Money versus Credit

I just want to make a simple, but important, point about money and credit that is being overlooked by just about everybody except David Malpass. That’s true of a lot of things, by they way.

When a commercial bank makes loans or purchases government securities, both sides of its balance sheet are affected. On the asset side, either loans or investments rise. We usually call that combination “credit.” At the same time, on the liability side of the balance sheet, deposits rise by an equal amount. Those deposits are usually considered part of the money supply. When the deposits are spent, they will end up on other banks balance sheets, but will remain somewhere in the banking system.

Economists are aware of the credit counterparts of deposit money, but they usually focus on the money side of the equation. Is too much money being created? Too little?

Normally, focusing on the liabilities or money side of bank balance sheets is fine. Credit is following along. They move together. However, credit is also created outside the commercial banking system when the counterpart is not counted as part of the money supply. As long as the relationship between money and credit remains pretty much unchanged, watching money only creates no problem. However, during the financial crisis over the past year, credit created outside the banking system—commercial paper, for example—has shrunk. The Fed has tried to counter that shrinkage by buying commercial paper directly, but credit has still shrunk. I repeat: credit has shrunk; not only bank credit that has a counterpart in the money measures, but non-bank credit as well.

My point is that, when people talk about excess money creation they usually forget that part of the money creation is necessary to offset the impact of the credit contraction. Money expansion is also necessary to counter the decline in the velocity of money. Both reasons are important in understanding that money creation so far has not been inflationary.

Comments (5)

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  1. T Le says:

    Where and what do you look at to determine that credit is still contracting?
    What do you think of the Fed’s program to do reverse repurchase agreements?
    Thank You

  2. Kevin says:

    So has the Deposit-to-Loans ratio increased? There have been many reports of banks just not lending, cutting lines of credit and jacking up rates on credit cards. More deposits and less loans? Presuming the banks are still taking in deposits, has the ratio of deposits to loans increased?

    What do you see breaking this squeeze in credit availability?

  3. Bob McTeer says:

    T.Le and Kevin:

    I really don’t follow credit volume, but we know it has shrunk because of the shut down of commercial paper markets for a while (still not fully back) and the shut down/drastic reductions in various securitizations and the fact that the Fed has had to step in to try to unfreeze those markets.

    I’m sure deposit to loan ratios have increased. As in all credit crunches, part of the reason is reduced demand and part is reduced supply. It is my impression that the reluctance of banks to lend and other conservative actions are based on the fact that banks are still not totally out of the woods. Banks are trying to preserve capital in a very dangerous environment. The fact that they are holding large amounts of excess reserves at a very small return suggests this as well. And there are the 700 or so banks that have received TARP funds. Don’t take seriously the statement that those funds were only given to banks in good condition. They were given to banks they thought would be in reasonably good condition AFTER they received TARP funds. As for the new repos, I haven’t studied that enough to have an opinion. My first impression is to wonder why use a method that is so short term or temporary rather than outright sales which is more permanent. I guess they are worried that the latter might affect rates more than the former and they want to tip toe into that unknown territory.

  4. Tony Pallotta says:

    Friday’s NFP report continued a positive trend (less negative is a positive right) and appears to have swung sentiment rather quickly towards job growth. Former Fed Governor Warsh was speaking on Friday about the reality that the deeper the recession history has shown the sharper the recovery, although he stopped short of calling for a robust recovery. What is your view on the combination of improving fundamentals (factories orders, durables, etc all improving) and banks paying down TARP leading to banks being more open to lending sooner than later? At some point greed will trump fear, it’s human nature.

  5. Lamiya says:

    One reason is beascue it would require massive government oversight. They are too busy spending tax money inappropriately on personal expenditures to regulate the credit card companies.Another reason is beascue in the free market, you need to be responsible for your own funds. It is your job as a consumer to make sure you are not over charged and/or billed for non-existant items. You can pay companies like LifeLock to watch over your credit scores and transactions, but to do it without spending money, you have to do it yourself.