The ongoing financial and economic crisis has not only stoked fears that it will end ininflation — as central banks will print up ever-greater amounts of money — but it has also given rise to a diametrically opposed concern: namely, that of deflation.
For instance, in December 2011 Christine Lagarde, head of the International Monetary Fund (IMF), warned that the world might risk sliding into a 1930s-style slump, such as the Great Depression.
This episode was characterized by worldwide defaulting banks, a shrinking of the money supply (or, deflation), which in turn led to falling prices across the board, sharply falling production and drastically rising unemployment.
This becomes obvious if one takes a look at the workings of today’s fiat-money system, a system in which the money supply can actually be increased at any point in time in any amount deemed politically desirable.
Commercial banks need two ingredients to produce additional bank-circulation credit, through which the fiat-money supply is increased, namely, central-bank money and equity capital.
Central-bank money is a “monopoly product,” produced by the central bank, typically through loaning to commercial banks.
Equity capital comes from investors who are willing to invest their money in commercial banks, thereby becoming owners of the banks.
Banks need central-bank money for three reasons. First, they have to hold a certain percentage of their liability vis-à-vis nonbanks in central-bank money; these are the so-called minimum reserves.
Second, banks need central-bank money for making payments in the interbank market. And third, banks keep central-bank money for meeting the cash drain, caused by clients demanding a cash payout of their deposits.
If, for instance, the minimum reserve rate for demand deposits is 2 percent, the banking sector as a whole can produce $50 of credit and fiat money with each $1 of central-bank money (that is 1 divided by 0.02).
Government regulation requires commercial banks to back up their “risky assets” (such as loans and securities) by a “minimum” equity capital. If, for instance, the minimum capital requirement is 8 percent, a bank can produce $12.50 of credit and money (that is 1 divided by 0.08) with a given $1 of equity capital.
If the risky weighting of risky assets is, say, 25 percent rather than 100 percent, a bank can produce credit and fiat money in the amount of $50 (that is $12.5 times 1 divided by 0.25). That said, a loss of $1 requires a bank to reduce its credit and money supply by $50.
Against this backdrop we find that the lower the minimum reserve ratio is, the more credit and fiat money the banking sector can produce with a given unit of central-bank money. And further, the lower the capital requirement and the risk weightings are, the higher will be the leveragebanks can build up with a given amount of equity capital.