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Why the Money Supply is Collapsing

Economics / Money Supply Jan 22, 2009 - 05:31 AM GMT

By: Joseph_Toronto

Economics Best Financial Markets Analysis ArticleInflation and deflation are almost always monetary phenomena as are booms and busts, recessions and depressions. The current economic environment has surprised nearly everyone with the sharpness of the decline, it's suddenness and it's sheer ferocity. To better understand what is happening in the economy and how it began, I believe it is helpful to understand the nature of modern money and banking, and the central bank's role.


Modern money is all “debt”. Debt owed to the banking system. It is nothing more than that. Nearly all money now in circulation was created in the form a debt someone owes to the banking system.

Under money and banking theory, the money supply must grow in conjunction with economic growth. The money supply must always be sufficient to accommodate and facilitate economic activity, trade and commerce. In this role, money is defined as little more than “units of economic transaction”. What is a little more murky, is how does our banking system get the money supply to grow in lock step with economic growth so that we don't experience inflation or deflation, or booms and busts. Under our current system, where our government has delegated control of the money supply to a central banking system, there is one and only one way the money supply can grow and that is by the bank issuing a “debt” to someone. 

A bank cannot simply print bills and spend them or write checks and buy stuff. They can only issue a debt to someone else, some private party, and that person then can spend the proceeds of his loan at his favorite merchant or supplier. The loan must eventually be paid back, with interest or at least rolled over or extended and re-extended. This means that in order for new money to enter into circulation, someone must borrow money from a bank and spend the proceeds (the amount of the loan) at their favorite merchant who in turn pays his suppliers who then pay their… and on and on it goes. The new money, “created” in the form of a loan from a bank is now part of the money supply and has entered into circulation in the economy.

But why isn't the money a bank lends already part of the money supply. Don't they just get the money they loan out from other people who deposit money at the bank as savings or checking deposits and earn interest? Well, yes and no. Depositor's savings obviously are a liability to the bank because they have to pay it back to the depositor or the owner upon demand. But as long as the bank has this persons money,  it sits idle as part of the bank's reserves until it is put to work by being loaned out to someone else. You may be asking yourself how the money supply grows if banks can only loan funds that others have deposited. Well, they don't. They can lend more, a lot more.

Once a bank gets a new deposit, they can create a lot of money out of thin air and loan it out in our system called fractional reserve banking which creates an effect called the multiplier effect. This means that a bank may lend and maintain a portfolio of loans far in excess of the reserves necessary to fund the deposits which created those loans. At present, our banks are required to maintain cash reserves of only 6% of its loan portfolio. This reserve ratio together with the multiplier effect allows the banking system to generate new loans, new money, of up to ten times the amount of a new deposit. Here's how the Federal Reserve describes this effect:

“Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500).”

This multiplier effect can cause the money supply to grow, and as we have recently witnessed, can also cause the money supply to collapse when loans default or as loans are paid back. The reverse multiplier effect as we shall call it can become exacerbated when, in uncertain times, banks become afraid to loan and fearing future defaults stop lending. Likewise debtors too can become fearful of going into debt and don't want to borrow. As we are experiencing now, the reverse multiplier effect can be sudden and ferocious, much like a collapsing ponzi pyramid. But dare we actually call it that?

Very Best Regards,

Joe

Affiliated investment Advisors,Inc.

http://joesinvestoblog.com

joe@aiadvisors.com

Joseph Toronto has been a portfolio manager for 26 years for some of the largest institutions in the western U.S. In 1993, Joe founded Affiliated Investment Advisors, Inc., as a registered investment advisor for serious investors seeking professional management for superior safety and returns. Mr. Toronto is a Chartered Financial Analyst and is a member of the Salt Lake City Chapter of the Financial Analysts Society and the Association for Investment Management and Research. He has a Master's degree in investment securities and a B.A. degree with a dual major in finance and management.

Affiliated Investment Advisors, Inc. is a "traditional" portfolio manager for retirement plans, profit sharing plans, individuals, IRA's and other trusts. Affiliated's portfolio management services are NOT alternative "hedge" fund style and are “fee only” taking no commissions or performance incentives. Affiliated is not a stock broker or financial planner and does not sell any investment or insurance fund or product.

Opinions expressed in these reports may change without prior notice. Joseph Toronto and/or the staffs at Affiliated Investment Advisors, Inc. may or may not have investments in any stocks, funds or investments cited above. © Copyright 2009 Joseph Toronto and Affiliated Investment Advisors, Inc. All trademarks and copyrights of information referenced herein are owned by their respective owners.

© 2009 Copyright Joseph Toronto - All Rights Reserved


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