Killing the Currency

by Chris Casey














 

. . . there is no record in the economic history of the whole world, anywhere or at any time, of a serious and prolonged inflation which has not been accompanied and made possible, if not directly caused, by a large increase in the quantity of money.

— Gottfried Haberler, Inflation, Its Causes and Cures (1960)[1]

The phrase “not worth a continental” may be vaguely familiar to Americans as an old and quirky saying, but to Revolutionary War–era Americans it would have been a harsh reminder of a recent nightmare. In order to finance the war, the Continental Congress authorized the issuance of money without rights of redemption in coin or precious metals (unlike other currencies in circulation). In short order, over $225 million Continentals were issued on top of an existing money supply of only $25 million. Initially traded on a one-for-one ratio with paper dollars backed by coin or precious metals, within a mere five years Continental currency had depreciated to worthlessness.[2] It was America’s first major experiment with a fiat currency, and it cost many newly free Americans their livelihood and savings.

Such expansion of the money supply is not relegated to America’s past. In response to the 2008 economic crisis, by some measurements the Federal Reserve has more than tripled the money supply. With such pronounced expansion, will the U.S. soon experience significant price inflation, and if so, how severe may it be?[3] Answering these questions requires an examination of the money supply.

The Money Supply

The Federal Reserve creates money by three methods:

• Purchasing Assets: For purposes of the effect upon the overall price level, it does not matter which assets are purchased as long as they are bought with newly created money. This action is performed by the Federal Reserve’s “open market operations” which historically has consisted of buying and selling Treasury securities (and now includes a large dose of mortgage-backed securities). Purchasing assets allows the Federal Reserve to instantly increase the supply of money and manipulate both interest rates and the prices of securities through its selection of assets to purchase. After successive rounds of “quantitative easing,” the Federal Reserve announced a self-described “highly accommodative stance of monetary policy” on September 13, 2012 in which it committed to monthly asset purchases of $85 billion.[4] This open-ended policy will result in annual purchases of $1 trillion (especially significant when compared to 2012 U.S. Gross Domestic Product of less than $16 trillion).
  
• Lending Money to Banks: The discount rate is the interest rate by which commercial banks may borrow additional reserves from the Federal Reserve. It is a rate set by the Federal Reserve. With lower rates, banks are more inclined to borrow money, thus expanding the money supply. Currently, the rate is set at the near-historically low level of 0.75 percent. To emphasize how significantly low this rate is, it was set above 6.00 percent as recently as 2006.
  
• Lowering Banking Reserve Requirements: While not commonly understood, it can have the most immediate and profound effect upon the money supply and the economy relative to the other monetary creation tools possessed by the Federal Reserve. Commercial banks, by lending out demand deposits, create additional dollars in the system above-and-beyond that of the Federal Reserve’s actions. The word “fractional” in fractional reserve means they hold but a fraction of what can be demanded from them at any given time. Currently, banks only need to have 10 percent of their demand deposits available for withdrawal by depositors.[5] This means that with a reserve requirement of 10 percent, banks can increase the money supply equal to 10 times their demand deposits.
  

These three methods are simple despite assertions by Treasury officials and bankers that actions such as “quantitative easing” are complex. In fact, “quantitative easing” is quite easy to understand: previously there was X amount of currency, and now there is X plus Y.
The money supply can be measured in a variety of ways depending upon the definition of money. Three measurements of money supply available on a monthly basis since 1959 include: BASE (“Adjusted Monetary Base”), M2, and MZM (“Money Zero Maturity”).[6][7][8]

• BASE. Currency in circulation and deposits held by domestic depository institutions at Federal Reserve Banks.
• M2 Currency in circulation, savings deposits, and retail money market mutual fund shares.
• MZM. M2 with the addition of institutional money funds.

Given its three tools, how has the Federal Reserve recently increased the money supply relative to its historical actions? The chart below describes, on a percentage basis, increases in each monetary category on a monthly basis relative to its level on January 1, 1959.



Three trends are readily apparent from this graph:

• First, regardless of the definition of money, the money supply has expanded dramatically over time as the increases are measured in thousands of percentage points;

• Second, the overall expansion appears to have begun in earnest in 1971 which is, not coincidentally, when President Nixon severed the last links of the U.S. dollar (and effectively all other major currencies), from gold; and

• Third, the money supply as measured by BASE has exploded since 2008 (up 245 percent from December 1, 2007 to March 1, 2013) while the money supply from the other two measurements has not followed the same degree of increase (although they too have experienced accelerated growth).

Why has M2 and MZM not followed BASE? Note that the definition of BASE includes “deposits held by domestic depository institutions at Federal Reserve Banks” which is not part of the M2 and MZM classifications. Traditionally, to maximize profits, banks hold their “excess reserves” at close to zero. That is, they tend to quickly lend out any reserves they have over-and-above their legally required minimum. So the difference in BASE relative to M2 and MZM reflects the current lack of new lending by commercial banks.[9]
As Austrian economist Mark Thornton has noted, we live in a unique:

economic and financial environment where bankers are afraid to lend, entrepreneurs are afraid to invest, and where everyone is afraid of the currencies with which they are forced to endure.[10]

Unless this difference becomes permanent (which would be unprecedented), M2 and MZM should experience additional significant increases. Importantly, however, the potential for substantial future price inflation does not rest upon M2 and MZM “catching up” to the increase in BASE, for each of these monetary categories has soared in their own right since December 1, 2007 (M2 by 61 percent and MZM by 43 percent).[11]

Price Inflation and the Money Supply

Increases in the supply of money create price inflation, all things being equal. But what is not “equal”? That is, why is the relationship between monetary increases and inflation not on a one-to-one basis? There are several primary reasons.

• First, as the economy experiences real growth, the demand for money increases due to both the larger number of entities holding cash balances (i.e., more firms are created as the economy grows) as well as the general trend for economic actors to increase cash holdings with greater economic opportunities (i.e., goods and services). Increased demand for money raises its value which decreases the prices of all goods and services. The higher demand for money helps mitigate the inflationary effects of monetary increases.

• Second, there are timing issues between the increase in the supply of money and the appearance of price inflation. The time delay is not consistent throughout history, and is influenced by a number of factors.

• Third, the U.S. economy is not a closed system. To the extent dollars circulate outside of the U.S., whether as “petrodollars” or as the de facto national currency of a different state, the diversion of such dollars from the U.S. economy helps alleviate price inflation due to increases in the money supply.

Although the timing of the emergence of price inflation can only be estimated, the correlation with money supply growth is indisputable.[12] Based on money supply growth — by any measure — since 2008, substantial price inflation is likely. And if price inflation mirrors the growth in money as measured by the monetary category BASE, the ensuring price inflation will be unprecedented since the Continental dollar.
It is important to note that regardless of any future curtailment of monetary expansion, the inflationary forces are already within the system. It does not matter if the Federal Reserve ends its “highly accommodative stance of monetary policy.” Its past actions will have a pronounced future reaction.

Conclusion

In the U.S., the last several years have witnessed an unprecedented expansion of the money supply. Even America’s failed experiment with Continental currency, while incorporating a larger expansion of the money supply, is not truly comparable. For in Revolutionary War-era America, alternative currencies were readily accessible and used in the daily course of business, thus providing a measure of ability to disengage from the failing Continental money. But no such options exist for today’s Americans who must transact their daily business in U.S. dollars. So while the Continental dollar was disastrous, the future situation for today’s dollar may prove far worse.