Monetary Realism

Understanding The Modern Monetary System…

Bad Inflation Bets and Why They Were Bad

(Cross posted via Pragmatic Capitalism):

Brad Delong rightly slams Austrian economist Robert Murphy this morning for a bet he made in 2009 regarding inflation.  Murphy stated that headline inflation would hit 10% by January 2013.  Well, here we are with 24 hours to go and the latest monthly CPI reading is 1.8%.  I don’t want to just pile on Murphy with personal attacks.  Instead, I think it’s constructive to understand why this prediction was wrong because it’s at the heart of an important economics and finance understanding.

If we jump in the Google time machine we can see what was said back in 2009 that was so wrong.  Murphy was working from the same premise that many economists work from.  He saw the Fed flooding the banking system with reserves and assumed that this would cause inflation.  He said:

“In order to keep those reserves from working their way back into the hands of the general public (where they can start pushing up prices), the Fed will have to raise the interest rate it pays to persuade the banks to keep the reserves parked at the Fed. But this simply postpones the day of reckoning, as the troublesome stockpile of excess reserves grows even faster.”

This is not correct and it displays a huge flaw in the model that Murphy is working with.  It’s worth noting that Delong and others are working under a model that actually isn’t that different (though their “liquidity trap” theory has stated that the Murphy model is temporarily broken).  Both models are wrong.

Monetary Realism starts from an understanding of modern banking.  We understand that the US monetary system is essentially privatized.  In other words, the money supply is controlled almost entirely by private banks whose ability to create loans creates deposits which are the primary form of money we all use.  The money supply expands and contracts (mostly expands) in an elastic form based on the public’s demand for loans.

The flaw in the Murphy model is that he assumed that reserves are somehow related to a banks ability to loan money.  He specifically shows the scary chart of M1 going parabolic and then states in clear terms that this money will work its way into the public.

This is really important so I am going to cover this point again.  There are two types of money in our monetary system.  Banks deposits (the money we all use) are inside money because it is created inside the private sector (controlled by an oligopoly of private banks).  Outside money facilitates inside money and exists in the form of cash, coins and bank reserves.  This money comes from outside the private sector.  It is supplied by the government to facilitate the use of inside money.  Cash, for instance, is issued by the US Treasury to allows member Fed banks to stock vaults for customers who wish to draw down their bank accounts for transactional convenience.  Coins serve a similar purpose.  See here formore.

Reserves are a bit different.  Reserves exist solely because of the Federal Reserve System.  And they serve two purposes – 1. helping banks settle interbank payments; 2. helping banks meet reserve requirements.  Bank reserves are just deposits held on reserve at Fed banks.  You can think of reserves as existing in their own market that is totally separate and inaccessible to the non-bank private sector.  In other words, reserves are the money banks use to do business with one another.

But more importantly, banks don’t lend their reserves.  Banks lend based on their solvency or capital constraint.  Reserves are merely an asset of the bank.  When the Fed implements monetary policy like QE they don’t change the capital position of the banks.  They swap a t-bond or MBS for a bank reserve.  This doesn’t change the net financial asset position of the private sector.  The bank literally has the same capital position it did before this policy was enacted.  So, the bank can’t create more inside money than it could have before.  And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system.  Anyone who understood this in 2009 (as many of us did) knew that Murphy was wrong because his understanding of the system was wrong.

So, as we’ve seen time and time again, misunderstanding modern banking and money has resulted in very bad predictions.  Unfortunately, I still don’t see many people agreeing on why Murphy and others were wrong.  That’s not progress.


Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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13 Responses

  1. Fed Up says

    “This is really important so I am going to cover this point again. There are two types of money in our monetary system.”

    And, “And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system.”

    It seems to me there are three types of money.

    Currency (a medium of exchange in the real economy)

    Central bank reserves (the demand deposits of the central bank that act only as a “medium of exchange” in the interbank system covered by the central bank)

    Demand deposits or bank deposits (a medium of exchange in the real economy)

  2. Fed Up says

    ” When the Fed implements monetary policy like QE they don’t change the capital position of the banks. They swap a t-bond or MBS for a bank reserve. This doesn’t change the net financial asset position of the private sector. The bank literally has the same capital position it did before this policy was enacted. ”

    Hoping JKH has taught me well. I don’t believe that is quite right. Let’s assume no capital gain or loss and the fed buys a loan/bond with a capital requirement of 2. That 2 of capital is now freed up for a new loan/bond to be made.

  3. Steve Wise says

    Following you over here from Pragcap. Looking forward to digging my through the updated site and trying to get a firmer grasp on MR.
    The financially curious public owes you (and others) an epic debt (no-pun intended) of gratitude.

  4. Prakash says


    What is the MR preferred definition of inflation ?

    I always wondered about the basket chosen, why it was chosen and how it interacts with future technological developments. I heard that typewriters and fountain pen ink are still present in India’s WPI basket, despite being pretty obsolete. Not sure of the truth of that statement, though.

    Scott Sumner wants to clear this entire stable by just looking at NGDP, targeting NGDP and dumping the concept of inflation altogether. That is one way to go about it.

    If I understand correctly from your introduction documents, the concept of inflation is fundamental to the MMR philosophy. Inflation is the constraint that the sovereign issuer faces. Kindly point out the post where the preferred definition of inflation is discussed here.

    • beowulf says

      What is the MR preferred definition of inflation ?

      We take the world as it is. “Inflation” has a definition for the same reason that “Christmas Day” is a public holiday, because the Senate and House of Representatives of the United States of America in Congress assembled says so.

      “The terms “inflation”, “prices”, and “reasonable price stability” refer to the rate of change or level of the consumer price index as set forth by the Bureau of Labor Statistics, United States Department of Labor.”
      15 USC 1022(e)

      “The following are legal public holidays:
      New Year’s Day, January 1.
      Birthday of Martin Luther King, Jr., the third Monday in January.
      Washington’s Birthday, the third Monday in February.
      Memorial Day, the last Monday in May.
      Independence Day, July 4.
      Labor Day, the first Monday in September.
      Columbus Day, the second Monday in October.
      Veterans Day, November 11.
      Thanksgiving Day, the fourth Thursday in November.
      Christmas Day, December 25.”

      5 USC 5103(a)

      • Prakash says

        Thanks for the reply.

        Does this imply that MR is a more a guideline for the present and not a new economic philosophy?

        A more long term view, I believe should take into account of how the basket is chosen.

        • beowulf says

          What use is a philosophy that isn’t a guideline for the present?

        • Prakash says

          I agree.

          But I think that when postulating a new way to look at events, a new economic philosophy that should be followed, that should try to be more general than an american government definition.

          Since inflation is one of the important concepts in MR, I wanted to know if there was some, if not timeless, a fairly long term definition of it, that the “founders” (Am i saying this correctly?) agree upon.

        • Michael Sankowski says

          The basket of goods for inflation calculation is very, very hard to standardize or define.

        • Prakash says

          Do you believe it should be done, or should the concept be abandoned like Scott Sumner wants and looking only at NGDP as a measure?

  5. Tom Hickey says

    The Austrian definition of “inflation” is an increase in the money supply rather than the price level, so I guess on his own criterion Murphy can claim to be correct. :)

    • KainIIIC says

      If you can’t win an argument based on logical extrapolations, simply change the dictionary so it makes sense! It’s a pretty common feature of Austrians, I’ve noticed.

    • Cullen Roche says

      No. His bet was specifically about the CPI yoy.