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Understanding why Austrian Economics is Flawed

Austrian economics has been through quite a rollercoaster ride over the last 10 years as the housing bubble appeared to vindicate many of their views and then the economic recovery proved many of their dire predictions completely wrong.  I think Austrian Economics is deficient and Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.  Allow me to provide three core reasons why I believe this:

1)  Austrian economics is a political ideology that masquerades as an economic school of thought.  Like most of the economic schools in existence today, Austrian Economics is predicated on a political ideology.  Austrians tend to be vehemently anti-government and pro-market.  So they build a world view that conforms to the world they want and not the world we actually have.

We’ve seen this time and time again in the last 5 years during the recovery as the government picked up spending when the private sector cratered.  There is always an excuse within Austrian Economics that implicitly assumes government cannot spend dollars any better than a household.  This might be true in a general sense, but it is not always true.  For that implies that households and businesses always make rational decisions.  As if choosing to have our government spend money on wars and welfare is all that much different than households spending money on the next release of the tech gadget they probably don’t need or the McMansion they can’t afford.

Austrians aren’t the only offenders of this (see here).  We see it in Keynesian approaches, Market Monetarist approaches, Monetarist approaches and just about all of economics these days.  Economics is built primarily on a bunch of political agendas designed to look like a science.  Austrians (particularly the Rothbardians) are so vehemently against government involvement in the economy that they are among the very worst offenders of trying to pass an ideology off as a school of thought.  It results in a very unbalanced presentation of our reality.

2)  Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system.

The act of targeting interest rates and implementing monetary policy are very much secondary to this primary purpose and the powers of such policy, as presently constructed, are vastly overstated by most economists.  Yes, the central bank controls a component of the interest rate that helps determine the spread at which banks can lend, but the central bank does not determine the rate at which banks borrow to customers.  It merely influences the spread.  Overemphasizing the Fed’s “control” over interest rates misunderstands how banks actually create money and influence economic output.

The primary flaw in the Austrian view of the central bank has been most obvious since Quantitative Easing started in 2008.  Austrian economists came out at the time saying that the increase in reserves in the banking system was the equivalent of “money printing” and that this would “devalue the dollar”, crash T-bonds and cause hyperinflation.  It was standard operating procedure to see charts of the monetary base like this one followed by dire predictions of high inflation or hyperinflation.  Of course, none of this actually panned out.  The high inflation never came, the hyperinflation definitely never came, the T-bond collapse was a terrible call and the USD has remained extremely stable.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds based model that most other economists use.  So they assumed that more reserves would mean more “multiplication” of money and thus hyperinflation.   Of course, as I’ve explained numerous times here before, banks are never reserve constrained and do not make loans when they have more reserves.  Further, QE is a simple asset swap that changes the composition of private sector assets.  Referring to this as “money printing” is highly misleading (see here for more details).  Austrians got this wrong because, in an attempt to attack government, they have devised a government centric view of money creation that misunderstand the way money is created primarily by private competitive banks endogenously.

3)  Austrians misunderstand inflation.  Austrian economists actually change the definition of inflation to serve their own ideological needs.  In Austrian Economics inflation is not the standard economics concept of a rise in the price level.  Inflation in Austrian economics is just a rise in the amount of money.  This leads to all sorts of emotional commentary, the most common of which, is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).   But this misunderstands several concepts and misleads us in understanding how the monetary system works.

First of all, the private sector creates lots of “money like” instruments that are not technically included in the money supply but comprise the vast majority of private sector net worth.  I use a “scale of moneyness” to help better understand this concept so that we don’t place an undue specialness on the idea of “money” when trying to understand inflation.  Instead, I try to explain that spending is a function of income relative to desired saving.  And that saving is comprised not only of “money”, but money-like instruments like stocks, bonds, options, etc.  To completely understand how the economy is impacted by inflation we shouldn’t merely focus on narrow definitions of “money”, but should understand the aggregate economic balance sheet.  For instance, if you sell a stock at no gain and obtain cash you’re not necessarily more likely to spend than you were before because your net worth is the same.  Your income relative to desired saving is precisely the same as it was before.  This is basically what QE is.  It is a swap of one type of asset for another and doesn’t actually alter the net worth of the private sector.  Changing the moneyness of private assets does not necessarily mean there will be higher inflation!

But there is a more egregious and nefarious error in this “decline” of the dollar myth.  It completely misunderstands how living standards can rise even while the money supply rises.  In our credit based monetary system the money supply rises primarily when banks make loans which create deposits.  In a highly productive economic environment these loans are distributed by private competitive banks and provide the borrower with the capability to invest in a manner that actually enhances the living standards of society.  So, you borrow $100,000 from the bank, you invent and distribute the washing machine and suddenly we’re all better off because we no longer have to go to the river to wash clothes.  The technological advancement enhances our lives by giving us more time to consume and produce OTHER goods and services.  In other words, the money supply has technically increased, but we’re not worse off because of it.  We’re better off because of it!  What’s happened since 1913 in the USA is just one gigantic version of the washing machine example where our living standards have exploded through the roof in tandem with a rising level of credit and an innovation boom that human beings have never come close to experiencing in the past.

Austrians, in their fervor to demonize the fiat money system, make several errors here.  First, they assume the government controls the money supply (which they don’t).  It’s actually controlled primarily by private banks in a market system that Austrians should love.  Second, they move the goal posts on the definition of inflation to imply that inflation is always and everywhere a bad thing (which, it can be, but generally isn’t).

That really just scratches the surface on some of the flaws in Austrian Economics.  I think Austrians provide some good insights on the way the economy and money works, but these are glaring flaws in the school of thought that render it highly inadequate in helping us understand the world of money in a balanced and objective way.

See also: 

Understand the Modern Monetary System

Monetary Realism Recommended Reading

“Don’t Work Harder, Work Smarter”

One of the cornerstones of Monetary Realism is understanding the importance of time.  We’re all here for a finite period and we can choose how we use that time and whether it’s going to work for us or against us.  Now, I’m not good at many things, but I think one of the few things I really understand is time management.  I really value my time.  And I use it wisely.

The saying “don’t work harder, work smarter” is one of those cheesy taglines that you hear all the time and never quite find any real world application for, but it’s dead on.  Here are a few thoughts about working smarter rather than working harder:

  • Don’t conform to everyone else’s schedule.  Yes, I know, most of us work for someone else and have to conform to their schedule, but that doesn’t mean you have zero flexibility within that schedule.  So what if you have to show up at 9 and leave by 5.  Does that mean you have 8 hours to do an allotted amount of work or does it mean you can design your 8 hours however you like?  Most of us have deadlines we have to meet and we build a schedule around your employer’s deadlines.  But you can still design your own deadlines and use your time how you like.  You don’t have to meet a deadline by Friday just because that’s when it’s due.  Can the work be done by Thursday so your Friday is open to focus on other things?  If so, why wait?  Don’t let everyone else control your schedule….
  • Stop procrastinating and create a sense of urgency.  Most of us procrastinate and wait until there’s a sense of urgency to get something done.  Create your own sense of urgency right now.  Set your own personal deadlines by creating goals and forcing yourself to work smarter.
  • Organize your schedule.  I spend a huge amount of time organizing a schedule.  I usually spend every Sunday evening planning my week.  When do I work on this project, that project, when I eat, when I workout, when I read, when I relax, etc.  If you’re not organized then working smarter is never going to work for you.
  • Make the robots work for you.  Don’t let the “world is ending because of robots” meme get you down.  All that technology is out there to help you work smarter so you don’t have to work harder.  Take advantage of it, learn about it and use it to become more efficient.
  • Stop getting distracted.  Are you on Twitter, Gchat, the phone, email or Facebook all day?  Why?  It’s a waste of time unless it’s helping you achieve your goals.  Cut out the waste!  Learn to stop filling your email box with clutter.  Stop spending time on the phone with people who are just chewing up time.  Stop Gchatting about what you’re going to do next weekend.  Stop checking Facebook.  It’s so easy to get distracted these days.  Yes, it’s perfectly fine to take time off, but don’t let it control the time when you should be getting things done.  Block out your time for social interaction so that it’s working to benefit you and not working against you. You don’t live to work, you work to live, but when you’re working you need to actually be working!

That’s my thought process about managing time efficiently.  If you have more tips or thoughts please add them in the comments.

H/t Medium.com

Stop With the “Money Printing” Madness

I never stop seeing the term “money printing” all over the place.  It has to be the most abused term in all of economics and finance.  The madness must end!  So let’s try to make this so simple that a 6 year old could understand it.

1)  Banks create most of the money in our system.  Loans create deposits and deposits are, by far, the most dominant form of money in the economy.  So, if you want to say someone “prints money” you would be most accurate saying that banks print money.

2)  The government is a user of bank money.  When the government taxes Paul they take Paul’s bank money and redistribute it to Peter when they spend.

3)  If the government runs a budget deficit (taxes less than it spends) then Paul buys a bond from the government and the government gives Paul’s bank deposit (which he used to buy the bond with) to Peter.  Paul gets a bond which the government created in much the same way that a private corporation creates a bond when they issue corporate debt.   If you want to say these entities “print” financial assets then fine.  Corporations print stocks and bonds every day and you don’t hear the world exploding with hyperinflation rants because of it….

4)  When the Fed performs quantitative easing they perform open market operations (just like they have for decades) which involve a clean asset swap where the bank essentially exchanges reserves for t-bonds.  The private sector loses a financial asset (the t-bond) and gains another (the reserves or deposits).   The result is no change in private sector net financial assets.  QE is a lot like changing your savings account into a checking account and then claiming you have more “money”.  No, the composition of your savings changed, but you don’t have more savings.

5)  Cash notes like the ones you have in your wallet are created by the US Treasury and are issued to the Federal Reserve upon demand by member banks.  This cash is literally “printed” by the Treasury, but serves primarily as a way for banks to service their customers.  In other words, if you have a bank account you can exchange your bank deposit for cash from the ATM or the bank teller. Cash is preceded by the dominant form of money, bank money.  But it doesn’t get printed off the presses and fired into the economy as some would have us believe.

See, there’s no “money printing” in any of this unless you want to distort the role of cash in the economy or refer to lending and security issuance as money printing.  Yes, QE alters the composition of private financial assets, but that’s about it.  No real “money printing” there either.   So, next time someone goes off on a “money printing” rant just point them in the direction of these 5 easy to understand steps.

* Confused?  See the following pieces:

1.  Understanding The Modern Monetary System

2.  Understanding Inside & Outside Money

3.  Understanding Moneyness

4.  Where Does Cash Come From?  

Towards a (Mostly) Cashless Monetary System

I often talk about the misconceptions of money being a physical thing.  Austrians tend to tell us that money is something like a physical commodity while many Keynesians tell us that the ultimate form of money is paper or cash.  There’s a smaller group of (mostly economists) who believe that the ultimate form of money is currency (bank reserves, cash and coins).  I think they’re all wrong.  Money is no longer dominated by a physical thing (though it can be) or by what the central bank or government creates (cash, coins and reserves).  Today’s money is created almost entirely by private banks and tracked electronically for record keeping within a payments system that they control and the rest of us have to be members of.

Of course, our textbooks also tell us that government money matters most.  They tell us that the central bank creates some amount of money and the banking system “leverages” or “multiplies” this money, but that’s not really true.  Banks create loans first and obtain reserves second if necessary.  The money multiplier is a myth.  And that puts the private banks squarely at the center of the money creation business.  When a bank makes a loan it results in the creation of a deposit.  And those deposits are what we are all chasing in a system that is dominated by electronic bank money.

The mainstream media is nearly as oblivious to this reality as the economic textbooks.  In the mainstream, the belief is that the government “prints money” as if it’s just running a printing press running up government debt all day long to pay for things.  But the reality is that the government is a massive redistributor of bank money.  That is, when the government taxes you they’re just taking bank deposits from person A to pay person B with bank deposits.  When the government runs a budget deficit they’re selling a bond to Person A and giving person A’s bank deposit to Person B.  There’s no “money printing”.  There’s only redistribution of bank deposits.  And because these bank deposits dominate the US payments system as the means of settling payments in the process of transacting business, we are all seeking out these deposits so we can interact within that payments system.

The reality of banks “ruling the monetary roost” has only become that much more apparent as technology has developed in recent decades.  In fact, I would argue that we’re becoming increasingly bank dependent as technology begins to reduce the importance of cash and other forms of government money in the economy.  Canada, for instance, has no reserve requirement as technology has made their interbank payments system extremely efficient.  The cash market for transactions is also taking a back seat to other transactions around the world.  In the USA, cash transactions account for just 27% of all transactions. That’s down from 80% just 50 years ago.  Credit and debit cards account for over 60% of transactions.  Cash is still the most frequently used form of payment  (because cash transactions tend to be in small denominations), but in total dollar volume it is becoming less and less significant.   If we include wire transfers in the volume of payments data the electronic market already dwarfs the cash market (via the Cleveland Fed):

And although the US has been ahead of the trend in many regards here, other developed nations like Sweden and Canada are already on the fast track towards a cashless economy.  For instance, in Sweden, less than 3% of all transactions occur in cash.

This doesn’t mean cash as a form of money is going away entirely.  But it is becoming increasingly less significant.  And that’s precisely due to the way our money system has been designed.  Banks have been placed in charge of managing and driving the payments system around the world.  So their money dominates that system.   That’s not going to change any time soon.  In fact, we’re becoming increasingly dependent on bank money as technology makes other forms of money less and less competitive/necessary with a highly efficient electronic (bank controlled) system.

Related:

Understanding Moneyness

Understanding the Modern Monetary System

Understanding Inside Money & Outside Money

Understanding Moneyness

This section will be a new addition/clarification to my paper on Understanding the Modern Monetary System.  

Modern forms of money are largely endogenous (created within the private banking system), but are organized under the realm of government law.  The specific unit of account in any nation deems what money will be denominated as.  The government therefore decides the unit of account and can restrict/allow certain media of exchange.  The unit of account in the USA is the US Dollar.  Organizing money under the realm of law increases a particular form of money’s credibility in the process of transaction.  The government also helps oversee the viability of the payments system and can decide what can be used within that payment system as a means of settlement.  In the USA the primary means of settlement are bank deposits and bank reserves.  Therefore, these forms of money serve as the most widely accepted forms of payment within the money system.

There are different forms of money within any society and they have varying forms of importance and “moneyness”.  Moneyness can be thought of as a form of money’s utility in meeting the primary purpose of money which is as a medium of exchange or a means of final payment.

In the USA the money supply has been privatized and is dominated by private banks who issue money as debt (which creates bank deposits).  Banks are granted charters by the government in the USA to maintain the payments system in a market based system.  Banking is essentially a business that revolves around helping customers settle payments.  So it’s helpful to think of banks as being the institutions that run the payments system and distribute the money within which that system operates.  Outside money (or money issued OUTSIDE the private sector – notes, coins and reserves) plays an important role in helping facilitate the use of the payments system, but primarily plays a supporting role to inside money (money created INSIDE the private sector such as bank deposits) and not the lead role.

Outside money could theoretically serve as the most dominant form of money in the system (for instance, if the government did not choose to use bank money to spend, but instead chose to simply credit accounts by issuing money directly), but takes a back seat to inside money by virtue of design.  That is, outside money always facilitates the use of inside money by serving as a support feature for inside money.  Cash, for instance, allows an inside money account holder to draw down their account for convenience in exchange.  Bank reserves help stabilize the banking system to serve interbank payment settlement.  These are facilitating roles to inside money.  Therefore, we place inside money as having the highest level of moneyness in the monetary system.

Inside money and outside money, however, are not the only types of money that exist in the money system.  It is helpful to think of money as existing on a scale of moneyness where particular forms of money vary in degrees of utility (see figure 1).  As Hyman Minsky once stated, anyone can create money, the trouble is in getting others to accept it.  Getting others to accept money as a means of payment is the ultimate use of money.  And while many things can serve as money they do not all serve as a final means of payment.

Since currencies are fungible on a foreign exchange market most foreign currencies have a moderately high level of moneyness. For instance, a Euro is not good in most stores in the USA, but can be easily exchanged for US Dollars of various forms.  SDRs and gold, which are broadly viewed as universal mediums of exchange, can be viewed similarly though they vary in degrees of convenience for obvious reasons.  Gold for instance, is widely viewed as money and can be easily exchanged for money, but is not widely accepted as a means of final payment.

Most financial assets like stocks and bonds are “money like” instruments, but do not meet the demands of money users in terms of having high liquidity or acceptability as a means of final payment.  These financial assets are easily convertible into instruments with higher moneyness, but are not widely accepted as a final means of payment.  Therefore, their “moneyness” is relatively low.

Lastly, most commodities and goods are low on the scale of money since they are unlikely to be accepted by most economic agents as a means of final payment.

(Figure 1 – The Scale of Moneyness)

Understand Your REAL, Real Returns

Just passing this paper along from the comments section.  It’s a very good read on real, real returns on various asset classes.  This is crucial to understanding how different assets generate total returns and how they can be viewed in totality:

“Investors often focus on nominal return — or the return they see quoted in the paper or on a financial news site — on a given investment. Unfortunately, there are several factors that often stand between a nominal-return figure and the building of real wealth. Sophisticated investors frequently refer to the real return, which is a nominal return adjusted to take inflation into account. At Thornburg, we take that analysis a few steps further and adjust stated performance numbers for additional factors — taxes and investment expenses among them. We believe that investors should be attentive to this return figure, the number that’s left after accounting for inflation, taxes, and investment expenses.”

Read it here.

Source: Thornburg

 

“Loans Create Deposits” – In Context

By JKH (cross posted at Monetary Realism)

Introduction

Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Systems

The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system. These restrictions include central bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and pricing of bank reserves that are consistent with the monetary policy interest rate target) and other guidelines (such as the reaction function of the policy rate to various measures of inflation, output, or employment). The full category of potential constraints is broad and varied. But none of this alters the fact that a monetary system is basically a bookkeeping device for the intermediation of real economic activity. It is a construct that enables moving beyond a barter economic system that can only be imagined as a counterfactual.

The Choice for Banking

Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the system include a competitive banking sector? More broadly, will financial capitalism exist in substance and form? Will there be competition? Within this landscape, will there be more than one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding how banks actually work. The competitive framework that is often taken for granted is in fact a choice for banking system design – including the presence of a reserve system that enables active management of individual bank balance sheets.

‘Loans Create Deposits’

When we say ‘loans create deposits’, we mean at least that the marginal impact of new lending will be to create a new asset and a new liability for the banking system – typically for the originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a new bank liability. Both of those accounting entries represent increases in their respective categories. This is operationally separate from any notion of reserves that may be required in association with the creation of bank deposits.

In another version of the same lending transaction, the lending bank presents the borrower with a cheque or bank draft. The lending bank debits the borrower’s loan account and credits a payment liability account. The bank’s balance sheet has grown. The borrower may then deposit that cheque with a second bank. At that moment, the balance sheet of the second bank – the deposit issuing bank – grows by the same amount, with a payment due asset and a deposit liability. This temporary duplication of balance sheet growth across two different banks is captured within the accounting classification of bank ‘float’. The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability. The end result is that the system balance sheet has grown by the amount of the original loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in different banks. The system has expanded in size. The growth is now reflected in the size of the deposit issuing bank’s balance sheet, with an increase in deposits and reserve balances. The lending bank’s balance sheet size is unchanged from the start (at least temporarily), with loan growth offset by a reserve balance decline.

Money Markets

In this latter example, it is possible and even likely, other things equal, that the lending bank additionally will seek to borrow new funding from wholesale money markets and that the deposit issuing bank will lend funds into this market. This is a natural response to the respective change in reserve distribution that has been created momentarily for the two banks. Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal. Adjusting positions through money market operations is a basic function of commercial bank reserve management. Thus, this example features the core role of bank reserves in clearing a payment from one bank to another. The final resolution of positions in this case is that the balance sheets of both banks will have expanded, indirectly connected through money market transactions that follow on from the initial ‘loans create deposits’ transaction. However, this too may be a temporary situation, as the original transaction involving two different banks will inevitably be followed up by further transactions that shift bank reserves between various bank counterparties and in various directions across the system.

The Money Multiplier Fable

The money multiplier story – a fable really – claims that banks expand loans and deposits on the basis of a central bank function that gradually feeds reserves to banks, allowing them to expand their balance sheets with new loans and reservable deposits – according to reserve ratios that bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of course. In fact, bank balance sheet expansion occurs largely through the endogenous process whereby loans create deposits. And central banks that impose reserve requirements provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred. The multiplier fable describes a central bank with direct exogenous control over bank expansion, based on a reserve supply function – which is a fiction. The facts of endogenous money creation have been demonstrated by empirical studies going back decades. Moreover, the facts are obvious to anybody who has actually been involved with or closely studied the actual reserve management operations of either a commercial bank or a central bank. In truth, no empirical ‘study’ is required – the banking world operates this way on a daily basis – and it is absurd that so many economics textbooks make up stories to the contrary. The truth of the ‘loans creates deposits’ meme is pretty well understood now – at least by those who take the time to learn the facts about it.

Central Bank Reserve Injections

A central bank that imposes a reserve requirement will follow up new deposit creation with a system reserve injection sufficient to accommodate the requirement of the individual bank that has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the central bank. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. Thus, there is a lag between two system growth impulses – ‘loans create deposits’ as the endogenous feature and a subsequent central bank reserve injection as an exogenous follow up. The required reserve injection is typically small by comparison, according to the reserve ratio. The central bank can provide the reserves in different ways, such as by purchasing bonds or by conducting system repurchase operations with investment dealers. In the case of either bond purchases or system repurchase agreements, additional system deposits might be created when the end seller (or lender) of the bonds is a non-bank. And that second order creation of deposits may be reservable as well. But what might appear to be a potentially infinite series of reserve injections is in fact highly controlled in the real world – because the reserve ratio is relatively small. Some countries such as Canada have no such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the nature of the money multiplier as an annoying analytical error and distraction from accurate comprehension of how banks actually work. But as a separate point, central bank injections of required reserves illustrate how not all deposits are necessarily created by commercial bank loans. ‘Loans create deposits’ is true, but not exclusive. This aspect is made clear also by the example of central bank ‘quantitative easing’, noted further below.

The Growth Dynamic

The ‘loans create deposits’ meme is best understood as a balance sheet growth dynamic, distinct from any reserve effect that might occur as part of an associated interbank clearing transaction at the time (e.g. the second example above) or as part of a deposit ratio requirement that might be activated at a later date. The banking system can be visualized in continuous time, punctuated by discrete banking transactions that are reflected as accounting entries. If one divides time into very small time intervals, individual banking transactions can be isolated as the only transactions that occur during a given interval of time. Thus, the growth dynamic of ‘loans create deposits’ can be conceived of as an instantaneous balance sheet expansion at the point of corresponding accounting entries. As noted in the examples above, this expansion may then migrate across individual banks when the lending and deposit issuing bank are different.

‘Deposits Fund Loans’

Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.

There is no inconsistency between the idea that ‘loans create deposits’ and the idea that banks need deposits to fund loans. Bank balance sheet management must respond to both growth dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types – including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the central bank is not a mere slush fund that provides unlimited funding to the banking system. In fact, active liability management is important in private sector banking – in the system we actually have. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists. Some analysts tend toward language that conflates factual and counterfactual cases in this regard. To repeat – bank liability management is very competitive in the system we have, by design. The ‘loans create deposits’ meme, while true, only touches on this competitive dynamic.

We note again that loans are not the sole source of deposit creation. A commercial bank’s purchase of securities from a non-bank will typically result in new deposit creation somewhere in the system. There are cases where deposit creation results from other liability or equity conversion – commercial bank debt redemption and stock buybacks are examples of this. Existing fixed term deposits can convert to demand deposits and vice versa. And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits. Nevertheless, ‘loans creates deposits’ is a reasonable reference point and standard for the process of deposit creation.

Bank Asset-Liability Management

The ‘loans create deposits’ dynamic comprises the production of much of the money that serves as a basic source of liquidity in a monetary economy. The originating accounting entries are simple – a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital – especially equity capital – to take risk – and to take credit risk in particular.

Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The ALM function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities.

The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity.

In examining all of these effects, it is helpful to consider the position of the banking system in its totality, in conjunction with the position of individual banks that constitute the whole. For example, the US commercial banking system is composed of thousands of individual banks. Between discrete ‘loans create deposits’ events, the banking system is in continuous balance sheet churn. Specifically, deposits are moving back and forth between individual banks, as a matter of normal payment system operations. They are also moving and inter-converting in the form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds economic activity of all sorts, where households, businesses, and governments are making payments to each other for various goods and services and other types of transactions, and are making choices about the portfolio structure of their liquid assets. This is the core liquidity provided by the banks to their customers. And this is the stuff that involves a good deal of transferring of reserves back and forth between banks, in order to affect accounting completion of balance sheets that are in continuous flux in size and composition.

Bank Reserve Management

The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets that are in balance, institution by institution – and where deposits fund loans, alongside various other asset-liability matching configurations. The reserve system records the effect of this balance sheet activity. The reserve account is the inverse exogenous money image of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset liability management coordination in order to match up assets and liabilities both in nominal terms and in a way that is financially effective. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis.

Conclusion

In summary, the original connection by which deposits are created by loans typically disappears at some point following deposit creation – at the micro bank level and/or the macro system level. The original demand deposits associated with specific loan creation become commingled as they move back and forth between different banks. And they not only move between banks, but they can change in form within any bank. They can be converted into term deposits or other funding forms such as bank debt or common and preferred stock. The task of dealing with this compositional flux falls under the joint coordination of bank asset-liability management and reserve management. The overarching point of observation is that both system growth and system competition for existing balance sheet composition are in constant operation. ‘Loans create deposits’ only describes the marginal growth dynamic at the inception of deposit creation. ‘Deposits fund loans’ is the more apt description that applies to a good portion of what constitutes ongoing balance sheet management in competitive banking.

On Using Technical Analysis

There’s been a broad discussion in recent weeks about the efficacy of technical analysis in investment strategy (see here & here).  I’ve touched on this briefly in the past (see here), but my position is rather simple and I think it’s a position most people should adopt, because, obviously, you should adopt my views of the world!  Just kidding of course.  You’re free to do with my thoughts as you wish and I am only here to provide one guy’s perspective and not pretend to offer some holy grail view of the world.

Anyhow, much of the confusion on this discussion starts with definitions. Technical analysis often gets a bad rap for being labelled as charting.  But they’re two different, but related things.  Charting is the use of chart reading in various ways to formulate strategies.  Technical analysis, on the other hand, is simply the use of past data to analyze future market direction.  Of course, a chart is merely a picture of past price action so charting is a subset of technical analysis, but does not comprise the universe of technical analysis – some of which can be extremely complex and sophisticated.

I find that understanding the past is an essential element in any good form of portfolio construction.  Perhaps you study the past to conclude that market timing is silly.  Or perhaps you study the past to conclude that buy and hold is silly.  But in the end, what most of us end up doing is essentially a branch of portfolio construction that begins with understanding past performance.  Of course, past performance is not indicative of future returns and while history rhymes, it rarely repeats perfectly.  So understanding past price performance and the history of price action is merely one building block in the development of a portfolio.  But that doesn’t mean it is a useless piece of the puzzle.  Whether you’re a trader or a buy and hold investor it’s useful to understand technical analysis and past price performance in order to better understand how one should go about attacking the future.

Of course, I am a very fundamentally driven analyst so I take the view that technical analysis is a good complement to good fundamental analysis, but to each his own.  In sum, keep an open mind.  There’s no holy grail to the world of portfolio construction and understanding and embedding many different approaches into your own will only make you a more well-rounded and informed investor/saver.

The Difference Between Central Banking and Market Manipulation

The kids are over on the internets using the Tweet machine to ask Ben Bernanke some questions.  There are also some adult questions mixed in there.  For instance, Jim Grant asks:

“Could you help me understand the difference between central banking and market manipulation?”

 Now, I’m no Ben Bernanke, but I would like to take a stab at this one.

First of all, it’s important to understand what central banking really is.  For instance, in the USA, the Fed system exists because rogue independent banking like we had in the 1800′s proved highly unstable.  In essence, payment processing was inefficient and extremely unstable during times of crisis.  The primary role of the Fed system is to bring payment clearing into one place.  We call this the “interbank” market in the USA.  It is where all the banks settle interbank payments.  They do so by being required to maintain deposits at the Fed.  You can think of it as being the best of all worlds between having a nationalized money system (like one national bank that clears ALL payments smoothly) and maintaining private competitive banking.   The Fed is a buffer of sorts.  It is neither a pure public entity nor a pure private entity.

But this system is a bit of an inconvenience for private banks who would really prefer not to have to engage in all of this “oversight” and central clearing to begin with.  In a perfect world they’d monopolize the money game and tell the government to take its ball and go home.  Obviously, that’s not what we have.  So we have a reserve system.  And to the banks who participate in this system it is, by mere existence, “excess”.  You can think of all reserve balances in this interbank market as being “excess” to private competitive banks.  So, they would prefer not to hold them.  This puts pressure on the overnight rate because the banking system will naturally try to rid itself of excesses.  So the Fed must make a choice.  Will it let the overnight rate drop to zero or will it support it in various ways?  Obviously, the Fed chooses to support the rate.  In other words, it manipulates the rate higher.

Things get a bit tricky here.  In addition to facilitating this essential clearing system, the central bank can manipulate the spread at which banks make a profit on their loans.  This can have a significant impact on profits generated by banks.  The problem is, this manipulation is far from an exact science.  And when you layer operations like QE on top of that we have to start worrying about market disequilibrium and potential unintended consequences of this intervention.  But yes, make no mistake, there is a clear distinction in the roles of the central bank.  Its most important role is as a facilitator to a smooth payment system.  Its secondary role is in influencing the price of inside money (bank money) in order to steer the economy.   The primary role is unquestionably positive.  The secondary role of what is definitely “manipulation” is up for debate.

Evaluating the Value of Active Management

The never ending debate about the merits of active investment management vs passive investment management rages on.   In a post this morning Josh Brown asked this important question:

“How do we determine the “value” of active management?”

I think there are two primary characteristics that define how valuable an active manager is.  The first is strategy value.  The second is alpha value.

Strategy value is a money manager’s ability to add value through unique portfolio composition.  The investment world is increasingly interconnected and blended by various approaches.  The product line that Wall Street has produced over the years has become increasingly diverse and makes the options for portfolio construction that much broader.  This is valuable in that we are then able to construct portfolios with varying correlations, risk levels and goals without having to be experts in specific individual security types or through having access to certain markets (which can be difficult in some cases).  Importantly, we are no longer boxed in by our portfolio options that force us to pick one asset class or one strategy.

Unfortunately, most active managers mimic or copy a large correlated index of some type.  There’s zero value add in this approach in most cases.  After taxes and fees a similarly correlated index will outperform these strategies because they’re essentially the summation of the index they’re copying.  By definition, they must underperform.

But there’s huge value in an approach that gives investors access to something that they can’t otherwise access through a broadly distributed index fund.   I used to use an event driven strategy when I ran my investment partnership.  I generated sizable risk adjusted returns with no negative full year returns during a 7 year period (in one of the most difficult environments in investment history).  If there had been an index that replicated my strategy I would have had a hard time outperforming it.  But there wasn’t (isn’t).  So my value add was through my approach.  I was giving my investors access to a unique strategy that helped them diversify their own portfolios through strategy value.

Of course, the strategy has to be valuable itself.  This is where alpha value comes in.   Alpha value is the ability of an active manager to generate high risk adjusted returns through their approach.  Most active managers can’t generate alpha because their approach is essentially some form of closet indexing.  In other words, large cap value funds don’t generate alpha because they tend to just copy the S&P 500.  Their risk adjusted returns are weak and even weaker after taxes and fees.  The average investor doesn’t even begin to study the importance of this when picking funds or managers.  And the managers don’t want you to understand it because they want you to think that their fund is better regardless of a fair apples to apples comparison.  How else could they justify the higher fee?

Of course, the key here is actually finding the active managers who can add value in one of these two ways over long periods of time.  Easier said than done, but they’re out there.

A Paradigm Shift: The Savings Portfolio

I really liked these quotes from Abnormal Returns which cite a blog post from The Zikomo Letter who riffs off my idea of the “savings portfolio”:

The second post at The Zikomo Letter makes a great point about the status of most of us investors, nee savers. The fact is that we aren’t traditional investors in the classic sense, we are in fact savers who should be focusing on generating real, risk-adjusted returns on our savings. The problem is that:

You are not an investor. You are, perhaps, an over-leveraged trader with unacknowledged cognitive biases and poor risk management.

That is okay however. There is much more to life than investing. The point being that we can generate “returns” much more easily on other important aspects of our lives than we ever can in the financial markets. There is a reason that professional money managers have a difficult time adding value over and above the fees they charge. The challenge for many is making this shift towards a more holistic view of their lives, finances included. TZL notes a simple nomenclature change can help:

You are not an investor, you are a saver. And that is good, because you are not very well positioned to be a successful investor, but you are well positioned to be a great saver.

This is so important.  I think this is a paradigm shift in the way people approach their portfolios.  The idea of investing is sold to people to give them the impression they’re actually doing something much sexier than what they probably should be doing.

Investing sounds sexy.  Who wants to save?  Saving is boring, slow, bleh.  But investing is awesome.  It’s high performance, sexy, you know, Warren Buffett does it!  It’s like buying a Ferrari.  It looks sexy, it goes fast and it’s expensive.  A Ferrari is the “investing” equivalent of a hedge fund.  The problem is, you’ve got your kids strapped in the back (maybe even in the trunk if you have a big family) and you probably have no idea whether the driver can actually control the vehicle (because you’re obviously not driving when you hire someone else to take care of your portfolio).

The reality is that you’re not investing in a secondary market.  You’re allocating your savings.  It’s not sexy.  It’s not fast, sleek and it shouldn’t be expensive.  It’s like driving a Honda Accord.  It’s not the Ferrari, but it will get you from point A to point B and it will do it much safer, far less expensively and best of all, you can operate it entirely on your own.  But the investment business doesn’t want you in a Honda Accord.  They want to sell you the Ferrari because, well, it’s more expensive.  9 times out of 10 you should probably leave the Ferrari in the garage and just take the Honda Accord….

The Disaggregation of Credit

Monetary Realism starts with the understanding that there are two forms of money in our monetary system.  The most important kind of money is the kind we all primarily use – credit money.  MR calls this “inside money” because it is created inside the private sector through banks.  Banks create this money by extending loans.  Loans create deposits.  The other type of money is “outside money”.  This includes cash, coins and bank reserves.  It is created outside the private sector by the government and serves as a facilitating feature to impact the use of inside money.  For more on this please see here.

The dominant form of money in our monetary system is inside money or credit.  Our entire monetary system is based on credit since the vast majority of transactions occur in this form of money.  As we like to say, inside money “rules the monetary roost”.  Most economists get this relationship entirely backwards and build some sort of government centric model for understanding the monetary system.  They generally start with the idea of the money multiplier which implies that the central bank has some sort of control over the supply of money when the reality is that the money multiplier is a complete myth and the central bank actually has far less control over the supply of money than most presume.  MR flips this all on its head and starts with understanding the banking system and the fact that the money supply is almost entirely privatized in nations like the USA.  In other words, the money supply is controlled by an oligopoly of private competitive entities who battle each other for the demand for money (loans).

But all money is not created equal.  The private competitive nature of this arrangement can be both extremely positive and extremely disruptive.   This is elaborated on in a concept that originates with German economist Richard Werner.  He calls it the “disaggregation of credit”.  I don’t have the time nor the space to do it justice here, but I will provide my brief analysis with a MR flavor since it complements our work so nicely.

The demand and issuance of credit can occur for many different economic transactions and purposes.   This can involve productive and unproductive uses.  A simple example of productive uses would be a corporation that maintains a line of credit with a bank in order to pay its expenses such as salaries, R&D or other investments.  As we like to say with MR, “investment is the backbone of private saving”.   This is the essential idea behind understanding our central equation S=I+(S-I).  But there are also unproductive uses of credit.  For instance, when loans are made to meet the growing demands of speculative real estate purchases you get environments like 2003-2007 where asset prices simply inflate due to the extension of credit for unproductive uses.   This is the essence behind the idea of a disaggregation of credit.  It is essential to understand that all credit is not created equal.  Money can be abused for the purposes of profit.  This is not remotely surprising in a capitalist monetary system like the USA.  But this is not an excuse for not understanding this concept.

While most of the economics profession is busy building government centric models that figure out various ways to blame the government (or give it credit) it’s equally important to understand how the private sector itself can be the cause of this economic disequilibrium.  Understanding the design of the modern monetary system and the concept of disaggregation of credit is central to this understanding.

Bad Inflation Bets and Why They Were Bad

Brad Delong rightly slams Austrian economist Robert Murphy this morning for a bet he made in 2009 regarding inflation.  Murphy stated that headline inflation would hit 10% by January 2013.  Well, here we are with 24 hours to go and the latest monthly CPI reading is 1.8%.  I don’t want to just pile on Murphy with personal attacks.  Instead, I think it’s constructive to understand why this prediction was wrong because it’s at the heart of an important economics and finance understanding.

If we jump in the Google time machine we can see what was said back in 2009 that was so wrong.  Murphy was working from the same premise that many economists work from.  He saw the Fed flooding the banking system with reserves and assumed that this would cause inflation.  He said:

“In order to keep those reserves from working their way back into the hands of the general public (where they can start pushing up prices), the Fed will have to raise the interest rate it pays to persuade the banks to keep the reserves parked at the Fed. But this simply postpones the day of reckoning, as the troublesome stockpile of excess reserves grows even faster.”

This is not correct and it displays a huge flaw in the model that Murphy is working with.  It’s worth noting that Delong and others are working under a model that actually isn’t that different (though their “liquidity trap” theory has stated that the Murphy model is temporarily broken).  Both models are wrong.

Monetary Realism starts from an understanding of modern banking.  We understand that the US monetary system is essentially privatized.  In other words, the money supply is controlled almost entirely by private banks whose ability to create loans creates deposits which are the primary form of money we all use.  The money supply expands and contracts (mostly expands) in an elastic form based on the public’s demand for loans.

The flaw in the Murphy model is that he assumed that reserves are somehow related to a banks ability to loan money.  He specifically shows the scary chart of M1 going parabolic and then states in clear terms that this money will work its way into the public.

This is really important so I am going to cover this point again.  There are two types of money in our monetary system.  Banks deposits (the money we all use) are inside money because it is created inside the private sector (controlled by an oligopoly of private banks).  Outside money facilitates inside money and exists in the form of cash, coins and bank reserves.  This money comes from outside the private sector.  It is supplied by the government to facilitate the use of inside money.  Cash, for instance, is issued by the US Treasury to allows member Fed banks to stock vaults for customers who wish to draw down their bank accounts for transactional convenience.  Coins serve a similar purpose.  See here for more.

Reserves are a bit different.  Reserves exist solely because of the Federal Reserve System.  And they serve two purposes – 1. helping banks settle interbank payments; 2. helping banks meet reserve requirements.  Bank reserves are just deposits held on reserve at Fed banks.  You can think of reserves as existing in their own market that is totally separate and inaccessible to the non-bank private sector.  In other words, reserves are the money banks use to do business with one another.

But more importantly, banks don’t lend their reserves.  Banks lend based on their solvency or capital constraint.  Reserves are merely an asset of the bank.  When the Fed implements monetary policy like QE they don’t change the capital position of the banks.  They swap a t-bond or MBS for a bank reserve.  This doesn’t change the net financial asset position of the private sector.  The bank literally has the same capital position it did before this policy was enacted.  So, the bank can’t create more inside money than it could have before.  And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system.  Anyone who understood this in 2009 (as many of us did) knew that Murphy was wrong because his understanding of the system was wrong.

So, as we’ve seen time and time again, misunderstanding modern banking and money has resulted in very bad predictions.  Unfortunately, I still don’t see many people agreeing on why Murphy and others were wrong.  That’s not progress.

 

The Biggest Problem with Modern Macro…

There’s been a lot of ink spilled in recent weeks over the problems (or lack thereof) in modern macroeconomics (see here and here).  I’ve expressed my opinion that the state of modern macro is moving in the right direction because there’s serious debate about the problems with the mainstream approaches which has resulted in the rise of competing ideas.  But any progress that’s been made shouldn’t completely overshadow the major problem at the heart of macroeconomics – political ideology.

If you study modern macro you inevitably end up studying some sort of policy.  Most economists don’t build their models around an understanding of the monetary system.  They build their understanding of the system to fit an ideology in a classic case of confirmation bias.  For instance, most Keynesians will fit their model of the way the system works to confirm some form of countercyclical government policy.  Market Monetarists fit their understanding of the monetary system to confirm NGDP Targeting.  Austrian economists fit their description of the monetary system to confirm a small government view.  Almost all of the major mainstream economic schools are attached to some specific policy agenda which is then confirmed by some politicized explanation of the monetary system.

The flaw in this approach is that it doesn’t actually result in any agreed upon understanding of the actual inner workings of the monetary system (like this).  So you have a bunch of economists who all essentially disagree on policy AND their understanding of the way the monetary system works.  Can you imagine if all of the surgeons in the world didn’t work from similar understandings of the way the human body functions and instead just experimented on the body with various hammers, scalpels and other fun toys?  Modern macro is not that far from that world where a bunch of PhDs just sit around hammering the body with their policy tool of choice screaming at one another about how their tool is better than another tool.  Obviously, that’s a silly approach.

I often talk about a Da Vinci approach to modern macro.  Leonardo Da Vinci was famous for his work in anatomy.  But Da Vinci didn’t take bodies apart so he could fix them.  He took them apart so he could understand them.  Da Vinci knew that you couldn’t even begin to fix a system until you understood it.  Curiously, modern macroeconomists still haven’t undergone this process of discovering an agreed upon understanding of the system.  There has been no Da Vinci approach in modern macro.  There are plenty of surgeons pretending to have the best tools.  But what we need is a Da Vinci (or group of Da Vincis).  Until then, the state of modern macro will remain fairly dismal.

Where Does “Cash” Come From?

There’s this obsession with physical money in life.  I don’t know where it comes from or why it persists, but it does.  I guess maybe it’s the sense of security of being able to feel something and hold it in your hands.  To many people a gold bar is pure money because you can pick it up, you can feel its density, and you can see how pretty it is.  Paper notes or cash are not quite as sexy.  But they’re still pretty cool.  Even a small child knows that a cash note is cool.  Give your kid a $1 bill and their eyes light up.  Give an Austrian economist a $1 bill and he’ll flick you off (and then he’ll go buy something without admitting that he loves using paper money).  You get the point.  Money is ultimately based on trust and being able to feel something tangible gives people a sense of security, I guess.

Anyhow, I don’t fully understand the obsession with money as a physical thing because money in a modern economy is almost never a physical thing.  It’s just a number in ledgers.  Technology and the evolution of banking is rendering physical money slowly, but surely extinct.  For instance, I bank online and I have for almost a decade.  I’ve never been inside my bank.  I don’t even know where it is.  I don’t deposit money in it.  I mean, I know there’s a physical address somewhere, but that doesn’t matter much to me.  All I know is that there are numbers in a computer system attached to my name and when I want to purchase goods and services I tell my bank to shift numbers from one account to someone else’s account.  On rare occasion I go to another bank’s ATM and withdraw physical cash.  After all, there are times in life when  a stack of 100 $1 bills are necessary….

But where does this cash come from?  And how does it relate to the money supply?  Our monetary system is designed around what Monetary Realism calls “inside money” (because it comes from inside the private sector).  That is, the most common form of money for every day transactional purposes exists in the form of bank deposits as numbers in a computer.  If you have an account at a bank you can withdraw cash for convenience purposes.  Cash is what MR refers to as a form of “outside money”.  That is, it comes from outside the private sector.    Wait, how does that work?

I’ll let the NY Fed explain this part of the process:

“Each of the 12 Federal Reserve Banks keeps an inventory of cash on hand to meet the needs of the depository institutions in its District. Extended custodial inventory sites in several continents promote the use of U.S. currency internationally, improve the collection of information on currency flows, and help local banks meet the public’s demand for U.S. currency. Additions to that supply come directly from the two divisions of the Treasury Department that produce the cash: the Bureau of Engraving and Printing, which prints currency, and the United States Mint, which makes coins. Most of the inventory consists of deposits by banks that had more cash than they needed to serve their customers and deposited the excess at the Fed to help meet their reserve requirements.

When a Federal Reserve Bank receives a cash deposit from a bank, it checks the individual notes to determine whether they are fit for future circulation. About one-third of the notes that the Fed receives are not fit, and the Fed destroys them. As shown in the table below, the life of a note varies according to its denomination. For example, a $1 bill, which gets the greatest use, remains in circulation an average of 21 months; a $100 bill lasts about 7.4 years.”

So you can see where the cash came from.  Cash is sold by the US Treasury to the Fed at cost and then distributed to the banking system.  It came from “outside” the private sector and exists to facilitate the use of inside money by allowing bank customers to draw upon their accounts.  In recent decades, the amount of currency or cash in circulation has actually increased in large part due to the convenience of the ATM.  But make no mistake.  Cash does not rule the monetary roost.  Cash is merely a convenient form of money for purchasing goods and services that facilitates the existence of inside money.