Banks are merely financial intermediaries that don’t use money as a medium of exchange for buying anything that contributes to GDP.  If local banks save money at the central bank (the Fed in the US), it is merely the local bank lending to another bank.  This is called bank reserves.  Because banks never use their reserves to buy real goods and services, they are not money.  Money is defined has being a medium of exchange, and bank reserves are never used as a medium of exchange.

Bank reserves are related to money in that reserves can be used to create real money, but reserves are not money any more than seed corn is food.  Seeds are planted in order to multiply them and create food, but the seed corn is not food unless it is actually eaten rather than planted (or hoarded).  Bank reserves are similar.  If banks hoard reserves instead of using the reserves to create loans, then the hoarded reserves are called “excess reserves” because they are not being used.  That is no more part of the money supply than stockpiles of unused seed corn is part of the food supply.  The hoarding of excessive seed corn and the hoarding of bank reserves can both produce a kind of famine.

For example, Amartya Sen wrote a history of the Bengal famine of 1943, in which he claims that there was enough grain available to feed everyone, but that millions starved due to excessive hoarding of grain.  When speculators started hoarding grain, they took it out of the markets which reduced the real supply and grain prices rose which made it too expensive for the poor to buy. As a result, two or three million people died. There is some dispute about how much grain hoarding was done by speculative Bengalis, but there is no dispute that there was plenty of grain in the world to feed Bengal and someone hoarded it away from the millions of dying Bengalis because it was not profitable enough to send it to them. Similarly, in the US and other developed nations, banking systems have been hoarding money in reserves since 2008.  That hoarding has not been benefiting the unemployed capital and workers that were sitting idle in the aftermath of the Great Recession of 2008.

Bank reserves are often called “high-powered money” because it could be multiplied into large quantities of money if banks use their reserves to increase lending and get real money to real businesses and consumers.  But “high-powered money” is a misnomer because it is not money.  Bank reserves are never actually used to exchange goods and services and it is the goods and services that matter.  It is just like seed corn can be multiplied into large amounts of food.  But seed that is not multiplied into food has no power at all.  Similarly, bank reserves can produce multiples of money if they are lent out to people who can use money, but the reserves themselves are never used just like seed corn is never eaten.  If germination rates drop in half due to being stored too long, the power of seed-corn drops in half.  Similarly the power of bank reserves solely depends upon whether it is used to make real money.  The power of the monetary base (mostly bank reserves) is called its multiplier.

FRED

As you can see in the above graph, in 2008, the monetary base (red line) suddenly doubled in 2008.  However, it’s power at creating money (M1 in green) simultaneously plummeted just as fast.  The quantity of bank reserves doesn’t matter unless banks use them to create real money that can be spent on goods and services.  Only real money matters because that is what is used to exchange of goods and services.  The 2008 recession definitively demonstrated that reserves are not money.  The FED pumped more money out to the banks, but they banks just hoarded the new money as excess reserves rather than letting the new money out into the economy where it could do some good to help feed people.

A better measure of the monetary base would exclude the excess reserves that are being hoarded in the bank vaults:

FRED

The blue line in the above graph shows the amount of bank reserves that have actually been used in the economy.  The gap between the red line and the blue line is the vast amount of hoarding (excess reserves) at US banks.  At the peak, almost twice as many bank reserves were being hoarded as were being used to influence the economy!

Numerous pundits have been warning about inflation because the Fed has quintupled the money supply since 2008 as the red line seems to show.  These people have been predicting that this unprecedented increase in “high-powered money” will cause hyperinflation and chaos, but their fears are misplaced because they are not understanding the difference between unused seed corn that is hoarded (like excess reserves) and corn that is available for food (like money).  The blue line shows the real change in the effective monetary base which is about the same as its growth during rest of US history.

The monetary base is not money and economists understood that when they created the main statistics for measuring money: M1, M2, M3, and MZM.  These are our best attempts to measure the money supply and none of them include any money that is hoarded in bank vaults because this is never part of the money supply.  Banks never directly use any of it for buying anything, so it isn’t really money and it doesn’t have any direct effect on the real economy.

 Lasse Lien posted a simple story about how a change in the money supply can reduce transactions costs and eliminate debt.  When the money supply increases, the circular flow of money tends to speed up.

A rich tourist came to a small town in the middle of the financial crisis. He went into the local hotel, placed a 200-dollar bill on the counter and went upstairs to check out what kind of rooms the hotel had to offer. In the meantime the hotel manager grabbed the bill, walked over to the butcher and used the bill to pay his debt. The butcher then took the bill to the cattle farmer and paid his debt to him. Next, the cattle farmer took the bill to the cattle feed supplier and paid his debt there. The cattle feed supplier then paid his debt to the local prostitute. The local prostitute brought the bill back to the hotel and paid her debt to the hotel manager. The hotel manager put the bill back on the counter. Then the rich tourist returns down the stairs and proclaims that he didn’t like the any of the rooms. He grabs the bill and leaves the city. A pity, but more importantly, the town was now debt free and optimism was back.

This story has Keynesian implications.  Debt cycles are one of the important reasons for recessions and cycles of optimism (or “animal spirits”) in Keynes’ story are another reason.  Plus, it is a story about the circular flow model of the economy.

Because this was posted on an Austrian Economics website, most of the comments criticize the story, but the critics are off the mark.  For example, one commenter complains that “money needs to keep appreciating.”  That’s ridiculous.  An appreciating currency is one that is suffering from deflation which fortunately has been a rare phenomenon since the Great Depression because deflation is generally harmful.

Normally we have a modest amount of inflation (a measure of the depreciation of money) and an unexpected increase in inflation gradually reduces debts and would serve the same function as the tourist’s money for wiping out the value of the debts.  Modest inflation and/or interest rates are irrelevant to the story.  For example, if everyone earned 10% interest (and paid 10% interest), it would make no difference. It would only complicate the story with irrelevant details that don’t fundamentally change the conclusion.

Another commenter objected that, “Everyone exchanged $200 owed for them for $200 owed TO them; this is a simple settling of outstanding accounts and didn’t affect anyone’s net position.”

Again, this too is a misunderstanding of basic macroeconomics.  Financial accounts always net out to zero (when the entire financial system is examined as a whole) because every debt is someone else’s asset.  My money only has value if others consider it to be a debt that they owe me.

Money helps reduce transactions costs and solve the dual coincidence of wants problem in the story.  Everyone in the story wants to get $200 from someone, but doesn’t know if he or she will ever get paid.  Meanwhile each person also is certain that they owe a debt to someone else.  If the loans were all legally due on that same day, everyone in this parable would have gone bankrupt if not for the unwitting loan from the tourist.

It is no accident that this story was written in the aftermath of the financial crisis because that was a similar situation.  There was financial gridlock because banks were unsure if they would get paid back the loans that they were owed and that prevented them from paying their depositors which prevented depositors from paying their debts too.  When the government’s TARP program bailed out the banks by effectively lending them cash, it ended financial gridlock and the economy recovered and optimism returned.  In the end, the banks paid back pretty much all the money to the government, so the net cost of the bailout to the US Treasury will be about zero percent (give or take a few).*  That is pretty much identical to the ending of the parable.

*The net TARP costs are “about zero” as of 2015, and I can’t give a definitive cost because the TARP program isn’t over yet, but the government projects that the net costs will be minimal.  Some moneys were not repaid, but other loans and investments made enough money in interest and capital gains that the bank bailout will probably end up making a nominal profit. The TARP funds were also used to subsidize some other sectors of the economy like the car manufacturers and home owners.  Some sectors have had lower repayment rates than the banks so the TARP program as a whole is expected to have some net cost to taxpayers, but even so, the total cost will only be a tiny fraction of the total bailout program of $700 billion.

A recession can either be caused by a lack of supply or a lack of demand.  A lack of supply could be caused by a drought reducing agricultural output or a war reducing the productive capacity to supply goods and services.  A lack of demand is caused by the hoarding of money. The idea that hoarding can cause a demand recession was probably first developed in the 1700s by French Physiocrat, Francois Quesnay who argued that money is more productive in the hands of poor people because they will spend it than in the hands of the rich who can afford to hoard it.

The cause of demand recessions became an active area of debate in economics in the early 1800s, but as Brad DeLong wrote, there is a simple explanation about why recessions happen:  hoarding of money.

The desire to hoard money varies at different times and whenever there is too little money relative to the amount of goods and services that could be produced, a recession, or “general glut” happens because some people hoard money rather than buying goods and services.

The opposite of a general glut is when there is too much money which causes inflation:

Sometimes when you go the market, you find the money prices that you have to pay higher than you expected—perhaps 10% higher than you expected last year when you made your plans. It seems that, somehow, there is too much spending money chasing too few goods.

When the money supply grows faster than the supply of goods, we get inflation because people have more money without getting more goods and so they become willing to spend more money on each good they buy.  That is a rise in prices (inflation).

Conversely, we can have the opposite problem—not a glut of money relative to goods, but what early-nineteenth century economists used to call a “general glut” of unsold commodities, idle factories and workshops, and idle workers all across the economy. Economists have important things to say about how to try to prevent these episodes and what to do when they happen to cure them…
Back in the 1820s the question of whether the circular flow of economic activity as mediated by the market system could break down and the economy become afflicted by a “general glut” of commodities was a live theoretical question. Everybody agreed that there could be particular gluts [in the market for a particular good like electricity, but there was disagreement whether all goods and services markets could have a glut at the same time].

Consider what happens should households decide that they want to spend less on electricity to power large-screen video and audio entertainment systems and more on yoga lessons to seek inner peace. The immediate consequence… of this shift in preferences is excess demand for yoga instructors and excess supply of electric power. Prices of electricity (and of large-screen TVs, and of audio systems) fall as unsold inventories pile up in stores and as generators spin down and stand idle. Yoga instructors, by contrast, find themselves over scheduled, working ten-hour days, and stressed out—and find the prices they can charge for their lessons going through the roof. Workers in electric power distribution and in video and audio production and sales find that they must either accept lower wages or find themselves out on the street without jobs.
Over time the market system provides individuals with changing incentives that resolve the excess-supply excess-demand disequilibrium. Seeing the fortunes to be earned by teaching yoga, more young people learn to properly regulate their svadisthana chakra and teach others to do so. Seeing unemployment and stagnant wages in electrical engineering, fewer people major in [it]. The supply of yoga instructors grows. The supply of electrical engineers shrinks. Wages of yoga instructors fall back towards normal. Wages of electrical engineers rise. And balanced equilibrium is restored. Thus we understand how there can be a glut of a particular commodity—in this case, electric power. And we understand that it is matched by an excess demand for another commodity—in this case, yoga instructor services to properly align your svadisthana chakra.
But can there be a general glut, a glut of everything?
Some economists early in the nineteenth century said yes. Other said that the idea of a “general glut” was logically incoherent. Jean Baptiste Say, for example, [in his 1821 Letters to Mr. Malthus]:

I regret to say, that I find in your doctrines some fundamental principles which… would occasion a retrograde movement in a science….
What is the cause of the general glut of all the markets in the world, to which merchandise is incessantly carried to be sold at a loss?… Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for…. From these premises I had drawn a conclusion… “that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce.”…
[W]henever there is a glut, a superabundance, [an excess supply] of several sorts of merchandise, it is because other articles [in excess demand] are not produced in sufficient quantities… if those who produce the latter could provide more… the former would then find the vent which they required…

Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: “every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared…” The general glut, Say wrote in 1829, had been triggered by a panicked financial flight… in financial markets. What was going on? The answer was nailed by John Stuart Mill:

Those who have… affirmed that there was an excess of all commodities, never pretended that money was one of these commodities…. What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute…. The result is, that all commodities fall in price, or become unsaleable…. [A]s there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence…

Note that these financial excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy…, et cetera.
It seems as if there is …almost always something that the government can do… that promises a welfare improvement over, say, waiting for prolonged nominal deflation to raise the real stock of liquid money, of bonds, or of high-quality AAA assets. Monetary policy open market operations swap AAA bonds for money. Quantitative easing that raises expected inflation diminishes demand for money and for AAA assets by taxing them. Non-standard monetary policy interventions swap risky bonds for AAA bonds or money. Fiscal policy affects both demand for goods and labor and the supply of AAA assets–as long as fiscal policy does not crack the status of government debt as AAA and diminish rather than increasing the supply of AAA assets. Government guarantees transform risky bonds into AAA assets. Et cetera…
And what if there is a glut not of commodities but inflation? Simply apply the same policy tools in reverse.
That is the last of the six things economists have to say in the public square: that the economy does not consistently balance itself at high employment with stable prices. The principle that it does economists have called Say’s Law—even though Say abandoned it by 1829. And it is important for economists to say, loudly, that Say’s Law is not true.

Modern era recessions are almost always caused by someone hoarding money without even realizing that they are doing it. GDP statistics divide up spending among four groups of people: 1. Households (Consumption spending), 2. Businesses (Investment spending), 3. Government, and 4. Foreigners (Net export spending).  In the US, you can mostly blame businesses for increasing hoarding during a recession.  That is why we commonly call a recession and expansion a “business cycle”.  When businesses get scared about future profits, they cut their spending on capital investment to hoard more of their money for the hard times that they foresee and that is the main cause of recessions as measured in the GDP statistics.

Banks can also hoard money during recessions because they get scared about lending out savings and they raise their lending standards.  That further depresses business investment spending because savings don’t get lent back out to stimulate the circular flow.

Households try to pay down debt during recessions which just increases the money that is being hoarded by banks. Consumers are forced to hoard money because unemployment rises and unemployed people have to cut back spending.  Even workers who keep their jobs are more worried about layoffs and tend to delay buying new cars or any purchases they can put off.  Even so, American consumers are so dedicated to consuming that overall consumption spending doesn’t change much, but it does have an impact.

For a more formal explanation, see my algebraic hoarding model.

I assign some Paul Krugman readings in my Macroeconomics class and because he is such a polarizing character, some people on both the right and the left seem to think he is just a blowhard.  If you are one of them, I think it is worth reading why you should read some of Krugman’s economics.

Although Paul Krugman is a controversial public intellectual, he has garnered tremendous professional respect. His Wikipedia entry lists numerous professional honors that he has won for his accomplishments including the Nobel Prize in Economics in 2008.  Although he is an outspoken liberal in his politics, he also gets a lot of attention and even respect from many conservatives for his economics.  For example, he was the favorite liberal economist among the conservatives at Econlog, a conservative (libertarian) organization. Another libertarian organization called Econ Journal Watch found him to be far and away the most popular economist under age 60 in a poll of professional economists (PDF).  Unlike most academic economists, he is a good writer who has a long history of explaining economics for general audiences.  According to web traffic, he has been by far the most read economics news and commentary writer on the internet since at least 2007, and his blog has sometimes gotten about as many readers as entire websites like The Onion.

Krugman was one of the few people who predicted some important parts of the the 2008 economic crisis. His predictions were not good enough to make money on like the guys Michael Lewis wrote about in The Big Short (an incredible story), but Krugman did predicted that the end of the real estate bubble would cause an economic crisis and once we were in the crisis, his predictions about inflation and monetary policy were better than most.

In addition to writing about economics, Krugman writes about politics and music on his blog.  Although Krugman is a great economist whose economic judgment I respect, I don’t see any reason to regard his ideas about other matters like politics and music as having more expertise than the average writer about these matters.

Once you separate Krugman’s economics from his politics, you can see that many of his economic theories have gotten a lot of support from conservatives.  One year when I taught Macroeconomics with a class of majority conservative students I assigned Krugman’s Return of Depression Economics and Raghuram Rajan’s Fault Lines. Although Rajan is a conservative economist and Krugman is a liberal, my students had a hard time finding much partisan bias in either book and some actually felt like Rajan’s thesis seemed more liberal because blamed rising inequality in the US as one of the root causes of the financial crisis.

Although it is impossible to completely separate economics and politics, most of the politics that influence macroeconomic theories are completely different from the political values that 95% of non-economists care about, so most of my students don’t see any strong political valence in most of the economics we read.