Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 23rd August 2009.

Recent arguments between deflationists (those who are forecasting deflation) and inflationists (those who are forecasting inflation) often boil down to opposing views about what will happen to the huge quantity of reserves that the Fed has supplied to the US banking industry over the past year. The inflationists claim that these reserves will, in the not-too-distant future, support a massive increase in the money supply via the famous "money multiplier" (for every additional dollar of reserves, the banking industry can supposedly create an additional 10 dollars of deposits). The deflationists, on the other hand, claim that this won't happen because the banking industry's collective balance sheet is now so grossly impaired that there will be no meaningful expansion in the total volume of bank lending for a long time to come. And in any case (according to the deflationists), even if the banks did want to lend there is now a dearth of credit-worthy borrowers to lend to. There is also a third group, that we'll call the 'just-rightists', who believe that the Fed has done a wonderful job of staving off deflation, and will, at the appropriate time in the future, remove the excess bank reserves before an inflation problem arises.

Our view, which will undoubtedly be considered sacrilegious in some quarters, is that the level of reserves within the banking system is not central to the inflation/deflation issue. We will explain why in a moment, but first we'll present charts that clearly illustrate the lack of any relationship between bank reserves and monetary inflation.

The first of the following charts shows the upward trend in True Money Supply (TMS) between January of 1990 and August of 2008. Specifically, it shows that TMS rose from $1,725B in Jan-1990 to $5,444B in Aug-2008 -- a percentage gain of 215% over the period in question. The second chart shows that the total quantity of bank reserves FELL from $63B to $45B over the same period. Taken together, the charts show that a 215% rise in total money supply was accompanied by a 28% decline in bank reserves. (By the way, TMS does not include bank reserves. It comprises currency in circulation plus demand deposits plus savings deposits).

The main reason that the money supply could grow to such an extent in the face of declining reserves is that US regulatory changes implemented during the early 1990s effectively removed the requirement for banks to hold reserves (they must hold reserves for "demand deposits", but through the process known as "sweeping" they are able to get around this requirement). To put it another way, any amount of bank reserves can now support any amount of bank deposits. This, in a nutshell, is why it makes no sense to agonise over what will happen to today's unusually large quantity of bank reserves as if the inflation/deflation issue hinged on the result. It is also why, in TSI commentaries over the years, we have only ever mentioned the "money multiplier" taught in economics courses to point out that it no longer exists in any meaningful way.

Given the above, why do so many analysts believe that bank reserves determine total money supply via a 10:1 (or some other) "money multiplier"? The answer, we guess, is that this was the way the monetary world worked once upon a time. The rules have changed, but old habits -- like assuming that the Fed prompts an increase in the economy-wide supply of money by boosting bank reserves -- die hard. The Fed does exert considerable influence over the money supply, but it does so by distorting interest rates and by simply being there (the Fed's existence enables the private banks and the government to do things they would not otherwise dare to do or be able to do).

With regard to the inflation/deflation issue, we think the smart deflationists (those who define deflation in terms of money supply, not prices) are right about most things. In particular, they are probably right that the banking industry won't contribute significantly to growth in the economy-wide supplies of money and credit over the years ahead, almost regardless of what happens to bank reserves. However, we think their overarching conclusion is wrong.

They are wrong, in our opinion, because they are failing to account for the fact that during prolonged periods of economic weakness the primary engine of inflation will be the government, not the banking establishment. The government, using the tool known as the central bank, can borrow a virtually unlimited* amount of new money into existence. For its part, the central bank can help things along through not only monetising (buying with money created out of nothing) whatever amount of government debt is not absorbed by other investors, but also through lending new money directly into the economy.

The past year has yielded solid evidence in support of our view that the inflationary efforts of the government will overwhelm the deflationary effects of private sector de-leveraging. For example, US bank lending has been stagnant since August of last year, and yet the economy-wide supply of credit has continued to expand and TMS is up by around 13%. The inflation is being driven primarily by a dramatic increase in government borrowing and secondarily by the Fed's** implementation of programs that bypass the commercial banks and inject new money directly into the economy.

In conclusion, while there is certainly a risk that the banking system's massive infusion of reserves will eventually contribute to the overall inflation problem, our inflation forecast in no way depends on such an eventuality. Over the past decade we have consistently maintained that if/when private banks and private borrowers became unwilling or unable to expand their respective balance sheets and debt burdens, the government would take control and borrow into existence whatever amount of new money was needed to perpetuate the inflation. There is no good reason for us to step away from this forecast now because the evidence of the past year strongly supports it.

*The bond and currency markets impose the only practical limitation, in that monetary inflation will become counterproductive (from the government's perspective) once bond yields begin to rocket upward and/or the currency's foreign exchange value begins to tank. As long as the bond and currency markets remain cooperative, the government will effectively have carte blanche on the monetary inflation front.

**Like the balance sheets of the private banks, the Fed's balance sheet is grossly impaired. However, although the Fed's shareholders are private banks (every bank operating within the US technically has an ownership stake in the Fed), the Fed does not operate under the same constraints as the private banks. If there was ever any doubt about this it should have been removed over the past year by the Fed's demonstrable willingness to obliterate its own balance sheet for the sake of adding money and credit to the economy. In effect, the Fed operates in similar fashion to a branch of the federal government. When a branch of the federal government gets into trouble it is often allocated more resources and more power.

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