Manna From Heaven

To begin with, the monetary base [sic] has never been a “base” (money multiplier), for the expansion of new money and credit. Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it was superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure included AMBLR (interbank demand deposits held at one of the 12 District Reserve banks, owned by the member banks, as well as “applied” vault cash, traditionally ->”prudential” or a part of a bank’s liquidity reserve balances before 1959), plus the volume of currency held by the private-sector’s non-bank public (Nobel Laureate Dr. Milton Friedman’s misnomer: “high powered money”).

Any expansion or contraction of DAMB is neither proof that the Market Group’s “trading desk” intends to follow an expansive, nor a contractive monetary policy (adding or draining interbank demand deposits, IBDDs).. Furthermore any expansion of the non-bank public’s holdings of currency, the “cash-drain” factor, merely changes the composition (but not the total volume) of the money stock. There is a shift out of demand deposits, NOW or ATS accounts, into currency. But this shifting does reduce member bank legal reserves by an equal, or approximately equal, amount.

In other words, we have a “managed” currency system, not a “fiat” one. In a fiat system the volume of currency issued is dictated by the deficit-financing requirements of the issuing government (like the Civil War Greenback). Whereas in a managed-currency system (ours), the volume of currency in circulation is impersonally determined by the public, and the amount which meets the needs of trade.

The basic process by which currency is put into and taken out of circulation is through the banking system. The volume of currency held by the public needs no formal or specific regulation since it is impossible for the public to acquire more of a given type of currency (or even less given current operating policies), without giving up other types of currency, or else bank deposits. In other words, under our managed system it is impossible for the public to add to the total money supply consequent to increasing its holdings of currency.

An expansion of the public’s holdings of currency will cause a multiple contraction of bank credit and “total checkable deposits” (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the desk typically offsets currency withdrawals with open market operations of the buying type (e.g., purchases of government securities for the portfolios of the Reserve Banks, an increase in the Central Bank’s System Open Market Account, SOMA). The reverse is true if there is a return flow of currency to the banks. Since the trend of the non-bank public’s holdings of currency is up (ever since 1930), return flows are purely seasonal & cannot therefore provide a permanent basis for bank credit and money expansion.

And all currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation; those historical instances when the U.S. Treasury borrowed from the Federal Reserve Banks (its prior, and given sequestration, too-long since abandoned “overdraft privilege”). However, it cannot be said (as of time-savings deposits), that increases in the public’s holdings of currency reflect prior commercial bank credit creation. It is more appropriate to say that expansions of currency are accompanied by concurrent expansions of Reserve Bank Credit (Manna from Heaven).

Although the DIDMCA of March 1980 made all depository institutions maintain uniform reserve requirements (but placed no restrictions on non-bank, MSB, CU, & S&L, correspondent clearing balances, or “pass thru” accounts), thereby expanding the “source base” from 65% of the member commercial banks to 100% of the money creating depository institutions; Paul Volcker’s unconventional reserves-based-operating-procedure” was not unsuccessful. It was untried; because the BOG attempted to target merely non-borrowed reserves, when at times, 10% of all required reserves were borrowed. I.e., $1b of legal reserves in 1980 (borrowed or otherwise), supported $16b of M1, ergo the M1 money multiplier was 16:1 (not as the FED erroneously reported: 2.5-2.6 in 1980).

I say Chairman Volcker “attempted” because legal reserves grew at a 17% annual rate-of-change, from April 1980, until the end of that year (contrary to Dr. Richard G. Anderson’s a posteriorir maligned required reserves’ reconstruction, viz., rewriting history). This, accompanied by the “time bomb” (the widespread introduction of ATS, NOW & MMDA bank accounts), presaged a 19.1% surge in N-gNp (American-owned, as opposed to a country’s geographic boundary), in the 1st qtr. 1981 (a twentieth century high “blowout”). 

Dissenting was Lawrence K. Roos, past President, FRB-STL and former part time member of the FOMC as cited in the WSJ’s “Notable and Quotable” column 4/10/86: “I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always and still is a preoccupation with stabilization of interest rates”. The Fed's monetary transmission mechanism is non sequitur, it presumes that a “liquidity preference” curve exists which represents the supply of money. In this system, interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world - a world in which interest is paid on checking accounts (the elimination of Reg. Q ceilings for commercial bankers, and the complete deregulation, “suppression” [sic] of interest rates).
Contrariwise, this so-called “experimental operating procedure” (monetarism), was never “abandoned”, it was never tried. Monetarism involves more than watching the aggregates, it involves properly controlling them. Monetarism is not identical to smoothing percolating reserve position pressures (see factors affecting reserve balances, H.4.1 release), or what Paul Meek’s (FRB-NY assistant V.P. of OMOs and Treasury issues), stated objective in his 3rd edition of “Open Market Operations” published in 1974: of “gauging the general availability of non-borrowed (interbank) reserves in the commercial banking system (which predates Paul Volcker’s rhetorical and “experimental” [sic] couched approach in Oct 1979.

One dollar of borrowed reserves provides the same legal-economic base for the expansion of the money supply as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. A new advance could be obtained, or the borrowing bank replaced by other borrowing banks. That's before the “discount” rate (perversely below the FFR during Volcker’s inflation) was made a “penalty” rate (perversely during Bernanke’s deflation), in January 2003 (see: Walter Bagehot in his book Lombard Street: "lend freely and at a penalty rate). And the Federal funds "bracket racket" was simply widened, not eliminated. Contrary to “Naked Capitalism’s” Yves Smith, monetarism has never been tried:

On October 6, 1979 Paul Volcker, Chairman, Board of Governors of the Federal Reserve System promised that the Fed was going to mend its ways. Hereafter the Fed would deemphasize the control of the federal funds rate and concentrate on holding the monetary aggregates in check. We were advised to “watch the money supply”. For approximately the first four months following this pronouncement the money supply increased at an annualized rate of 20 percent...up from the 8 percent increase in the prior five months...obviously there had been no significant change in monetary policy. 

And Paul Volcker’s version of monetarism (along with credit controls: the Emergency Credit Controls program of March 14, 1980), was limited to Feb, Mar, & Apr of 1980. With the intro of the DIDMCA, total legal reserves increased at a 17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 year-end).

Between 1942 and September 2008, member commercial banks operated with no excess legal reserves of consequence.

However, legal reserves were only “binding” between c. 1942 until 1995. By mid-1995 (a deliberate and misguided policy change by Alan Greenspan), legal (fractional) reserves ceased to be binding – as increasing levels of vault cash/larger ATM networks, retail deposit sweep programs (c. 1994), fewer applicable deposit classifications (including allocating "low-reserve tranche" & "reservable liabilities exemption amounts" c. 1982) & lower reserve ratios (requirements dropping by 40 percent c. 1990-91), & reserve simplification procedures (c. 2012), combined to remove reserve, & reserve ratio, restrictions (i.e., Chairman Alan Greenspan spuriously reduced legal reserve requirements by 40 percent to speciously / artificially counteract the July 1990-Mar 1991 recession precipitating the real-estate boom, the precursor of the GFC).  

This unleashed unrecognized inflation, money illusion (not factored into the CPI), the real-estate bubble and the dot.com boom. This growth was largely a velocity phenomenon driven by financial re-engineering, innovation, and new money substitutes (accelerating Vt – something the FOMC doesn’t discuss).

Subsequent to this period (in conjunction with the Emergency Economic Stabilization Act of 2008), Regulation D was amended, & the Board gave the District Reserve Banks the authority to pay the member banks quarterly interest on their (1) required and (2) excess reserves. As a result of the FOMC’s initiatives, QE programs, unused excess reserves expanded dramatically (absent credit worthy borrowers and a paucity of existing safe-assets, e.g., new Treasury short-term T-bill issuance, viz., Treasury-Federal Reserve corroboration). 

This new policy instrument (remunerating IBDDs), was contractionary (reminiscent of Reg. Q ceilings between the DFIs and the NBFIs), & induces dis-intermediation within the non-banks (where the non-banks shrink in size, and savings are idled, & the commercial banking system’s size remains unaffected, and new money is used as a monetary offset to an errant policy induced deceleration in AD).

In our Federal Reserve System, 92 percent of “MO” (domestic adjusted monetary base) was represented by the currency component prior to Oct. 6, 2008. There is no “expansion coefficient” assigned to the currency component. And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (and declining); that to measure the rate-of-change in currency held by the non-bank public, to the rate-of-change in M1 (where 54% was currency), is, yes, to measure currency vs. currency (cum hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.

William Barnett (a former NASA “rocket scientist), is right, the Fed should establish a "Bureau of Financial Statistics". The data the Fed collects and compiles is unusable

Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation, to domestic currency circulation. The FED’s research staff estimates that foreigners hold one half to two thirds of all U.S. currency (this spread can result in a wide margin of error). Inflows and outflows of foreign-held U.S. currency (e.g., seldom are untaxedearnings ever repatriated) are attributed to political, and price, instability (as well as to seasonal flows), and all are immeasurable in the short run. I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency.

The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts of the United States” & in the BEAs estimates of the net international investment position of the United States.

The volatility of the (1) K-ratio, the public’s desired ratio of currency to transactions deposits (or currency-deposit-ratio), and the volatility in (2) the ratio of foreign-held, to domestic U.S. currency, both influence the trend rate for the cash drain factor (the movement of the domestic currency component of the DAMB). And the evidence points to sizable (& unpredictable), shifts in the money multiplier (MULT – St. Louis), for the constantly changing shifts in the composition of the “M’s”.

The Federal Reserve Bank of Chicago uses legal reserves (“t”-accounts), exclusively, to explain the creation of new money and credit in the booklet “Modern Money Mechanics”. The booklet is a workbook on bank reserves and deposit expansion (changes in a bank’s deposits-loans resulting from open market operations). The stated purpose of the booklet is to “describe the basic process of money creation in a "fractional reserve" banking system” - the monetary base plays no role at all in this analysis.

It is therefore both incorrect in theory, and thus inaccurate in practice, to refer the DAMB figure as a monetary base [sic]. The only base for an expansion of total bank credit and the money supply is the volume of legal reserves supplied to the member banks by the Fed, in excess of the volume necessary to (1) offset currency outflows from the banking system & (2) offset fluctuations in the level of member bank’s reserve balances (diverted & detained via the remuneration rate), in the 12 District Reserve Banks. The adjusted member bank legal reserve figure is that base.