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Money Matters

The following is excerpted from a commentary originally posted at www.speculative-investor.com on 21st April 2013.


There's a lot of confusion about money and about what does and does not form part of the money supply. Our goal in this short discussion is to reduce the confusion.

We were prompted to revisit this issue in today's report by the first few paragraphs of John Hussman's15th April missive. Although there aren't any glaring errors in Hussman's money-supply comments, they add to the confusion by failing to properly distinguish between bank reserves, electronic money ("bits and bytes") in bank checking and savings accounts, and physical currency (notes and coins) in circulation. For the purposes of this discussion we'll refer to electronic money in bank accounts as deposit currency.

The first point to be understood is that in the US economy only about 10% of the economy-wide money supply, as determined by the True Money Supply (TMS) calculation, is in the form of physical notes and coins. The rest is deposit currency. Consequently, if percentages remained the same then there would usually be about 9 dollars of deposit currency added to the money supply for every new dollar of physical currency. For example, with the amount of physical currency in circulation having increased by $320B dollars since the Fed commenced its "quantitative easing" in September of 2008, it would be normal for the amount of deposit currency to have increased by about $2.9T over the same period to give a total TMS gain of about $3.2T. We calculate that TMS actually increased by $3.7T over the period in question, which is in the right ballpark and close to what we would expect considering that the public's need for physical currency would not have kept pace with the Fed's electronic printing press.

The second point to be understood is that bank reserves should not be counted in the money supply (they are not available to be spent within the economy) and are therefore not included in the TMS calculation. (Note: bank reserves are also not included in the M1, M2, M3 and MZM calculations). An implication is that the "bits and bytes" held in the accounts of bank customers (which do count in the money supply) are different to the "bits and bytes" held in reserve by the commercial banks. It's important not to confuse the two.

The third point to be understood is that when the Fed monetises assets under its "QE" programs it does not only add to bank reserves; it adds to bank reserves AND deposit currency in equal dollar amounts. For example, when a Primary Dealer sells $100M of bonds to the Fed, the Fed adds $100M to the bank account of the Dealer and $100M to the reserves of the Dealer's bank.

The fourth point to understand is that the inflationary effect of a dollar added to deposit currency is the same as the inflationary effect of a dollar added to physical currency. In fact, deposit currency is subject to conversion on demand to physical currency. There is presently a lot more deposit currency than physical currency in existence, but the Fed stands ready to make up any difference between the amount of physical currency held by the banks and the amount of physical currency demanded by bank customers.

Above are the main points we wanted to make/reiterate, but here are some additional points to bear in mind:

a) Money Market Funds (MMFs) are not money, they are investments in income-paying securities.

b) Time deposits are not money, they are loans to banks.

c) It could be argued that savings deposits are not money for the same reason that time deposits are not money, but the critical difference between these two types of deposit is that money in a savings account is available on demand at par whereas putting money into a time deposit involves giving up the ability to use that money for a certain period. Savings deposits are therefore counted in the money supply.

d) The money supply cannot be affected by money going into or coming out of the stock or bond markets, because money never goes into or comes out of any market. For every transaction there is always a buyer and a seller, so asset purchases involve transfers between bank accounts as opposed to money going into or coming out of an asset. Another way to say this is that cash levels on an economy-wide basis cannot shrink or expand as a result of rising or falling asset prices.

e) All the cash in the economy must always be held by someone, so an increase in the amount of cash being held does not reflect an increase in the general desire to hold cash. It simply reflects an increase in the money supply. For example, if 1 trillion dollars is added to the US money supply over the next 12 months, then the sum of all cash holdings in the US will have to increase by 1 trillion dollars over the next 12 months regardless of whether the average person/corporation wants to hold more cash. For another example, much has been made of the increase in cash on the balance sheets of US corporations, but the fact is that someone has to hold all the additional cash that has been created. If not the corporations, then the general public.

f) In modern, developed economies such as that of the US, the money supply can only increase via central bank asset monetisation and/or the expansion of commercial bank credit, and the money supply can only decrease via central bank asset sales and/or the contraction of commercial bank credit and/or deposits being wiped out due to banks going bust.

g) Although uninsured deposit currency could be wiped out when a bank goes bust, in the US this usually won't happen for two reasons. First, the sum of the equity and debt of the large US banks is, on average, about 30% of total assets, which means that the banks would have to suffer declines in assets of at least 30% before uninsured depositors would start to become vulnerable. Second, the Fed appears to be willing to underwrite everything using its ability to create an unlimited amount of new money.


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