Political greasing, Quantitative easing, Goose teasing and Society's fleecing

Not only have bankers turned ordinary paper to gold, they bred a golden goose, trained it into a lean, mean, money printing machine, then paddled it silly for ten years. Somebody call the RSPCA. Finally the poor old duck got a decade down the racetrack and simply gave out.

Long live the goose.

For several years alarmists have been screaming about how hyperinflation is going to engulf the world because of the unrestrained money printing being undertaken by Central banks around the world. And let’s face it, most of what I’ve told you says that money printing only begets inflation, at least in the long run. But whenever I talk about money printing and inflation, you’ll notice I always explain it not with an abstract equation involving unannounced assumptions, but in terms of the sequence of events that leads to inflation. In Is Gold a good hedge against inflation I talked about people banging down doors with the copious amounts of extra money in the economy and overwhelming suppliers in the economy. When talking about the other side of the money supply/interest rate coin, I highlight how increased money supply lowers interest rates, enticing borrowers to spend more, overwhelming suppliers from the other side. These are all based on an “all else equal” scenario, designed to isolate the one factor we want to analyse (a change in the money supply) and see what happens if nothing else changes (if you want to dazzle your friends with some fancy Latin, us the phrase “ceretis paribus”: all else being equal). However, something has changed, and it’s this change I want to talk about: banks have stopped lending.

Now that we’ve seen the phenomenal affect that bank lending has on increasing the money supply in Has the printing press lost its value, we can appreciate how hard it is to increase that money supply by a full percentage point when lending breaks down. If banks decide to stop lending as they do in Textbook Land, then the money supply only increases by the amount that the Federal Reserve prints. To increase the money supply by ten percent the Federal Reserve actually has to print ten percent of the value of the money supply.

I could give you some patronising physics style analogy that doesn’t really shed any light or comprehension on the idea; something like, travelling 39,900,000,000,000km to our nearest star would be like travelling 3,652,000,000km to Pluto and then back again 5463 times. Thanks for that. I could work out some ridiculous scenario aimed at making me feel smart and you feel dumb, so will:

If you took the money required to be printed to increase the (M2) money supply three percent (in June 2012) laid it end to end and walked across it to Pluto and back four times (using fresh dollar bills every time for your delicate feet), then walked one thirtieth of the way to Pluto, thought what a stupid idea it was to be doing this, and walked back to Earth (always laying fresh dollar bills as you go), then decided you didn’t like it on the Gold Coast (Australia) and walked across a new dollar bridge to Vegas, you would still have half as much money as Warren Buffet. Our interstellar travel analogy not doin it for ya?

Better yet, if you went straight to Vegas and hit the strip clubs, once Misty Star had enticed all your dollar bills from you, if she went straight to the bank to pay off her student loan, she handed all the dollar bills over with her nimble fingers at the blistering rate of 100 bills per minute (wonder where she honed those skills?) it would take her 186992 years to hand it all over. And she would have the record for most expensive university course ever undertaken in human history.

Now if that has complicated the matter and confused you well good, that is the purpose of physics analogies (to take something complicated and make it more complicated). What’s important to understand is why hyperinflation has not taken flight however.  If banks in Textbook Land refused to lend, although the amount of physical cash in the economy can be increased as it is printed by the central bank, the actual increase in the money supply is meaningless: a statistical discrepancy in a world where big numbers must carry 18 zeros on the end to even begin to impress the female numbers. If the money were not lent out, inflation would be near impossible to engineer. (be aware that this is still an analogy because the fed doesn’t actually print money, but the problem with electronically crediting banks’ accounts with money is the same, they won’t lend it or their will be no demand for loans).  Another way to think about this sprouts from our understanding of why money printing begets inflation from Is gold a good hedge against inflation. When the central bank prints money, the amount that people want to save is assumed to be unchanged (ceretis paribus) so when they have these extra balances, they spend them (banging own shopkeepers doors). However people are currently afraid and the amount they want to save has increased (the amount they want to borrow (the opposite of saving) has certainly decreased) so they are hoarding the extra printed money. All else is not equal! You can see now how quickly a printing press loses its ability to reduce the value of the money you hold in a recession. Sometimes it might be hard to stop your money from GAINING value (god forbid) as prices fall.

It’s hard to believe that it is the same species to put a man on the moon, and who conjured such ingenious inventions such as money, then went and gave someone the right to print as much of it as they want (the only thing that could destroy it!) and this person only gets worried when they lose the ability to devalue money. As discussed in The evil, ever present, value eroding effect of inflation on...Gameshows, what money creators really fear is deflation. I praise our modern society highly for its triumphs, and I certainly don’t have a better one: but I do worry that one day some advanced alien race will stumble upon the ruins of our long dead society. Surveying the landscape for any remnants of our civilisation which are doomed to define us, little remains. They scout the foreign landscape, only to find a World War 2 picture book, a Steven Segal film, that episode of Southpark where a four storey anal probe emerges from Eric Cartman, something that says there are 16 seasons of Southpark, a Midnight Oil music video, and a macroeconomics textbook. I only hope they can’t read our writing.

Has the printing press lost its value?

I’m hoping that right now you’re asking; “How can something that prints money not be valuable!?”  If you’re like me and you find the ridiculous paradoxes erected by us human beings in our all too regular bouts of absolute insanity, you’ll be interested in this one. What follows is a relatively brief explanation of a theory called the money multiplier, which has been explained to death on blogs already. More interesting is the analysis that follows of why it is faltering.

Fractional Reserve Banking

If a country decides to start its own currency, it can print off $1000 (it could choose any amount, but this country thinks $1000 is a nice round number) and give it to the country’s citizens, making the money supply $1000. Some citizens will put the currency in the bank and some will spend it. The money which is spent would then be in the possession of other citizens, some whom will put the money in the bank, and some who will choose to spend it. Eventually it is likely that all the money will end up being deposited in the bank. Never-the-less the money supply is still $1000, all of which is now in the bank. What happens now is that the bank keeps some fraction (lets say one tenth or ten percent) of the deposits and lends the rest out to borrowers. The people who deposited their money at the bank still believe (rightly so) they have their money, which totals $1000, but now the bank has lent $900 out to people who believe (rightly so) that they have this borrowed money. So the money supply now totals $1900. This is the magic of fractional reserve banking. If the borrowers of the bank’s money (and I use that apostrophe lightly) somehow got into financial trouble and couldn't pay back the loans, the depositors would lose their deposits (all but ten percent of them anyways). The process does not stop here though. The newly borrowed $900 is spent by the borrowers with some other citizen, who will now either put this money in the bank or spend it with someone else who might put it in the bank. Eventually all $900 of the borrowed money is likely to find its way into the bank again as deposits.

Once the bank sees these new deposits enter, it will keep ten percent of them ($90) as reserves, and lend out the remaining $810. The money supply now consists of $1900 in deposits people believe they have, plus the $1710 that borrowers believe they have. The $810 of new loans is spent and eventually finds its way back to the bank again, where ten percent of it or $81 is kept as reserves and the remaining $729 is lent out. Each time a smaller amount is lent out, resulting in a smaller amount coming back in as deposits, and a smaller amount being lent out again during the next round. Eventually the whole process peters out and the money supply will have ballooned from the original $1000 printed by the central bank to a whopping $10000. The beautiful part of the maths is, you can still just print a three percent increase in the physical notes and coins, and they will go through our fractional reserve banking process and result in a three percent increase in the money supply. It is called the multiplier model because you can derive a simple formula that spits out a number which you can multiply the monetary base by to give you the total money supply.

A lot of people realised during the GFC that when you put your money in the bank it doesn’t stay there. Banks loan out most of it so that they can charge interest. They give you a little less interest on the money you deposit with them, and the difference is their profit. Banks only keep a tiny fraction of the money deposited with them in their vaults unloaned, and this is so they have some cash on hand for the few people that actually want to withdraw some funds during the day. This is why it is called “fractional reserve banking” and the existence of this process became increasingly clear to people during the GFC as they realised that if these loans couldn’t be paid back, then the money they thought was safely at the bank would disappear. What’s more interesting than this is the recent breakdown of this multiplier mechanism and the relative helplessness this has thrust upon the central bank in its attempts to fan some inflation. That’s the topic of our next article.

Fractional Reserve Banking

Money multiplier

Loans

Deposits