The Link between Money and Credit in the Fractionally Reserved Banking System
We have gone over some of this ground before, but will do so again after seeing this article at Zero-Hedge: “Deflationists Take Note: Bernanke Succeeds In Offsetting Shadow Banking Collapse”.
It is often said that few things in economics confuse people more than money and that is indeed true – we come across proof of this assertion every day. We will use a few simple examples to illustrate in what way money and credit are interlinked in the fractionally reserved fiat money system and why there nevertheless still exists an important difference between them, a difference that is especially pertinent in today‘s system.
Let us say John has $1,000 in currency which he deposits in a checking account at Yellen Bank. After John has made this deposit, Yellen Bank will record an increase of $1,000 in vault cash on the asset side of its balance sheet and a $1,000 deposit liability to John on the liability side.
Note that at this point, nothing fundamental has changed – since John has given his currency to the bank for the purpose of warehousing and facilitating payments (by check or via electronic transfers), John retains full command over his money. He did not ‘lend it to the bank’ (although it should be mentioned that Anglo-Saxon legal tradition via case precedent has sadly frequently disagreed with this view).
Further we assume that the reserve requirement for bank deposits is set at 10% and that Yellen Bank was ‘fully loaned up’ at the time John made his deposit. The deposit thus enables Yellen Bank to lend $900 to Sue (at 5% p.a.), who wants to borrow the money for the duration of one year. Once this transaction is completed, and assuming that Sue also has an account with Yellen Bank, there would now be an additional asset on the bank’s balance sheet, namely the $900 loan to Sue, and a new deposit liability of $900 in the form of the money that now resides in Sue’s account.
What has changed at that point? John continues to retain full command of his $1,000. Sue now has command over $900 that did not exist before. At the same time, a $900 loan has come into existence.
Therefore, the end result of these transaction is that credit in the economy has increased by $900, while the money supply has likewise increased by $900 – with money created literally from thin air.
Suppose now Sue were to withdraw the $900 from her account with Yellen Bank. Then Yellen Bank’s vault cash would decrease by $900, while its deposit liabilities would decrease by the same amount. The newly increased money supply would remain in place as it was right after the credit transaction was concluded – John continues to retain command over his deposited $1,000, and Sue now has $900 in cash that did not exist before, although in a practical sense it is now John who holds the ‘virtual’ money (or fiduciary medium).
What if instead, John had decided to lend $900 directly to Sue for the duration of one year? Then credit in the economy would also have increased by $900, but the money supply would have remained unaltered.
We can therefore see that credit and money are linked in a fractionally reserved system insofar as the extension of credit can lead to the creation of additional money, but nevertheless, money and credit are not literally the same thing. If John had deposited his money into a time deposit account for the duration of one year for the purpose of saving instead of into a checking account and Yellen Bank had thereafter lent this money to Sue, then the money supply would have remained unaltered as well. The decisive difference is that in the case of the time deposit, John would have relinquished his command over the deposited money for the specified duration. He would indeed have ‘lent money to the bank’, which would have acted as a perfectly legitimate intermediary in the credit business by then lending this money to Sue.
Let us say that Sue takes her $900 to Tim the shoemaker to buy an expensive pair of leather boots and Tim takes the $900 in currency he receives from Sue and deposits them in his checking account at Plosser Bank.
The above process could then be repeated, with Plosser Bank lending $810 (90% of the $900) to Curt. Tim would retain command over his $900, while Curt now has command over $810 that simply did not exist before. In this manner, new deposits are created over and over again in the fractionally reserved system, leading to a large expansion in the supply of money concurrent with an increase in outstanding credit.
How should money be defined? The primary function of money is that of a medium of exchange (other functions, such its usefulness as store of value flow from this primary function). In other words, money is a present good that is exchanged for other goods or services. Currency can be regarded as ‘money proper’ as Mises put it, while all the forms of money that can be exchanged for currency on demand, such as deposits (in practice, this includes both demand and savings deposits nowadays) are part of the stock of money – they are de facto economically indistinguishable from money proper.
Note the term ‘fiduciary medium’ we mentioned in the first paragraph. All deposit money that is not backed by money proper represents fiduciary media. A brief explanation seems in order: the term comes from the Latin word fiducia, or ‘trust’. George Reisman in ‘Capitalism’ explains fiduciary media as follows:
“Fiduciary media are transferable claims to standard money, payable by the issuer on demand, and accepted as the equivalent of standard money, but for which no standard money actually exists”
In short, their existence depends on the fiducia of depositors, their trust that they will actually be repaid. Note here that this is not necessarily equivalent to trust that all depositors will get repaid. In fact, in a fractionally reserved system (we leave aside for a moment the central bank with its unlimited money creation powers) it is simply not possible to pay out all , or even a relatively small percentage, of extant deposit claims concurrently. Therefore it is also not possible to have ‘trust’ that this will ever happen – every depositor simply hopes that when the time comes for him to exercise his claim, there will still be enough money proper available at the bank for him to exercise it successfully.
In the modern-day system , this expectation is in fact very reasonable. There is a central bank that can create more money as required (one of the main reasons why bankers always wished for a central bank to be instituted was that they wanted to do away with the cleansing bank runs that previously held their credit and money expansions in check), and there is in addition the FDIC (or its equivalent in other countries) insuring all deposits up to a certain size. We can see here that one of the ways in which deposit money that was created from thin air has often disappeared in the past, namely via bank failures, is no longer a problem people need to consider. Unfortunately it means that both depositors and banks are liable to take risks they would otherwise not take – it is a prime example of moral hazard.
Inflation and Deflation of the Money Supply
In the first paragraph we showed how the supply of money is inflated by creating unbacked credit and hence unbacked deposits in a fractionally reserved banking system. How then can it be deflated? If you consider our first example, if Sue were to pay back her $900 loan after one year, then both the loan would be extinguished, as well as the $900 in fiduciary media originally created by Yellen Bank. Assuming Sue were to pay in cash, vault cash at the bank would increase by $900, but this is money that as we know always belonged to John, the original depositor, anyway.
Therefore, if unbacked (unbacked by existing money) credit is paid back, the money supply decreases commensurately. In short, the paying back of credit created from thin air is deflationary. In practice, the central bank-led banking cartel tends to create far more new credit and fiduciary media than are extinguished most of the time. You might say the system is geared for inflation.
However, there are occasional exceptions to the rule, such as in the period following the 2008 crisis, when more credit is actually paid back then is created. We already established that not all credit is necessarily inflationary. To the extent that lending is based on time deposits or CDs – instruments in which the owner of money temporarily relinquishes the use of his funds – the extension and payback of credit will not alter the money supply.
Only the portion of credit that is unbacked and has created fiduciary media is of concern in the process of deflation that can result from a net paying back of credit.
What we want to establish here is that a deflation of the money supply is possible in principle – it is in the nature of the fractionally reserved system as it were. A deflation of the money supply could also be engineered by the central bank if it so wishes. As an example , all commercial banks must hold reserves against their deposits with the central bank, which in turn can alter reserve requirements. While this has nowadays no longer much practical importance (for all practical purposes the introduction of sweeps has rendered these so-called ‘required reserves’ irrelevant), it still would be in the central bank’s power to increase such reserve requirements. This would force a fully loaned up banking system to reduce outstanding loans and fiduciary media to the extent necessary to comply with the higher reserve requirements. China’s PBoC in fact makes ample use of this tool to loosen or tighten monetary policy (although it is rumored that China’s banks have found ways to circumvent loan quotas and reserve requirements by creating their own ‘shadow banking system’).
To come back to the time after the 2008 crisis, net bank credit outstanding indeed began to decline by 2009. It is a good bet that a large portion thereof was unbacked credit, so normally one would have expected the money supply to decline as well. However, measures of the money supply as defined in the second paragraph not only did not decline, but were actually increasing sharply. The measure of the money supply we are using , Austrian money TMS (compiled by) and have shown several times in the past, reveals this:
As can be seen in this chart, the growth rate of both ‘TMS1’ (which excludes savings deposits) and ‘TMS2′(which includes them) went up sharply in the wake of the crisis – in spite of a decline in bank credit. Specifically the growth rate in both measures continued to increase until mid to late 2009, and while it has since moderated, it remains in positive territory – click for higher resolution – click to enlarge.
So what explains that bank credit declined during this time while measures of money supply actually grew aggressively? The answer can be found in the gray shaded area in the first chart: monetary pumping by the Federal Reserve. Indeed, between June and December of 2008, the growth of the Fed’s balance sheet went from an annualized 2.9% in June to an annualized 152% in December. The Fed was pumping money into the system furiously, and not only into commercial banks. In December of 2008 alone, it pumped $408 billion into non-banks. The Fed does this by buying securities which it pays for with – you guessed it – money it creates from thin air.
As we have previously mentioned in ‘Quantitative Easing Explained‘, when the Fed buys securities from non-banks, not only does this increase deposit money directly (the recipient of the Fed’s check deposits it into his account), but it also increases bank reserves by a like amount. Thus the vast increase in excess reserves since 2008. These reserves of course can be used for a further expansion of bank credit and fiduciary media. We would note here that obviously the banks have not used the excess reserves piling up at the Fed after the crisis for this purpose until very recently (excess reserves have begun to decline somewhat lately).
Their biggest fear following the denouement was a repeat of the interbank funding crisis that triggered all the manic activity by the Fed and ECB (beginning in late 2007 already), which were providing an alphabet soup of ’emergency lending facilities’ for banks and other large financial players alike, that had all stopped trusting each other. The banks certainly don’t like to have to rely on emergency funding by the Fed if they can avoid it. After all, you never know who will and who won’t be bailed out (cue: Lehman).
Still, even though the banks have become very cautious in 2008-2009 and reduced outstanding bank credit (note here also that borrowers were equally cautious), the exertions by the Fed – after the ’emergency facilities’ were running off, it began to implement first ‘QE1’ and now ‘QE2’ – were more than sufficient to vastly grow the supply of money anyway.
We can conclude: although a deflation of unbacked credit in a fractionally reserved system can indeed lead to a deflation of the money supply, it has yet to happen. This is entirely due to the Fed’s interventions.
How Does the ‘Shadow Banking System’ Fit In?
The so-called ‘shadow banking system’ was a creature of the securitization of loans as well as the large commercial paper market that was used to finance off-balance sheet vehicles the banks created to hold such securitized paper – essentially conduits between lenders and borrowers outside of the traditional banking system. Initially, securitization was a way for banks to vastly increase credit inflation by getting assets off their books by bundling them and selling them as securities to investors. They collected fees on the sale of these securities and collected the spreads between the loans they continued to service and the yields these securities paid. Later they went one step further, creating ‘SPV’s and ‘SIV’s’ (‘Special Purpose Vehicles’ and ‘Structured Investment Vehicles’) that were used to hold assets the banks did not want to hold on their balance sheets, but which they thought could yield even more spread profit.
An additional constraint for banks aside from reserve requirements are minimum capital rules as per the Basel accords (as mentioned, reserve requirements no longer represented a real constraint anyway since the 1995 introduction of MMDA’s – ‘money market deposit accounts’ – that can be used for ‘sweeps’, whereby sight deposits effectively masquerade as savings deposits overnight).
These rules regulate how much capital a depository institution must set aside for various types of assets it holds, whereby the amounts vary according to the inherent risk the assets concerned are assumed to harbor. Government bonds are deemed to have the least risk in this framework and require no capital at all – a potentially dangerous miscalculation as recent events in the euro area have shown.
The ‘shadow banking system’ was a way to get around these rules, as assets could be housed in special purpose vehicles that were legally at arm’s length from the banks creating them, while still allowing them to profit from the spreads these vehicles earned. However, since these shadow banking entities financed themselves in the commercial paper market, continually rolling over short term commercial paper to fund holdings of long term securities of all stripes (for a more detailed explanation and the complex structures used see here), the banks were forced to issue ‘liquidity guarantees’ to these entities.
In other words, while not part of the banks in the legal sense, they were still part of the banks in another, practical sense. The guarantees had to be issued so that investors would be confident enough to buy the commercial paper issued by these entities, but they also meant that the banks continued to be legally liable for the SIV’s liabilities – while at the same time not having to reserve any capital against this risk.
Naturally, once the credit bubble broke, this ‘shadow banking’ system turned into a giant head-ache for its guarantors. The earlier mentioned Zerohedge article contains a chart that shows various ‘liabilities of the shadow banking system’ which we reproduce below:
Various components of shadow-banking system as per the Zerohedge article: money market mutual funds, GSEs, agency mortgage pools, ABS issuers, funding corporations, repos, open market paper – click for higher resolution.
We would however note, as inventive and destructive as the shadow banking system eventually proved to be, it is not by itself ‘creating money’ and in fact never has. A money market mutual fund, to take an example from the above chart, gets money from investors to whom it issues securities. It then as a rule invests this money in highly rated short term commercial paper or even t-bills. It is completely immaterial to the money supply whether outstanding money market fund securities increase or decline. Whenever someone buys an MMF security, he must give up money, which then is channeled by the MMF to a borrower in the commercial paper market who gets to use it. If the amount of securities on both sides of these credit transactions declines, it does not mean the money supply has declined.
Increases and decreases of the money supply are the sole province of the fractionally reserved banking system and the central bank. It may be true that forcing off-balance sheet assets back from SIV’s unto bank balance sheets (as happened due to a FASB ruling in early 2010 in the case of consumer loans held off bank balance sheets), then the future ability and willingness of banks to increase inflationary credit further will decline. Alas, that is how far as it goes. Commingling genuine credit transactions where the shadow banking conduits acted as intermediaries with the issue of money supply inflation is analytically erroneous.
Therefore, the article’s thrust that deflationists should take heed because the combined liabilities of banks and shadow banking entities are once again growing misses the mark somewhat. All we need to look at to ascertain whether there is or isn’t inflation of the money supply is – the money supply itself!
We would however agree that an increase in inflationary bank credit can already be noticed in recent data, and that future money supply growth can be expected to rely somewhat less on the direct effects of the Fed’s pumping (i.e. its securities purchases and enlarging of its balance sheet) , but that the commercial banking system may have become confident enough to ‘put its toe back into the water’ so to speak.
Here we should take a step back one more time and consider what happens if Sue from our example in the first paragraph above were to fail to pay back her loan to Yellen Bank, i.e. were to default on her loan.
In this case, the bank would take a hit to its capital. However, and this is very important, the money supply would not decrease. Sue has after all spent the money she received from the loan and it has become the currency holdings, resp. the deposit, of someone else. If she does not return the money, it remains in someone else’s hands to do with as they will.
The Yellen Bank meanwhile still owes the full $1,000 to John, whose deposit it used as the basis to extend money from thin air to Sue. Thus both money claims continue to exist, and no offsetting payback of the loan has occurred. If John claims his deposit, the bank must either make him whole from its own capital, or if it is bankrupted by his claim, must call in the FDIC – which then will in turn proceed to make him whole.
The important point here is that as long as large banks are considered ‘too big to fail’ and are bailed out by a combination of Fed and treasury intervention and as long as deposits at smaller banks that are allowed to fail are covered by the FDIC, it will be very difficult to see a money supply deflation on account of defaults.
The only sense in which defaults or ‘toxic assets’ on the books of banks that have been valued at ‘reasonable stab’ instead of being marked to market can influence the inflation-deflation issue is that they might lead banks to decrease their net inflationary lending in the future.
Alas, as we have seen, the Fed stands ready to counteract such bank credit deflation with its own pumping activities. Furthermore it should be noted that an incipient decline of total credit market debt outstanding on account of consumer deleveraging is strongly counteracted by the federal government’s debt expansion, which has grown to truly absurd proportions since 2008.
Lastly, while it is true that the ‘general price level’ as represented by the flawed measure of CPI has continued to show moderating rates of growth, the money supply inflation has most definitely led to a sharp distortion of relative prices – just compare the huge price increases in raw materials with the tame price increases in many final goods.
Among the reasons for the relatively tame behavior of final goods prices we find both rising productivity and a still quite high demand for money due to the uncertainties created by the economic contraction. The exchange value of money is after all not only a function of its supply, but also a function of the demand for cash balances by the public.
Had the Fed refrained from inflating the money supply as much as it has, then we would almost certainly have experienced genuine deflation (i.e., the money supply would have decreased), sharply falling prices and – most importantly – a reordering of economic power in society.
It is this latter point that is the chief concern of the powers-that-be when they argue that we must avoid deflation at all costs.
Charts by: Zerohedge, St. Louis Federal Reserve Research
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
7 Responses to “Money and Credit – There Is A Difference”
Most read in the last 20 days:
- Ganging Up on Gold
So Far a Normal Correction In last week's update on the gold sector, we mentioned that there was a lot of negative sentiment detectable on an anecdotal basis. From a positioning perspective only the commitments of traders still appeared a bit stretched though, while from a technical perspective we felt that a pullback to the 200-day moving average in both gold and gold stocks shouldn't be regarded as anything but a normal - and in this case actually long overdue -...
- Gold Sector Correction – Where Do Things Stand?
Sentiment and Positioning When we last discussed the gold sector correction (which had only just begun at the time), we mentioned we would update sentiment and positioning data on occasion. For a while, not much changed in these indicators, but as one would expect, last week's sharp sell-off did in fact move the needle a bit. Gold - just as nice to look at as it always is, but slightly cheaper since last week. Photo via The Times Of India The commitments of...
- Australian property bubble on a scale like no other
Australian property bubble on a scale like no other Yesterday Citi produced a new index which pinned the Australian property bubble at 16 year highs: Bubble trouble. Whether we label them bubbles, the Australian economy has experienced a series of developments that potentially could have the economy lurching from boom to bust and back. In recent years these have included: the record run up in commodity prices and subsequent correction; the associated...
- Pope Francis: Traitor to Western Civilization
Disqualified There has been no greater advocate of mass Muslim migration into Europe than the purported head of the Catholic Church, Pope Francis. At a recent conference, he urged that “asylum seekers” be accepted, “through the acts of mercy that promote their integration into the European context and beyond.”* Before we let Antonius continue with his refreshingly politically incorrect disquisition, we want to remind readers of two previous articles that have...
- Bubble Dissection
The Long Term Outlook for the Asset Bubble Due to strong internals, John Hussman has given the stock market rally since the February low the benefit of the doubt for a while. Lately he has returned to issuing warnings about the market's potential to deliver a big negative surprise once it runs out of greater fools. In his weekly market missive published on Monday (entitled “Sizing Up the Bubble” - we highly recommend reading it), he presents inter alia the following eye-popping...
- US Stock Market - a Spanking May be on its Way
Iffy Looking Charts The stock market has held up quite well this year in the face of numerous developments that are usually regarded as negative (from declining earnings, to the Brexit, to a US presidential election that leaves a lot to be desired, to put it mildly). Of course, the market is never driven by the news – it is exactly the other way around. It is the market that actually writes the news. It may finally be time for a spanking though. Time for some old-fashioned...
- Doomed to Failure
Larded Up and Larded Over We’ve been waiting for the U.S. economy to reach escape velocity for the last six years. What we mean is we’ve been waiting for the economy to finally become self-stimulating and no longer require monetary or fiscal stimulus to keep it from stalling out. Unfortunately, this may not be possible the way things are going. As Milton Jones once revealed: “A month before he died, my grandfather covered his back in lard. After that, he went...
- A Looming Banking Crisis – Is a Perfect Storm About to Hit?
Andy Duncan Interviews Claudio Grass Andy Duncan of FinLingo.com has interviewed our friend Claudio Grass, managing director of Global Gold in Switzerland. Below is a transcript excerpting the main parts of the first section of the interview on the problems in the European banking system and what measures might be taken if push were to come to shove. Andy Duncan of FinLingo.com (left) and Claudio Grass of Global Gold (right) Andy Duncan: How do you see the...
- Are the Deep State’s Drones Coming for You?
What’s Aleppo? Look out kid Don’t matter what you did Walk on your tip toes Don’t try "No Doz" Better stay away from those That carry around a fire hose Keep a clean nose Watch the plain clothes You don’t need a weather man To know which way the wind blows – “Subterranean Homesick Blues,” Bob Dylan The entrance to Baghdad's “Green Zone”. Photo credit: Karim Kadim / AP DELRAY BEACH, Florida – Biggest foreign policy blunder...
- Interview with Doug Casey
Natalie Vein of BFI speaks with Doug Casey Our friend Natalie Vein recently had the opportunity to conduct an extensive interview with Doug Casey for BFI, the parent company of Global Gold. Based on his decades-long experience in investing and his many travels, he shares his views on the state of the world economy, his outlook on critical political developments in the US and in Europe, as well as his investment insights and his approach to gold, as part of a viable strategy for...
- Meet Your New Stimulus Allocation Czar
March Towards Midnight The march towards midnight is both stirring and foreboding. Like a death row inmate sitting down to savor his last meal, a grim excitement greets the reality of impending doom. Thoughts of imminent mortality haunt each bite. Tic-toc, tic-toc... As far as the economy’s concerned, there’s no stopping its march towards midnight. The witching hour’s rapidly approaching. We intend to savor each moment and make the best of...
- Evacuate or Die...
Escaping the Hurricane BALTIMORE – Last week, we got a peek at the End of the World. As Hurricane Matthew approached the coast of Florida, a panic set in. Gas stations ran out of fuel. Stores ran out of food. Banks ran out of cash. A satellite image of hurricane Matthew taken on October 4. He didn't look very friendly. Image via twitter.com “Evacuate or die,” we were told. Not wanting to do either, we rented a car and drove to Maryland. “We’ll just...