In part 3 we begin to cover the lead role of the private sector in the economy and the importance of the private banking system. I use a simple car analogy to describe the system and elaborate on how the private banking system works. The myth of the money multiplier is also briefly touched upon.
If you missed parts 1 and 2 I recommend seeing here and here. If you want to read the entire paper with all 6 sections please see here. I hope you find this section helpful. As always, comments welcome.
Part III – The Lead Role of the Private Sector & “Inside Money”
Understanding The “Machine”
The monetary system is a machine. The metaphor of a car is useful to understand how all the pieces fit together. Monetary policy is akin to the brake and accelerator pads. When the central bank raises the Federal Funds Rate it does so typically to suppress inflationary pressures. When the Fed increases the Federal Funds Rate (i.e. the short-term interest rate on which monetary policy pivots) this raises borrowing costs across the spectrum of credit products thus putting a brake on economic activity. Vice versa when the Fed lowers the Federal Funds Rate, typically to counteract a swelling in the number of underemployed, this decreases borrowing costs across the spectrum of credit products (especially loans made on a shorter-term basis) thus accelerating economic activity. Monetary policy is mainly about manipulating short-term interest rates though there are other factors.
Fiscal policy is the gear stick. Economists often talk about aggregate supply and aggregate demand. The former is the total amount of final goods and services produced by an economy over a given time period. The latter is the total amount of final goods and services purchased by agents over a given time period. What we produce as a nation and the market prices at which goods and services are sold can be different; hence, the labels of aggregate supply and aggregate demand.
When the economy is booming during an upswing aggregate demand can exceed aggregate supply leading to inflationary pressures. When the economy is depressed during a downturn aggregate supply can exceed aggregate demand leading to disinflationary or even deflationary pressures. If the economy is suffering from a lack of aggregate demand the government sector can, through larger deficits (i.e. spending in excess of revenues), shift the economy up a gear (please note this can be done by reducing taxes OR increasing spending). In fact, as tax receipts and certain government outlays (e.g. unemployment benefits) both rise and fall in a countercyclical fashion, much of the federal government’s budget stance is beyond the control of policymakers and instead determined by the endogenous performance of the economy. This is known as automatic stabilizers. Things like unemployment benefits and other “automatic” forms of spending can rise without any new government action during a downturn.
As Michael Kalecki has famously noted, Government deficits (whether it be via lower taxes or increased spending) can also help sustain the revenues and profits of businesses enabling them to employ more people. You may have noticed the sharp rebound in corporate profits over the course of the post-financial crisis period. This was due, in large part, to government deficit spending; though as of 2012 it has failed to translate into a strong and sustainable recovery. I won’t dive into this in great detail, but the reason for this is rather simple as seen in the following equation derived from Kalecki’s work:
Proﬁts = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
Continuing on with the metaphor, government regulation can be annoying (bureaucratic red tape) but when not overdone it is like the safety features built into modern cars (e.g. seatbelts, airbags, etc.) with the purpose to keep economic activities within acceptable boundaries, but without constraining the vehicle from moving. In some respects the government sector is like a “safety net” there to correct and curb market failures (though admittedly, it can also exacerbate problems if misunderstood). Hyman Minsky has noted that capitalist economies are periodically prone to what he called “endogenous” financial instability by which he meant that the “normal” workings of the market system can generate financial excess. He advised on the need to update regulation in view of new developments and for policymakers and theorists alike to humbly acknowledge the possibility that what worked in the past may no longer do so. Minsky was overlooked. I believe that humans are inherently fallible and inherently irrational. Since economies are the summation of the decisions of these irrational actors it is not surprising that the economy has a tendency to veer in the direction of extremes at times. As Minksy famously noted, “stability breeds instability” as economic agents becoming increasingly comfortable and complacent during the boom phase of the business cycle inevitably leading to excess and bust.
Everything else in the car is the private sector. The nonfinancial business sector is the engine, the chassis, the wheels and the seats (what we might think of as the “core” pieces of the car). Nonfinancial businesses are the biggest employers and make most of the products and services essential to increasing living standards. The household sector is the driver and any passengers in the car. As employers, employees, investors and consumers we determine the overall direction of the economic system. The financial sector provides the lubricants in the car (e.g. the oil, coolant, etc). The main role of finance is to facilitate the development of the productive capital assets of the economy and to provide the monetary and financial resources that allow us to undertake activities of our own liking (e.g. buy or build homes). The fuel in the car that motors the economic system is the drive to earn a living, make a profit and save for the future.
Private Bank “Inside Money”
The US monetary system is designed to cater for the creation of the public’s money supply primarily by private banks. Most modern money takes the form of bank deposits and most market exchanges involving private agents are transacted in private bank money: it is “inside money“ which rules the roost so to speak in the day-to-day functioning of modern fiat monetary systems. The role of the public sector “outside money” creation is comparatively minor.
Like the government, banks are also money issuers, but not issuers of net financial assets. That is, banking transactions always involve the creation of an asset and a liability. Banks create loans independent of government constraint (outside of the regulatory framework). As we will explain below, banks make loans independent of their reserve position with the government. So the textbook money multiplier model where banks lend deposits is in fact wrong.
The monetary system in the USA is designed specifically around a competitive private banking system. It is not a public/private partnership serving public purpose as the Federal Reserve essentially is. The banking system in the USA is a privately owned component of the system run for private profit. This was designed intentionally in order to disperse the power of money creation away from a centralized government and into the hands of non-government entities. Because the Fed finds itself as an agent of the US government working its policies primarily through these private entities it is often the center of much controversy. This will at times appear like a conflict of interest as the Federal Reserve, an agent of the government, is often seen as being in collusion with the banks and at odds with the achievement of public purpose. The government’s relationship with the private banking system is more a support mechanism than anything else. In this regard, I like to think of the government as being a facilitator in helping sustain a viable credit based money system although the banks as private profit seeking entities sometimes find their motives at odds with the overall goal of public purpose.
The Myth of the Money Multiplier
It’s important to understand that banks are unconstrained by the government (outside of the regulatory framework) in terms of how they create credit. When we go through business school we are taught that banks obtain deposits and then leverage those deposits up by 10X or so. This is why we call the modern banking system a “Fractional Reserve Banking” system. Banks supposedly lend a portion of their “reserves”. There’s just one problem here. Banks are never reserve constrained! Banks are always capital constrained. This can best be seen in countries such as Canada where there are no reserve requirements.8 Reserves are used for only two purposes – to settle payments in the overnight market and to meet the Fed’s reserve requirements. Aside from this, reserves have very little impact on the day-to-day lending operations of banks in the USA. This was recently confirmed in a Fed paper:
“Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected.”9
This is very important to understand because many have assumed that various Fed policies in recent years would be inflationary or even hyperinflationary. But all the Fed has been doing is adding reserves to the banking system in exchange for (mostly) government bonds. Because banks are not reserve constrained, i.e, they don’t lend their reserves or multiply their reserves, this doesn’t necessarily lead to more lending and will not result in the private sector being able to access more capital. Because banks are not reserve constrained it can only mean one thing – banks lend when creditworthy customers have demand for loans. Loans create deposits, not vice versa. Banks create new loans independent of their reserve position and the Federal Reserve is in the business of altering the composition of outstanding financial assets in an effort to maintain a target interest rate and maintaining the smoothly operating payments system that it oversees. In the loan creation process, banks will make loans first (resulting in new deposits) and will find necessary reserves after the fact (either in the overnight market or via the Fed).
So, contrary to what we are all taught in school, loans actually create deposits and not the other way around, as the money multiplier would have us all believe. When a bank makes a loan it debits the Loans Receivable account on its books. To balance this transaction it will create a new liability in the name of the borrower. This loan will create a deposit somewhere else in the banking system (possibly at the same bank) that will cause this new bank to also account for its new liability (the deposit) and change in reserves at the Fed. Scott Fullwiler elaborates on this confusing point (see here for more on this from Fullwiler):
“The bank does not “use” cash to make a loan. The loan creates a deposit. If cash is withdrawn by the borrower this reduces its deposits. So, the cash is “used” in the process of settling a borrower’s withdrawal. This is the key point that confuses so many–banks don’t “use” cash or reserves to make loans since those are merely bookkeeping entries. They need cash or reserves to settle withdrawals that arise from creating the loan/deposit.”
It is important to note though that the banks wield enormous control over the money supply through the powers granted to them via the government. The modern banking system is fragmented in such a way so as to disperse the power of money creation across both the private and public sectors. This is consistent with our form of government that is structured in such a way so as to avoid providing any branch of government with unchecked powers. So while the banks wield enormous power over the money supply it is incredibly important that the check on the banking sector be enforced via regulation, but also that the government’s power over money be regulated by the people.