reposted? The Speculative Investor (TSI) has "volumes" of anlaysis regarding all of these issues. But this article was not 20 pages long, it was 5 paragraphs. It was not an all encompassing dissertation, it was an observation on a very specific subject. Please read his other work before passing such perfunctory judgement.

Second, regarding Fed not having much control over the money supply. .... uhhh. Are you seriously suggesting that?. The whole point of this article is that TMS is growing ***despite*** a reduction in bank reserves. Money, newly created out of nothing by the Fed, is bypassing the banking sector altogether and is going directly to the private sector. How? The Treasury. The government is directly subsidizing the consumer and private enterprise (FRE, AIG, finanicals, cash for clunkers, new home tax credits, etc. etc.). The Treasury has *no money*. They are selling government debt to foreigners, who are not buying (specifically they are buying much less). So who is picking up the tab? The Fed. The can expand the monetary base at will and purchase unlimited about of Treasury debt by printing new dollars. This is the core of Quantative Easing. All debt is being monetized and this is directly inflationary.

I would like to see some other opinions before I buy into Saville's primary arguments.

Dude, what is your damage? Sometimes we have nice conversations, but then sometime you always throw in the "I need more info to *buy* that" type statement. I am not asking you to buy anything. I am not trying to convince you of anything. I am not suggesting anything that you should do with your money. Whether you read these statements from Saville, or my orginal analysis, or my EWP counts, or *anything* that comes from one of my blogs, and your read it and it makes sense to you. Great!. Or maybe you read it and think it is stupid: Fantastic!!! Or maybe you are totally indifferent: Beautiful !!!!

The point is NOT to convince you of anything. The whole point is to share them and to discuss. Whether you "buy it" or not is completely irrelevant.

So please stop bringing it up.

All that said, thanks for the comments.

russiangambit,

Your first 2 comments are excellent. Thank you.

However, since banks are using these loans to stay solvent and not lending the money, how is that inflationary.

That was the whole pont of this post. The fact that the banks are not lending is *obviously* not inflationary. However, does that mean there will not be inflation despite the banks not lending? NO!!!

This is the part of the same answer above to StopLaughing.

The whole point of this article is that TMS is growing ***despite*** a reduction in bank reserves. Money, newly created out of nothing by the Fed, is bypassing the banking sector altogether and is going directly to the private sector. How? The Treasury. The government is directly subsidizing the consumer and private enterprise (FRE, AIG, finanicals, cash for clunkers, new home tax credits, etc. etc.). The Treasury has *no money*. They are selling government debt to foreigners, who are not buying (specifically they are buying much less). So who is picking up the tab? The Fed. The can expand the monetary base at will and purchase unlimited about of Treasury debt by printing new dollars. This is the core of Quantative Easing. All debt is being monetized and this is directly inflationary.

Thanks for the comments.

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#7) On August 25, 2009 at 3:57 PM, binv271828 (< 20) wrote:

kstarich, Thanks!.

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