Who Actually Makes Money?

In an earlier post, I described a contradiction between popular economic theory and statistical data.

In this post, I will describe true premises upon which we can develop more accurate theories.

Popular Assumptions

Reserves held at the Federal Reserve somehow act as money — so goes popular assumption. When the Fed adds dollars to bank reserves, that simultaneously adds an equal number of dollars to the quantity of money. For a long time, empirical evidence seemed to confirm that theory.

Around 1973 evidence began to appear that contradicted this popular assumption. Since that time, the money supply has grown much more rapidly than have bank reserves.

In 2008 the assumed connection between bank reserves and the quantity of money completely broke down. The quantity of bank reserves skyrocketed while the money supply chugged along at about the same historical rate.

This contradiction exposed a critical question. Where did the error exist? — In the data? Or in the theory?

Flawed Premises

The error existed in the theory, for the theory started with a couple of false premises:

  • dollars = dollars
  • dollars always play the role of money

When a person selects one dollar bill over another from their wallet, they provide evidence that they do not value two, seemingly identical, dollars the same. People frequently confuse the idea of fungibility with that of equal value. Fungibility means that in a practical application, two nearly identical commodities can substitute for each other. On the other hand, no two individual commodities have equal value, for the simple fact that no two items are identical in all respects, and no individual will value them the same.

Every dollar is different from every other dollar. They have different serial numbers; some are new and crisp and others not; some dollars exist as Federal Reserve notes; some dollars exist as coins; some dollars even exist as negotiable checks. Thus, the idea that every dollar equals every other dollar either physically or in value proves false.

Every dollar does not play the role of money. The dollars with which you pay for your latte act as money. Any dollar you use in any exchange acts as money. Some dollars, however, do not act as money.

I once ate in a restaurant in which the walls were covered with dollar bills. People had written on those bills, laminated them, and hung them on the walls. These dollars did not act as money.

Dollars held in the accounts of banks at the Federal Reserve also do not act as money. For dollars to act as money, the public must be allowed to own and use those dollars for indirect exchange. The public cannot hold (or have a claim on) dollars held as bank reserves. We cannot, therefore, consider bank reserves as a form of money.

The Role of Bank Reserves

Bank reserves do not act as a form of money. They never have. When people use gold as a form of money, and banks had 100% reserves, banks would hold gold to back the claims represented by banknotes or checks. While held as reserves, gold no longer played the role of money. Only after the holders of banknotes and checks exercise their claim on gold (at which time the holders claim on the gold would be canceled), with the gold return to its former role as money. Gold and banknotes/checks would never play the role of money at the same time.

In the modern banking system, in which we have fractional reserve banking and reserves created by the Federal Reserve, this relationship has not changed. Bank reserves still do not play a role as money. They act more like a control mechanism on the ability of banks to create money.

In an hypothetical situation in which banks must hold a reserve equal to 50% of their deposit liabilities, a bank with $1,000 in reserves (2,000 reserve dollars) could create 2,000 money dollars (I use the phrase money dollars to distinguish them from dollars held as bank reserves). If the Federal Reserve created another thousand dollars in reserves, to pay for assets they acquired from the bank, the bank would have no obligation to create another 2,000 money dollars.

Historically, because of the relatively low level of bank reserves, when the Fed increased the quantity of reserves, banks would have sufficient demand for money that they would buy an adequate number of notes to fully use the capacity of their moneymaking capability. With the massive run-up in bank reserves at the time of the financial crisis in 2008, banks no longer had access to a sufficient number of quality notes for which to use their full moneymaking capacity.

Conclusion

The premise that the Federal Reserve adds directly to the money supply when it increases bank reserves contained flaws from the beginning. Bank reserves have never acted as a form of money.

When the Federal Reserve does increase the amount of bank reserves (under a fractional reserve banking system), banks have no obligation to use their full moneymaking capacity.

Thus, when we understand the distinction between dollars held as bank reserves (reserve dollars) and dollars held by the public for indirect exchange (money dollars), we have a more accurate premise from which to develop a theory about the relationship between bank reserves in the money supply. It makes perfectly good sense for bank reserves and the money supply to grow and contract at somewhat different rates.

 

Money Supply and Bank Reserves

Introduction

The fact that we perpetuate false or inaccurate theories causes at least one problem for understanding money and its role.

For years economic classes have taught that the Federal Reserve controls the supply of money. When they buy government bonds from banks, they pump reserves into the banks’ reserve accounts, and that addition to reserves somehow causes an expansion in the supply of money.

We continue to talk in these terms even though (thanks to Ben Bernanke) we now have evidence that that might not be the case. And possibly never was the case.

Contradiction

This chart shows the money supply (the Blue Line — scale on the left) rising continually from April 2014 to April 2019.

During that same period, bank reserves (the reddish line — scale on the right) declines continuously. (The thin green line at the bottom shows required reserves during that same period.)[1]

Figure 1 -2014-04-01 to 2019-04-01[2]

According to popular theory, this behavior should not happen. When bank reserves decline, the money supply should also decline.

Real behavior, at least for this period, seems to contradict popular theory. The data and the theory both cannot be true. Either the data contains an error (or an unknown influence), or the theory contains an error.

An Apparent Connection

If we look at historical data from past periods, we can see how people made a connection between bank reserves and the money supply.

During the period from 1963 to 1973, both bank reserves and the money supply traced similar patterns. Only in the latter part of those ten years did the patterns diverge.

Figure 2 – 1963-01-01 to 1973-01-01

In the chart below, as bank reserves rose from 1985 to roughly 1989, the money supply followed a similar pattern. Only at the end of this period from 1989 into 1990 did the patterns of bank reserves and the money supply diverge.

Figure 3 – 1985-04-01 to 1990-04-01

The two periods represented by these two charts seem to indicate a reasonably close connection between the rise of bank reserves and the increase of the money supply. They seem to confirm the popular theory that the Federal Reserve drives the growth of the money supply.

Can we reconcile the apparent contradiction between this evidence and that shown in the first chart?

Sign of Broken Connection

When we look at a longer period — from 1985 to 2008, we have evidence that no connection exists between bank reserves and the quantity of money.

Figure 4 – 1985-04-01 to 2008-04-01

Could this chart, and the first chart, provide signs that a pre-existing connection between bank reserves and the money supply had broken?

If there was a connection that no longer exists, that calls the original theory (or the data) into question.

Let’s look at a longer period of time to see if it gives evidence as to which to question — the data or the theory.

A Break From the Theory

If we look at a chart for an extended period, from 1985 to 2019, we see that the data seems to have had a fairly long break from the theory.

Figure 5 – 1985-04-01 to 2019-04-01

During that period bank reserves rose at a relatively insignificant rate up until 2008. During that same period, the money supply grew at a much faster pace.

Then, in 2008 — in response to the financial crisis of that same year, bank reserves grew at a phenomenal rate until roughly 2015 at which time the quantity of bank reserves began to decline. During this entire period, from 1985 two 2019, the money supply grew at a fairly consistent rate, never in real correlation with the level of bank reserves.

Can we draw any firm conclusions from the evidence that I have given above?

Conclusion

We need to find some way to reconcile the apparent conflict between popular theory and the data that I have provided in the charts above.

If the theory contains no flaws, a very powerful influence must exist to cause the data to diverge so far from what the theory would dictate.

If, on the other hand, the data reflects reality, we must conduct a thorough examination of the popular theory.

In future posts, I will explain why the popular theory contains fatal flaws. A more accurate theory will explain and predict results consistent with the data given.


Footnotes:

  1. I divided the Reserve Balances Required, which were stated in millions of dollars, by 1000 to convert the quantities into billions of dollars, making the figures uniformly comparable between total reserves and required reserves.
  2. The Federal Reserve Economic Data (FRED) site at the St. Louis reserve bank generated all the charts used in this article.

 

Climate, Freedom, & Money

Introduction

“Climate change” represents the crisis de jure. We have no choice but to accept that human activity has created a crisis level of change in the climate of the world. To deal with this crisis, we must implement an unprecedented level of government intervention.

The complexity of this subject boggles the mind. How do we determine the validity of this problem, and what to do about it? To reduce the complexity, I will address only a couple of questions I have about this “problem” and the proposed intervention.

The Problem

Consensus

One reason people give for why we should believe in this crisis: 97% of scientists agree on calamitous findings regarding climate change.

Now I don’t have any certified credentials in science. I do, however, know enough to know that real scientists pride themselves on believing in the principle of non-confirmation. They do not believe in “settled” science. Even as a layman I know we cannot determine facts by popular vote. Those who believe otherwise must not have heard of Einstein, Copernicus, etc. Need I continue?

Carbon Poison

I have some important questions about carbon. Much of what I hear does not make any sense to me.

Believers in the impending climate crisis want to reduce the amount of CO2 created by human activity. They talk as if CO2 were a poison. Does that make sense?

I remember from high school biology that CO2 provides a food source for plants. Without enough CO2, plants would die. Without plants, we would die.

I admit my years in high school occurred a really long time ago. Maybe new technology has found a poisonous property in CO2. But, don’t people who run greenhouses add CO2 to the air inside?

Does it make sense to reduce our production of plant food?

The people who believe in the risk of climate change all think the solution will require some form of economic intervention. These interventions consist of everything from taxes on the use of carbon-based fuels to complete government take over of the economy.

Before I discuss the proposed interventions, I would like to make a general review of some of our current interventions. That might give us a clue as to the most effective interventions for the future.

Existing Intervention

I will reflect on the three categories of interventions: 1) monetary policy, 2) spending, and 3) regulation.

Money

Expanding the money supply has become one of politicians favorite ways to meddle with the economy. It’s stealthy—few people notice it. It taxes citizens without the painful process of passing tax legislation. It’s easy. But it has consequences.

Artificial monetary expansion distorts price signals. This misinformation leads people to misallocate resources. People spend money on goods they cannot afford. Investors acquire producer goods they do not need.

Monetary expansion leads to inefficient burning of carbon fuels.

Spending

Government officials have adopted the euphemism “spending” for a broad range of redistributions. In general, government redistributes resources from producers to consumers. “Spending” leads to less effective, efficient use of resources.

Government “spending” leads to more use of carbon fuels than would occur without redistribution.

Regulation

Regulation forces segments of the population to engage in activities which they would not otherwise choose. They must consume resources they would not consume if left to their own choices.

Similar to spending, regulation leads to the use of more carbon fuels than would have occurred without such regulation.

Proposed Intervention

Instead of examining the current political environment, the people with deep-seated concern about climate change propose additional government intervention. I will discuss those in the reverse order.

Regulation

Instead of trusting people to clean up their personal environments, politicians, as usual, think they can achieve a better result by forcing people to change their behavior. As a result, people will engage in behaviors in which they would not otherwise engage. In doing so, they will either follow the regulations or figure a way to work around the rules.

Spending

Politicians recommend massive spending programs in order to “clean up the environment.” Somehow, magically, they think they can do that without consuming additional resources or burning additional fossil fuels.

They have not learned that the redistribution of resources by government spending always leads to less efficient use of resources.

Money

When asked how they plan to pay for it, the people promoting green projects say that should not be a problem. That amounts to code for “we’ll just have the government print money.”

This attitude indicates they have not come to grips with the connection between monetary expansion and the wasteful boom and bust cycles in the economy. The malinvestments created as a result of monetary expansion create far more pollution than actors in a free-market would create on their own.

A Solution

Examine the Science

People making disastrous predictions regarding climate change should first go back and re-examine their science. Who knows; they might be correct. But, as long as one dissenting voice exists — and there are many — the science requires re-examination.

Answer, for example, the question I posed at the beginning of this article. Why do we consider carbon dioxide (a food for life) as a poison that could kill us?

Rollback Regulation, Spending, and Monetary Expansion

Instead of adding new interventions to the already ineffective interventions, rollback those that are already contributing to the ineffective use of resources and the excessive consumption of carbon fuels.

Conclusion

When you take a close look at the people promoting “Green New Deals” and Paris Accords, you realize that the majority of them either have political power or seek political power. Whether the people advocating these programs have the science correct or not, should we allow them to take further control of our lives?

This environmental scare, when you pull back the curtain, amounts to a great power grab, whether you agree with their desired results or not.

 

Disrupting the Money Cycle

Artificial changes in the money supply always disrupt the money cycle and cause price disruptions that lead to production problems in otherwise normally functioning markets.

Introduction

The complexity of large markets makes the diagramming of market processes difficult at best. One must take great care in not overstepping the bounds of logic and systems thinking.

However, occasionally a small diagram can at least trigger questions that need to be asked about the system under discussion. In this article, I will discuss an extremely simple — possibly overly simple — diagram depicting the cycle of money in two markets.

First, I will describe the cycle of money in a free and voluntary market without monetary intervention.

Second, I will give a brief description of the market subject to monetary intervention.

My objective consists of getting you to ask more pertinent questions regarding assumptions about monetary expansion, used by the Federal Reserve system and strongly advocated by the modern monetary theorists.

Free Market

The ridiculously simple diagram that I have provided below should open your thinking to questions about the operation of a free and voluntary market.

In this diagram, I have represented three producers/consumers named Eddy, Joe, and Max. I think you can see already that this does not accurately portray the immense complexity of any market. But, bear with me, and I think this diagram will help me make a significant point.

I have identified the steps in this process by the circled numerals.

  1. Eddy, also the producer of Good1, finds what I refer to as Good0. (The quantity of this Good found by Eddy represents all that exists in the system.) This Good will, in this diagram, come to be accepted as a form of money—a medium of indirect exchange. I have used dollar signs to indicate money, but dynamics applies to any form of money.
  2. Eddy exchanges his newfound money with Joe for Good2, produced by Joe. Eddy consumes all of the Good2 that he has acquired. The cycle can repeat through time as long as Joe produces more Good2 in Eddy as a source for money. I will explain how Eddy gets money in the next few steps.
  3. Joe uses the money that he received in the exchange with Eddy for Good3 produced by Max. Joe consumes all of the Good3 that he acquires. Max now has money that he can use for exchange.
  4. Max exchanges his newly acquired money for Good1, produced by Eddy. Eddy now has money he can use to repeat the cycle, returning to step 2).

This diagram provides a terribly oversimplified model of the daisy chain of events that make up a market system. A real market will consist of billions of the exchanges similar to those depicted in this diagram, all connected in very complex ways.

Despite the oversimplification of the system depicted in this diagram, each individual transaction works precisely the same as a transaction in the real market. One person exchanges money for a Good he values more than the money he gives up. These individual exchanges provide the foundation of a complex system that provides effective price discovery and efficient resource allocation.

Two essential things happen during this cycle. First, the fixed quantity of money, first found by Eddy, has served for three transactions. The system has required no additional money. Second, each transaction has produced an objective money price — the ratio of money given to goods received. This money price will serve to inform the allocation of resources in future cycles.

For the sake of this example, each person in these exchanges requires the Good that he receives for his subsistence. If he does not receive that good, he will perish.

Monetary Intervention

I have modified the diagram given in the free-market example to demonstrate the effects of monetary intervention. The steps are very much the same as in the first example with one significant difference in step one.

  1. Instead of finding a Good that he can use as money, the government gives Eddy the money he needs to purchase the goods he requires. Eddy produces nothing. (Create your own reason why Eddy produces nothing to trade. Maybe he likes being on the dole.)
  2. Eddy makes the same exchange with Joe and consumes the Good that he receives.
  3. Joe makes the same exchange described above with Max and also consumes all of the Good that he receives.

Max now has all the money he requires to buy Good1 that he requires for subsistence. But, no one in this system now produces Good1 and Max perishes.

With the absence of Max, no Good3 exists to provide subsistence for Joe, who also perishes. With the demise of Joe, Eddy gets no Good2, and he also perishes.

Thus, with the injection of new money into the system, for the purpose of keeping it going, the process has reversed itself and the system has died.

Conclusion

I’m sure that you can see that I have left a number of factors out of this discussion to make it as simple as possible. For example, I have not addressed the effect of rising money prices caused by the addition of new money. And, I have not taken this example to any level of reasonable complexity.

I have created this example the sole purpose of raising one fundamental question: what happens when no one produces any Good to acquire the money that enters the system—regardless of source?

Very complex systems, unlike my oversimplified example, can absorb a large quantity of artificially created money before this question becomes significant. But, at some point, the system responds to this unanswered question.

In the case of the real estate crash that occurred in 2008, it had taken from 45 to 50 years for the money artificially funneled into real estate to wreak havoc on the market. The advocates of MMT want to create a perpetual hole in the production cycle through the artificial expansion of money that they propose.

Watch out for the free lunch. It could cost you everything.

 

The Dangers of Modern Monetary Theory

At the core of Modern Monetary Theory (MMT) lies the implicit premise that the acquisition of money represents an end of itself. MMT bases its argument on what some people refer to as a “missing premise.” They present a proposition that contains an unstated premise that they assume everyone accepts. Give people more money, created out of nothing, and their spending will increase economic activity.

Although this premise seems quite appealing to many people, it contains a flaw that invalidates the entire theory.

Introduction

I first encountered MMT several years ago on one of the social media platforms. The people involved seemed almost fanatical about the idea, but I found it lacking logical consistency. For that reason, I thought the whole idea would die a natural death.

Recently, almost by accident, I have encountered several new references to MMT. This seeming resurgence may have occurred because one of the economic advisors for Bernie Sanders strongly advocates for MMT. In addition, I think that the rise in popularity in socialist ideas has given new vigor the conversation about MMT. People seem to like the idea — advocated by MMT — that you can receive things at no cost, e.g., medical care, schooling, retirement, etc.

I hope to point out, in this post, some of the weaknesses in the argument for MMT. To accomplish this, I would like to address just a few basic premises that the advocates of MMT either ignore or misunderstand.

  • They seem ignorant of the role of money as a medium of indirect exchange.
  • Demand does not exist in the aggregate or without the prior production of goods.
  • Double entry bookkeeping proves nothing about the results of expanding the money supply.

I cannot make exhaustive comments in the space that I have allotted myself. I only want to open your thought to some of the unanswered questions left by advocates of MMT.

The Role of Money

If you consult almost any textbook on economic theory, the author will describe money as a “medium of exchange.” This phrase, although accurate, does not explicitly portray the real role of money. Money actually acts as a medium of indirect exchange. Ignoring the importance of this fact brings MMT to its knees (as it does any theory about monetary manipulation adhered to by the Federal Reserve).

Any good that somebody exchanges for another good acts as a medium of exchange. The important distinction comes in identifying mediums of indirect exchange. With an indirect exchange, one party accepts a good for the purpose of exchanging it a second time for yet another good. That good has little or no value to them without the possibility of exchanging it for the third good. A medium of indirect exchange simply facilitates an otherwise goods-for-goods exchange. One must understand this distinction to comprehend the role of money clearly.

The single role of money consists of its use as a medium of indirect exchange. Unlike other goods, it never gets exchanged for the purpose of consumption. For that reason, the system requires no change in the quantity of money. It only requires, to accommodate declining money prices, that whatever good (or claim on that good) used for money can be divided almost indefinitely. The government or the banking system need not increase the quantity of money—for any reason.

In a market system, with goods prices based on money, the relationship of the goods-for-goods prices become distorted when the quantity of money changes arbitrarily. This price distortion forms the basis for economic malinvestment and boom and bust cycles, which wreak significant havoc on economic activity.

MMT (along with the Federal Reserve) ignore the critical importance of the real role of money. The ignorant use of monetary expansion leads to the economic boom and bust cycles addressed by the Austrian Business Cycle Theory.

Aggregate Demand

MMT relies to a significant degree on the concept of “aggregate demand.” This idea, popularized by John Maynard Keynes, claims that the government should stimulate an economy by doing something to increase aggregate demand. The idea of aggregate demand, however, represents a pure fantasy.

First, demand cannot exist without prior production. In the goods-for-goods exchanges facilitated by media of indirect exchange, some good must be given up in the acquisition of money. Without that good being given up, a reduction in the overall goods and services occurs. With the introduction of artificially created money, some traders find they have exchanged something for nothing. (For more insight, refer to “Increasing Demand Won’t Make the Economy Grow” by Frank Shostak.)

Providing money for nothing means that eventually, some buyer discovers that sufficient goods do not exist to complete transactions. But, we cannot know specifically what goods the economy lacks. Which leads to the second problem with aggregate demand.

Second, one cannot aggregate, or sum, the demand for a multitude of separate goods. You cannot add five chickens, two iPads, four Chevy Volts, etc. and derive a meaningful total. Summing the dollars exchanged in an economy gives no real information about the sum and substance of the goods exchanged.

Double Entry Bookkeeping

MMT advocates make a big deal about the importance of double entry bookkeeping and balance sheets. One person’s spending does indeed represent another person’s income. This tautological statement proves nothing regarding the validity of the argument for expanding the money supply to “stimulate demand.” It only means that in a double entry bookkeeping system debits and credits must always equal.

Since the entries in bookkeeping systems reflect quantities of money (both debits and credits), this only means that when somebody gives up money for a particular good, they record (as a debit) the amount of money given up. They do not record the quantity, or the characteristics, of the thing acquired.

Remember that money denominated double entry bookkeeping does not reveal what goods, if any, were given up to acquire that money. Although the books may balance, if the money used in the underlying transaction has been created ex nihilo (out of nothing), the transaction represents a fraud somewhere in the system.

Conclusion

The increasing popularity the socialism, and socialist politicians, leads me to believe that MMT presents a real danger. The danger lies in its appeal to people’s desire to get something for nothing. Socialism by itself cannot allocate economic resources effectively and efficiently. The implementation of what I would describe as a “free money policy” would only add to the misallocation of resources caused by the administration of a socialist system.

People need to learn the valid propositions behind sound money. We live in an environment in which people accept monetary expansion as a natural phenomenon. Artificial monetary expansion represents a stealthy form of violent intervention—it dilutes the purchasing power of personal property. Despite the problems with our current monetary system (also based monetary expansion), the system could be worse. The implementation of monetary policy based on Modern Monetary Theory would undoubtedly be worse than what we already have.

 

Fed Funds Explained

The financial press makes a big deal about whether the Federal Reserve will either leave the fed funds rate where it is, raise it, or get really silly, and drive interest rates below zero. In making these comments, however, they seem to assume that everyone understands the fed funds market and how it operates.

Fed Funds Redux - 16
Fed Funds Market Dynamics

Can the Fed actually control interest rates? And, does the fed funds rate actually have a significant influence on broader market interest rates?

To answer these questions one must first understand what is the fed funds market and how does it operate. To help you gain this understanding I have put together a presentation entitled “Fed Funds Explained.” You can find that presentation at this link: Fed Funds Explained.

Fed Funds Rate; Who Cares?

People who care about financial markets have speculated about the effects of the Fed “raising” the fed funds rate. Would it cause the stock market to decline? Would the economy return to recession? Would mortgage rates start to rise and kill the housing recovery?

A person does not need a plethora of charts and graphs to gain a basic understanding of relationships between fed actions, fed funds rates, financial markets, and economic activity.

First, the Fed does not “set” interest rates in any market, including the fed funds market. Interest rates consist of the ratio of future money to current money. As a ratio— calculated from two independent variables — an interest rate is a dependent variable. It cannot be set or determined directly. One or more of the dependent variables must change in order for an interest rate to change.

Second, participation in the fed funds market is limited to financial institutions that have accounts with the Fed. As a closed market the total number of dollars borrowed equals the total number of dollars lent. Net lending in the fed funds market equals zero. Thus, the level of total excess reserves does not affect rates. It’s the interbank imbalances in reserve accounts that cause fed funds borrowing. So what determines interest rates?

Third, because of the closed nature of the fed funds market, the Fed funds rate is determined by the relative levels of excess reserves between banks in the system. To discover the determinants of fed funds rates, you need to examine the factors that affect those relative excess reserve balances. Those factors can include: Fed open market activities, which either increase or decrease excess reserves in individual banks; the demand for bank funds (i.e. deposit liabilities); or the willingness of banks to create more deposits for the purchase of notes.

Fourth, with a banking system awash in excess reserves, what would cause rates to change? How many securities would the Fed need to sell to have the slightest effect on the fed funds rate? A lot. Simply announcing a rate hike does not change that. The Fed funds rate is zero because banks don’t have a need for reserves. Fed action has not changed that.

I will address, in more detail, questions raised by my comments above in future posts.

Bye