Gary North

Dec. 23, 2009

Mish Shedlock is a professional photographer. He also runs a website on economic policy and market actions. It is a useful site. He has links to articles and news stories. He offers his comments, which are anti-Keynesian.

He is famous as a predictor of price deflation. He also says gold is a good investment in a time of price deflation. This sells well in the hard-money circles. Unfortunately, it makes no sense. I have commented on this self-contradictory position before.

As I have said, if you think deflation is coming, sell your gold.

Robert Murphy, an economist, is the author of a study guide for Mises' Human Action and Rothbard's Man, Economy and State. He is the author of two books in the

Politically Incorrect series: one on capitalism and the other on the Great Depression and the New Deal. He is an expert on the causes and the effects of price deflation.

In July, Dr. Murphy challenged Mr. Shedlock's prediction of price deflation. Then I did the same. Mr. Shedlock replied to me. In December, Dr. Murphy responded to Mr. Shedlock's reply to me. Then Mr. Shedlock replied to both of us.

DEFLATION NEVER COMES

This three-way debate serves as a good introduction to the debate between hard-money deflationists and hard-money inflationists. The debate goes back to the early 1970's. Consumer prices in 1972 were approximately one-fifth of consumer prices today. You can verify this with the Inflation Calculator of the Bureau of Labor Statistics.

Despite the fact that the deflationists' scenario was wrong by a staggering five to one (so far), the intellectual heirs of those long-forgotten forecasters still find ready believers. Yet there has not been a single year since 1955 in which the CPI has fallen, and in 1955, it fell by a tiny 1%. There has not been a year in which prices have fallen by as much as 3% since 1933, the year before the creation of the FDIC, which ended the threat of bank runs by depositors withdrawing currency -- the major cause of monetary deflation in a fractional reserve banking system.

For over seven decades, there has been no price deflation. Yet newcomers with no knowledge of American economic history since 1934 still flock to websites that predict price deflation. Mish Shedlock's is the most popular of these sites.

To understand why Mr. Shedlock is wrong, you must first understand how the banking system works. Let us begin with Federal Reserve policy.

FEDERAL RESERVE POLICY TOOLS

Any standard textbook in money and banking inform us of the three tools of monetary policy possessed by the Federal Reserve System. They always neglect the tool of 2008: swapping at face value the potentially worthless toxic debt of the largest banks for Treasury debt. This kept the banks solvent. The worthless assets went onto the books of the FED, where they serve as backing for the dollar. This backing is a matter of legality, not economic value. A toxic loan made by a bank and bought by the FED has equal standing with gold, which is priced by the FED at $42.22 per ounce. These assets are legal fictions.

The following is from the website of the Federal Bank of New York, which executes policy officially established by the Board of Governors.

Tools of Monetary Policy

Open Market Operations
Reserve Requirements
Discount Window Lending

The Fed has three monetary policy tools--open market operations, reserve requirements and discount window lending. Open Market Operations

Open market operations are the most important and active tool of monetary policy that the Fed uses. These operations consist of the Fed buying and selling previously issued U.S. government securities, or IOUs of the federal government.

The Fed adds extra credit to the banking system when it buys Treasury securities from the dealers, and drains credit when it sells to the dealers. As the laws of supply and demand take over in the reserves market, the cost of funds for the remaining reserves finds its level at the federal funds rate.

The federal funds rate is the interest rate banks charge each other for overnight loans. . . .

Reserve Requirements

Reserve requirements are the percentages of certain types of deposits that banks must keep on hand in their own vaults or on deposit at a Federal Reserve Bank. The Fed has the authority to set reserve requirements on checking accounts and certain types of savings accounts. . . .

The Fed rarely changes the reserve requirements. The last change made to the reserve requirement was in April 1992, when they lowered the rate from 12% to 10% of transaction deposits. . . .

Discount Window Lending

Discount rate, another tool of monetary policy, is the interest rate that the Fed charges banks for short-term loans. Changes in the discount rate typically occur in conjunction with changes in the federal funds rate.

Through the discount window, Federal Reserve Banks lend funds to depository institutions. All depository institutions that maintain transaction accounts or non-personal time deposits subject to reserve requirements are entitled to borrow at the discount window.

The main tool is buying and selling assets. The second tool --rarely used -- is a change in reserve requirements. The third is also rarely used.

EXCESS RESERVES

For the purposes of this report, the reserve requirement (tool #2) is the key to understanding why Federal Reserve monetary inflation (tool #1) has not created hyperinflation.

If the FED were to raise reserve requirements from 10% to 20%, this would be deflationary. The money supply (M1) would fall by 50%. The banks could legally lend only 50% of the money they loaned out before the change in the requirement. This is basic fractional reserve economics. The process is described in any textbook on money and banking. Here, I quote from Murray Rothbard's textbook on money and banking, The Mystery of Banking.

Since banks earn their profits by creating new money and lending it out, banks will keep fully loaned up unless highly unusual circumstances prevail. Since the origin of the Federal Reserve System, U.S. banks have remained fully loaned up except during the Great Depression of the 1930s, when banks were understandably fearful of bankruptcies crashing around them, and could find few borrowers who could be trusted to remain solvent and repay the loan. In that era, the banks allowed excess reserves to pile up, that is, reserves upon which they did not pyramid loans and deposits by the legally permissible money multiplier.

The determinants of the money supply under central banking, then, are reserve requirements and total reserves. The Central Bank can determine the amount of the money supply at any time by manipulating and controlling either the reserve requirements and/or the total of commercial bank reserves (pp. 136-37).

Here is the key fact: a voluntary increase in excess reserves by commercial banks has the same effect as an increase in the reserve requirement.

In a previous report, I described how the increase in excess reserves since September 2008 is in the range of $1.1 trillion. The increase in the Federal Reserve's adjusted monetary base has also been in the range of $1.1 trillion. Hence, the two figures offset. This is why Federal Reserve tool #1 did not produce hyperinflation. The commercial banks offset the increase in the monetary base.

So, we inflationists have an answer to the question: "If monetary inflation is the source of price inflation, as Austrian School economists argue and Chicago School monetarists also argue, why is there only mild price inflation, if any?"

Mr. Shedlock rejects this answer. He says that excess reserves are a myth. If so, they are a myth held by every school of economic opinion. His article is titled, "Fictional Reserve Lending And The Myth Of Excess Reserves."

Here is my argument. (1) Something is better than nothing. (2) A risk of losing something is preferable to a guaranteed loss. (3) If the Federal Reserve were to impose a fee on all commercial bank deposits as excess reserves held at the FED, the bankers would reduce excess reserves to zero and lend the money. (4) Therefore, since the FED has not imposed this fee, it accepts the decision of banks to increase excess reserves.

Why does the FED accept this outcome? Because, if the commercial banks did not voluntarily increase their excess reserves, the FED would have only two tools to keep a doubling of the monetary base from doubling M1 and thereby doubling the price level: (1) Sell all the assets it bought, including the toxic waste loans they swapped T-bills to buy; (2) increase reserve requirement.

First, the FED cannot sell these assets -- no market (at face value). Second, the FED does not want to get blamed for raising reserve requirements, for this would indicate publicly that what it did in September and October 2008 was inherently inflationary. The FED prefers to do nothing and let the bankers do the rest: increase excess reserves. The FED can play innocent regarding the lack of lending. "We're not to blame for banks not lending. We are leaving this to the free market." The FED is off the hook.

Does this argument seem far-fetched? It does to Mr. Shedlock. He writes:

Money Multiplier Theory Is Wrong

The above hypotheses regarding "Excess Reserves" are wrong for five reasons.

1) Lending comes first and what little reserves there are (if any) come later.
2) There really are no excess reserves.
3) Not only are there no excess reserves, there are essentially no reserves to speak of at all. Indeed, bank reserves are completely "fictional".
4) Banks are capital constrained not reserve constrained.
5) Banks aren't lending because there are few credit worthy borrowers worth the risk.

The first two are not true. He is making this up. The first is gibberish. The second is simply not true. If the FED says there are excess reserves, there are excess reserves. As soon as these are withdrawn, they become money, as I shall explain.

The third also is not true: bank reserves are not legally fictional. The FED must return these deposits on demand, and as soon as it does, they become money. They are loaned out. They can be held only as legal assets: loans. All debt is money, with one exception: reserves held at the FED. These reserves are not lent into circulation by the FED. This is why they are economically significant. They offset the increase in the monetary base.

His fourth point is irrelevant. He is playing word games. There are always constraints in this life, beginning with this one: "There are no free lunches."

The fifth is true, as every economist would say, "at some price." I am arguing that the Federal Reserve can create millions of credit-worthy borrowers by charging a fee on excess reserves. The bankers definition of credit-worthy would change if the FED imposed (say) a 10% fee on excess reserves.

He spends 14 pages in a futile effort to prove that which cannot be proved.

I'll now prove this to you.

MISH SHEDLOCK VS. THE ECONOMISTS

He stands against every economist who has written a description of fractional reserve banking. He has not just rejected my view, Murphy's view, and Steve Saville's view; he has rejected Murray Rothbard's discussion of excess reserves and the money multiplier.

Mish Shedlock thinks he is right and Murray Rothbard, Milton Friedman, and the entire economics profession are wrong. He thinks a few pages on a blog refutes a century of detailed analysis of how fractional reserve banking works.

If he says that he does not reject their views in theory, but only in today's situation, he has to show why they were correct in theory, but their theory does not apply to today's situation.

He is saying that the Federal Reserve's reports on excess reserves are mythical. There are no reserves, he says.

He does not understand fractional reserve banking. Except for money held as excess reserves as the FED, a bank has to lend. Every liability has to be offset by an asset. If a bank has deposits (liabilities), then it has to have an asset (loan). It has to lend, if only to buy T-bills. If it buys T-bills, the government spends the money. The money multiplier takes over. The monetary base turns into M-1. The only bank asset that does not get into the economy in the form of money is a deposit at the FED called a reserve.

This is not a matter of banking. This is true of all accounting. Assets must match liabilities.

So, if a bank withdraws money from its account at the FED -- an excess reserve -- it can do this only by simultaneously purchasing an asset, i.e., by making a loan. Unless the bank makes the withdrawal in the form of currency, and then places this in its vault, it must make a loan. If the currency is in the vault, it remains a part of the bank's reserves.

A BANK RUN FOR CURRENCY

All deflationists say there can be a bank run. If people withdraw currency from the banks, and this money is not re-deposited in a bank, this implodes the fractional reserve process. The money supply shrinks because of this implosion -- the reverse of what happens when currency is deposited. We inflationists agree. This was what shrank the money supply, 1930-33: bank runs and collapsing banks. But then the FDIC was invented in 1934. So, people have ceased making bank runs. That was when monetary deflation ended. Price deflation also ended.

But there can still be a "bank run" for currency. When a bank puts currency in its vault instead of making a loan, this currency counts as part of its reserves. Ben Bernanke referred to this fact in footnote 4 in a 2005 speech. "Banks' holdings of vault cash also count toward meeting legally required reserves." The asset ceases to be digital money. It is not lent out. It leaves the economy. It is locked in the vault.

Are we agreed? Do you understand this? I mean really, truly understand it? If so, let us continue.

Reserves -- mandated and excess -- are liquid bank assets that are not loaned out. They do not get spent into the economy. They do not enter the fractional reserve process of money creation: the multiplier. This applies to all legal bank reserves, not just to currency. This is why currency has always served as a legal reserve.

"YES, MISH, THERE REALLY ARE EXCESS RESERVES"

If the FED says a bank has excess reserves, the bank can legally convert these reserves into money that can be loaned out. There is no other way for the bank to record a non-reserve asset on its books to offset deposits. The balance sheet must balance. (What an amazing concept!)

How could Mish not understand this? I offer this explanation. He has never read a textbook on money and banking. If he has, then he did not understand it.

To prove me wrong, he needs to cite a passage verbatim from a money and banking textbook that says that a bank can hold a deposit without simultaneously owning an asset. He had better cite the page number, too. He will not do this because no such textbook exists. If he refuses to do this, rest assured that he is intellectually defenseless. He cannot defend his position on the myth of excess reserves.

Why would he resort to utter nonsense to explain away excess reserves? Because he is intellectually desperate to save his deflationist scenario. He is trying to make inflationists look bad. How? By removing their explanation for the absence of hyperinflation. He is trying to persuade readers that the banking system is inherently deflationary today, and only the FED's injection of a trillion dollars (the monetary base) has kept the economy from imploding in mass deflation.

To make his case, he must reject the entire economics profession's explanation of reserve requirements and excess reserves.

No economist takes him seriously on this point. Readers who have no understanding of modern banking may take him seriously. I hope you are not among this group.

CONCLUSION

A professional photographer who thinks of himself as an Austrian School economist, but who rejects Murray Rothbard's explanation of fractional reserves, is not an Austrian School economist.

He is a self-taught man who has picked up a great deal of information about markets. In the few years that he has been on-line, he has taught himself a great deal. But he is utterly blind in certain areas. The main one is monetary theory. He has not had time to master the intricacies of money and banking.

He is in way over his head on the matter of excess reserves. He really should sit down and read Rothbard's book, The Mystery of Banking. He had better go through the T-accounts exercise, which is basic to any course in money and banking. It is clear to me that he has not done this. It's time.

He is unlikely to do this. If he did, he might become an Austrian School analyst. He would then have to give up deflationism. He would have to switch to predicting inflation, just as Martin Weiss did. He would lose his positioning as the #1 gold-advocating deflationist. This is too painful for most people to do. Weiss did it, but it took over 27 years.

So, readers, don't excpect Mish to change. It is up to you to decide who has the better arguments: the entire economics profession or a photographer.