Monday, September 9, 2013

Federal Debt and Bank Expansion of the Money Supply

It is widely accepted that Fractional Reserve Banking allows bank loans based on deposits.   Considering banks as a whole, any loan creates a new deposit without reducing the deposit of any other customer.  The lending bank creates a new asset (a contract to repay) and assumes a new liability (an obligation to restore full value of money to all depositors) in exchange for making this loan and deposit available.

Once expanded by a loan, an increase in available deposits remains in the system as an expanded money supply until the loan is repaid.

If there were no limits to this process, the increased value of all deposits could be used as justification for increased loans.  A new loan would equal a new deposit automatically so would there be no need for deposits to precede loans.  Loans and deposits could be created simultaneously.  This is prevented with limits.

In the United States, the Federal Reserve legally requires banks to hold reserves, currently 10% of all demand deposits.  This effectively limits loans to 90% of deposits and creates a limit to deposit expansion.  A 10% reserve allows a theoretical expansion of ten times the original deposit.

If the discussion stopped here, we would expect bank loans to be about 10 times reported deposits but data available from the Federal Reserves indicates that the ratio is dramatically less than an average of 1:1.  What is going on?
Figure 1.  Ratio of bank loans to deposits is unexpectedly less than 1:1 on an average.
The logic of money supply expansion has one important precondition: The borrowed money must be available to be loaned again.  This precondition is fulfilled theoretically by assuming that the loan-based-deposit is spent into the system and then continues to exist someplace as an account entry until the loan is repaid.  The single bank equivalent is a loan which once spent, comes back to the bank in a closed system, such as a bank on an isolated island.  In both cases, the loan-based-deposit could be used as a base a second, then third time, and so on. The precondition is considered completed.

This precondition may not be met in the United States Economy.  Follow the path of a loan-based-deposit as it is spent.  Until it gets into the hands of savers, it moves very quickly through the hands of the private economy and government, moving from bank to bank.. Fast moving money is extremely risky for use as a monetary base.  A bank would certainly not want to lend money based on a deposit that might only reside in the bank for one day!  The large number of banks in the United States acts like a divider of the whole-bank concept, negating the expansion precondition of stable availability.  Only the initial expansion is certain, and this is an expansion of two (a doubling), not ten.

As previously mentioned,  even a doubling is more expansion than is indicated by Federal Reserved Data. The data suggests that loans are nearly always much less than deposits, barely exceeding a 1:1 ratio just prior to recessions.  Does this suggest that the system is operated without limits?  No, there is another path that accounts for the less than 1:1 ratio.

The Federal Government has run a deficit for most of the last 50 years.  Most of the deficit is funded with money borrowed from the private economy. Government borrows (first) the excess expansion from bank loans and then, if more is needed, from itself acting through the Federal Reserve. Finally, Government purchases from the private economy, thereby providing money for future loans.

The result can be tracked using Federal Reserve Data.  About half the expanded money supply is held in banks as deposits.  The second half is held in the form of Federal Debt (Note 1.) which is near money and accepted at face value for purposes of complying with Reserve Requirements.   Figure 2 shows the sum of bank deposits added to Federal Debt, which will be about double loans at banks, on the long term average.

Figure 2.  When Federal Debt held by the public is added to bank deposits, the relationship to bank loans is about 2:1 on the average.  This relationship builds the case for considering Federal Debt as part of money supply.
This post will conclude by pointing out that bank loans result in deposits.  Each bank loan has an original deposit that preceded the loan so we could expect to locate two deposits for each loan.  Surprisingly, the expected result of two deposits to one loan is not observable in Federal Reserve Data.  The deposits not-accounted-for have been loaned to the Federal Government and can be found accounted as Federal Debt.

Being debt of government and very safe assets, these missing deposits in the form of Federal Debt can legally be counted as bank reserves. These missing deposits in the form of Federal Debt could also be counted as part of the national money supply.

Note 1.  The label "Federal Debt" is used generically but a more precise definition would be "Federal Debt held by the public".  Federal Debt as a trust fund obligation is not counted.  Federal Debt held by the public, as defined in this post, is accounted by the Federal Reserve as data series FDHBPIN.


1 comment:

  1. Roger,

    In a simple model where a bank balance sheet consists of only deposits and loans, they will always be equal, because the balance sheet must balance. And loans and deposits do account for the majority of bank balance sheets. But there are also other things on bank balance sheets as well, so deposits and loans will not in general be equal.


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