Bank Money vs Paper Money, Which Matters More?

Professor Steve Hanke's take on bank money versus Fed money
October 28, 2013 Updated: November 13, 2015    

NEW YORK—The Federal Reserve prints money to keep the economy going, or so the theory goes. In fact, most of what we consider “money” is created within the banking system. This kind of money is shrinking, and its responsible for sluggish economic growth and low employment.

“Money is important and it matters, in fact it dominates. The traditional models used in economics don’t include banking and don’t include money,” said Steve Hanke, professor of applied economics at the Johns Hopkins University. 

In fact, there are two kinds of money. One kind, the Fed can print, mostly U.S. dollar paper bills. The Fed can also print that money electronically by crediting banks’ reserves, and the banks can then demand conversion into paper money at a later time. 

“The rest of the money supply is produced by banks. It’s called bank money,” said Hanke, who gave a speech on the topic at the Committee of Monetary Research and Education fall meeting in New York, Oct. 24. 

Banks manufacture this kind of money in electronic form by creating a matching amount of loans and deposits. 

Say you want a mortgage for your house worth $300,000. Once the bank approved the loan, your deposit balance will have gone up by $300,000 and the amount of loans held by the bank will have also risen by $300,000. Since you will use the deposit balance of $300,000 as a form of payment, money has just been created that previously did not exist. 

Economic Growth 

For monetary policy to work, the sum of both Fed money and bank money needs to grow to stimulate growth. This hasn’t been the case, which is one of the reasons why the recovery has been slow. 

“If you look at aggregate demand in the economy, the economy is extremely weak,” said Hanke, who researched that all the goods and services demanded domestically are only growing at around 3 percent in nominal terms, i.e. not adjusted for inflation. Normally, they should be growing at around 5 percent. 

“The economy is very weak, because the money supply is weak when you add state money and bank money together.” 

According to the Fed’s flow of funds report, traditional banking money stood at $14.6 trillion at the end of June. Fed money on the other hand consisted of $1.15 trillion in notes in circulation, and another $2.1 trillion in electronic reserves, as of the last balance sheet update July 24. 

Money printed by the Fed increased by 3.5 times since the collapse of Lehman Brothers in 2008 and now constitutes 20 percent of the total money supply. Bank money has decreased 12 percent, bringing down the total increase to around 3 percent, which is not very much. 

Money Determines Growth 

According to Hanke, the growth in money supply is the prime impetus for growth.

“Money has been very misunderstood. Bank money is the big one, the one that really makes the system turn,” he said. He cited historical examples where monetary policy trumped fiscal policy.

“Japan in 1990 had a huge fiscal expansion and [it has] been continuing since 1990. The money supply hasn’t grown at all, and as a result, you had a deflationary environment with essentially two whole generations lost in terms of economic growth.”

He also cites the Clinton years which reduced expenditure in terms of GDP but saw unprecedented growth and fiscal surpluses because of an expansion in bank money.

Regulation Strangles Money Creation 

While the Fed has been printing full tilt ever since Lehman, traditional banking was stifled by pro-cyclical regulation.

One of the pieces of regulation is Basel III, which forces banks to increase their capital asset ratios (CAR), or simply bolstering their equity versus their risky assets.

One way is to issue new shares. “The problem is you are not going to be issuing shares, if your share price is below book value, because you dilute all the existing shareholders,” Hanke said, and indeed very few banks have issued shares.

The other way is to get rid of risky assets and replace them with assets that do not require additional capital under Basel III. “What do you do, you go into government bonds or cash. Because they are supposedly risk free and do not require capital backing under the Basel accord,” said Hanke. None of these assets encourage private risk taking or productive investments though, as would commercial loans for example. 

The next hurdle is a comprehensive piece of legislation called Dodd-Frank, which is aimed at regulating the banking industry.

“Everything in Dodd-Frank spells deleveraging. Deleveraging with a capital D. Those are factors that also come in that reduce the risk assets you want on your balance sheet,” said Hanke.

Last but not least, there is the discretion that bank examiners use when implementing regulation. 

“Bank examiners are very pro-cyclical. When the boom is on, the bank examiners tend to relax, everything is going fine, everything is booming away, there are not very stringent, and being good bureaucrats, bank examiners of course want to keep their jobs and their benefits, and as a result of that, when trouble comes, they get very scared and very stringent, and apply the rules in a much tougher way than when the boom is on. They aggravate the situation,” said Hanke.

As a result, he anticipates slow growth to continue along with tight bank money “as far as the eye can see.”