A Primer on Money and Banking by William F Hummel May 3, 2016 The Elusive
Concept of Money Money
can be
defined as whatever is widely accepted as a medium of exchange. Of
course
to be accepted, it must be seen as a store of value. However these
basic properties do not explain how something gains status as money and
how it is to be
measured. Keynes held that the primary concept in the theory of
money is
the unit of account. Throughout history, States have
established what is to serve as legal tender. They have done so by (1) giving a
name to the unit of account; (2) declaring what token is legal tender measured
in that unit; and (3) enforcing debts and contracts payable in that
token. The point is
that debts and contract prices must be expressed in terms of the unit of
account while the token can be whatever the government chooses, and can be
changed independent of the unit of account. In the U.S. the unit of
account is the dollar, and the token is a dollar bill. When
the U.S. established the dollar in 1792, the token was a silver and copper
alloy coin weighing 27.0 grams, containing 24.1 grams of pure silver. The
Evolution of Fractional Reserve Banking London goldsmiths, originally operating as money changers, accepted coins and other gold objects for safekeeping for a fee, and issued receipts to the depositors. This became known as warehouse banking. By the mid 17th century, people found it more convenient to exchange the receipts rather than the coins when making payments among themselves. This facilitated trade within the economy, and the receipts themselves gradually became the accepted form of money. The
goldsmiths found that people would
rarely redeem the deposited gold for their receipts. Consequently they
began lending receipts, unbacked by gold deposits. Thus began the
transition from warehouse banking to fractional reserve banking in
England. Unbacked
receipts evolved into notes loaned by banks, payable in gold coin to
the bearer on demand. Fractional reserve
banking was an attractive means of expanding the money supply and
increasing
profits. However the tendency toward over-lending by bankers created
problems. When
their notes could not be fully honored, bank runs often followed,
sometimes with serious consequences for the local economy. Transition to Fiat Money As the US economy
grew ever larger and more complex, precious metal coins as money became a perennial problem. The
financial panics and depressions of the 19th and early 20th
century
owe
their origin to the constraints of a metal-based monetary system in an
economy that depends on the availability of ample credit. A major
financial
crisis in 1907 led to the creation in 1913 of a central bank known as
the Federal Reserve or simply the Fed. Its main purpose was to establish a flexible currency and act as a lender of last resort.
However the dependence of credit on gold remained in place for another twenty years. Bank deposits and dollar bills were convertible into gold coin on demand until 1933. It took a major financial crisis leading to the Great Depression for government to finally break the link to gold. With the end of the gold standard in the US, definitive money became credit issued by the Fed. We call that credit fiat money because it is money by government fiat. Creating Fiat Money The Fed creates
fiat money by lending to banks or by purchasing securities in the open market
and crediting the seller’s bank with a deposit at the Fed. The bank then
credits the seller with an equal deposit in his own account. Private bank
deposits are claims on fiat money, not actual fiat money. Fiat
money
exists in just two forms – as deposits at the Fed and as cash,
i.e. notes and
coins. Cash is simply the tangible form of fiat money, and the only
form with which the non-bank public has direct contact. Deposits at the Fed
are
owned by financial institutions, mainly banks and the Treasury.
Bank-owned deposits
are known as Fed funds, and can be converted into cash on
demand. A bank’s vault cash and its Fed funds comprise its most liquid assets, known as reserves.
Unlike a
bank, the Fed can issue credit without limit. Banks can also issue credit,
but they do so by lending and are limited by the capital ratio
requirement. A bank lends by simply crediting the borrower with a deposit in
his account. When a depositor makes a payment by check or electronic means, the
payer's bank debits his transaction account and must surrender that amount of
reserves to the payee’s bank, which then credits the payee with an equal
deposit. The Monetary Base Any sovereign State
with the power to tax can establish its own currency by declaring what token is
to be legal tender. All modern States have adopted intrinsically
worthless tokens for their currencies. The State
necessarily holds a monopoly on the issue of fiat money. Fiat money held by the private sector comprises the monetary
base, which we will refer to as base money. Thus the reserves of banks and currency in circulation are base money. The Dual Role of Banks We will use the term banks to mean any financial institution that serves as a depository, such as commercial banks and thrifts. That does not include so-called investment banks or bank holding companies, which cannot accept deposits but are permitted to engage in a variety of investment activities and to hold assets not allowed to banks themselves.Banks play two distinct roles: as profit-seeking enterprises and as depositories. Their profit-seeking activities include a variety of services. We will focus on their service as intermediaries who provide a link between those with savings to invest and those in need of funds. For most banks, the main source of income is by lending at a markup over their cost of acquiring funds. As depositories banks accept deposits, provide payment facilities, and issue cash on demand in exchange for debits against their deposit liabilities. They pay no interest on demand deposits and very modest interest on savings deposits. They also offer term deposits at higher interest rates because those deposits provide a more stable supply of funding to back their lending. The Money
Supply What is
meant by the money supply? The term itself implies that a
certain amount of money exists at any given time. However in a fractional reserve system, there can be no meaningful
measure of the money supply, as will be explained. The Fed has
its own measures of the money supply which it once used to help guide its
monetary policy decisions. It defines the money supply as the total cash
in circulation and the deposit liabilities of banks and thrifts. At one
time it set targets for the growth of the money supply. Now it largely ignores
its own measures because it has found little correlation between them and its
major policy objectives – limiting inflation and unemployment. The Fed's definition of the money supply includes only what the non-bank sector holds. Thus the reserves of banks, i.e. vault cash and deposits at the Fed, are not included in the monetary aggregates, even though they are a part of the monetary base. That means when a bank makes payments to the public, it increases the money supply. When a bank receives payments from the public such as interest on loans, the money supply decreases. Lines of Credit The Fed's definition of money ignores bank lines of credit which can be
exercised at the discretion of the borrower. Some firms hold substantial lines
of credit at their banks, which they can use on short notice. Likewise
consumers hold lines of credit in their credit card accounts that are just as
useful for purchases as checking accounts or the cash in their
wallets. Lines of credit increase liquidity, which is important in terms of aggregate demand. When someone
uses a credit card in a purchase, he automatically expands the money
supply. The seller receives a new deposit in his account, which increases
the total of demand deposits in the banking system – until the buyer pays off
the loan. Consumers who roll over their credit card loans rather than paying
them off have increased the money supply on their own initiative by hundreds of
billions of dollars. Thus the effective money supply is substantially larger
and less measurable than the Fed's definition. The Role of the Fed Since base
money is a monopoly of the State, the Fed must provide whatever reserves the banking system needs to ensure the liquidity
of the payment system. When the Fed needs to increase aggregate reserves, it
buys Treasury securities from the public and credits the sellers' banks with
additional deposits at the Fed. Conversely the Fed sells Treasury
securities to the public from its own portfolio when it needs to decrease
aggregate bank reserves. Bank reserves are only a small part of the monetary base,
but they play a key role because they are the grease that enables the bank
credit system to function. These
transactions by the Fed are designed to balance supply and demand for bank
reserves at the Fed's target interest rate on overnight loans between banks,
otherwise known as the Fed funds rate. The Fed funds rate is the
benchmark for all short-term interest rates. It has a significant
influence on the amount of bank money issued, and thus the liquidity of the
private sector. In controlling the Fed funds rate, the Fed necessarily
relinquishes control of the amount of base money it issues. The private sector
itself determines the net amount issued. Treasury
Operations The Treasury spends out of its account at the Fed. It continually replenishes that account with transfers from its accounts in commercial banks where it deposits its receipts from taxes and the sale of bonds. These so-called Treasury Tax and Loan accounts, like all other bank transaction accounts, must be backed in accordance with the reserve ratio requirement. The Treasury targets a fixed balance in its Fed account in order to minimize disturbances to aggregate banking system reserves. The purpose is to facilitate the Fed's control of the interest rate on interbank loans, i.e. the Fed funds rate. The Treasury maintains an approximate balance between total inflows and outflows in order to avoid significant disturbance in the aggregate transaction deposits of the private sector. It does so by selling securities as needed to cover its deficit spending. If it sold less than needed, its general fund would ultimately be depleted. It has no incentive to sell more than needed; that would unnecessarily increase its interest expenses. Thus on balance, the government spending has no net effect on the money supply except when it needs to change the target balance in its general fund. Normally it simply recycles the base money it has previously acquired. Managing
Inflationary Expectations The interest
rate the Treasury must pay to borrow is a market rate which is influenced by
Fed policy. The short-term rate closely tracks the Fed funds rate due to
arbitrage. Longer-term rates include a premium over the Fed funds rate which
varies with inflationary expectations. Although many diverse factors affect those
expectations, the Fed itself has considerable influence through its monetary
policy decisions. It is therefore up to the Fed to keep inflationary
expectations within acceptable limits. By doing that well, it protects the
purchasing power of money, and ensures that interest rates on long term
borrowing will not become so burdensome as to hinder economic growth. The
historical record shows no significant correlation between the amount of
deficit spending and the inflation rate or interest rates. Most central banks
now target a small positive inflation rate to provide a margin against a
deflation trap. Deflation hurts aggregate demand by creating a
money-hoarding psychology which is difficult to overcome, and may result in a
prolonged recession. Under the gold-based system, the State's ability to
counter inflationary and deflationary pressures was very limited. The Role of
Bank Reserves The bulk of
all money transactions involve the transfer of bank deposits and an equal amount of reserves. A bank
must hold enough reserves to meet the cash
withdrawals of its depositors and to cover the checks written against their
accounts. When a
depositor makes a payment out of his account, his bank must surrender that
amount of reserves to the payee’s bank. Thus reserves move from one bank to another as payments are made and
cleared. At the end of the day, some banks will be short of reserves and
others long. Banks redistribute reserves among themselves by trading in the Fed
funds market. Those long on reserves will normally lend to those
short. The interest rate on interbank loans, known as the Fed funds
rate, varies with supply and demand. The
reserve
requirement applies only to a bank's transaction deposits, not its
savings or term
deposits. Thus when a bank depositor transfers funds in a
transaction account to a savings or term account, he frees up reserves that were held
against those transaction deposits. The bank can then use the free
reserves in
several ways. For example, it can hold them to back further
lending, buy
interest-earning Treasury securities, or lend them to other banks in
the Fed
funds market. The Fed
funds rate is effectively the upper limit on the cost of reserves to banks,
and thus determines the interest rate that banks must charge the public for
loans. Reserve
Requirements All
depository institutions -- commercial banks and thrifts -- in the
United States
are subject to reserve requirements on customer deposits. The required
reserve
ratio depends on the amount of checkable deposits a bank holds. As of
year-end 2015, no reserves are required on the first $15.2
million. Between $15.2 million and $110.2 million, deposits are
subject to
a 3% reserve. Above $110.2 million they are subject to a 10%
reserve. These breakpoints are adjusted annually in accordance
with money
supply growth. No reserves are required against term deposits or
savings
accounts. Reserves are
figured as the average held over a 14-day period, ending every second
Wednesday. On any single day, a bank needs only enough to cover its customer's
withdrawals. A bank may hold its reserves in any combination of vault cash
and deposits at the Fed. As profit-seeking enterprises, banks try to keep
their reserves close to the required minimum, since they earn no
interest. Factors Affecting Aggregate Reserves A bank loses
reserves whenever it pays out cash or transfers funds by wire for its
customers. Customer checks to pay out of town bills funnel back through
the Fed and are charged against its reserves. A bank may also lose
reserves when it advances loans or buys securities. Conversely a bank
gains reserves when it receives new deposits. There are many factors outside of the Fed’s control that influence aggregate reserves. They include changes in currency holdings of the public, changes in the Treasury’s cash balances at the Fed, checking system float, and foreign central bank transactions. The Fed actively compensates for these variations by adding or draining system reserves as needed to avoid large fluctuations in their market price, i.e. the Fed funds rate. The growing demand for currency is the largest single factor requiring reserve injections. An active
market in reserves helps to redistribute reserves to those banks that need them. If a bank faces a reserve deficiency, it has several options. It can try to borrow
reserves for one or more days from another bank; sell marketable assets such
as government securities; bid for funds in the money market such as large CDs
or Eurodollars; or it can pledge collateral and borrow at the Fed’s discount
window at a penalty rate. Bank
Liquidity Liquidity for a bank means the ability to meet its financial
obligations as they come due. Commercial banks differ widely in how they
manage liquidity. A small bank derives its funds primarily from customer
deposits, normally a fairly stable source in the aggregate. Its assets are
mostly loans to small firms and households, and it usually has more deposits
than it can find creditworthy borrowers for. Excess funds are typically
invested in assets that will provide it with liquidity such as Fed funds loaned
and U.S. government securities. The holding of assets that can readily be
turned into cash when needed, is known as asset management banking.
Large banks
generally lack sufficient deposits to fund their main business -- dealing with
large companies, governments, other financial institutions, and wealthy
individuals. Most borrow the funds they need from other major lenders in the
form of short-term liabilities which must be continually rolled over. This
is known as liability management, a much riskier method than
asset management. A small bank will lose potential income if it gets its
asset management wrong. A large bank that gets its liability management wrong
may fail. A bank's most vital asset is its creditworthiness. If there is any doubt about its credit, depositors can easily switch to another bank. The rate a bank must pay to borrow will go up rapidly with the slightest indication of trouble. If there is serious doubt, it will be unable to borrow at any rate, and will go under. With the advent of deposit insurance, bank runs by small depositors are largely a thing of the past. Insurance is currently limited to $250,000 per deposit, which provides complete coverage to about 99% of all depositors. But it covers only about three-fourths of the total amount of deposits because many accounts far exceed the insurance limits. Distortions due to the Recent Financial Crisis The Fed's response to the financial crisis greatly distorted its balance sheet and altered some of its practices. As of 2014, banks still hold a large excess of reserves. That forces the Fed to use different methods of implementing monetary policy than outlined above. Since It is likely the Fed will gradually recapture the excess reserves and return to its pre-crisis mode of operaton, we have dealt only with the Fed's normal mode of operation. |