Where Does the Fed's Stimulus Money Go? Part II Attempting to Understand Money Creation by D. R. Barton, Jr.

[You must be registered and logged in to see this image.]Where Does the Fed's Stimulus Money Go?
Part II

Attempting to Understand Money Creation

by D. R. Barton, Jr.

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Each spring, the University of Delaware holds an economics competition for elementary school children from all over the state. It gives me great joy to participate in coaching teams of 3rd through 6th graders on the basics of economics, entrepreneurship, and presentation skills so they can learn through competing.

The test portion of the competition always includes a question about the meaning of money, so I teach the kids the classic economics definition: “Money serves as a medium of exchange, a store of value or a unit of account.” Originally, items with perceived value were used as money—things like shells and eventually precious metals. Now, paper (gasp!) serves as the physical representation of money in most parts of the world, backed by nothing but a government (or coalition) promise. In reality, the majority of money, as it is used in commerce today, is just a concept, tracked by 1’s and 0’s in the electronic ether…

One of the great misunderstandings of modern finance is exactly how money is created and the significant effects that new financial innovations are exerting on the money supply.

This Is Not Your Momma’s Money Creation

What many policy makers learned in school 20 or more years ago about money creation has not worked in at least two decades, according to Peter Stella, former head of Central Banking and Monetary and Foreign Exchange Operations Divisions at the International Monetary Fund. (I can only assume that he got tired of carrying around business cards large enough to hold that title and left the IMF to form his own consulting company…)

Stella, in his blog, lists the textbook money creation stream as follows:

All credit was provided by banks.

All bank credit (assets) was funded by the issuance, or creation, of depository liabilities (money) subject to a reserve requirement.

Central banks controlled credit/money/inflation by rationing bank reserves. A stable 'money multiplier' was hypothesized to allow central banks to accurately predict the eventual impact of changes in bank reserves on money and credit.

While that’s a beautiful theory, Stella states his problem with it; “…none of those three assumptions has been true for at least a generation.” First of all, the Fed no longer rations reserves (understatement of the year). As I mentioned in last week’s article (LINK), bank reserves have grown by $2.2 trillion since 2008. At the same time, credit from commercial banks has not gone up at all. Today, central banks main technique for influencing credit is by altering the interest rates that banks must pay on their reserves.

So why have reserves at all? Stella again clarifies—to facilitate the management of the payment system. Hence the Fed’s balance sheet expansion has the system primed with plenty of lubricant for payments and settling transaction among banks. (To be fair, the QE has certainly provided other effects, including important psychological ones that we’ll cover in a future article.)

In short, bank reserves held at the Fed have very little direct relation to lending and credit. This leads us to the conclusion that, today, traditional “monetary policy” has almost nothing to do with money!

Most of the credit created today does not come from central bank reserves but from the so-called shadow banking: a stew of hedge funds, money market funds, investment companies, etc. In a 2013 IMF paper, Stella and Claessens define shadow banking as, “all activities except traditional banking that require a private or public backstop.”

If new credit creation is not coming from the banks, as shown by the added $2.2 trillion in reserves since 2008, with zero growth in commercial bank loan amounts, why does QE continue?

We’ll dive deeper into that question next week. Until then, your thoughts and comments are welcome — please send them to drbarton “at” vantharp.com

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

Where Does the Fed's Stimulus Money Go? Part II Attempting to Understand Money Creation by D. R. Barton, Jr.

Where Does the Fed's Stimulus Money Go? Part II Attempting to Understand Money Creation by D. R. Barton, Jr.

Where Does the Fed's Stimulus Money Go? Part II Attempting to Understand Money Creation by D. R. Barton, Jr. :: Comments