Money, Debt, Reserves, Money and Debt

[ADDENDUM (yes, here at the top!): This post contains factual errors which were pointed out to me by Sigi. Happily (in my eyes anyway) my error, when corrected, does not lead to a different conclusion. The voluminous comments to this post are therefore a very important part of it. And, no doubt, I shall be returning to this topic and MMT generally, in due course. 22.08.2011]

I had a wee exchange last week (I think) with rebeleconomist over at Naked Capitalism, who suggested I did not understand that banks have reserves backing their loans (or some such formulation of same). Rebeleconomist appears to support, or think sound, the current money creation system of FRB (fractional reserve banking). Today I had a look at Steve Keen’s “The Roving Cavaliers of Credit” again, wanting to brush up on the data of money creation upon seeing it referenced in Eisenstein’s “Sacred Economics”, so copy-and-pasted the article into a word document at work (naughty me) for leisurely perusal. As I reached the bottom of the web page I noticed , scrolling into view, a comment-exchange between Steve Keen and “Spike1606”, along the lines of ‘the amount of money in existence at worst only equals debt, but mostly exceeds it’. Steve Keen appeared to agree with this assessment (the chat happened early April this year) despite his article demonstrating the opposite. He also claimed not to be expert enough on the fine details of Central Banks and commercial banking generally. I was shocked. I still am. Naturally I ran straight to Wikipedia.

“Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often acting independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. There are several monetary policy tools available to a central bank to expand the money supply of a country: decreasing interest rates by fiat [encourage lending—Toby]; increasing the monetary base [government borrowing—Toby]; and decreasing reserve requirements [encourage lending—Toby]. All have the effect of expanding the money supply.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial assets, such as treasury bills, government bonds, or foreign currencies. Purchases of these assets result in currency [synonymous with “money” it seems—Toby] entering market circulation (while sales of these assets remove money from circulation).

Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency, the price of gold, or indices such as Consumer Price Index. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight. The other primary means of conducting monetary policy include: (i) Discount window lending (as lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics.” [My emphasis.]

The middle paragraph is key. Though brief and incomplete it wields the jargon of banking in precisely the manner which so confuses the layman (me included). What is money? All sorts of things, like M0, M1, M2 and so on? Sort of. Is it debt? Not according to orthodox economics. The money which is really really money is “high powered money” (see italicized sentence in quote below). Hence selling debt-instruments into the economy takes ‘money’ out of the economy in exchange for bonds, treasuries, etc. What would that ‘money’ otherwise be doing? Creating inflation, one assumes—in that it is (part of) commercial banks’ reserves which enable the extension of credit—hence the need to remove it from the economy. Is it exclusively high powered money which is removed from the economy when these sales occur? How could anyone know? High powered money is not marked to denote it as such, though I suppose its ‘initiating existence’ in particular accounts at commercial banks is a kind of marking. If these accounts were repositories only for transactions with the Federal Reserve, and if bonds and treasuries bought from the Fed could only be purchased with money out of these accounts, that might be a way of tying high powered money directly to such federal monetary operations. And yet even if things were that tight, such money, though “high powered”, was created as debt and is owed back to someone, somewhere.

So what is high powered money? Wiki again:

“In modern economies, relatively little of the money supply is in physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money. The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.

Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g. by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.” [My emphasis.]

(I suspect that 10% figure is quite deliberate, or dependent on whichever definition of money is required to produce it; everywhere else I see assertions of 3-5%. Perhaps it needs to be 10% because FRB requirements are, classically speaking, 10%. Neat, huh?)

So, “purchase of these assets” involves “high powered money”, which is money credited to accounts at commercial banks, money which can be notes and coins. Where does this money come from? Thin air in effect, but in terms of being ‘backed’, it originates from the Government—not from commercial banks—that is, it is backed by The People’s future labour. The CB ‘creates’ ‘new’ ‘money’ in exchange for acquiring and then selling on government debt (in the form of bonds, treasuries etc.). So this “high powered money” originates as debt. This “high powered money” is (part of) the “reserves” of commercial banks.

But what does that mean, "reserves"? In which accounts? Government accounts, business accounts, private accounts … bank accounts! So that money belongs to the various account holders, not to the bank, and yet it represents reserves, debts which are assets (or is that the other way around?). Furthermore, all high powered money is owed by the government to the central bank (or other owners of the initiating debt instrument) upon maturity of the debt (plus interest of course). Who owns the central bank? That is the topic of many books, but private interests it is, otherwise it is The People borrowing from themselves at interest. Which is weird. Even the British Central Bank, “purchased” by the Labour government shortly after the second world war, was paid for by borrowed money which came from unnamed entities. Do you think the British Government have paid that debt off? Austria’s central bank was recently nationalised. I wonder where the government got the money to buy it. Perhaps from the ECB. Who owns that? Smaller European central banks. And so on.

So “high powered money” originates as debt, becomes “reserves” which are monies owned by account holders and owed by the government to holders of the corresponding debt instruments, “reserves” which act as a base from which new money can be lent into existence in the commercial sphere by commercial banks. And loaned money can buy things, so always ends up in some seller's account and can be exchanged for notes and coins. I.e., commercial bank credit-money can be 'transformed' into high powered money. Throughout the system, the monies mingle with rampant abandon. Some of it might be in your pocket right now, or in your bank account. And, legally, you own it, owe it to nobody. And yet it is owed, by someone, somewhere.

(And this is only the conventional theory. “The Roving Cavaliers of Credit” demonstrates that it is actually commercial banks which initiate expansion of the money supply. The research the article cites shows how the central bank is forced, from time to time, to fill the holes in commercial bank balance sheets in order to keep the system going. (Also known as TBTF.))

In the end, money is either created as an explicit debt, or it is not. This is an inescapable binary. Whether we reference reserves or high powered money, treasuries, gilts, or notes and coins, we are denoting money created somehow. The differences are of liquidity, or ease of use in economic exchange. Money does not grow on trees (or does it?—are not economies as natural as trees, are trees ‘lazy?’), so, logically, must be created by something somehow. Is it owed back to its source (plus interest), or isn’t it? If, at every step of the way, ‘money’ is created as a debt, and furthermore as a debt bearing interest, then the amount of ‘money’ out there cannot be more than the debt owed. Money is always debt if it is created as debt. And because of interest, principal must be less than what is owed. P < P+I. Always. The only way to assert otherwise is to have jargon definitions of ‘money’ in its various forms, such that only “high powered money” is money, and the rest is somehow vapour, or “nets to zero”, or is ‘credit’ to be expunged, etc., and yet even with that concession, with reserve requirements at around 10% (allegedly), the claim that ‘money’ exceeds debt in the system seems untenable to me. Bank run, anyone?

Look at the third paragraph of the first quote, which informs us the Central Bank’s goal is control of short term interest rates (with an eye to inflation). The interest rate is like the gas flame under the economy’s pot. Control it, and you control the intensity at which the economy cooks. That’s the theory. What we see today after years of historically low interest rates (“cheap money”) and anemic to zero ‘growth,’ is that this theory is obviously insufficient. Japan is a case in point. The system ‘works’ when the economy can grow, but breaks down when it can’t. That’s happening now, with government repeatedly forced to borrow on behalf of us all. The explanation for this phenomenon is debt collapse in an economy at peak debt levels (including a slowly changing Zeitgeist), which equates to a collapse of the (effective) money supply, in an economy which is not growing, which means it can no longer borrow more money into existence. All that fresh “high powered money” out there finding no matching economic activity to make it ‘real,’ except in commodities, stocks and other stock market shenanigans, the rises of which we might see as deferred inflation. Apparently, all those jargon distinctions are of no real use. Label it as you will, money created as debt is debt.

What backs debt? Put another way; what backs money? Certainly not reserves or high powered money, since that originates as debt. Money does not back money (yes it does: “I promise to pay the bearer on demand the sum of five pounds”!), as gold does not back gold. Perhaps a thought-exercise would be helpful:

Imagine I create a trillion TDs (TobyDollars) at home for my family to become an economy at last. There it is, TD1tr. Sitting on the kitchen table, twinkling in the moonlight. What is it valuing? At first, absolutely nothing. I have to spend it into our wee economy for it to have any meaning. Before we Russells have economic activity between ourselves, the money has zero ‘value,’ or no utility. Maybe I start paying my daughters for smiles, and they pay me for hugs and play time together. (I won’t list what my wife and I might pay each other for. Too boring.) At first, a hug might cost TD100m, a smile TD10m, but as the number of things we do for one another ‘grows’ (tying each other’s shoe laces, pouring each other’s milk, buttering each other’s toast, massages, story telling, use of the piano, etc.), so the price per exchange falls in classic, market style.

What backs money is therefore economic activity, or buying and selling. So if we are to prevent inflation, when we create new money it needs to be met by some amount of new economic activity (new goods and services), as equal in ‘value’ to that money as possible. So, in an economy in which the money supply is forced to expand (P < P+I is an equation for a Ponzi or Pyramid Scheme), growth of economic activity backs money (or debt, the terms are synonymous). In an economy where money is created as debt, such that the created amount is destroyed upon final repayment, leaving only the interest behind in the hands of the lender, we have a screaming need for constantly increasing (on average) lending and borrowing. This is why recessions and depressions are Bad, and growth is Good. This is why economic activity is Good.

And even if money is not created as debt—as in my example above—the (household) economy becomes instantly ‘indebted’ or beholden to money as soon as it is there to be used—why else create it. Money is, in its broader systemic effects, a claim on and a systemic pressure to engage in economic activity, or price-based exchange (buying and selling). The economic principle of thrift we all know—living within one’s means—is in fact impossible to adhere to when money is designed in such a way as to demand growth, since, in time, this can only lead to humanity demanding too much energy from its environment, as well as asking it to process too much waste. And since growth appears to be forced upon us by social hierarchies such as nation-states and corporations (in their current forms), which, in deeper history was selected for as a consequence of attempting to control nature through farming, it is clear that we, as a species, still have a lot to learn about true economics, what we might call the ecology of economics. Right now there’s too much jargon and not enough sense.