The Pulse of Capitalism

Issue 98-3, October 1998

Where Did All the Money Come From?

In 1997 Americans poured $263.4 billion into mutual funds. They have spent $600 million to see the movie Titanic since its opening. Exxon president L. R. Raymond received annual compensation of $3.3 million plus long term compensation of $7.0 million. Dallas football player Flipper Anderson was paid $2.4 million. Baseball player Barry Bond received $8.4 million, while basketball player Patrick Ewing received $20.5 million, far below Michael Jordon's $33.1 million. And, Americans from all walks of life willingly paid from $20 to $30 for a ticket to see their favorite sport, concert, or drama.

Comparison of M-2, Consumer Price Index, and Real GDP

Where did all the money come from to support expenditures on so grand a scale? As recently as 30 years ago, they would have been unthinkable. In 1970 the M-2 money supply totaled $628.1 billion, whereas in 1997 it totaled $4,041.3 billion, a more than six-fold increase. Obviously, we have undergone a huge (and unprecedented) expansion of bank-created credit (the basis of all checkable deposits) with little public discussion being directed toward it. Historically, such an expansion would be expected to produce commensurate price inflation, but this has not really happened, as the chart shows. What has caused this great expansion in the money supply, and what are its implications?

We Americans seem unaware of such questions. We are assured that our financial system is the safest in the world, and we tend to accept these assurances. But how valid are they? Are there weaknesses in our banking system that we are unaware of? These questions may seem new to us, but some of our neighbors in Canada have been grappling with them for some time.

William Krehm, (Toronto, 3284 Yonge Street, Suite 500, M4N3M7), writing in Economic Reform (6/98 pg.6) comments as follows:

"Our banks have undergone a mutation during which they have changed their very food chain. Time there was when barring the local undertaker, the banker was the most solemn citizen in town. Not surprisingly, for he had been entrusted with the administration of a miracle - money creation. That enjoined a severe discipline. Though in a figurative sense they may have distributed wine and wafers, it was inconceivable that these priest-like characters should end up taking over wineries and bakeries in a battle for market share. That, however, is what has come to pass.

"The miracle of money-creation is more easily understood if we track its history. Originally drafts on banks were redeemable in precious metals. When there was clearly not enough gold to go around, banks turned to issuing their own notes. But backing those notes, they had to leave a percentage of legal tender - government debt - in Canada, first with the Ministry of Finance, and with the Bank of Canada after it opened its doors in 1935.

"In the early 1970s even theoretical equivalence between gold and the currency disappeared. Money became government debt and nothing else. That reduced it to an abstraction - a medium in which miracles are more readily brought to pass.

"Repeatedly when bankers got themselves into difficulty by disregarding their vows, banks were allowed to write the scenario for their bailout by the government. By mid-1994 the cash reserves the banks held with Bank of Canada had been done away with. Along with the Bank for International Settlements Risk-Based Requirements, this allowed them to increase their holdings of federal debt by some $60 billion to a total around $80 billion without putting up any cash of their own. This has been the equivalent of an annual subsidy - an entitlement - of at least $5 billion. With the removal of restrictions on what banks can invest in, this subsidy has been parlayed into the acquisition of brokerages, insurance companies, derivative boutiques, to the point where the ratio of bank assets to the legal tender in their possession has soared from 11.1:1 in 1946 to 347:1 currently."

Banking in Canada has been more concentrated than in the U.S. Does this make their experience greatly different from ours? And did the elimination of required bank reserves make their banking system less manageable or less safe than ours? A little background suggests that it did not.

Monetary Policy in the U.S.

The fundamental role of banks is to receive funds from depositors and then to invest those funds in earning assets such as loans, mortgages, securities, etc. Part of those funds, however, they have traditionally been required by banking legislation to keep as reserves in a non-interest bearing account at a Federal Reserve Bank or in the form of vault cash. The purpose of these reserves was to provide a cushion in case the banks had a sudden and unexpected need for funds. By drawing on their reserve accounts, banks could avoid making a sudden sale of assets on possibly unfavorable terms. The reserves also gave the Federal Reserve a tool by which they could control the total amount of bank credit that could be created from a given infusion of new reserves.

Required reserves have varied considerably over the years. It is a bit difficult to compare them because banks have been classified in different ways with different requirements, and new types of bank accounts have been introduced. However, the following is a fair comparison:

Another way is to compare total deposits with total required reserves.

Taken together, these comparisons indicate that required reserves in 1997 were only about one-fourth as large as in 1970.

Most of this reduction occurred in the 1990s. In December 1990, the rate for non-transaction or savings deposits was reduced from 3 percent to zero, a reduction of about one-third or $10 billion. In April, 1992, the rate for transaction deposits in the upper tier was reduced from 12 percent to 10 percent. Again, this cut required reserves about one-third or $6 billion. Then starting in 1994, banks began to implement "sweep" programs to reduce required reserves. These are purely bookkeeping transactions in which demand or checking deposits are reclassified for reporting purposes into a savings category, which is not subject to reserve requirements. Bank customers know nothing about this treatment of their deposits (and receive no interest on their funds now classified by the bank as "savings"), but the bank finds its required reserves reduced and therefore has more funds available for investment in earning assets. "In 1997, deposits initially affected by new or expanded sweep programs totaled $85 billion, bringing the cumulative value of these programs since their inception in 1994 to $252 billion." (FR Bulletin 7/98 p 518) As a result of these programs required reserves have again been reduced by about one-third or $15 billion.

It should be noted that the two reductions occurring in 1990 and 1992 were made when the banking system was under considerable stress due to large losses in commercial real estate loans. (This was also the time when S&Ls were being "restructured" through a government bailout.) Undoubtedly they greatly aided the banks' recovery from this episode. The funds made available to them could immediately be invested in Treasury securities, thereby increasing both their income and their asset quality.

It should also be noted that the reserve reductions resulting from sweep programs were initiated by the banks themselves rather than by the Fed, which apparently acquiesced in their implementation. This raises the question of whether the Fed now shares its monetary policy role with the banks to which it applies.

Reserve accounts at the Fed are used by banks to facilitate transactions with other banks such as clearing checks and making electronic transfers of funds, as well as to meet reserve requirements. The accounts of large banks are extremely active and must be managed very carefully both to meet reserve requirements and to avoid overdrafts, which are penalized. Due to the successive reductions in required reserves, many banks now find that they need higher balances to meet their payment-related needs than to satisfy their reserve requirements, and they have negotiated agreements with the Fed to hold "required clearing balances" that are higher than their "required reserve balance" The total of these two types of balances is now referred to as "total required balances". This development is discussed in the Federal Reserve Bulletin, November, 1997, p 868:

"Innovations in the 1990s have reduced required reserve balances. Although depository institutions have increased the amount of balances they contract to hold in the form of required clearing balances, total required balances have dropped to historically low levels. This development has implications for the conduct of open market operations and for the federal funds rate.

"Until the early 1990s depository institution demand for balances at the Federal Reserve was high and relatively stable. This environment facilitated the conduct of open market operations. High required reserves created a stable, predictable demand for reserve balances, so the Desk could more readily achieve the FOMC's reserve market objective by manipulating the supply of reserve balances and the averaging method used to satisfy them allowed depository institutions to manage their daily account balances flexibly, thus helping to smooth the federal funds rate.

"The size of the balance that a depository institution wants to hold at the end of the day in most cases is either its required reserve balance (plus perhaps a desired amount of excess reserves) or the balance it chooses to hold to protect itself against unanticipated debits that could leave its account overdrawn at the end of the day - its payment-related demand. When required reserve balances are high relative to payment-related balances, depository institutions have a great deal of flexibility in managing their daily account balances because they can substitute a balance held on one day for a balance held on another day. A depository institution that finds its balance at the Federal Reserve unexpectedly high on one day (for instance, because a customer made an unexpected deposit or an expected payment was not made) does not have to offer to lend the extra balance at very low rates; it can absorb the surplus by choosing to hold lower balances over the remainder of the period and still meet its balance requirement. Holding a lower balance on a subsequent day of the period does not necessarily increase the likelihood that the depository institution will incur an overnight overdraft because its targeted balance is still high relative to its payment-related demand for balances. Imbalances between the daily supply of and demand for reserves could be relatively sizable without affecting the federal funds rate as long as cumulative-average balances were close to period-average requirements. For example, unexpected deviations of reserve supply from projections generally did not create volatility in the federal funds market until near the end of the reserve maintenance period."

The Money Multiplier

In addition to providing a safety net for banks, required reserves were designed to give the Fed a tool for controlling the total amount of credit created by banks. Consider what will happen if required reserves are 50% of demand deposits:

The Fed buys a $1,000 Treasury bond from a dealer. The dealer deposits the Fed's check in his bank, raising that bank's deposits by $1,000. The bank must keep $500 in its reserve account but is free to loan the other $500 to another customer. That customer then writes a check which is deposited in bank B, whose deposits increase $500. Bank B must keep half of the $500 or $250 in its reserve account but is free to loan the other $250. Thus this process goes on: $500 - $250 - $125 - $62.50 until it is virtually zero. The total amount of credit that can be created by the banking system is established by the initial reserve requirement that must be maintained. The lower the reserve requirement, the more credit can be credited. Compare the above with what happens when reserve requirements are set at 2%. An initial infusion of $1,000 can then be multiplied as follows: $980 - $960.40 - $941.19 - $922.37, etc. Thus the lowering of required reserves multiplies enormously the capacity of the banking system to expand loans. This process is known among economists as the money multiplier.

Vault Cash

In addition to initiating sweep programs to reduce their required reserves, banks are now seeking to minimize the amount of vault cash they hold and which counts as part of their reserves. The Federal Reserve Bulletin (1/98 p 519) comments on this development as follows:

"Many banks that now have no required balances have explored ways to economize on their vault cash holdings to minimize the opportunity cost associated with their surplus vault cash."

Some Conclusions

We can now, perhaps, begin to address the issues raised at the beginning of this article.

First, in regard to the complete elimination of reserve requirements in Canada, our actions have been less drastic but to a considerable extent have been equivalent. Many banks can now satisfy their reserve requirement with their vault cash holdings. Many others need to keep larger balances at the Fed to meet payments-related needs than to meet required reserves. In both cases, these banks are essentially in the same situation as banks in Canada. However, the remaining reserve requirement in the U.S. does provide some cushion to meet emergency needs and do impose a small limitation on the expansion of bank credit. Controlling required clearing balances does not have this effect.

Second, as the chart above shows, consumer price inflation has been persistent but moderate and has tended to slow rather than accelerate, despite a large increase in the money supply. This is not what economists expected, but they have taken a simplistic view of inflation by focusing only on the monetary side. Today, we have not just an excess supply of money but also an excess supply of goods and services. The prices of goods and services rise mainly because some sectors of the economy have achieved a significant degree of control over their prices or, as in health services, the link between consumer and provider has been severed through insurance schemes. The prices of many other goods and services, on the other hand, are constrained by severe price competition resulting from oversupply. Currently the metals price index, for example, is only 70 percent of its level in 1990. People do not continue to buy goods and services in excess of their needs and wants just because they have the money to do so. Instead, they use the excess money to try to make more money through investment in a whole host of new and old instruments - securities, mortgages, options, futures, swaps, puts and calls, derivatives, etc. That is where the money has gone, and that is where the inflation is.

Third, there is the question of the safety of the banking system. As we have seen, required reserves for banks were cut severely during the 1990s, thereby making large amounts of bank funds available for loans and other investments. At the same time, these cuts were helping the banks to recover from the losses they sustained from prior unwise lending. The history of the banks is not reassuring in this respect. In the early 1980s, U.S. banks incurred huge losses on loans, made to Mexico, Brazil and other third world countries. Major losses were incurred in the early 1990s on commercial real estate and other loans. Today, losses are being revealed on loans to Southeast Asia and to Russia. Rumors are circulating about much larger possible losses to come on other loans made to South American countries. The market price of Citibank's stock has recently fallen by 50 percent.

With this background, one would have to be quite an optimist to believe that the banks will never again face a credit problem resulting from bad judgement. This is all the more so because banks, with so little required to be maintained as reserves, are under increasing pressure to put all their funds to work as earning assets. And, due to the money multiplier, those funds continue to mushroom. But if the banks do face another financial crisis, the Fed will be less able to help them. Required reserves have not been increased for decades. The remaining balances that must be held at the Fed are now down to $10 billion. Making further cuts even in an emergency would be difficult.

Finally, where did all the money come from? The answer is found in the near-elimination of required reserves combined with the operation of the money multiplier. High reserve requirements limit the amount of bank credit, the source of check deposits, that can be created from a given infusion of new reserves by the Fed. With low or no required reserves, the only constraint on banks to expand credit is the maintenance of balances sufficient to meet their payment-related needs, and vault cash sufficient to meet normal customer demands. [The capital requirements for banks are now defined by guidelines established by the Bank for International Settlements.]

Banks, of course, will not knowingly make loans that are unsound. But the difficulty is that the quality of loans changes quickly if economic conditions change. This was demonstrated in East Asia. When currencies depreciated, loans that seemed sound suddenly lost much of their value. The value of high required reserves is that, by limiting the amount of credit, its quality will almost surely be higher.

At present, there is considerable pressure on the Fed to lower the federal funds rate. To do this, it would have to accelerate its purchases of Treasury securities, thereby increasing total reserves in the banking system. These reserves would then become the basis for creating even more bank credit. But the bank experiences cited above do not suggest that this would be a wise choice.

The question of where all the money came from seems ultimately to be explained in the word of a former Fed Chairman: the Fed failed "to take the punch bowl away just as the party livened up".

GDP growth rates slowed in all five economies in the first half of 1998, with Japan registering a negative 3.7 percent. Industrial production continued to rise except in Japan. Retail sales volume, however, has weakened except in the U.S. Interestingly, although German industrial production rose 5.6 points, retail sales fell 3.1 percent.

Interest rates registered an uptick except in the U.S. where the Fed has maintained a 5 percent fed. funds rate. Consumer prices maintained their upward march at a slightly slower pace.

Stock markets rose quite strongly in the first half, apparently ignoring growing weakness in the world economy. This all changed since then as markets all declined, led by the U.S. Many U.S. forecasters now expect a decline in U.S. corporate profits, which should limit any move to the upside.

Unemployment has trended down except in Japan; the U.K. figure represents a new series. Employment growth has been positive in Canada, the U.K., and the U.S. but almost neutral in Japan and negative in Germany.

Canada's current account remains seriously negative, depressing the value of the Canadian dollar. Germany's trade surplus has soared despite the Mark's decline in dollar terms. Japan's current account balance and trade surplus again are over $100 billion. Britain's current account balance is almost neutral, but the U.S. seems headed for another record deficit. Exchange rates in this environment are volatile.

Real GDP rose 1.6 percent in the second quarter after rising 5.5 percent in the first. The deceleration was accounted for by a slowdown in inventory investment and a slowdown in business spending for equipment. The strike at General Motors also contributed.

Industrial production stayed strong through May but fell in June and July. Consumer goods and equipment both declined. Capacity utilization was down to 80.5 percent in July from 83.3 percent in December. New construction expenditures, however, advanced as strongly in the first half as in 1997. The residential and commercial/industrial sectors were strong, but government construction declined. The contracts index was 139 in July compared with 144 in April.

The decline in inventory accumulation previously noted restrained real domestic investment in the second quarter. Investment for producers' durable equipment rose strongly, but investment for nonresidential structures declined. The strong rise in the first quarter offset these weaknesses in the second.

Since March, business sales and inventories have been little changed. Retail sales trended upward until May with little change in June and July; retail inventories declined after April.

Real per capita consumption expenditures advanced quite strongly in the first half as disposable income rose and saving fell to only .6 percent of income in the second quarter, a new low.

Employment growth was strong all the way through August, but a divergence is appearing. Employment in goods production was 25.3 million in January but only 25.2 million in August. Employment in services rose from 99.3 million in January to 101.0 million in August.

National income advanced 3.9 percent in the first half, a stronger pace than in either of the preceding two years; compensation of employees again led the way. Real per capita income rose a strong 2.7 percent, and real weekly earnings rose $5.94.

In August, the Bureau of Economic Analysis made its annual revision to the National Income and Product Accounts. The revisions incorporate only moderate changes to Gross Saving, but Personal Saving (the difference between disposable personal income and personal outlays) has been revised down sharply for 1995, 1996, and 1997. Under the new criteria, personal saving in the first half of 1998 is only $53.1 billion annual rate as compared with the previous $222.2 billion annual rate for the first quarter. The second quarter savings rate was the lowest of the decade.

The commodity price index weakened further in the first half to just 91 percent of the 1990 level, with the metals index down to 68.7. Producer prices have also been falling with most of the weakness in the consumer goods sector; capital equipment prices, after increasing for years, peaked in 1996 and are now slightly below that level. These price weaknesses are key elements in the emerging economic crisis.

Corporate profits are a key element in determining the direction of stock prices. After rising for many years, they peaked in the third quarter of 1997 at $840.9 billion but have been below that level in the three succeeding quarters; some observers now forecast negative growth for the second half of 1998. Interest rates have dropped precipitously, with even the 30 year Treasury rate now below 5 percent. Much of this drop is due to weakness in the stock market as investors seek safety for their capital.

It is interesting that all this financial weakness occurs despite a continuation of strong M-3 money supply growth. The demand for funds keeps growing even though it does not stimulate growth in the real economy of goods production. We may have to wait for several years for a full explanation of this phenomenon.

Commercial bank credit continued to expand strongly in the first half in all areas except government securities and consumer credit. Total consumer credit, however, expanded slightly faster than in 1997. Growth of domestic nonfinancial debt accelerated to a 6.1 percent annual rate in the first half, the fastest since 1990, despite a decline in federal debt. Household, business, and state/local government sectors all rose.

The trade imbalance grew significantly in the first half of 1998; if present trends continue, the increase could reach 50 percent. This deterioration is entirely in the goods category and reflects the effects of a strong dollar and depressed economies abroad.

The net international investment position of the U.S. worsened from $-767.1 billion in 1996 to $-1,223.6 billion in 1997, a 60 percent increase. This increase represents a combination of new capital flows, price changes, exchange rate changes and other changes.

• Direct investment: Capital flows of $93.4 bn were partly offset by negative changes of $8.4 bn for a net increase of $84.9 bn.
• Treasury Securities: New investment totaled $139.4 bn with a total change of $154.1 bn.
• U.S. currency: Currency held abroad increased $24.8 bn, mostly due to demand from Eastern Europe.
• Other U.S. securities: Official and private holdings of other U.S. securities increased $395.0 bn mostly as a result of record net purchases and a sizable rise in U.S. stock prices. Demand was strongest from Western Europe, particularly Great Britain.

The U.S. has now experienced three consecutive years of exceptionally strong growth of foreign assets in the U.S.