Saturday, May 29, 2010

Where or Where Did the Money Supply Go?

The graphs on the left  and right (may show as lower left and upper right) are courtesy of the St. Louis Federal Reserve Bank. The graph on your left is of M-1, the supply of cash and checking accounts or demand deposits. As you can see, the uptrend since 1975 (actually the uptrend begins with the founding of the Fed) was sharp, but it increased even more in 2008.  The graph on your right is of the monetary base.  The monetary base is the cash and deposits in banks that the Fed has created out of thin air.  Banks lend the reserves to borrowers so that the money supply is a multiple of the monetary base.  It is not true that the entire money supply is based on debt, but government debt is used as the means by which the monetary base is increased. The Fed buys treasury bonds from money center commercial banks, creating the money to buy the bonds out of thin air. The banking system then lends up to ten times the deposit.  It is able to do this because only a small percentage of cash on deposit is redeemed each day.  Thus, the entire monetary system is based on counterfeit.  The Fed counterfeits the new reserves and the banking system counterfeits loans.

When the United States was at its greatest there was no Federal Reserve Bank. Immigrants, including my great grandparents and grandparents, came here to escape monarchical and socialistic Europe. Innovation increased at an increasing rate.  The possibilities for America seemed endless. The fly in the ointment was that there was deflation during this period. The deflation lasted for 30 years in the late 19th century.  Deflation means that prices are going down.  When you go to the supermarket you pay less this week than you paid last week.  Most of us benefit from lower prices, hence we are better off because of deflation. 

However, four groups do not benefit from deflation: (a) stock speculators (b) real estate speculators (c) profit seeking business (d) banks and other financial institutions.  Stock speculators do not benefit because lower prices mean lower profits and therefore lower stock prices. However, the loans borrowed to purchase the stocks have to be paid in more valuable dollars.  Real estate speculators do not benefit from deflation because lower prices mean that real estate prices fall. However, the loans borrowed to purchase the real estate also have to be paid in more valuable dollars.  Profit seeking business dislikes deflation because profits decline because of the lower prices.  Banks dislike deflation because there is less money available to counterfeit (because the cause of the deflation is a contracting money supply).

The founding fathers were split on this subject.  The friends of the farmer and working man, Jefferson, Sam Adams, other anti-Federalists and many of Jefferson's Democratic Republicans were opposed to inflation. Hamilton and other Federalists who believed in strong government, socialism and subsidization of business and banking, favored inflation. As well, the US financed the Revolutionary War through inflationary means, the Continental.  However, it was evident from that experience that inflation harmed the average person.

The central bank was abolished in the 1830s, but in order to finance the Civil War paper money was introduced.  The result was a post-Civil War inflation.  In stopping the inflation and recalling the greenbacks the US government committed what Milton Friedman has called the "crime of 1873".  Instead of introducing a bi-metallic standard a pure gold standard was introduced.  This led to the deflation of the next three decades, during which there were several "depressions".  It is important to understand, though, that the deflation and the depressions were highly beneficial to the average American.  Most Americans were far, far better off in 1900 than they were in 1873.  David Ames Wells, author of Recent Economic Changes in 1889 observed that the real wage had doubled in about 40 years.

However, several groups were unhappy.  Not surprisingly, they were the same groups who benefit from inflation today: real estate speculators, stock speculators, bankers and business owners.  Although the business community was unhappy with deflation, it was the period of greatest innnovation in the history of the world. Inventions like wireless, television and radio, that are still motivating progress now, were conceptualized in that period. Wells lists hundreds of inventions and commercial improvements that had been made in the USA. The names of Kettering, Edison, and Tesla were only the impressive tip of a massive iceberg of innovation, dwarfing the level of innovation that has occurred in our lifetime.  As Wells points out, the stimulus for the innovation was the deflation that forced businesses to compete.

After 1913, the process went into reverse.  The Fed created paper money inflation from its inception.  The booms and busts were far worse and far more dramatic than the mild depressions that occurred in the late 19th century.  Starting in the 1970s the real hourly wage started to decline for the first time in American history.  However, Wall Street's power began growing coincidentally with the establishment of the Federal Reserve Bank.  All that counterfeit monety available for stock investments to wealthy borrowers.

Beginning in the 1930s, the Wall Street, banker, real estate and business elite (which has increasingly become a Wall Street elite) began to take control of universities.  This was done via John Maynard Keynes's economic theories, which became dominant. Keynes's theories were not at all new.  They were just a rehash of ideas that David Hume and other mercantilists had advocated and that Hamilton advocated in the 18th century, copying Hume's ideas directly in his argument for a central bank. However, what was new in Keynesian economics was the emphasis on mathematical models and econometrics, all of which turned out to be wrong.  Almost all who disagreed with the mercantilist/Federalist/Whig model of economics, the claim that monetary creation would spur growth, were banished from universities.  The socialistic Whig ideology even reached unrelated fields like psychology.

By the 1970s the Keynesian model turned out to be wrong.  Its major predictions had been contradicted by evidence.  However, economists clung loyally to the Whig model.  Of course, the fact that investment and commercial banks donated to the universities at which they taught had little to do with it, at least according to them.

The outcome of the commitment to Keynesian economics is the exact reverse of the outcome to the Democratic and then Republican Party philosophy of the 19th century.  Whereas profits were flagging and Wall Street was weakening in the 19th century, whereas real wages were growing in the 19th century, in the 20th century real hourly wages began to decline in the 1970s and have, after 40 years, remained flat.  However, the stock market, real estate prices, banking profits, government employment and corporate profits have all exploded.

Jim Crum sent me a link to Ambrose Evans-Pritchard's UK Telegraph article about the US money supply, which claims that the US money supply has plunged (see above graphs).  The government stopped publishing the M3 monetary statistic several years ago, but the article attributes the statistic to an unnamed conspiracy of  "British and European monetarists." Evans-Pritchard claims that M3 has plunged (look at the graph of M1 above) and that Larry Summers and other incompetent economists claim that the trillion dollars that was spent by government last year was not enough (it failed to reduce unemployment) and that additional wasteful spending is needed.

Note that the difference between M1 and M3 has little to do with expanding the monetary base or M1, as the article claims (were the government to expand the money supply, as Mr. Congdon states in the article, it would be M1, not M3).  The difference between M1 and M3 is easy to find on Wikipedia.  M3 includes savings and time deposits whereas M1 excludes them but includes checking accounts, cash, and travelers' checks.  Thus, the massive increase in M1's being offset by an even more massive decline in savings accounts seems unlikely, but even if it has occurred the explanation is likely that more people are living off their savings because of higher prices (despite bogus inflation numbers showing near zero inflation, not deflation as occurred in the 1930s) and because of the unemployment that is higher now after a trillion dollars in the moronic, failed "stimulus" that Mr. Summers and President Obama squandered last year and resulted in seasonally unadjusted unemployment's rising to just under ten percent. 

As I have pointed out recently, banking interests have a taste for government debt, for they profit handsomely from the sale of government bonds.  Thus, Mr. Summers and his coterie of Wall Street water boys in Washington are eager to waste more money at your grandchildren's expense.


Doug Plumb said...

Its been my understanding that the banks create money from promises. You seem to imply that the sale of government bonds does not include this "created from thin air" property- which really means promise. Is a government bond not just another form of a promise ?

The discovery of electricity drove lots of innovation and I think Tesla gets credit that is undue. In reality, electrical engineering textbooks of today are completely filled with the works of Oliver Heaviside. He simplified Maxwells equations into their present form and created the mathematical methods now known as Laplace operators and transforms - these two ideas are the mainstay of electrical engineering analysis.

Maxwells equations (in present form- 4 equations) contain the affects of relativity and were conceived by Heaviside out of Maxwells 20 equations long before Einstein came to be.

In reality, our texts should have his name wherever the names of Maxwell and Laplace appear. Its very strange that this is not so and that he is forgotten. Everything is attributed to Maxwell or Laplace.

Mitchell Langbert said...

The banks create money when they lend it to borrowers. The sale of government bonds is just borrowing. It is just like when General Electric borrows money. It sells bonds or promises to repay the money plus interest. The bond buyers lend the money to GE. The same as with the federal government. It borrows by issuing bonds. Nothing is created from thin air at that point. Yes, a bond is a promise. It is an IOU, just like a loan that you might take from a friend. The promises can exist without creating anything out of thin air. You lend me your lawn mower and ask for a $10 use fee. I use the mower and return it to you with the fee. Nothing is created out of thin air.

What creates the money out of thin air is the Fed. The Fed simply adds to the money supply. It has the power to tell the bank to deposit so much and so much money. The money didn't exist previously. The Fed has the power to simply create the money.

It does this when it buys government bonds from the banks. That's where the reserves are created.

Then, the bank lends 80% of the deposit to a borrower. The borrower deposits it in his checking account. The borrower's bank then lends 80% of the 80% or 64% to a second borrower. The second borrower deposits the loan in his checking account. The second borrower's bank then can lend 80% of the 64% or 51.2% to a third borrower. Etc. Ultimately, if the reserve requirement is 20%, then five times of the original Fed deposit is created.

The creation of money is thus in two steps. The first is when the Fed deposits new reserves when it buys bonds. The second is when the banking system lends a multiple of the reserves. Legally, the banking system can have reserves of 10%.

Bonds don't have the property of monetary creation. They are just promises. Money is created through bank loans and Fed reserve credits.

Interesting stuff about electrical engineering. That is over my head, but I appreciate the insights.

Doug Plumb said...

Mitchell"What creates the money out of thin air is the Fed. The Fed simply adds to the money supply. It has the power to tell the bank to deposit so much and so much money. The money didn't exist previously. The Fed has the power to simply create the money."

I'm not sure what you mean by this - do you mean a method other than bonds ?

Mitchell Langbert said...

Doug--yes, there is no method. They simply create the money, no different from what a counterfeiter would do.

If the Fed wants to it can tell a bank to deposit a million dollars in your account. It sends "reserves" to the bank and directs them into your account. They have the power to simply "create" or counterfeit the reserves.

In practice, the Fed does this by buying bonds. But they could buy a car from you simply by depositing $20,000 into your account. When the Fed purchased various derivatives from investment banks it simply created the money, expanding the money supply. The money simply didn't exist previously.