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 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
You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add 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:
- Modi’s Great Leap Forward
India’s Currency Ban – Part VIII India’s Prime Minister, Narendra Modi, announced on 8th November 2016 that Rs 500 (~$7.50) and Rs 1,000 (~$15) banknotes would no longer be legal tender. Linked are Part-I, Part-II, Part-III, Part-IV, Part-V, Part-VI and Part-VII, which provide updates on the demonetization saga and how Modi is acting as a catalyst to hasten the rapid degradation of India and what remains of its institutions. India’s Pride and Joy Indians are...
- US Financial Markets – Alarm Bells are Ringing
A Shift in Expectations When discussing the outlook for so-called “risk assets”, i.e., mainly stocks and corporate bonds (particularly low-grade bonds) and their counterparts on the “safe haven” end of the spectrum (such as gold and government bonds with strong ratings), one has to consider different time frames and the indicators applicable to these time frames. Since Donald Trump's election victory, there have been sizable moves in stocks, gold and treasury bonds, as the election...
- Global Recession and Other Visions for 2017
Conjuring Up Visions Today’s a day for considering new hopes, new dreams, and new hallucinations. The New Year is here, after all. Now is the time to turn over a new leaf and start afresh. Naturally, 2017 will be the year you get exactly what’s coming to you. Both good and bad. But what else will happen? Image of a recently discarded vision... Image by Michael Del Mundo Here we begin by closing our eyes and slowing our breath. We let our mind...
- The Great El Monte Public Pension Swindle
Nowhere City California There are places in Southern California where, although the sun always shines, they haven’t seen a ray of light for over 50-years. There’s a no man’s land of urban blight along Interstate 10, from East Los Angeles through the San Gabriel Valley, where cities you’ve never heard of and would never go to, are jumbled together like shipping containers on Terminal Island. El Monte, California, is one of those places. Advice dispensed on Interstate...
- A Trade Deal Trump Cannot Improve
Worst in Class BALTIMORE – People can believe whatever they want. But sooner or later, real life intervenes. We just like to see the looks on their faces when it does. By that measure, 2017 may be our best year ever. Rarely have so many people believed so many impossible things. Alice laughed. "There's no use trying," she said: "one can't believe impossible things." "I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for...
- Pope Francis Now International Monetary Guru
Neo-Marxist Pope Francis Argues for Global Central Bank As the new year dawns, it seems the current occupant of St. Peter’s Chair will take on a new function which is outside the purview of the office that the Divine Founder of his institution had clearly mandated. Neo-Papist transmogrification. We highly recommend the economic thought of one of Francis' storied predecessors, John Paul II, which we have written about on previous occasions. In “A Tale of Two Popes” and...
- Where’s the Outrage?
Blind to Crony Socialism Whenever a failed CEO is fired with a cushy payoff, the outrage is swift and voluminous. The liberal press usually misrepresents this as a hypocritical “jobs for the boys” program within the capitalist class. In reality, the payoffs are almost always contractual obligations, often for deferred compensation, that the companies vigorously try to avoid. Believe me. I’ve been on both sides of this kind of dispute (except, of course, for the “failed”...
- Trump’s Trade Catastrophe?
“Trade Cheaters” It is worse than “voodoo economics,” says former Treasury Secretary Larry Summers. It is the “economic equivalent of creationism.” Wait a minute - Larry Summers is wrong about almost everything. Could he be right about this? Larry Summers, the man who is usually wrong about almost everything. As we have always argued, the economy is much safer when he sleeps, so his tendency to fall asleep on all sorts of occasions should definitely be welcomed....
- Trump’s Plan to Close the Trade Deficit with China
Rags to Riches Jack Ma is an amiable fellow. Back in 1994, while visiting the United States he decided to give that newfangled internet thing a whirl. At a moment of peak inspiration, he executed his first search engine request by typing in the word beer. Jack Ma, founder and CEO of Alibaba, China's largest e-commerce firm. Once he was a school teacher, but it turned out that he had enormous entrepreneurial talent and that the world of wheelers, dealers, movers and...
- Money Creation and the Boom-Bust Cycle
A Difference of Opinions In his various writings, Murray Rothbard argued that in a free market economy that operates on a gold standard, the creation of credit that is not fully backed up by gold (fractional-reserve banking) sets in motion the menace of the boom-bust cycle. In his The Case for 100 Percent Gold Dollar Rothbard wrote: I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud...
- Side Notes, January 14 - Red Flags Over Goldman Sachs
Red Flags Over Goldman Sachs Just to prove that I am an even-handed insulter, here is a rant about my former employer, Goldman Sachs. The scandal at 1MDB, the Malaysian sovereign wealth fund from which it appears that billions were stolen by politicians all the way up to the Prime Minister, continues to unfold. The main players in the 1MDB scandal. Irony alert: apparently money siphoned off from 1MDB was used to inter alia finance Martin Scorcese's movie “The Wolf of...
- Silver’s Got Fundamentals - Precious Metals Supply-Demand Report
Supply-Demand Fundamentals Improve Noticeably Last week was another short week, due to the New Year holiday. We look forward to getting back to our regularly scheduled market action. Photo via thedailycoin.org The prices of both metals moved up again this week. Something very noticeable is occurring in the supply and demand fundamentals. We will give an update on that, but first, here’s the graph of the metals’ prices. Prices of gold and silver...