It is commonly believed that the Federal Reserve Bank controls the money supply, but this is not exactly correct. There are two definitions of the money supply. The narrowest measure of the money supply is M1, which consists of money outside bank vaults (in people's pockets, cash registers at businesses, etc.) plus bank checking accounts. The broader measure of the money supply is M2, which adds short term bank savings accounts to M1. As of March 31, 2013, M1 was $2.490 trillion and M2 was $10.561 trillion.
The Federal Reserve Bank creates reserves, not necessarily the same thing as money. In fact, reserves are not counted either in M1 or M2. Reserves belong to the banks themselves and are kept either in the form of cash in bank vaults or in a checking account, called a "reserve account", at one of the twelve branches of the Federal Reserve Bank. Most reserves are in the latter form. As of March 31, 2013 total bank reserves were $1.811 trillion, out of which only $.051 trillion was in the form of cash in bank vaults.
Banks are required to keep minimum reserves, called "required reserves", based upon the total size of their customers' checking and savings accounts. Reserves held by banks that exceed their minimum requirement are called "excess reserves". Ours is a fractional reserve system, meaning that banks are required to hold only a small percent of reserves to satisfy the anticipated demands of their customers for actual cash. As of March 31, 2013 excess reserves dwarfed required reserves. Required reserves totaled only $.113 trillion, whereas excess reserves were $1.698 trillion. Historically excess reserves were a trivial amount, seldom exceeding $.002 trillion.
Bank Lending Creates Money
Banks create money through their lending operations. When they make a loan, they credit the borrower's checking account rather than hand over actual cash. This is important, because it explains the inflationary danger from the current mountain of excess reserves. Banks always seek to maximize profit, therefore they seek to lend as much money as possible. One of the constraints on their ability to lend is the amount of excess reserves they have to support the newly created checking account balances that emerge from their lending operations. Without new reserves the money supply cannot grow. But even with new reserves, money supply growth depends upon the additional step of bank lending.
Currently the banks are not expanding their loans, due to another constraint upon their operations--the size of their capital accounts. When banks write off bad loans, their capital accounts diminish, and the ratio of their capital account (the numerator) to the size of their total assets (the denominator) falls below regulatory (and prudent) minimums. In recent years the banks have been writing off bad loans from the subprime lending bubble era. Their capital accounts are under stress from this source. Plus, the banking regulators are contemplating requiring banks to hold a higher ratio of capital to total assets.
The banks have three options for meeting their capital requirements: one, sell new capital; two, reduce the size of their total assets; or three, allow for retained earnings from their operations to slowly rebuild capital. The quickest way out of their capital problems would be to sell more capital to investors, but this is difficult in today's politicized banking market. Therefore, despite the massive excess reserves, the money supply is unlikely to expand. This is the reason that all the world's central banks are seeing their newly created reserves simply become "excess" reserves on their own books.
The Arithmetic Potential of Excess Reserves
But, let's calculate the potential size of the money supply SHOULD the banks start to lend more, which would move reserves from the "excess" category to the "required" category. One way to do this is to assume that banks will utilize their reserves as efficiently in the future as they have in the past, eventually moving all reserves into the "required" category. Since we know the ratio of current "required reserves" to M1 and M2 and since we know the size of total reserves, we can calculate the potential size of M1 or M2 using the same ratios.
Right now $.113 reserves support $2.489 trillion of M1; therefore, the ratio of required reserves to M1 is 4.54%. Should all $1.811 trillion total reserves move into the "required" category at the same efficient manner, M1 could expand to $39.9 trillion. Those same $.113 required reserves support $10.561 trillion of M2; therefore, required reserves to M2 is only 1.07%. If all $1.811 trillion of reserves were utilized to support bank lending operations and, therefore, expand the money supply, M2 could go to $987.0 trillion!
The Political Elite Want More Bank Lending
Remember, the banks want to make loans and they want to use all of their reserves as efficiently as possible to support their lending operations, of which a byproduct is an increase in the money supply. There is no doubt that increasing the money supply to its full arithmetic possibilities would cause huge price increases, probably even hyperinflation and the collapse of the dollar as a desire medium of exchange. Currently capital requirements prevent banks from expanding their lending and increasing the money supply. But there is no doubt that the political elite view increased lending as a desirable goal to reviving the economy. Where there is a political will, there usually is a political way.
The Fed's determination to kick start the economy with injection of reserves has failed so far. Let's hope that the Fed comes to its senses and starts to pull some of these reserves from the system through sales of its own assets. This may trigger increases in the interest rate, but so be it. A recession is preferable to total monetary collapse, which is a real possibility should the Fed persist in its obsession with quantitative easing and the political elite find a way to release the banks from the constraints imposed by capital requirements.