MONETARY EXPANSION is a pleasant sounding phrase, like
"an expanding economy, " "an expanding world view," and the like. It is
associated with expanding employment, expanding investment, an expanding
standard of living. Some are so taken by its euphoric connotations that
the only difference among them is the desirable rate of ballooning. One
economist of our acquaintance argues that the money supply ought to grow
in direct proportion to population growth; another would have it plod
ahead at a fixed rate regardless of population, economic activity, or
whatsoever. Still others, influential in Congress, apparently would like
it to explode until every man, woman and child looking for a job had
employment-or a guaranteed income.
Monetary growth, in short, is regarded by these
exponents of expansion as the key to unlock the door to limitless
wealth. They would repeat John Law's facile proposal for enlarging the
wealth of France. "Wealth," Law said, "depends on commerce; and commerce
depends on circulation. A state must have a certain quantity of money
proportioned to the number of its people. What I propose is to make a
currency equal to the value of the land."
The Money Pump
In the U.S. the fountain from which issues what passes
for money is the Federal Reserve System. Here is the cock that adjusts
the flow of flat purchasing power into the economy. If business is
slack, if interest rates are rising, open the cock a little wider.
"Freeing up the money supply"-to use the phrase of former senator and
presidential candidate Fred Harris-is the answer to our economic
problems.
The money supply--the so-called M1--is enlarged two
ways: by the issuance of paper notes (Federal Reserve notes) and by
increasing the reserves to the commercial banks by which they may
increase their loans and deposits. The determination of the amount and
rate at which notes and reserves are to be created is set by the Federal
Reserve Board.
Prior to 1965 the Federal Reserve's power to increase
the money supply was limited by a statutory requirement of a gold
reserve against Federal Reserve banks' deposit liabilities and Federal
Reserve notes in circulation. In that year Congress removed the gold
reserve against deposits, and in 1968 the reserve against notes.
The Spurting Fountain
The Federal Reserve may now issue notes in unlimited
amount simply by purchasing Treasury obligations and paying for them
with a piece of paper, Formerly these pieces of paper were the same as
commercial demand notes; i.e., promises to redeem on demand in lawful
money. But a few years ago the phrase "redeemable in lawful money" was
quietly removed, and today their only validity as money is that they
must be accepted as legal payment of any debt public or private.
About one-fourth of the so-called money supply (M1)
consists of paper notes and debased coinage. The balance consists of
commercial bank deposits. Member banks of the Federal Reserve System are
required by law to maintain a minimum reserve in cash or on deposit with
the Federal Reserve banks--10 per cent of demand deposits for reserve
city banks.
Again, the Fed can make more reserves available to the
commercial banks by the purchase of Treasury obligations and paying for
them by check on itself; the effect is to create deposit credits in
favor of the commercial banks which enable them in turn to increase
their lending and their deposit credits to customers. At the same time
the use of Treasury obligations as reserve for Federal Reserve notes and
deposits is to monetize the public debt--just a step removed from the
government itself issuing greenbacks.
Are there limits to the amount of money that can be
created by this mechanism? Theoretically none. The Fed is hampered by no
gold or other reserve requirement in its power to flood the economy with
currency and credit. Elements in Congress regard this tremendous
economic power with suspicion or envy, and would like to transfer it to
the hands of Congress, where no doubt it would be exercised with less
restraint than presently.
Brakes on the Well Pulley
Actually there are restraints which the planners, the
theorists, and the politicians have overlooked. With their gaze fixed on
the Utopia of an ever-expanding money to energize an ever-expanding
economy to provide an ever-expanding affluence to the citizenry, they
assume that all the Fed need do is to wave its wand.
The theory of Federal Reserve action assumes that as
the Fed increases member bank reserves the effect will be a
corresponding expansion of total bank credit (loans) by the so-called
multiplier of 5 to 6 times. It is also assumed that this added credit
will flow into the channels of business stimulating new construction,
capital investment and employment.
But for a bank to expand its loans it must have
borrowers willing and wanting to borrow. With interest rates soaring in
recent years (a reciprocal of a declining value of the dollar), and
business uncertainty rising, borrowers are fewer and more reluctant to
put their heads on the block. Since the events of 1974 businesses have
been paying off debts and getting more liquid. Thus, commercial
borrowing at large commercial banks (the bulk of the commercial loans)
dropped from around $131 billion at 1974 year end to as low as $111
billion during 1976 (although rising somewhat since).
Once Bit, Twice Shy
With a paucity of loan applications, the banks, to make
use of their reserves, have invested heavily in Treasury obligations,
with the funds going to finance government expenditures much of which is
for welfare and other non-productive uses rather than business
enterprise that creates employment. Between the end of 1974 and 1976
year end, bank holdings of Treasury bonds nearly doubled with some $45
billion going into such obligations. The demand for Treasury obligations
has also facilitated the financing of the deficit and lulled both
Congress and the Administration into complacency about the steady
build-up of the Federal debt.
Few are willing to recognize the truth that the policy
of monetary expansion under the guise of "bank credit" is simply one of
increasing the burden of debt already enormous with its continually
rising interest cost. The persistence of a policy of monetary expansion
is resulting in increasing suspicion of the soundness of the economy and
the certainty of the outlook, leading the business community to caution
about commitments.
The consequences of so much added purchasing power
flowing into Treasury obligations instead of business are found in the
rise in prices. Contrary to popular expectations, the injection of so
much excess purchasing power into the economy, by fiat rather than the
production of goods and services, does not stimulate enterprise but
deadens it. It has the same result as too much water in the body: an
economic dropsy occurs, reflected in a bloated price structure, that has
nearly doubled the consumer price index since the removal of the gold
reserve against notes.
The Specter of Default
The failure of so many real estate investment trusts,
which the banks have financed, amounting to a REIT debacle, has made
banks reluctant lenders to the real estate market, and all the
propaganda against "red lining" (limiting mortgage loans to certain
preferred metropolitan districts) will not put Humpty-Dumpty together
again. With cities everywhere in distress, municipal loans are less
attractive. Nor are the banks aggressive lenders to business, having in
mind the number of major collapses in recent years.
A further and more critical limit overlooked by the
planners in their fiat to "free up the money supply" is that imposed by
capital reserves.
Capital reserves--equity or stockholders'
investment--provide the protection to depositors against banks' losses
on bad debts and un-collectible loans. Such reserves are not regulated
by law, as are deposits, and supervision over banks' operations is
fragmented among three Federal agencies. The Federal Deposit Insurance
Corporation examines state chartered non-member banks; the Comptroller
of the Currency national banks; and the Federal Reserve, state chartered
member banks. Since adequacy of bank capital is a matter of judgment
rather than formula, with the judgment of the examiner put against that
of the management, regulatory authority becomes more admonitory than
injunctive.
Banks generally have a naive, optimistic view of
capital adequacy. Thus, while bankers would be aghast at a loan
application showing $90 liabilities supported by only $10 equity, they
consider this generous for banking, for which the average capital is
around 7.5 per cent of total liabilities.
With the recent heavy write-offs of loans to REITs,
municipals and some large businesses, the adequacy of the capital
structure of the banking system is being quietly questioned here and
there--quietly so as not to disturb confidence.
The End of the Road?
A bigger concern as to the banking structure arises
from their foreign loans, particularly those to the less developed
countries. Total LDC borrowings abroad are estimated to exceed $200
billion, of which some $50 billion are debts to private banks, mainly
U.S. banks. Opinions differ as to the danger of default of these loans,
the World Bank naturally taking an optimistic view. In any case, the
mere fact of the question invites doubt. In addition to the LDC debt is
the amount of debt owed by the Soviet Union to Western lenders. Having
in mind that in Communist philosophy the end justifies the means and
expediency is the rule, one would hesitate to stamp Soviet obligations
as gilt-edged.
Needless to say, the banks themselves are becoming as
much concerned about their attenuated reserves as anyone, a fact that
stands chockablock against the policy of continual monetary expansion
advocated in more ethereal precincts.
The real question today is whether the Administration
and the expansionist element in Congress are sufficiently aware of the
danger in trying to stimulate business by forcing more Federal Reserve
credit into the banking system in an effort to "free up the money
supply." This could well be the straw to break the camel's back. The
True Convertibility of Sterling
At the time of the original publication, Elgin
Groseclose, Ph.D., of Groseclose, Williams & Associates, financial
consultants of Washington, D.C., served as executive director of
Institute for Monetary Research, Inc. He is the author of Money and
Man, Fifty Years of Managed Money, and other works.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
May, 1977, Vol. 27, No. 5.
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