There are three money supply statistics that every citizen should understand. They are the monetary base, M1, and M2.
The Monetary Base
Sometimes called “standard money” or “high powered money”, the monetary base is that monetary unit beyond which there is no further claim. It is composed of two parts: (1) cash, whether located in bank vaults or outside bank vaults (this is important later) and (2) bank reserve balances held at the Federal Reserve Bank. Bank reserves held at the Fed may be exchanged for cash upon demand; in other words, bank reserve balances are a mere convenience for banks to relieve them of the burden of holding masses of cash in their vaults and shipping it to other banks to settle normal bank clearings. The following link will lead to the Federal Reserve Bank’s site of the monetary base:
Bank reserve balances at the Fed were $1.775 trillion. Cash was $1.701 trillion, making the monetary base $3.476 trillion.
The monetary base can be increased or decreased only through the Fed’s open market operations. When the Fed buys an asset from the banks, it increases the monetary base. When the Fed sells an asset to the banks, it decreases the monetary base. As recently as January 2000 the monetary base was $.591 trillion, about one-sixth of its current size.
Also notice from that bank Total Reserves were $1.841 trillion, of which only $.192 trillion were required. This becomes important when discussing the banks’ ability to create money, which has led to the explosive growth of the other two money supply statistics — M1 and M2.
M1 and M2
When most people think of money, they think of cash in their wallet, money in their checking account, and money in their savings account. The main distinction between the monetary base and M1 and M2 is that the Fed does not have direct control over the size of M1 and M2, because the banks create more M1 each time they book a loan. Likewise M1 decreases each time the bank receives a principal payment on a loan.
M1 consists of two main parts: money not in bank vaults — such as money in wallets, cookie jars, or business cash tills–and balances in checking accounts (but not savings accounts). (M2 merely adds short term savings deposits to M1.) Think of M1 as belonging to people or businesses only, not banks. Money held in bank vaults for the purpose of cashing checks and filling cash orders for businesses does not count as part of M1. But cash in bank vaults becomes part of M1 as soon as the ownership of some of the bank’s vault cash is handed over to the person cashing a check or to the business manager picking up money for his till.
When banks lend money they actually create more M1, because they credit a checking account. Banks are allowed to do this through the Fed’s fractional reserve rule, whereby a bank is required to hold only a small fraction of cash reserves (either in the form of cash in the bank’s vault or in its reserve account at the Fed) to support its checking account balances. (Thus the term “high powered money” when referring to the monetary base.) In the US this fractional reserve rule is roughly ten percent. Via the magic of leveraging its reserves fractionally the banking system can add ten dollars to the money supply for every new dollar of reserves added to the banking system by the Fed through its open market operations.
This first graph below begins with January 1971. I picked January 1971, because by the end of the year President Nixon had taken the US off the gold exchange standard, the last legal barrier to preventing the Fed and the banking system from creating an unlimited amount of money out of thin air.
At the end of January 1971, M1 was $.220 trillion and M2 was $.635 trillion. At the end of November 2018, M1 was $3.736 trillion and M2 was $14.243 trillion.
M1 has increased by approximately seventeen times and M2 has increased by approximately twenty-two times! Remember that the monetary base, over which the Fed has absolute control, currently is $3.476 trillion, yet M2 is approximately four times this size at $14.243 trillion. M2 balances are easily transferred from savings accounts to checking accounts. For example, most banks’ online computer systems give the account holder the capability to do this instantaneously via a home computer, making the distinction between M1 and M2 an anachronism.
One can see that M1 and the monetary base are almost equal at this time. This is unprecedented in modern monetary history. Usually the monetary base is a fraction of M1. The reason can be found in the fact that bank excess reserves stand at $1.649 trillion (Total reserves of $1.841 trillion minus required reserves of only $.192 trillion). This volume of excess reserves is a recent development. Prior to the massive expansion of the monetary base in recent times, excess bank reserves were only a few billion dollars. Banks fully leveraged their reserves via lending in order to maximize earnings. The banks have NOT been leveraging their reserves to the fullest extent in recent years. Were they to do so, M1 could increase by ten times this excess amount or an incredible $16.490 trillion ($1.649 excess reserves times ten), which would result in huge price inflation.
Taking the US off the gold standard in 1971 has removed an important market discipline over the Fed’s ability to increase the money supply. It has created the impression that resources are unlimited, since the potential size of the money supply is unlimited. Such is not the case, of course. Real economic resources must be painstakingly built over time. The disconnect between money and real resources will create problems that currently seem to be the purview of countries like Zimbabwe and Venezuela. These small countries may be the proverbial canaries in the coal mine, warning us of danger ahead.
Patrick Barron is a private consultant to the banking industry. He has taught an introductory course in Austrian economics for several years at the University of Iowa. He has also taught at the Graduate School of Banking at the University of Wisconsin for over twenty-five years, and has delivered many presentations at the European Parliament.
THIS ARTICLE ORIGINALLY PUBLISHED HERE.