Errors of Inflation Hawks, Part II
Let’s begin our examination of the errors of the inflation-hawk view of the world by bringing into focus one of its central assumptions: that the quantity of bank reserves determines the quantity of money and bank lending.
In the standard view, the Federal Reserve first creates reserves, which are then multiplied throughout the economy through the process of fractional reserve banking. Economists call this the money-multiplier effect.
If this view were true, the enormous rise in bank reserves that we’ve seen since 2008 should have resulted in a massive expansion of bank lending. This credit expansion should have produced inflation in the strict sense of a rise in the quantity of money. And this inflation should be producing asset bubbles and, eventually, rising prices.
But these things are not happening. Bank lending actually fell during the first quarter of this year—despite the Fed’s quantitative easing.
The rising prices we’ve seen in many areas—food and energy in particular—seem driven by fundamentals, rather than a general devaluing of money.
What seems to have happened is that changes in the banking system have reduced the traditional reserve requirement lending limitations to irrelevance. Bank lending is no longer constrained or expanded by the size of monetary reserves. Why not?
- Sweeping. Banks can now sweep funds customers deposit in checking-accounts into special-purpose money market accounts on a daily basis. The swept funds can be lent out—with no reserve requirement at all.
- Funding Markets. Banks are no longer really dependent on reservable deposits to fund their lending. They have access to external funding markets and are indifferent to the sources of their income. Too Big To Fail guarantees have only decreased the cost of external funding for our biggest banks, making deposits even less important.
- Globalization. Global sources of funding mean that banks are not as responsive to domestic monetary policy as they once were. If they face domestic shocks to reservable deposits, they can seek funding from around the world.
In fact, the level of reserves seem not to figure at all when it comes to bank lending. Instead, as a 2009 study produced by the Bank of International Settlements found, “the amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.”
To put it differently, the textbook money multiplier doesn't exist anymore. This means that Fed attempts to juice the economy by raising the quantity of reserves—the basic effect of quantitative easing—are bound to fail.
But it also means that predictions of massive inflation resulting from the rising reserves are also likely to be wrong.
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