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In today's fiat-money world, money
is mostly produced through bank lending. Whenever a commercial bank provides
credit to, say, consumers, firms, and government entities, it issues new
money, thereby increasing the economy's money stock.
Economists from the Austrian School
of economics call this kind of money production "money creation out of
thin air," as the increase in money through bank circulation credit
doesn't require the existence of real savings.
If money is produced through bank
credit, one should expect a positive relation between changes in bank credit
and changes in the money stock. Over longer periods there is detectable a
positive and highly correlated relation between these two magnitudes.
Of course, any comovement
of bank credit and the money stock wouldn't necessarily be
"perfect" at all points in time. In fact, there might be periods in
which bank-credit expansion can decouple from money growth.
For instance, banks can and do make
clients shift from short-term deposits, which are subject to reserve
requirements, into those bank liabilities that are exempt from reserve
holdings.
By doing so, banks can "free
up" reserves, which can then be used for additional lending and money
creation. These transactions typically lead to an expansion of bank credit
while the money stock remains unchanged.[1]
Lately, however, the discrepancy in
the United States between bank credit and M2 growth has become particularly
noteworthy: Bank credit grew by just 0.5 percent year on year in the middle
of August 2011, while M2 rose 10.2 percent year on year. The increase in M2
was driven by a strong expansion of M1, with demand deposits rising by more
than 50 percent year on year.
 
These observations may, on the one
hand, serve as a reminder that in today's fiat-money standard the fear
that sluggish lending on the part of commercial banks could result in
"too little money expansion," thereby causing deflation, may be
unwarranted.
On the other hand, they may
encourage finding out more about how the central bank can keep up, or even
increase, the money stock in an environment where commercial banks are no
longer willing or in a position to keep up lending.
II. The
Central Bank Purchases Assets from Commercial Banks
In the ongoing financial and
economic crisis, central banks have increased, and quite substantially so,
banks' "excess reserves." This has been brought about largely by
central banks' purchasing securities held by commercial banks against issuing
new base money balances.
These transactions can be
illustrated by taking a look at (stylized) balance sheets. If, for instance,
the central bank buys securities in the amount of US$100 from commercial
banks, it records the securities as an asset on its balance sheet.
At the same time, the central bank
credits commercial banks' accounts, held with the central bank, with the
purchasing price of US$100. The latter is base money — and represents a
liability on the central bank's balance sheet.
Commercial banks hand over US$100
securities against receiving money deposits held with the central bank. The
composition of banks' assets changes in the following way: securities decline
by US$100; base money increases in the same amount.
The commercial-bank sector can use
its "excess reserves" for stepping up lending and money creation.
What, however, if banks (or more precisely: their shareholders) are no longer
willing or in a position (because of equity capital shortage) to lend and take
additional credit risks?
Or even worse for the adherents of
relentless monetary expansionists: What if commercial banks, despite high
excess reserves, start calling in maturing loans and contract the credit
supply? This would actually lead to a shrinking of the money stock —
and cause deflation.
III.
Commercial Banks Purchase Assets from Nonbanks
If politically desired, the central
bank can prevent the fiat-money supply from shrinking. For instance, it can
purchase assets from nonbanks (private households, pension funds, insurance
companies, etc.) and pay with newly created base money.
What happens if, for instance, the
central bank purchases a security from a nonbank in the amount of US$100? In
this case the central bank hands over the money directly to the seller, who
holds his account with commercial banks.
Commercial banks, in turn, receive
a US$100 base-money payment from the central bank. The money stock in the
hands of nonbanks (M1) rises by US$100, and so do
excess reserves in the hands of banks.
If the central bank monetizes newly
issued government bonds (by purchasing them in the primary or secondary
market), the same effect results: banks' excess reserves increase, and the
money stock (M1) rises, as government will use the new money to pay for its
outlays.
IV. Some
Effects of Preventing the Fiat-Money Stock from Shrinking
If the central bank purchases
bonds, the original issuers of the bonds will have to keep paying interest
and principal to the central bank. Such payments reduce the money supply in
the form of M1 and M2 over time.
In other words, by purchasing
bonds, the central bank just postpones the inevitable — namely, the
shrinking of the fiat-money supply through contractual debt (re)payments on
the part of borrowers ("deleveraging").
For upholding the outstanding
fiat-money stock once and for all, the central bank could buy debt in the
amount of the money stock (say M1) — and then forgive the debt. This,
of course, would favor those borrowers whose debt would be forgiven over all
other economic actors.
Alternatively, the central bank
could start purchasing noncredit assets such as stocks, housing, etc.,
thereby issuing fiat money that doesn't have to be repaid. This, however,
would amount to nationalizing the assets purchased — with all the
well-known, detrimental consequences of socialist policies.
One should note in this context
that a rise in the money stock is never neutral. Those receiving the
newly created money first will benefit at the expense of those who receive
the new money at a later point in time or not at all.
Having said that, it becomes
obvious that a policy of preventing the fiat-money supply from shrinking
(which it would in the absence of such measures) entails coercive
redistribution effects.
It favors holders of goods and
services at the expense of money holders: buyers will be prevented from
getting hold of vendible items at lower prices, while sellers are granted the
favor of selling their supplies at higher prices.
V. The Way
toward High Inflation
Technically speaking, a policy of
upholding or expanding the fiat-money stock in an environment where banks are
no longer willing to extend credit and issue new fiat money appears to be technically
possible.
However, the Austrian School of
economics points out that an economy's production structure will be turned
upside down once the hitherto relentless rise of fiat money, injected by bank
circulation credit, slows down, or even starts contracting.
Once the credit growth dries up,
the fiat-money-induced "boom" will turn into "bust," as
the Austrian trade-cycle theory shows. A bust will cause market interest
rates to go up as people's time preference and required risk premiums
increase.
Rising interest rates threaten to
bring down leveraged banks. Defaulting banks would reduce the fiat-money
stock. So to prevent the fiat-money stock from declining in a bust, the
central bank has to keep market interest rates low.
However, the outlook of ongoing
debt monetization through the central bank could provoke selling pressures in
bond markets: investors, concerned about higher inflation, start dumping
bonds, thereby pushing up market interest rates.
The central bank would then have to
purchase ever-greater amounts of debt, thereby issuing ever-greater amounts
of fiat money. The ongoing attempt to keep down the interest rate to prevent
the fiat-money stock from declining could easily lead toward a policy of high
inflation, even hyperinflation.
Article originally published on www.mises .org
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