In the latest Fed minutes, it is increasingly likely that the interest rate will be lifted in December this year. This will have a profound effect on the money supply in the US economy. Since 2008, the Fed has engaged in several quantitative easing programs by swapping bank securities with interest-bearing reserves. This led to a dramatic increase in excess reserves held by banks. These are additional (excess) cash or deposits with the Fed that banks hold beyond the requirements by the Fed.
Changing the monetary policy will have significant effects on money supply and overall economy.
I came across today two interesting articles that ask a similar question.
Should the money itself generate any return?
I don’t claim to understand the explanation given in this article, but I think it is worth reading. In the nutshell, it comes down to this assumption in economics: investors should be rewarded monetarily for taking financial risk. And
“money”, of course, is short duration or zero duration financial assets and always bears some level of risk (credit risk, reinvestment risk, inflation risk, etc).
Money may be modelled as a long-term government zero coupon bond with no reinvestment risk and no default risk. In reality, there is always default risk. Just think of Grexit saga or the US debt ceiling crisis in 2011.
Interesting read on the most likely cause of the increase in credit supply during the housing boom prior to the GFC.
Credit Supply and the Housing Boom
Alejandro Justiniano, Giorgio Primiceri, and Andrea Tambalotti
Liberty Street Economics, APRIL 20, 2015
In a nutshell:
… When savers and financial institutions are less restricted in their lending, the supply of credit increases and interest rates fall. Since access to credit requires collateral, the increased availability of funds at lower interest rates makes the existing collateral—houses—scarcer and hence more valuable. As a result of higher real estate values, borrowers can increase their debt, even though their debt-to-collateral ratio remains unchanged. These responses of debt, house prices, aggregate leverage, and mortgage rates match well the empirical facts illustrated in the previous four charts. We conclude from this experiment that a shift in credit supply, associated with looser lending constraints, was the fundamental driver of the credit and housing boom that preceded the Great Recession.
It is a myth that only banks create money out of thin air. We all do. However, let me begin by admitting that I don’t know precisely the mechanics of money creation. This post is, therefore, a place for me to organise some thoughts on the subject. There is a great video that touches on the subject in relation to the economy as a whole.
To discuss such a delicate subject it is worth defining what do we mean by money. Wikipedia gives a pretty good definition: money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context.
There are a few subtle points on this definition:
- It can be any item. Early types of money were cattle and sheep. The use of metal for financial transaction came much later.
- It can be a verifiable record. Today banks mostly use computerised form of record as money.
- It must be generally accepted as payment to settle any debts in a particular socio-economic area. In most countries, this is legally recognised as legal tender. This means that any debtor must consider the debt settled if the debtee repays using a particular legal tender. So, when you want to pay for goods, a shopkeeper in England may refuse your Scottish pound (it is not a legal tender in England). He may also choose to refuse your British pound, but that means you can walk away with that goods, as the debt is considered settled.
Most of money that we know is what some refer as credit.
Credit is a form of verifiable record. Like in the video, it is a bit like setting up a bar tab. In creating a bar tab, you are now holding liability in form of debt that must be repaid in the near future, and the bartender now has an asset in form of expected future cash. This is how credit (money) is created.
…credit is created when any two parties are willing to accept each other’s liabilities.
Similarly, when I seek a loan from a bank, I am essentially creating a financial liability that the bank may or may not want to hold. If it believes that I can repay on the loan, then it will accept my liabilities. In creating a loan, the bank now holds an asset (loan) and I, on the other hand, now hold a liability (loan). Essentially credit is created when any two parties are willing to swap one’s assets for the other’s liabilities.
Credit requires both parties making and honouring the transaction. In a recession, there is less willingness to enter an agreement on loan, because banks would find majority of people “uncreditworthy” (more likely to default on their loans at particular interest rate). This means the money supply during a recession usually goes down, and normally the central bank would lower interest rate to ensure that more loans (credit) are created enough so that the money supply can increase at a steady rate (read — within inflation target).
The central bank has another tool at disposal when interest rate is at zero. It can physically print banknotes. This generally doesn’t add much into the money supply, since cash makes up a tiny percent of money supply. The central bank can also create credit in form of bank reserves. It is like a bank account, each private bank have at the central bank. There are some rules and regulations regarding bank reserve holding. And that is one of many ways, the central bank control the money supply.
The trick is to create at the right rate. Otherwise, we can get a hyperinflation that German experienced in the 1920s.
I find this article today. In short, it is complicated.
In my opinion, it is almost insufficient to only consider what the QE3 has brought us without considering the alternative of doing nothing. It is easy, in hindsight, to criticise the Federal Reserve’s QE3 program, but can we really imagine what the world (or the US) would be like without it?
Economists generally love to find a real world example to learn from. In that spirit, I would suggest looking at Europe and Japan. Both, initially, did not embrace aggressive credit stimulus program. Europe is under constant threat of deflation. Japan has been in deflation for a decade. Both central banks are now engaging in programs similar to the QE programs.
Having said this, I am not trying to simplify the difficulty in understanding the usefulness of QE3. Problems for European and Japanese economies are subtle than I have suggested. I simply wish to allude to their money supply problems.
I will write more on the QE programs later.