Increasing "Excess Reserves"
The demise of
fiat-money regimes around the world has become unmistakable. They can only be
kept alive by central banks creating ever greater amounts of base money and
governments underwriting commercial banks' liabilities.
The US Federal
Reserve, for instance, increased the stock of the monetary base — which
includes banks' demand deposits held with the Fed, plus coins and notes in
circulation — from $870.9 billion in August 2008 to $1735.3 billion in
January 2009.
Banks'
"excess reserves" — banks' base-money holdings minus required
reserves — rose from $1.9 billion to $798.2 billion. These excess
reserves allow the banking sector, which operates under fractional reserves,
to increase the credit and money supply manifold.
The monetary base
expands when the central bank takes over the troubled assets of commercial
banks in order to extend new credit to those banks. This process is gaining
momentum: on March 18, 2009, the Federal Open Market Committee (FOMC)
announced that it will increase base money by purchasing another $1,150
billion of securities. It is also considering increasing base money by
extending credit to private households and small businesses.
Causing
Inflation
What the Fed does
is produce inflation — and this is a truth
that stands in sharp contrast to what mainstream economists say, namely that
the rise in base money will just increase the liquidity in the interbank market and
will not affect the money holdings in the hands of consumers, firms, and the
government, which — they admit — could then inflate consumer
prices.
In contrast,
Austrian economists stress that inflation
is a result of a rise in the stock of money. This viewpoint rests on sound
economics, firmly rooted in the notion that, first and foremost, value is a
subjective concept. Money is a good, like any other, and it is therefore
subject to the law of
diminishing marginal utility.
A rise in the
money stock necessarily reduces the marginal utility of a money unit —
and therefore its value — from the viewpoint of the individual;
likewise, the marginal utility of a money unit — and therefore its
value — would increase if the money stock declines.
Changes in the
value individuals assign to a money unit are reflected in prices for vendible
items. For instance, if the money stock in the hands of an individual rises,
he may wish to increase his holdings of other goods. As he exchanges money
against vendible items, the prices of the latter are bid up.
In that sense,
the change in the money stock is what must be called inflation, while changes
in the prices for goods and services are just symptoms of the underlying cause, which
is the change in the stock of money.
What the rise in
base money has done so far is prevent prices of banks' security holdings to
decline to free-market levels. In other words, the money injection helps to
keep asset prices at artificially elevated levels, thereby preventing prices
in financial markets, credit markets in particular, from adjusting.
The Path
Toward Ever-Higher Inflation
The government
controlled fiat-money regime is highly inflationary, as it allows for an
increase in the stock of money mostly through bank credit in excess of real
savings (circulation
credit). The rising money stock pushes up prices — be it
consumer or asset prices (such as stocks, housing, etc.).
Expanding the
money stock through circulation credit sets into motion an illusionary boom,
leading to malinvestment.
However, the latter does not come to the surface as long as the credit and
money supply keeps growing.
If money supply
growth slows down all of a sudden, however, investor expectations are
disappointed, and investment projects, which were — in a world of ever
more money and rising prices — considered economically viable, become
unprofitable.
The slowing down
of money growth reveals that the production structure does not comply with
actual demand, thereby unmasking the squandering of scarce resources. And so
the artificial boom, induced by new money injections, turns into bust.
A policy of
holding up the artificial boom would require ever-greater increases in money. Ludwig
von Mises saw that this would lead to disaster:
There is no means
of avoiding the final collapse of a boom brought about by credit expansion.
The alternative is only whether the crisis should come sooner as the result
of a voluntary abandonment of further credit expansion, or later as a final
and total catastrophe of the currency system involved.[1]
Schemes
for Producing Inflation
In an attempt to
keep credit and money supply from slowing down and the economies from going
into recession, monetary policies around the world are about to push
short-term interest rates towards zero and expand the stock of base money,
and thereby banks' excess reserves, drastically.
Commercial banks
can be expected to put their excess reserves to use, because base-money
balances do not yield any interest: banks need to generate income to be in a
position to pay interest on their liabilities (demand, time and savings
deposits, and debentures).
Extending loans
is one option. However, in an economic environment of financially
overstretched borrowers, banks might be hesitant to increase their loan
exposure vis-à-vis households and firms. In fact, it might be
increasingly difficult for banks to do so given that equity capital has
become increasingly scarce and costly.
So commercial
banks may wish to monetize government debt, as the latter does not require
putting equity capital to use. The government then spends the
additionally created money stock on politically expedient projects
(unemployment benefits, infrastructure, defense, etc.), and the money stock
in the hands of households and firms rises.
If, however,
commercial banks decide to refrain from additional lending, and even call in
loans falling due, the government may decide — as another drastic, but
logically consequential step of interventionism — to nationalize the
banking industry (or at least a great part of it). By doing so, it can make
the banks increase the credit and money supply.
Alternatively,
the central bank could print additional money, distributing it to households
and firms as a transfer payment.[2] Under a fiat-money regime, this can be done at any
time and without limit, as Federal Reserve Chairman Ben S. Bernanke made
unmistakably clear in a notorious speech in 2002:
[T]he U.S.
government has a technology, called a printing press (or, today, its
electronic equivalent), that allows it to produce as many U.S. dollars as it
wishes at essentially no cost. By increasing the number of U.S. dollars in
circulation, or even by credibly threatening to do so, the U.S. government
can also reduce the value of a dollar in terms of goods and services, which
is equivalent to raising the prices in dollars of those goods and services.
We conclude that, under a paper-money system, a determined government can
always generate higher spending and hence positive inflation.[3]
The Way Toward
Hyperinflation
Government-controlled
fiat money is fraudulent money. It is money that is created out of thin air,
in violation of property rights: fiat-money production doesn't require any of
the wealth-producing activities characteristic of the free market. It is and
will always be, by construction, fraudulent money.
What is more,
fiat money created through bank credit expansion necessarily causes
boom-and-bust cycles, inducing governments to push back free-market forces to
prop up the economy and keep the fiat-money regime afloat; in fact, fiat
money will increasingly undermine the free-market order.
Mises was well
aware of the final consequences of a monetary regime that rests on
ever-greater increases in the money stock produced by banks' expanding circulation credit. It
would, at some point, lead to bankruptcies on the grandest scale, resulting
in a contraction of the credit and money supply (deflation).
Or it would end
in hyperinflation:
But if once
public opinion is convinced that the increase in the quantity of money will
continue and never come to an end, and that consequently the prices of all
commodities and services will not cease to rise, everybody becomes eager to
buy as much as possible and to restrict his cash holding to a minimum size. For
under these circumstances the regular costs incurred by holding cash are
increased by the losses caused by the progressive fall in purchasing power.
The advantages of holding cash must be paid for by sacrifices which are
deemed unreasonably burdensome. This phenomenon was, in the great European
inflations of the 'twenties, called flight into real goods (Flucht in die Sachwerte)
or crack-up boom (Katastrophenhausse).[4]
Mises knew very
well what he was referring to. He had lived through the period of great
inflation that started in Europe in 1914 with World War I. This finally led
to hyperinflation
and a complete destruction of Germany's Reichsmark in 1923. On a technical
level, Germany's hyperinflation was the result of the German Reichsbank
monetizing the growing government debt, issued for financing social benefits,
subsidies, and reparation payments.
In Age of Inflation
(1979), reviewing Germany's hyperinflation from a political-economic
viewpoint, Hans F. Sennholz asked, "Who would inflict on a great nation
such evil which had ominous economic, social, and political ramifications not
only for Germany but for the whole world?"[5] His sobering answer was that
[e]very mark was
printed by Germans and issued by a central bank that was governed by Germans
under a government that was purely German. It was German political parties,
such as the Socialists, the Catholic Centre Party, and the Democrats, forming
various coalition governments that were solely responsible for the policies
they conducted. Of course, admission of responsibility for any calamity
cannot be expected from any political party.[6]
That said, the
German hyperinflation was the result of a policy that considered the
financing of government debt by an accelerating increase in the money stock
as the politically least unfavorable method. It seems that the state of
opinion hasn't actually changed much. Today, there is great public support
when it comes to expanding the base-money stock for financing ailing banks,
insurance companies and, most important, rising government debt.
"The
doctrines and theories that led to the German monetary destruction have since
then caused destruction in many other countries. In fact, they may be at work
right now all over the western world."[7] Austrian economics would rightly maintain that
current fiat-money polices have become increasingly inflationary — and
they should have little doubt that the forces and instruments that can pave
the way towards hyperinflation are already in place and gaining strength by
the day .
The solution to a
destruction of the currency is the return to sound money — free-market money
— as outlined by Mises and further developed by Murray N. Rothbard. It
would presumably, at least in the initial stage, result in gold-backed money
under 100% reserves. The edging up of the gold price seems to support the
view that people consider gold as the ultimate
means of payment — a status that will become increasingly
obvious once people fear that the exchange value of fiat money will be eroded
substantially.
Thorsten Polleit
Thorsten Polleit is Honorary Professor at the Frankfurt School
of Finance & Management.
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