Re: Does the contraction of bank balance sheets counterbalance the effects of the FED expanding the money supply?

krazy kaju — Thu, 30 Apr 2009 01:48:05 GMT

Using Rothbardian terms, the "demand for hold" of money has increased. In other words, more banks have raised their reserves significantly, soaking up the extra money, and individuals prefer to hold their cash than to lend it out or spend it. This is also what mainstream economists would call "falling velocity" of money.

Does the contraction of bank balance sheets counterbalance the effects of the FED expanding the money supply?

Canuck1 — Thu, 30 Apr 2009 00:46:18 GMT

In a commentary on Kitco.com, the author dug up some material he quoted in an attempt to debunk the concerns that people have about the massive expansion of the money supply leading to severe inflation down the road. (Which is my concern)

I believe the writer of the qouted material is claiming that bank balance sheets shrunk to the point where the FED's reactionary policies could not create inflation as they didn't even fill the gap caused by last year's contraction. But I'm curious, what is the Austrian view on this.

Now, I realize that the FED cannot creat "capital" since "capital" comes from people's savings and not from the printing press. However, is it true that the contraction somehow negates the inflationary effects of the new credit creation since the banking system had already lost so much?

I have a lot to learn when it comes to economics so please pardon my fledgling knowledge :D. For example, if the bank loses money on mortgages etc, that money is still circulating somewhere else, correct? Perhaps someone could suggest some material I could read to learn more on this.

Can anybody please give me any feedback on the following? Please especially note the beginning of the second last paragraph at the very bottom. I've underlined everything that I'm quoting.

http://www.kitco.com/ind/nadler/apr292009A.html (Here's the full article.)

Thank you!

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" THE FEDERAL RESERVE has been roundly castigated in some quarters -- even former high officials of the central bank -- for its aggressive and unprecedented steps to combat the credit crisis.

But data just released by the Bank for International Settlements suggest that, if anything, the expansionary measures taken by the Fed (and in concert with the Treasury) were dwarfed by the record contraction in the global banking system brought on by the crisis. According to the BIS, which acts as a central bank for central banks, total bank claims shrank by $1.8 trillion in the fourth quarter, or 5.4%, to $31 trillion. This was the largest decline ever recorded.

In other words, there never was a global run on the banking system such as the one seen in the final three months of 2008, which followed the bankruptcy of Lehman Brothers and the near-collapse of American International Group in September. The numbers serve to confirm the extent of the tsunami the swept through the world's financial system.

As the balance sheets of the global banking system threatened to shrink like a dying star and create an economic black hole that could suck in the world's economy, central banks and treasuries around the world responded in kind. In the U.S., the Fed doubled the size of its balance sheet, to about $2 trillion from $900 billion in the fourth quarter, and is in the process of adding another $1.15 trillion to its assets through the purchase of Treasury and U.S. agency obligations and mortgage-backed securities. Meanwhile, the federal government established the Troubled Asset Relief Program to pump $700 billion into the banking system.

the effects of the shrinkage of the private banking system's balance sheet are unequivocally evident. It's now history that fourth-quarter gross domestic product shriveled at a 6.3% annual rate. What's become apparent is that the real output of the finance industry shrank last year at nearly twice the previous record rate of decline, according to JP Morgan Chase economist Michael Feroli.

Real output in the finance industry fell 3.0% in 2008, compared to the previous record of a 1.6% decline in 1958. Because finance looms much larger in the economy, last year's contraction shaved a hefty 0.24% from GDP, compared to just 0.05% in 1958. From 1997 to 2000, finance typically kicked about 0.5 percentage points to GDP growth, Feroli notes. In 2008, only construction and manufacturing detracted as much or more than finance from GDP, 0.24% and 0.32%, respectively.

Construction and manufacturing are directly affected by the collapse in credit, so the financial travails extend far beyond Wall Street. Now, however, policy makers are accused of being too solicitous of Wall Street. To be sure, banks, including the I-banks, have benefited from the actions of the Fed and the Treasury. But that is separate from the question of the macroeconomic impact of their actions.

Those who contend that the expansion of central bank balance sheets is inflationary ignore the contraction of balance sheets in the banking system, as well as the so-called shadow banking system of assets and liabilities not recorded on banks' books. This analysis is very different from arguments that appeal to the "output gap," the difference between the economy's potential output and actual production. That analysis effectively says that high unemployment will hold down wages and prices, which manifestly did not happen in the stagflationary 'Seventies.

Inflation, as Milton Friedman taught, is always and everywhere a monetary phenomenon. Yet the current central-bank expansion is offsetting the contraction in the banking system -- which Friedman criticized the Fed for failing to do in the 1930s.The new BIS data bear out the justification for the Fed's actions, notwithstanding the critics' claims."

Economics Questions

Re: Does the contraction of bank balance sheets counterbalance the effects of the FED expanding the money supply?

Does the contraction of bank balance sheets counterbalance the effects of the FED expanding the money supply?