Friday, March 23, 2012

Who decides to increase the Money Supply?

Who decides to increase the Money Supply? Throughout most of the world we are taught it is the central banks who perform this function. In the United States expanding the Money Supply is acknowledged to be one of the core functions of the Federal Reserve Bank. They are given this responsibility since it is a fundamental technique of monetary policy. The central banks were created to execute monetary policy and keep the economy robust. This monetarist is an outgrowth of a 17th century theory about money. This theory is known as the Quantity Theory of Money (QTM).

The current formation of the theory is captured in a short equation developed by Irving Fisher: M = (P + Q) / V , where M equals the Money Supply; P equals an average price; Q equals the quantity of goods and services offered for sale; and V equals the velocity of money or the number of hands money passes through in the period of study. In another blog the end of last year I showed V or velocity of money is an invalid concept. It really does not matter for the validity of the QTM idea. Let's assume you find the average price of all the goods and services for sale in a period and if all are to sell the amount of M or money must equal the total value of the for sale items.

The more interesting question is how do the central banks know what the total retail price of all these goods and services equals. The answer is they do not have much of a clue. The solution does not come from the top down. It percolates up from all the individual banks in a country and slowly rises through the bank system as wholesalers borrow to fund the acquisition and manufacturing of products. This results in more of a guessing game and less a matching game. There are huge gaps in the system that totally miss the banking industry. One such circumstance is the lending of short term credit between manufacturers and merchants and between suppliers and manufacturers. Numerous non-monetary transactions occur to incentivize sales and maintain trading relationships. This gets even more complicated when subsidiary companies exist or when multi-national companies engage in asset sales or transfers. The point is central banks are too far removed from the action to clearly see what action they need to undertake, and hopelessly out of the loop to be an effective mechanism for fine tuning the Money Supply.

Who does decide to increase the Money Supply? It is not the central banks. It is the community loan officer who chooses to make a bank loan. Her decision certainly facilitated by the central banking system, but her decision is what prompts the creation of "new" capital. "New" capital is money created out of air and put to use to buy products or services. Until money is spent in a financial transaction it is only an electronic notation in a ledger with no affect on the economy. In N Theory I explain it is incorrect to think that central banks play a significant role in expansion of the Money Supply. The recent Global Financial Crisis in 2008 and the huge cash creation strategies employed by central banks throughout the world show the ineffectiveness of their ability to create "new" money. The only person who can effectively do that is your local loan officer.

Here is a medical analogy to make this concept more easily understood. The National Medical Agency might train a 1,000 new doctors, but the health of the country will not improve until the doctor sees a patient and prescribes a treatment. Even though in the Global Financial Crisis the central banks polished up the balance sheets of the banks, it was not until the banks made "new" loans, that the economy got any better.

No comments:

Post a Comment