Money Supply

princeofpounds

Doesn't that imply that underlying it all is a slow printing of completely new money as a separate notion to money as debt? (Clapton and theEnd posters seem to believe so).

Yes, although as I said then money is printed electronically and lent, not given out.


It's a mistake to think of it as a slow grind either - typically it comes in tranches, often it isn't slow, it isn't always an increase, and it typically arrives in response to overnight interest rates between banks, not some consideration about the number of pounds in existence. It 's a mistake to think of it as some kind of ongoing continuous process.


But, here is the tricky conceptual bit. This sort of behaviour does not happen because of the 'nature of money'.


This happens because we want a centrally-banked fiat money system, we want banks to maintain liquidity reserves, and we want to try to control the inflation rate. It is a consequence of a bunch of related policy decisions that seem to produce a financial economy that works well.


As Generali pointed out, we have had long experience in history of periods when money creation was defined by the amount of precious metals dug from the ground.


There are some 'natural' reasons this solution works to a degree as a monetary system - gold works as a natural store of value, it is easily transactable, the growth in supply tends to increase a bit over time. But it also has some big drawbacks I won't go into here.


Other cultures have experimented with money supplies that were driven by weird things; the stone rings of Yap being a famous example, which at various points were either fairly fixed, or depended on the productivity of quarrying and trade. People are kind of weird, right?


https://en.wikipedia.org/wiki/Rai_stones


You can pretty much pick any kind of base money you like. Obviously the ones that don't work disappear very quickly or more likely never even get adopted. But the growth of credit money can happen on top of any kind of base money system, and in any kind of 'financialised' economy tends to be vastly important. Obviously it can happen in many different ways depending on the base money system AND the regulations and policies that sit on top of it.

cells

mwpt wrote: »

Surely in a fractional reserve system there is an upper limit on how much money we can actually create, because, well, maths. If you have to retain a fraction of the original money, you converge on an upper limit.

But over the long term, as we go through credit easing and credit tightening, wouldn't we just cycle around a stable broad money base? We don't seem to. Broad money seems to increase over the long term and we cycle around this increasing trend line. (EDIT: I may be using the incorrect term here, broad money, apologies, but hopefully you get my point).

Doesn't that imply that underlying it all is a slow printing of completely new money as a separate notion to money as debt? (Clapton and theEnd posters seem to believe so).

think of it this way

a bank can create as much debt/credit as it wants. infinite

the government comes along as says hold on a second, if we dont regulate you there is nothing to stop you pumping it all up making some dosh and running away once the shtf. so we the government will force you to put something you own into this business so if things go south you will lose your shirt

Now this something can be anything, a gold bar a house your liver and we the government will let you create 20 x the value of the asset you put down

now various other regulations stop you from putting just any old asset in place, the require 'high quality assets' which tends to be cash or government gilts but you can still put your house down or your liver you just need to sell them first and buy the government gilt

So what is the upper limit to the credit, well there still isnt really one. A bank can go to its shareholders and ask for another £10 billion and the shareholders had them over a gilt with the number 10 billion on it, the shareholders got this 10 billion iou from the government for giving the government various things in return like services medical equipment foods whatever. The bank with this 10 billion IOU can now create anoher 200 billion in credit.

IOUs on top of IOUs on top of IOUs no real limit


The limit in practise is how much of a return the banks can make on their capital. The banks will not ask their shareholders for more capital if they cant earn a net profit from the additional lending to make it attractive enough for the shareholders to give them more capital.

princeofpounds

Again Cells, what you are trying to discuss here is the Capital Adequacy of a Bank. This is NOT the same thing as liquidity or the Fractional Reserve Requirement, and frankly it confuses the topic unless it is made clear that it is a separate issue.


Furthermore, it is important to note that banks that pursue the 'no real limit' model you describe are not realistic, unless they were explicitly set up as frauds. Shareholders who want a sustainable banking business will always maintain some capital in the bank, otherwise the first loan that goes bad will bankrupt the bank. That is not a stable equilibrium in any economy, even a totally unregulated one.
Regulation is only necessary because shareholders - like anyone - tend to get a bit optimistic in good times and underestimate how much they need.


I mention that because I think it's important for people to realise that banking system failures are driven by overconfidence, not co-ordinated fraudulent behaviour. Sometimes that overconfidence might be the ability to deal with a single bank fraud however; frauds are often the spark of a banking crisis but they are not the wood on which it burns.


Anyway, I will try to distinguish the two topics with the following statements:


The Capital Adequacy rules limit how much an individual bank, with a given amount of equity capital, can create in credit. It exists to try to make sure that a bank that makes bad loans can in theory still repay all its depositors, because the shareholders buffer them by taking the first loss on their own equity capital.


But on a system level, you can always invest a bit more equity capital in the bank, or add another bank. It is not a direct limit on the system's creation of credit.


The Reserve Requirement rules limit how much credit a bank AND a banking system can create based on a given money supply. It exists to try to make sure the bank can repay any depositors wanting immediate liquidity, because it ensures the banks keep liquid cash hanging around on their balance sheet.


Now these two concept are distinct but related and they do interact. A bank that is insolvent quickly ends up illiquid, as people run to get their money back before the doors shut, and an illiquid bank is often in danger of ending up insolvent as it has to firesale assets or raise expensive emergency funding to generate liquidity.


http://www.economicshelp.org/blog/5043/economics/difference-between-liquidity-crisis-and-solvency-crisis/


So a capital adequacy rule might help limit the amount of total credit creation in a system IF the number of banking licenses is limited, AND the amount of equity capital is fixed (either by regulation or economic incentives) AND the limit is lower than the limit imposed by the reserve requirement.


But given most banking systems, except as a product of a crisis situation or perhaps extreme and reckless growth, have surplus capital adequacy then we know by definition this is not normally a directly limiting factor on total credit creation in the economy - because banks could still loan another pounds (or dollar, or lira, or whatever)


I think people often conflate these two issues because both do act as restrictions on credit creation, and illiquidity and insolvency often land a bank in the same hole.


But basically one system is there to ensure depositors can get all their money back at some point in the future, and the other system is there to ensure depositors can get some of their money back today.

Thrugelmir

mwpt wrote: »

Unless I’m missing something, I get all this. My question is more subtle. How do we get inflation if the system is in fact truly closed and all loans must net out at the end?

In 1971 the UK banks were hardly leveraged at all. Lending £106 for every £100 of capital reserves on their balance sheet. In 2008 Barclays were lending £7200 for every £100 of capital reserves on their balance sheet. Deflating the credit bubble is a long slow process. Which will take many many years.

princeofpounds

Thrugelmir wrote: »

In 1971 the UK banks were hardly leveraged at all. Lending £106 for every £100 of capital reserves on their balance sheet. In 2008 Barclays were lending £7200 for every £100 of capital reserves on their balance sheet. Deflating the credit bubble is a long slow process. Which will take many many years.

I don't know enough about 1971 to tell you if this is true, but what I can tell you is that both numbers are equally bonkers.

One is the corollary of 'I'm happy to go bust if just 2% of my loans go bad'. The other basically says 'I assume borrowers are going to torch almost half of the money'.

And of course neither number is related to the OP's question on liquidity or money supply.

princeofpounds

Just skimmed some PDF papers on monetary policy in the 60s. There was some bonkers stuff going on then. Note there were caps on loans to private entities until 1971, which is probably why thrugelmir's number is as weird as it is. I also suspect that more of the balance sheet was lent out than that number suggests, but into government securities rather than private loans. Quite common in high interest rate environments where government borrowing crowds out private. But that's just a hypothesis.

antrobus

princeofpounds wrote: »

Again Cells, what you are trying to discuss here is the Capital Adequacy of a Bank. This is NOT the same thing as liquidity or the Fractional Reserve Requirement, and frankly it confuses the topic unless it is made clear that it is a separate issue. ....

There is no Fractional Reserve Requirement in the UK.

princeofpounds

There is no Fractional Reserve Requirement in the UK.

True.


This is one of those areas where I have been fibbing a bit for the sake of simplification.


The BoE used to have a Reserve Requirement Regulation, but it actually removed it some time ago, 1981. It then moved to a system where the banks established their own targets, which they notified to the BoE and an agreed contract was signed instead of a regulation. Obviously the BOE still had oversight, so it still was a kind of regulation.


Then after 2009, they changed it again. The BoE moved to a policy where required reserves were abolished, and instead interest was paid on so-called excess reserves.


It used to be, IIRC, that interest was paid on required reserves, but not on 'excess' reserves above that level. Now all reserves are excess reserves, and interest is paid. So banks put money there by choice (or rather the BoE controls their choice by adjusting the interest rate on deposits)


That's about the point at which my knowledge peters out, but there is one basic concept here - when you want to control money supply then there are two variables we can play with. We can control the quantity of money, or we can control the price of money. And they are inextricably linked by supply/demand.


So the BoE basically moved from emphasising quantity control of money to price control of money, in this area at least.


But most economies do have Required Reserve Ratio policies. In some it is a very important tool for managing the money supply; in China for instance it is ~18% I think. It used to be 20% in the UK four decades ago, it went down to 1.5%.


Not so strangely, banks also want to have reserves in place. Because they would quite like to have working ATMs and cash desks when someone walks in to extract a deposit. Banks might be too greedy at times, but they will always self-regulate to some degree.


There is also a subtle difference between reserves at the central Bank and cash liquidity of a bank. Because of course not all cash needs to be held at the Central Bank.


In practice what can happen is not so much the Central Bank saying 'you must hold £100m in your account with us', although as I said many economies do precisely that. What also actually happens is the Central Bank saying 'If you need to borrow cash you can get it from us at X% overnight if you have the right collateral, and if you have excess cash you can put it with us overnight for Y%'.


Meh, that's a bit of a rambling explanation. But hope it fills in the details.

Generali

AIUI, Reserve Requirements weren't a method of regulating banks as such. They were a way of withdrawing liquidity from the system in an attempt to control inflation without the requirement to raise interest rates along with other twaddle like incomes policies.

princeofpounds

Generali wrote: »

AIUI, Reserve Requirements weren't a method of regulating banks as such. They were a way of withdrawing liquidity from the system in an attempt to control inflation without the requirement to raise interest rates along with other twaddle like incomes policies.

Yep. Although I would rephrase that slightly; it's an attempt to do what you say, but through the regulation of the banks, rather than with regulation of the banks as the end objective.