Introduction
This article has more to do with clear thinking than it does about the important, but widely misunderstood, subjects of money and banking. When one of the many talking heads on YouTube and elsewhere makes definitive statements about money and banking, and the federal reserve stop to ask yourself whether all the pieces actually fit together.
I don’t pretend to understand the many theories and calculations used in the cosmological argument of Albert Einstein, but I do understand that the theories based on sound thinking cannot stand in contradiction. If, as Einstein theorized, nothing in the universe can travel faster than the speed of light, then gravity cannot, as Newton assumed, travel instantaneously from the Sun to the Earth. One of the two theories must have a flaw.
It turns out that both are sufficiently accurate if one limits the boundaries of the system. In a sufficiently limited system Newton’s assumption provides acceptably accurate answers. Beyond that limit, one must rely on the General Theory of Gravitational force.
Fully understanding a proposition requires knowing which assumptions to include in your analysis. In terms of systems thinking, a person must clearly understand the extent of the system’s boundaries. Set the boundaries too narrowly, and you will probably leave out important influences. Set the boundaries too broadly, and you define the system at a level of complexity that the human mind—even with the aid of computer modeling—cannot comprehend.
To demonstrate, I have included two line graphs related to money, banking, and bank reserves.
Line Graph A
The first graph plots the quantity of money (M2) over the period from 1985 to 2020[1]. What definitive statements can you make about the money supply over that period of time?
You might say that, over that period, The Fed has had a pretty steady hand on the money supply until 2020. Whatever effect monetary expansion has had on inflation has been steady if not a bit too high. Based on this data, one can ignore monetary expansion as a contributing factor to any dramatic economic events.
I would argue that the graph does not contain enough data to make definitive statements about monetary expansion and the role of The Fed.
To demonstrate, I will refer to the second graph.
Line Graph B
The following graph shows the reserve balances required of banks to either hold at The Fed or in their vaults (dotted line) and the excess reserves of depository institutions (solid line). I have also noted changes in reserve requirements on the approximate dates[2].
The data plotted on this graph reflect changes in reserve accounts that should have a significant influence on the quantity of money (“money dollars.”)
Required Reserves Ratios (%)
I indicated the changes in required reserves ratios only to highlight a significant influence that analysts seldom mention. When analyzing the quantity of money, one should always ask whether required reserves ratios have changed. In 2020, The Fed acknowledged that the required reserves ratios had become meaningless after the 2009 reserve expansion and eliminated them altogether.
Reserve Balances Required
You will notice that the reserve balances have changed little during this entire period.
(In a future post, I will explain why required reserves ratios should consist of a multiple, not a fraction.)
Excess Reserves
Until 2009, excess reserves had the most influence on the money-creating power of banks. When the system contained larger excess reserves, banks could create more money dollars. When the amount of excess reserves declined, banks could create fewer money dollars.
The Fed would influence the amount of excess reserves primarily through open market purchases and sales of financial assets. Banks with deficit reserves would borrow from banks with excess reserves, thus the Fed Funds Rate served as a bellwether for market rates, but it has never been a “base rate” for the bond market. Banks traded Fed Funds in a closed market.
Most of the time, sufficient credit demand existed that when banks had excess reserves, they would create “money dollars” to buy interest-bearing assets. Finally, the largest source of monetary expansion resulted from the purchase of federal government debt.
All that changed in 2009 when The Fed performed what they deceptively referred to as “quantitative easing.”
When The Fed bought a large quantity of government securities in 2009, traditional theory held that the market would see a comparable increase in the quantity of money. If you look at graph A, you will see that did not happen. Maybe The Fed does not “control” the expansion of the money supply. But, did the reserves expansion in 2020 reassert the historical connection?
The events of 2020 actually pointed to the government as the culprit in monetary inflation.
Conclusion
This article has a singular purpose: to encourage you to question everything you hear from market and financial analysts. Take a lesson from the physical scientists: no theory exists beyond examination.