Understanding Money Mechanics: A Crash Course on the Fed
[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in late 2020.]
The purpose of this short book is to provide the intelligent layperson a concise yet comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States. Although the author (Murphy) considers himself an Austrian school economist, most of the material in this book is a neutral presentation of historical facts and an objective description of the mechanics of money creation in today’s world.
The book is intended to be a reference for all readers, whether “Austrian” or not. (For this reason, when possible, material coming from Federal Reserve–affiliated sources is cited.) To be sure, those readers interested in a more detailed treatment of the theory and history of central banking from an Austrian perspective should pursue the topic, starting with the seminal works of Murray Rothbard.1 The Chicago Federal Reserve’s booklet “Modern Money Mechanics” is also a useful guide.2 The present book is not intended as a substitute for the more detailed treatment of Rothbard and others.
Yet despite the existence of several “classic” treatments of money and banking, the difficulty is that they can be difficult reading, especially in our day of social media and short attention spans. At the same time, the “extraordinary” measures of quantitative easing (QE) implemented by central banks around the world following the 2008 crisis have made these issues incredibly relevant. Discussions of QE vs. TARP (Troubled Asset Relief Program) are difficult if half of the commentators don’t really know the difference between granting a loan and recapitalization. And it’s difficult to evaluate the wisdom of the Fed’s operations in the repo market, when most people don’t really know what “the repo market” is. The present book seeks to bridge the gap by providing a crash course in the necessary theory and history while keeping the discussion tethered to current events.
Finally, the present book addresses some of the challenges to the textbook treatment that have arisen over the years. For example, is it true that commercial banks must wait for new deposits before they can advance new loans — or does it work the other way around in the real world? Why didn’t consumer prices go through the roof after the start of QE programs, as many economists (including the present author!) were worried might occur? And how does the standard economist story about the emergence of money out of a state of barter apply — if at all — to cryptocurrencies like bitcoin?
Although the present book with its necessarily brief treatment will not provide definitive resolutions to these controversies, it will seek to at least clarify the disputes so that readers can advance their own understanding of the issues.
The Table of Contents below summarizes the scope and content of the book. Every two weeks, the Mises Institute will release an additional chapter (though the release schedule will not necessarily follow the order of the Table of Contents). After the final chapter has been released online, the entire book will be released.
Table of Contents for Understanding Money Mechanics
Chapter 1. Introduction
Lays out the scope and purpose of the booklet, and the schedule for release.
PART I: THEORY AND HISTORY
Chapter 2. The Theory and Brief History of Money and Banking
Explains Mises’s framework for handling money within subjective value theory, which covers his taxonomy (medium of exchange, money, money-substitutes, fiduciary media, commodity credit, circulation credit, etc.) as well as the regression theorem. Covers Menger’s theory of the origin of money, and briefly mentions the anthropological critique (David Graeber). Gives a standard history of the origin and development of modern banking, including some important court rulings. Mentions the history of private mints.
Chapter 3. A Brief History of the Gold Standard, with a Focus on the United States
Explains why gold is the market’s money of choice — and stresses the difference between the definition of money (“commonly accepted medium of exchange”) and the attributes that make something a convenient money (durability, homogeneity, etc.). Draws a connection with Menger’s theory, presented in the previous chapter, and shows why gold (and silver) have chosen, rather than (say) diamonds or platinum. Explains the operation of the classical gold standard and how it evolved during the World Wars, Bretton Woods, and, finally, the Nixon Shock. Also includes a discussion of Civil War inflation.
Chapter 4. The History and Structure of the Federal Reserve System
Explains the unusual circumstances of the Fed’s origin, and mentions “conspiracy theory” treatments. Explains how power was consolidated in DC and away from Reserve Banks under FDR, and how the Fed’s mandate again altered in 1977. Concludes with an overview of the modern organization of the Fed, including the number of member banks, how the Federal Open Market Committee (FOMC) is selected (length of terms, etc.), how the chairman is picked, etc.
PART II: THE MECHANICS
Chapter 5. Standard Open Market Operations: How the Fed and Commercial Banks “Create Money”
Explains the “textbook” mechanics of the Fed buying assets to create new reserves, and then how commercial banks create new loans on top. Defines the various monetary aggregates (base, M1, M2, “Austrian true money supply,” etc.).
Chapter 6. Beyond the Fed: “Shadow Banking” and the Global Market for Dollars
Defines the concept of shadow banking and gives a brief history, plus some stats for context. Defines things like “eurodollar,” LIBOR, etc. Explains the Bank of International Settlements (BIS) and the Basel Accords. Explain the basics of the repo market and the difference between capital requirements and reserve requirements.
Chapter 7. Central Banking Since the 2008 Financial Crisis
Explains the “emergency” measures that the Fed adopted (Term Auction Facility, QE rounds, interest on reserves) and negative interest rates abroad. Mentions the moves to suppress cash (tied up with negative interest rates, at least rhetorically). Discusses the “corridor/floor system” a la Selgin. Explains how Maiden Lane programs are arguably illegal.
PART III: APPLICATIONS
Chapter 8. Ludwig von Mises’s “Circulation Credit Theory of the Trade Cycle”
Lays out the basics of Austrian boom-bust theory. Explains that Mises developed it in The Theory of Money and Credit, in which he also said that fiat money was a theoretical possibility (!); this means that Mises clearly didn’t think that boom-bust was restricted to fiat money regimes. Using Mises’s analogy of a master builder running out of bricks, illustrates the difference between “overinvestment” and “malinvestment” theories, and also why continued pump-priming a bad idea.
Chapter 9. Monetary Inflation and Price Inflation
Starts with Friedman’s measures of money stock and (consumer price) inflation, and summarizes cases of hyperinflation (Civil War, Weimar Republic, Zimbabwe, Venezuela). Documents change in how the word “inflation” is used, and explains how “currency boards” are used by some countries to limit the ravages of inflation. Explains the famous equation of exchange (MV=PQ) and why Mises and Rothbard didn’t like it.
Chapter 10. The Inverted Yield Curve and Recession
Documents this surprisingly good forecasting tool, and then shows that it fits quite nicely within Austrian framework.
Chapter 11. The Fed and the Housing Bubble/Bust
Shows that the textbook Austrian story fits the empirical facts of the housing boom/bust.
PART IV: CHALLENGES
Chapter 12. Does Textbook Explanation Get Money and Banking Backwards?
Is the “textbook” description (covered in Chapter 5 above) actually wrong? Deals with the (relatively) recent claims — coming not just from internet critics but also a major UK institution — that bank lending is not reserve constrained. Also addresses that idea that “lending creates deposits” rather than vice-versa, as the orthodox economists claim.
Chapter 13. Crying Wolf on (Hyper)Inflation?
Explains that some (including the present author) made erroneous warnings about (consumer price) inflation when QE was first implemented, and asks whether this invalidates the textbook treatment. Is it true that QE was “just an asset swap” and “wasn’t money printing”?
Chapter 14. The Keynesians on the Cause of, and Cure for, Depression
Explains the Keynesian perspective. Contrasts Austrians and Keynesians on the Great Depression. Explains the “liquidity trap” and why Keynesians think Say’s law works in the special case of “full employment” but that we need a general theory of employment, etc.
Chapter 15. The “Market Monetarists” and NGDP Targeting
Gives a brief history of the historical battles between original monetarists and Keynesians (Friedman/Phelps on the Phillips curve, the Robert Lucas critique, and rational expectations framework). Then explains how people like Scott Sumner updated Friedman’s monetarism and now offer the goal of “level targeting” of stable NGDP growth, which some Austrians argue is similar to Hayek’s approach.
Chapter 16. Bitcoin and Other Cryptocurrencies
Applies the earlier theoretical framework to bitcoin, to answer questions such as “Is it money?.” Addresses the challenge that bitcoin violates Mises’s regression theorem.
- 1. For example, see Murray N. Rothbard’s The Case Against the Fed (1994; repr. Auburn, AL: Ludwig von Mises Institute, 2007); The Mystery of Banking, 2d ed. (Auburn, AL: Ludwig von Mises Institute, 2008); and The Origins of the Federal Reserve (Auburn, AL: Ludwig von Mises Institute, 2009). The latter is an excerpt from his treatment of the subject in A History of Money and Banking in the United States: The Colonial Era to World War II (Auburn, AL: Ludwig von Mises Institute, 2002). All items available for free in PDF form at www.Mises.org.
- 2. Dorothy M. Nichols, Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, rev. Anne Marie L. Gonczy, rev. ed. (1961; Chicago: Federal Reserve Bank of Chicago, 1994). Available at https://upload.wikimedia.org/wikipedia/commons/4/4a/Modern_Money_Mechanics.pdf.