Whether due to its absence from school curriculums, a lack-of-interest from media outlets, a misunderstanding on the part of the financial community, or merely due to its elusive nature, a base understanding of the monetary system is shockingly absent in broad society, even though its presence can be keen and biting… similar to that slowly creeping ache, when one can not identify its origin.
The caustic nature of monetary policy has already been discussed in Income Stagnation, The Orchestration of Debt-Based Expansions, Current Textbooks Are Not Equipped to Deal with Our Economic World, The Questionable State—and Abusive Use—of Economics, and Financialization & the Erosion of Growth;
but its process has only been mentioned briefly in Economic Constraints and Policy Options and The Fractional-Reserve Banking System and Currency Creation / Why Some People Like Gold, and so requires further explanation.
Monetary System: The Creation & Circulation of Currency — Monetary Base, M2 Money Supply, and Velocity of Money
The mere reference to these terms are often enough to prompt the closing of a book or webpage, or the silencing of a radio or television program; but they’re not nearly as obscure and incomprehensible as they may seem. A visual representation may be the most striking way to view “invisible” money.
Following 25+ years of progressively more severe interest rate reductions, the Fed funds rate reached the near-zero mark in 2008 (see Why doesn’t anyone earn anything in a bank account anymore?) and has remained below 1/2% since then. As the Fed’s most effective policy tool (influence over short-term interest rates via the Fed funds rate) could no longer be used to temporarily boost growth (Fed funds rate was already near zero), alternate — more experimental — policies were pursued to attempt to boost growth, including an expansion of the monetary base by more than three trillion dollars.
When looking at the above chart, an obvious question arises: Where did all of this money come from?
The response: Debt was created; currency and debt are created at the same time, and when debt is extinguished so too is currency. The debt that was created is held by the Fed, and the currency that was created is held by banks, either directly at the Fed or as vault cash (directly at the bank). The monetary base (shown above) details the more-than-three-trillion-dollars supplied to the banking system since 2008.
M2 Money Supply
The monetary base may then be lent out by banks to create more debt and currency. As the M2 money supply (orange line above) includes both the monetary base and the currency created by the banking system from loans, one can see that the bulk of the debt and currency in the economy are the result of loans created in the banking system, not from the expansion of the monetary base.
Velocity of Money
The velocity of money then measures the circulation of the money supply; it measures the rate at which money is exchanged in an economy, and it has implications for economic growth via the equation of exchange (Velocity*Money Supply=GDP). If there are more frequent transactions (purchases, sales, etc.), money moves between individuals more frequently, and velocity moves up; if there are less frequent transactions velocity falls.
A common misinterpretation may occur when viewing the money creation process and it may go something like this: “Since the Fed can affect the monetary base, it can affect the M2 money supply and the velocity of money“.
However, the above misconception requires a correction, the Fed can not control the M2 money supply or the velocity of money, as the Fed can not create aggregate demand.
- The Fed can not control the M2 money supply: While it can boost the monetary base, creating currency held by banks, the currency created may or may not be loaned out. As discussed, the M2 money supply’s more significant influence comes from loans in the banking system — the aggregate decisions of banks and borrowers (i.e. Do they want to lend/borrow?). As the Fed can not force people to borrow from banks, they can only create the potential for loans to take place — a pool of currency is created that remains “invisible” to the majority of the population unless it is loaned out, which may or may not happen; the decisions of banks and borrowers ultimately determine whether the money supply is loaned out.
- The Fed can not control the velocity of money: If the M2 money supply expands, the velocity would need to remain stable for GDP to rise in proportion (Velocity*Money Supply=GDP); however, velocity is not stable — it’s affected by innovation and it’s very significantly affected by the productiveness of debt.
Productiveness of Debt
As discussed, when a debt is created, currency is simultaneously created in the banking system (the borrower receives currency, the lender holds the debt certificate); but it’s the quality of that loan that can change the velocity of money.
If the loan is productive (i.e. creates an income stream to repay the principal amount borrowed and the interest on the debt) then velocity will rise, as GDP rises by more than the original amount borrowed; if the debt is unproductive — or counterproductive(debt detracts from future income) — there is not an income stream generated by the debt, and velocity falls as GDP does not rise by more than the original amount borrowed.
It is then that one can see that debt used only for consumption, or to pay interest, or that is defaulted on, is unproductive/counterproductive and leads to a fall in the velocity of money.
Monetary Policy Inefficacy
To solidify the understanding that central banks can not control money, velocity, or real long-term interest rates, there are several striking points to make – more specifically, those that highlight the inefficacy and dangerous nature of existing monetary policy:
1. The dramatic expansion of the monetary base has not significantly affected the growth of the money supply;
instead the currency remains “invisible” to the majority of the population (i.e. excess reserves), as the currency is not making its way out of banks in the form of loans (discussed in Current Textbooks Are Not Equipped to Deal with Our Economic World)…
…and this unresponsiveness can also be seen in the money multiplier, which shows the conversion of monetary base into money supply. The money multiplier trended down during the massive monetary base expansion, showing some of the lowest readings in 100 years.
2. The velocity of money also continued to fall throughout the monetary base expansion, and it’s at its lowest level in about 70 years — a direct result of excessive debt levels (high unproductive/counterproductive debt). One can see the correlation of debt-to-velocity in the article entitled Debt Levels; higher debt levels(that include large amounts of unproductive/counterproductive debt) correspond to a lower velocity of money. One can see the restrictive nature that unproductive debt and falling velocity have on economic growth by revisiting the equation of exchange (velocity*money supply=GDP); a fall in the velocity of money negatively affects the economic growth of a country.
3. Although the majority-in-the-economy doesn’t directly see the billions of dollars created, the dangerous nature of the creation-of-“invisible”-money (excess reserves) is that its affects are felt indirectly. The excess reserves created have the potential to fund speculative activity; when faced with near-zero interest rates, it’s not surprising if banks move assets from the low-return commercial banking side to their proprietary trading desks to pursue leveraged asset speculation. If the trade-off from low-risk/guaranteed-low-return to high-risk/potential-for-return takes place, it may actually deprive the economy of potential funds while banks temporarily improve earnings through risk-taking — a point made by Robert Hall at the Jackson Hole Monetary Conference in 2013: “An expansion of reserves contracts the economy.” After reading Financialization & the Erosion of Growth it may become clear that excessive risk-taking has already occurred; it should be noted that this misallocation-of-capital worsens the already significant income and wealth divide, and creates excess capacity, resulting in more disinflationary pressure — i.e. a short-term boost to risk assets occurs at the expense of the broad economy.