Monetary Base and Money Supply

Frank Shostak has written an article for the Mises Institute about the Fed and the money supply.  Shostak is one of my favorite writers when it comes Austrian school economics and monetary policy in general.

In this article, Shostak says that the Fed could delay its tapering until after December.  In other words, the Fed may keep its foot on the accelerator and continue to pump in $85 billion per month.  He sees this happening because he is predicting a slowdown in growth.

Shostak rightly differentiates between the Fed’s balance sheet and measures of the money supply.  Shostak in particular uses “AMS”, a measure of money supply that he prefers.  The Fed’s balance sheet (I usually refer to the monetary base) is what the Fed directly controls.  But the lending of fractional reserves by banking institutions then drive the money supply in circulation.

The whole ballgame has changed since 2008.  Excess reserves are well above the $2 trillion mark.  They were a rounding error above zero back at the beginning of 2008.  Before the fall of 2008, banks lent out most of the available deposits.  They just kept enough on hand to meet reserve requirements.  The lending process of fractional reserves essentially multiplies the money supply in circulation.

Since the large majority of new monetary base money has gone into excess reserves, this has kept the money supply in circulation from rising as dramatically as it would have.  It is important to understand this because this is one of the reasons for what has allowed the Fed to pump in so much money without seeing really high consumer price inflation.

So despite the massive pumping (QE) by the Fed, Shostak still sees a reduced rate of growth.  He sees the economy weakening and hence his prediction that the Fed could delay tapering past December.

This is basically a lesson in the Austrian Business Cycle Theory.  You can still have a bust with continual increases in the money supply.  Just a reduced rate of increase is often enough to trigger the bust.  Of course, a bust is virtually inevitable when the boom is built upon loose money and artificially low interest rates.

In conclusion, if Shostak is right about all of this, then we may see a recession in the somewhat near future.  Unfortunately, if we do have another official recession hit, then it may just encourage the Fed to create even more money out of thin air.  This will mean an even greater misallocation of resources and a worse standard of living for the average person.  It also means we have to continual fear bank lending and the possibility of much higher price inflation.