One of the hottest (if not the
hottest) intra-Austrian debates today is between what is sometimes referred to as deflationists and inflationists/stagflationists. This is not a policy debate of course, as all Austrians is anti-inflation, but rather a debate about whether the current recession will be associated with deflation or inflation. Examples of deflationists are Frank Shostak, Mike Shedlock and Gary North while examples of stagflationists include me, Antony Mueller and Peter Schiff. The dispute is largely originated in a dispute over the definition of the money supply. I have already dealt with that issue extensively (see for example here
) so I will not repeat this here. Instead, I will focus on the appeal made by the deflationists to the development of the monetary base, which have been largely stagnant for the latest year.
The implicit or explicit argument from the deflationists appear to be that 1)The Fed controls the monetary base, so it is a good reflection of how tight its policy is 2) The monetary base determines the money supply, so the stagnant monetary base implies a stagnant money supply. Yet both of these assertions are simply wrong, at least given the current financial structure.
I have actually once answered
the monetary base argument before. At that time I pointed out that more than 90% of the monetary base is made up by what in monetary statistics is called currency in circulation, which is to say paper notes and metal coins held by the public. And I also pointed out that the amount of currency in circulation is determined by public preference for making payments using notes and coins versus making electronic transactions. In the U.S. this is also determined by demand in high inflation third world countries for using dollars as means of payments instead of local currencies. Most likely the stagnant amount of currency in circulation reflects the trend towards a cashless society as well as growing repatriation of previously exported dollar notes and coins due to the distrust of the dollar that the decline in its purchasing power has caused.
I also illustrated that point by pointing out that during the inflationary boom of the 1920s, the monetary base was stagnant. By contrast, the monetary base soared during the deflationary depression of the 1930s, as bank collapses caused people to prefer to hold money in the form of cash instead of deposit money.
However, I now realize that this response was unsatisfactory in one aspect. Namely, because my focus on the currency in circulation part of the monetary base seemed
to imply that the other part of the monetary base, bank reserves, do in fact have the characteristics that the deflationists claim. That's not what I meant, although now I realize that the post was written in a way which could reasonably be interpreted that way. And as I see Robert Murphy write a whole article
focusing on bank reserves as a proxy for monetary conditions it is clear that the issue must be addressed. So I will now clarify: bank reserves are in today's system basically irrelevant too, both as a proxy of Fed policy and of monetary conditions.
The reason is that there really isn’t any demand for bank reserves. To the contrary, banks do everything they can to minimize it because reserves inflict opportunity costs for them in the form of foregone interest income. In the past, banks still felt compelled to keep large reserves because of the risk of bank runs. But with the Fed providing unlimited quantities of liquidity in the case of unexpected increases in withdrawals, this is not an issue anymore. Today, the only thing preventing banks from reducing reserves to zero is formal reserve requirements and the need to have cash available for withdrawals from bank offices and ATMs. But with the banks moving away from deposits with reserve requirements such as demand deposits and instead finance its operations in for example Money Market Mutual Fund accounts (And using so called sweep operations the banks ensure that the level of demand deposits are always minimized even if customers deposit money there) that don't have any reserve requirements the level of required reserves is declining in importance. And with the increasing use of electronic transactions, cash for customer withdrawals is also becoming less important and is at an absolute level very low. Because of this, bank reserves are increasingly disconnected from the level of money supply.
Indeed, if Robert Murphy had looked more closely at figure 1, he would have seen this point. Bank reserves in early 1990 were $60 billion as compared to $42 billion now. If bank reserves really had been a good proxy for the money supply, then that would have implied a cumulative monetary deflation of 30% during the latest 18 years. The Fed under Greenspan would, if bank reserves were really a good proxy of monetary conditions, have been the ultimate hard money institution, providing more deflationary conditions than a gold standard. Nor do the trends show any correlations with the housing bubble, as it started already in 2001 while the monetary base was flat until 2003. And after a brief upswing in 2003-04 it was basically flat after that. In other words, bank reserves have in today's system nearly no correlation with monetary conditions.
But if the Fed performs open market operations, won't that expand bank reserves? Well, no. While it may result in brief spikes, these spikes won't last as the banks will lend out or invest the money the open market operations produce, either as bank loans or investments in securities. The reason why they are unlikely to keep the money more than a few days is the above mentioned fact that reserves represent opportunity costs and that it is more profitable for the banks to lend/invest. Contrary to what Murphy claimed, it is not the Fed that has moved away reserves from the systems, it is the banks themselves. If you doubt that, just check out the statistics for bank credit
, which have soared in recent months.
Because the banks have the opportunity to lend/invest the money they get from the Fed and the incentive to do so, the Fed has almost no control over bank reserves. If they started to impose reserve requirements on all deposits, they could have controlled it, but as it is they don't. Nor is it a reflection of credit conditions or monetary conditions as bank credit grows at double digit rates.
To summarize, the stagnant monetary base and bank reserves have absolutely nothing to do with interest rate policy, and is instead a reflection of the trend in the payment system to move away from currency in circulation and deposits with formal reserve requirements to deposits without reserve requirements, combined with the Fed's promise to help all banks with unlimited quantities of liquidity if they need it. The deflationist claim that the Fed is not inflating is not only serious because it implies misleading investment advice, such as staying away from gold and buying treasuries. It is also damaging because it implies that Bernanke is actually mimicking market conditions (something which Murphy actually explicitly wrote in his article), thus effectively destroying all opposition to Bernanke's inflationary policies. Unwittingly, the deflationists are thus helping Bernanke.