[ronigafni]

I recently heard a lecture about how if all the money the federal reserve created and gave to the banks was released into the economy the price of goods would multiply by a factor of 8. If the banks then know that so much of their money is not really loanable because the fed cant let it all pour into the economy (they have mentioned several times before that they have specific tools to prevent this like increasing the interest they will pay banks on it) why are the interest rates so low? Do the banks really have this glut of loanable funds if they cannot lend it out to businesses? Or did I miss something in my understanding?

[jmherbener]

Demand for credit has collapsed, which is not unusual during a bust. Both consumers and entrepreneurs take on too much debt during the boom and pay it down during the bust.

Interest rates move down if either demand declines or supply increases. You can tell the difference between the two cases because a decline in demand will reduce the quantity of the good traded (in this case present money lent) while an increase in supply will increase the quantity of the good traded. Since both the interest rate and the quantity of credit have declined, we know that demand for credit fell.,

The banks did an asset swap with the Fed during the crisis. They sold mortgage backed securities to the Fed in exchange for reserves (bank accounts at the Fed that pay interest). Reserves serve as the basis for issuing fiduciary media. Banks have, so far, been content to hold reserves and not issue more fiduciary media by creating new credit. This is in part because the prospects for the loans will not pay high enough interest rates to compensate them for putting risky assets back on their balance sheets. There is some evidence, however, that bank credit may be thawing, in which case we’ll get to see if Bernanke’s tools work to restrain monetary inflation.

[ronigafni]

I can appreciate the fact that the lack of lending indicates that the interest rate has fallen as a result of a drop in demand for money. On the other hand, what of the massive increases to M1 and M2 over the past few years? Didn’t they give a tremendous amount of liquidity to the banks? If so, does this glut of high powered money not also put tremendous downward pressure on interest rates or does it not because that money is not being lent now anyways?

[jmherbener]

The demand for credit has fallen but the demand for money has risen. This is the tendency in every bust. People borrowed too much during the boom and so their demand for credit declines. At the same time people anticipate a decline the price of assets they acquired during the boom and so their demand to hold money increases. The effect is both low interest rate (from the reduced demand for credit) and low price inflation (from the increased demand to hold money).

As you say, the Fed’s QE1, QE2, and QE3 have been bailouts to financial institutions. The Fed bought their bad assets (or claims to assets) and paid with cash (technically, checking account balances at the Fed). This made the financial institutions both more solvent and more liquid. If banks use their excess reserves as the basis of issuing fiduciary media, then the money stock will explode and serious price inflation will result. But until banks use their excess reserves to increase the supply of credit by issuing more fiduciary media, the conditions in the credit market have not changed.

[porphyrogenitus]

I too have been trying to work out why we haven’t seen all the price inflation we might normally expect. Does the significant decline in the “velocity of money” have anything to do with that? (I’m no expert, but looking at what Professor Herbener wrote, I surmise that the decline in the velocity of money is connected to the demand to hold money).

If the velocity of money were to return to the normal trend line* would we start to see price inflation increase?

*Maybe there is no “normal trend line” for monetary velocity anymore; from what I gather it has gyrated since about the mid 80s.

[ronigafni]

I have a few questions about your responses:
1. Your wrote: “The demand for credit has fallen but the demand for money has risen.” If people are looking to pay back debt and aren’t looking to borrow, where is the demand for money coming from?
2. You wrote: “But until banks use their excess reserves to increase the supply of credit by issuing more fiduciary media, the conditions in the credit market have not changed.” But isn’t the government borrowing an incredible amount of money? Also, how can we say their is no demand for credit when the Government id borrowing so much, shouldn’t that cause interest rates to rise from historic lows?
3. Just generally, I hear so often from people in the Austrian school that Bernanke is printing money to keep the interest rates low so as to stimulate x,y and z sectors of the economy (and not just that the interest rates fell because of lack of demand). Is this not something that people like Ron Paul and Tom have spoken about extensively?

[jmherbener]

1. The demand for money is the demand to hold money. People are building up their cash holdings by selling other assets and reducing their disbursement of income on spending. Demand to hold money does not affect interest rates. Along with the stock of money, the demand to hold money determines money’s purchasing power.

2. Yes, federal government borrowing has increased, but the net increase in demand for credit has been relatively small. The Fed has increased its holding of Treasury Securities from less than $500 billion in 2008 to almost $1.7 trillion today and it is adding $45 billion a month. Foreigners, mainly central banks, have increased their holdings from $3.3 trillion in 2008 to $5.5 trillion today.

My quote that you cite is not referring to the demand side, but to the supply of credit by bank fiduciary issue. I didn’t say there was “no demand” for credit, but only that demand for credit hasn’t increased sufficiently to start pushing up interest rates.

3. The Fed can directly manipulate only the Federal Funds Rate. It does this by providing more reserves to banks. For other interest rates to be affected by expansionary monetary policy, the banks must issue fiduciary media and create credit and supply it into the various credit markets. In normal times, banks do just that with additional reserves they obtain. But, in depressions they tend to hold reserves and restrain from issuing fiduciary media and creating credit.

[ronigafni]

Let me address the 3 answers you gave again.
1. I seem to have not understood what “demand for money was”, I thought it was demand for credit. Thank you for clearing that up.
2. So much of the money that we talk about being printed by the fed was the asset swaps and lending to other central banks. But these are not sufficient to raise the interest rates for record lows because in the bigger picture the public’s desire to hold money has meant relatively low lending overall. The swaps have given only 1.2 trillion to the banks, which could become over 10 trillion but haven’t due to lack of lending and other central banks can’t issue fiduciary media. Wasn’t there a Bloomberg article that said the central bank gave away 7.7 trillion in 2008? Where did that go to?
3. I understand now that the people don’t want to borrow that much, but do the banks themselves want to lend if they could or are they satisfied with so little in interest from the fed when there is no risk?
Thank you so much for all of your patience in answering my questions, this is very greatly appreciated

[jmherbener]

2. The money went to non-bank institutions, like Fannie Mae, Freddie Mac, and AIG and foreign banks.

3. Banks are less eager to lend than in normal times. But as the Fed bailout improves their balance sheets, they will return to a more normal outlook on issuing fiduciary media and creating credit. At that point, the Fed will have to drain the excess reserves to prevent significant monetary inflation.

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