The Money Supply, the Price of Money, Monetary Policy and Inflation

Much confusion surrounds the items in this article’s title. Thanks to orthodox viewpoints we have nearly an entire populace that believes Jack and the Beanstalk is a true story. Now, of course, I’m not being literal. I am, however, trying to make a point. Like, say, Tolkien, orthodox economists fashion a fantasy world all their own. Unlike Tolkien however, these economists write their fantasies down and then push it onto the populace as reality. Much of it is mere assumption.

Orthodox economists have a pre-conceived notion of how the world works: Everything is dismal, limited, hopeless and depressing. They then seek out ways to confirm their dystopian viewpoint. In my view, the orthodox economics motto should be, “Abandon hope, all ye who enter” and their economics textbooks should bear equally dismal titles such as, “What’s the Point of Even Trying?”, “Be Afraid. Be Very Afraid!”, “We Can’t Possibly Do That” and “We’re All Doomed”. When you think about it, people who maintain this type of outlook in any other context would be urged to seek psychological help. Let a mainstream economist continuously express this kind of outlook publicly and even a psychiatrist will say, “He’s right, you know.”

As an example of how orthodox economists confirm their depressing viewpoint, let’s consider their assumption concerning how banks operate. They want to believe that banks take customer deposits, build up reserves, then lend those reserves out. Thus, because they want to believe it, then it must be so. You can see the problem here. Hey, I want the moon to be mauve and follow me wherever I go, but mere wanting doesn’t make it so, no matter how complex my theory and the mathematics employed to support my conclusion is. Without observational evidence, it’s mere speculation.

There are many professions that can cause enduring pain or kill. Two of them are medicine and economics. Medicine has been able to leap past the point where mystical beliefs such as swallowing black powder cures the flu, placing burning hot glass jars on the back of patients cures all sorts of maladies and bleeding a patient cures fever are considered fact. The economics profession, however, hasn’t been able to lift itself out of the middle ages. Hardly scientific, orthodox (mainstream) economics is more mysticism than reality, which is why the profession is an utter embarrassment. Often times, I reflect on the subject with great sympathy for economics students in particular, who have taken on tens of thousands of dollars in student loan debt to unwittingly study creative fiction. Of the many items of creative fiction peddled by mainstream economics, today we will look at the false notion that the government controls the money supply and challenge the notion that monetary policy causes inflation.

“The federal government expanding the money supply will be the death of us all”, says the orthodox economist. The assumption is that the Federal Reserve (central bank) controls the money supply. To understand why such an assumption is ridiculous, we must first examine what’s called the unit of account and where it comes from, then take a look at “money” and bank lending.

The unit of account is defined by the national government which then levies a tax payable in that unit of account and issues currency so the tax liability can be satisfied. In the simplest terms possible, the US Government issues the US dollar, the Australian Government issues the Australian dollar and the UK Government issues the British Pound and when these governments demand a tax payable only in their respective currencies, a demand for that currency is created.

The currency-issuing national government has a monopoly over its product. No private entity can issue currency. Using its monopoly power over its own product, the particular national government in question both funds and regulates the market and the national economy.

The general public uses the term “money” in, well, a very general way. The definition of money is quite vague, but for the purposes of our discussion, we will narrow down the concept to define two distinct forms: Currency and Credit.

Using the US Government as an example, the “money” issued by the federal government is a net financial asset. It is an asset that has no equal liability attached to it. In other words, when the US Government gives you $4,000, you don’t have to pay it back. US dollars are created and destroyed by transactions between the federal government and the non-government sector, which we call “vertical transactions”.

Credit, on the other hand, is “money” that private banks create. Contrary to the orthodox opinion, banks do not lend customer deposits. Banks lend their own IOU, which is then denominated in the government’s unit of account, allowing those IOUs to act as “money” which must be paid back. Hence, unlike currency issued by the federal government, bank credit money is an asset with a corresponding liability attached to it. Credit “money” is created and destroyed through transactions within the private sector, which we call “horizontal transactions”. These transactions occur inside the private sector and so, are “endogenous”. Endogenous, being defined as having an internal origin. It is here where the “money supply” so often discussed by the general public, comes in to play.

Again, contrary to orthodox opinion, the “money supply” is an endogenous phenomenon, determined by demand for bank credit. When demand for credit expands, the “money supply” expands and when demand contracts, the “money supply” contracts. The quantity of “money” is outside of the Federal Reserve’s control, because the Fed sets the price of money, or in layman’s terms, it sets the interest rate.

As the federal government is both the currency issuing and regulatory authority, it can choose to exercise control over either the supply of money, or the interest rate, but it cannot do both at the same time. In order to exercise control over the money supply, the federal government would have to declare bank credit illegal and in doing so, the Federal Reserve would then lose its ability to set the interest rate, which is part of monetary policy.

First of all, as we’ve discussed, bank loans are IOUs, not reserves being lent out. Further, bank loans are made regardless of what a bank might have in reserves. Should a bank find itself short of reserves later on, it can borrow from another bank. If the entire banking system is short of reserves, the bank has two choices:

1. Sell bonds to the Federal Reserve
2. Borrow reserves from the Fed’s discount window and pay a penalty

Note that borrowing from the discount window reduces the return that the bank expects from lending which gives us a clue:
If the difference between the rate the bank pays and what it can profit from lending is acceptable, the bank will continue to lend. Therefore, should a bank expand its lending to the point that it becomes short of reserves, the bank might stop lending if the price it would have to pay using the Fed’s discount window is too high. In other words:

Bank lending is not reserve constrained, but rather, it is constrained by expectations of profit and solvency.

Thus, we understand that banks neither lend out reserves, nor are they constrained by such as is suggested by orthodoxy.

Secondly, we can also clearly see that the Federal Reserve does not expand the “money supply” through open market operations either. The purchase of bonds from the market by the central bank will add reserves, true, but banks do not lend out reserves. Banks will lend reserves to other banks on the FFR, however, the resulting competition will push the FFR down. If it wishes to maintain control over monetary policy the Federal Reserve must intervene and drain off any excess reserves that it injected through open market operations.

Since the Federal Reserve clearly sets the interest rate, it cannot control the “money supply”. Hence, the “money supply” is determined by demand for bank credit, which in turn determines the monetary base and so, the orthodox viewpoint collapses.

Lastly, I want to very briefly touch on the errant concept that monetary policy causes inflation. The root cause of this false belief is the inability to understand the difference between fiscal and monetary policy.

In the simplest terms possible, fiscal policy adds US dollars to the non-government sector and monetary policy merely shifts around what was added by fiscal policy. Monetary policy will change a portfolio composition from all liquid dollars to some liquid and some bonds and vice versa, but will not “add” dollars to the system. If we wish to create inflation, we need fiscal policy.
So try as they might, orthodox economists can ask the Federal Reserve to QE the system to the moon, raise or lower interest rates, or perhaps do a fancy inflation dance if they’re so inclined.

But, since monetary policy is just the shifting around of what already exists, it doesn’t add any dollars to the system and so, it will never create inflation.