Elgin Groseclose, Ph.D., of Groseclose, Williams & Associates, financial consultants of Washington, D.C., serves 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.
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 fiat 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 uncollectible 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.