The Myth of All-Powerful Central Banks

Contrary to Economics 101, credit markets beat money supply
By James H. Nolt, Senior Fellow, World Policy Institute
August 7, 2018 Updated: August 8, 2018

If you take a standard economics course, such as macroeconomics or money and banking, you will learn that prices are regulated by government-controlled central banks using their power over something called “the money supply.”

Such textbooks rarely mention what happened before central banks existed (the U.S. Federal Reserve system was only created in 1913) or before they were nationalized and came under government control, as occurred with the Bank of England only in 1946. Furthermore, these courses’ descriptions of some of the key processes for typical central-bank operations are purely mythological, bearing no resemblance to reality.

Central banks do have influence—not control—over modern economies, but less for reasons of special legal privilege and more because they have large resources to sway markets. That is, if you understand the power of big banks in general, you will also understand the power, interests, and influence of central banks in particular. Few of the powers they exercise are unique to central banks in the sense that most textbooks claim.

Insofar as a central bank acts as the collective agent of the other large banks (assuming all are in rough agreement), its apparent powers are strongly due to its collaboration with other bankers. When a central bank faces the opposition of a faction of private banks, its power to act is seriously constrained, and its policies may be defeated, as happens often to the central banks of smaller countries and sometimes to those of larger ones.

Defining Money

Before we move on, we need to address a fundamental question: What is money? One thing everyone agrees is that coins and paper currency held by the public are money. However, in modern societies, those make up a small portion of the total money circulating in the economy.

Economists define several species of money. The most commonly used is M1, which includes currency plus demand deposits, more often known as checking accounts and other accounts that can be accessed by an ATM card. The balances in checking accounts are typically much larger than the currency stock, a feature of the fractional-reserve banking system.

When news reports say “the money supply increased by 2 percent last quarter,” they are usually talking about M1. In the United States, the M1 money stock stands at around $3.6 trillion.

Economists also define, and governments often report, other measures of money that are narrower than M1 (such as M0), but mostly broader, such as M2, M3, etc. If you compare across websites and even economics textbooks of all stripes, you will find that definitions of these various species of money are remarkably vague and inconsistent in what they emphasize.

Part of the reason for this is that different central banks have slightly different definitions, but a larger reason is that few people, even economists, really grasp the intent behind these definitions (what they are trying to capture). All definitions of money, in fact, fail to capture what they intend to show.

The purpose of economists’ definitions of money is to capture the quantity of a mythological substance called money, which is the means of payment for all currently produced goods and services, in order to complete the equation that embodies the quantity theory of money.

The equation is M x V = Y x P, or, in plain English, the stock of money (e.g., M1) times the velocity of money (the number of times on average each unit of money makes a purchase in a year) equals national income (equivalent to national output or GDP) times the price level. If the price level is greater than one, that means inflation; otherwise, it means deflation.

Two huge problems with this equation are seldom taught in economics classes. However money is defined, it isn’t the means of payment for most transactions, and people use money to buy many things other than current output, such as financial assets, assets not produced this year, etc.

Keynes, in his “A Treatise on Money,” tried to address this second problem by distinguishing financial circulation—money used to buy financial assets—from the more mundane sorts of money used to buy ordinary products and services. Unfortunately, he dropped this complication in his later and more famous book “The General Theory of Employment, Interest, and Money.”

Economists have since followed suit, but the intent behind different definitions of money remains embedded in those definitions. This is because, for example, the “money” you might have in a brokerage account to buy stocks and bonds is not counted as money in M1, but it is counted in the broader M3. Similarly, certain small savings accounts are included in M2, whereas large accounts are included in M3. The implicit theory behind this apparent contradiction is that rich people will spend more of their money on assets, which do not directly stimulate output, whereas ordinary people spend most of their money on goods and services that do stimulate current output.

Why Credit Is Key

The fact is, however, that most transactions are made with credit, not money. Credit cards widely used in commerce are not money. Businesses use a much broader variety of credit than consumers do, and have done so for centuries. Economists, when pressed, say that credit payment does not matter because debts must eventually be settled using money.

But that is not true, either. Many loans are not settled with money, but rolled over with fresh credit. Often the final reckoning does not come until an economic crisis hits. Of course, there must be some relationship between income and expenditure. Few people or institutions can bullishly buy on credit indefinitely, but the limits are elastic, certainly more flexible than taught in economics courses. Consequently, the “money supply,” however measured, is not a very interesting artifact of economies in which credit is far more important than money.

Credit expands and contracts more dramatically than money, so the focus of macroeconomics should be on the supply and demand for credit, not the money supply. Nevertheless, only a handful of critics outside the mainstream teach much that is useful about credit markets. The daily focus is on the Wizard of Oz in the foreground, the great and powerful central bank “regulating the money supply,” not on the main actors behind the curtain: banks and other businesses expanding or contracting credit according to their private strategies.

What central banks such as the U.S. Federal Reserve actually do, day to day, is not regulate the money supply, but influence the bill market with so-called open-market operations, which involve buying and selling government bills.

Like any large bill trader, a central bank can influence the price of bills through its operations, but it isn’t the only player in the market. Its influence can be gamed or overcome by other powerful players if they take a contrary position. That is what George Soros and associated traders famously did in their 1992 defeat of the Bank of England’s effort to peg the pound to a basket of European currencies that would become the euro.

The yield on government bills does influence other aspects of the economy, but there is no direct and reliable link between open-market operations and inflation, unemployment, or any other macroeconomic variable. The effects of central-bank policies ultimately depend on the state of the business cycle, or, in my terms, the dynamics of the private struggle between bears and bulls.

This is why the worldwide policies of “quantitative easing” in the aftermath of the 2008 financial crisis didn’t have the effects advertised either by proponents or their most-vocal critics.

James H. Nolt is a senior fellow at the World Policy Institute and author of “International Political Economy.”