Brad Delong rightly slams Austrian economist Robert Murphy this morning for a bet he made in 2009 regarding inflation. Murphy stated that headline inflation would hit 10% by January 2013. Well, here we are with 24 hours to go and the latest monthly CPI reading is 1.8%. I don’t want to just pile on Murphy with personal attacks. Instead, I think it’s constructive to understand why this prediction was wrong because it’s at the heart of an important economics and finance understanding.
If we jump in the Google time machine we can see what was said back in 2009 that was so wrong. Murphy was working from the same premise that many economists work from. He saw the Fed flooding the banking system with reserves and assumed that this would cause inflation. He said:
“In order to keep those reserves from working their way back into the hands of the general public (where they can start pushing up prices), the Fed will have to raise the interest rate it pays to persuade the banks to keep the reserves parked at the Fed. But this simply postpones the day of reckoning, as the troublesome stockpile of excess reserves grows even faster.”
This is not correct and it displays a huge flaw in the model that Murphy is working with. It’s worth noting that Delong and others are working under a model that actually isn’t that different (though their “liquidity trap” theory has stated that the Murphy model is temporarily broken). Both models are wrong.
Monetary Realism starts from an understanding of modern banking. We understand that the US monetary system is essentially privatized. In other words, the money supply is controlled almost entirely by private banks whose ability to create loans creates deposits which are the primary form of money we all use. The money supply expands and contracts (mostly expands) in an elastic form based on the public’s demand for loans.
The flaw in the Murphy model is that he assumed that reserves are somehow related to a banks ability to loan money. He specifically shows the scary chart of M1 going parabolic and then states in clear terms that this money will work its way into the public.
This is really important so I am going to cover this point again. There are two types of money in our monetary system. Banks deposits (the money we all use) are inside money because it is created inside the private sector (controlled by an oligopoly of private banks). Outside money facilitates inside money and exists in the form of cash, coins and bank reserves. This money comes from outside the private sector. It is supplied by the government to facilitate the use of inside money. Cash, for instance, is issued by the US Treasury to allows member Fed banks to stock vaults for customers who wish to draw down their bank accounts for transactional convenience. Coins serve a similar purpose. See here for more.
Reserves are a bit different. Reserves exist solely because of the Federal Reserve System. And they serve two purposes – 1. helping banks settle interbank payments; 2. helping banks meet reserve requirements. Bank reserves are just deposits held on reserve at Fed banks. You can think of reserves as existing in their own market that is totally separate and inaccessible to the non-bank private sector. In other words, reserves are the money banks use to do business with one another.
But more importantly, banks don’t lend their reserves. Banks lend based on their solvency or capital constraint. Reserves are merely an asset of the bank. When the Fed implements monetary policy like QE they don’t change the capital position of the banks. They swap a t-bond or MBS for a bank reserve. This doesn’t change the net financial asset position of the private sector. The bank literally has the same capital position it did before this policy was enacted. So, the bank can’t create more inside money than it could have before. And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system. Anyone who understood this in 2009 (as many of us did) knew that Murphy was wrong because his understanding of the system was wrong.
So, as we’ve seen time and time again, misunderstanding modern banking and money has resulted in very bad predictions. Unfortunately, I still don’t see many people agreeing on why Murphy and others were wrong. That’s not progress.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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