Critique of Monetary Realism

I’ve recently been fairly active on the message boards at Pragmatic Capitalism, which is a great site put together by the very talented Cullen Roche.  The folks at Pragcap subscribe to a theory of money called “Monetary Realism,” which you can read more about at their site.  

Typically I try to only explicitly and actively voice my opinion on my site through my monthly investment letters; however monetary philosophy is something that I think is crucial to understanding the investment environment, and I’ve generated a lot of content at Pragcap which I think is important to share with my readers here.  

The basic framework of monetary realism is that the monetary system consists of “inside money” issued by private banks as deposits and “outside money” issued by central banks as currency and reserves.  The philosophy contends that a private banking oligopoly is outsourced the right to create money by the US government.  “Outside money” is only in existence to facilitate the clearing of transactions made with “inside money.”

I disagree with parts of the philosophy, I agree with other parts of it, but my main frustration lies in how it defines its terms and the narrow prism through which it attempts to describe the monetary system.   It arbitrarily draws lines where they don’t need to be, and my sense is that the bulk of that is because of disagreements with a predecessor theory called MMT, which has its own shortcomings.  Below is a comment which I posted this evening that sums up my important criticisms of the framework.  Presented un-edited:

(in response to a previous comment)

After thinking some more about the issue of non-banks creating inside money I am willing to acknowledge that I am wrong to say that anyone has the ability to create “inside money” as MR defines it. In trying to incorporate MR’s framework and definitions into my framework for looking at savings markets, I erred and do see that banks are the only entity that can create deposits. We are now 100% in agreement on this point. Deposits are the sole domain of the commercial banking system. This explains why deposits are created when a bank buys a security but not when a non-bank individual buys a security.

The reason that I said that non-corporate entities could contribute inside money was based on my intuition that there is clearly net financial value created outside of the banking system in securities markets, which can be converted to deposits. If I buy an equity security which appreciates in value, net value is being added to society. If a company issues a corporate bond, a net savings product is being added to society. In attempting to draw a link between deposits and securities as a savings mechanism I do concede that I overextended the ability of securities markets to unilaterally effect the banking system.

However, this does not change the fact that I continue to believe that the MR framework is incomplete as a description of the modern monetary system because of the lack of incorporation of the bulk of the way that modern households do store their wealth. Empirically deposits are not the primary way that Americans save. In order to spend savings it is true that a crucial step is to clear through bank deposit markets. However, this clearing step should hold no more significance to aggregate economic purchasing power than the interbank clearing process via what MR refers to as “outside money.” Both are facilitating transactions based on purchasing power that is not dictated by the quantity of deposits held within the commercial banking sector.

To the extent that a monetary framework should describe the aggregate purchasing power and savings of a society, a truly modern paradigm for the US must include the securities markets as a centerpiece. As of March 2012 an average American household holds 15% of their financial assets as deposits. Any attempt to describe the liquid purchasing power of American households must include the other 85% of their financial holdings, which can easily be converted to bank deposits.

At the other end of the money spectrum lies USD. What is USD? I will continue to contend that the US dollar is the sole domain of the US government and that quantity in circulation does not matter only that it does have a specific value. It is a yardstick of economic value. There doesn’t need to be enough yardsticks to measure everything in the world to define what a yard is. The yard is a clearly defined unit of measurement endorsed by a) the government, but more importantly by b) the people and convention. The USD is no different, and derives its direct value from the quantity of the liabilities on the Fed’s balance sheet relative to the value of the assets on that balance sheet. This is no different from a foot deriving its base from a monarch’s forearm. A foot is “backed” by the length of the king’s forearm. Importantly although the size of the monarch’s forearm may change from monarch to monarch and the numerical value of feet from my couch to my door may change, there is nothing that the unit of measurement can do to change the real physical distance that I observe.

So where do deposits fit in this framework? They are a specific type of security which has a value generally equal to 1 USD. They are backed by the assets of the issuing bank ALONE, and their value cannot exceed 1 USD, even if their uninsured value can be less than 1 USD. (Just ask uninsured depositors of Indymac bank).

Deposits are a type of security. USD is a type of security. Corporate Bonds are a type of security. Equities are a type of security. All have an issuer and a holder. None is “ruler” of any other. All are means of saving. All have tradable value in relation to each other. All are “money” in some sense. Only one is USD.

Monetary Base Grew Last Week

One indicator that we pay close attention to is the monetary base, the sum of currency and reserve balances at the Fed.  Over the last two weeks the base has grown by $43B, about 1.5%.  The base is important to us because of the relationship that it has had with commodity prices over the last several years.  If the relationship holds, it might suggest that commodity prices like oil and gold will trend sideways rather than down.

As far as Fed Balance sheet trends go, it’s also worth noting that reserve balances continue to fall.  The “reserve balances” line is a perennially misunderstood line-item, which is often used as evidence that excess liquidity is just being stored at the Fed rather than entering the economy.  In actually the high level of excess reserves is just a symptom of QE because in the aggregate all of the reserves in the system must return to the Fed even if different banks hold them.  At any rate, these reserves are now starting to be converted more rapidly into hard currency, which should render the argument over excess reserves moot.

Fed Liabilities Portion of Balance Sheet:

Deposit Growth at US Banks

Citigroup reported strong earnings this morning as did JP Morgan and Wells Fargo last week.  All three banks also reported strong deposit growth as well.  Systemically, despite low interest rates, US banks have been growing deposits at an above average rate.  Y/Y, savings deposits grew by 11.5% as of the week of July 2.  On average, since 1985, savings deposits have grown by 8.4% Y/Y.  The higher than average growth in deposits since ’09 suggests that Americans are more comfortable saving via deposits rather than capital markets.

Cumulative Bond and Equity Fund Flows Since 1996

Reposted here from zerohedge is a stunning chart of cumulative flows to bond and equity funds since 1996.  It shows that total fund flows into equity funds are negative over the last 16 years.  Considering that US households have saved $5.4T over this time period (according to the BEA), the fact that equity funds have not seen positive inflows is staggering.