Currency, the Multiplier, the Divisor, Velocity, and Deflation: Minor Problems for Bankers

What if a central bank prints up currency for expected bank runs? The Federal Reserve says it has $150 billion in reserve. No independent agency has verified this claim. It began saying in mid-1998 that it planned to print up $50 billion more. No one has verified this claim, either. Some agency should. It is inherently improbable.

The Bureau of Engraving and Printing runs its presses 24 hours a day, 7 days a week. Most new currency merely replaces old currency. This is especially true of $1 bills, which wear out in about 18 months.

So, if the FED really did have the BEP print up all this money, then we can be sure it's in large bills. This will surely be handy for the illegal drug business.

If it's in large bills, it will wipe out cash-based businesses that must make change. McDonald's and Burger King will be in big trouble if there is a run on the banks. "We have five happy meals. That will be $20, even." "I want one happy meal." "I'm sorry; we sell them only in units of five."

When people go to currency, they make fewer exchanges per unit of time. This is called a reduction in the velocity of money. It is price deflationary. Any substitution of currency for checks or credit card funds is deflationary. In a bank run scenario, there will be even fewer exchanges, compared to normal currency exchanges. People will hold onto currency. Businesses will find strong consumer resistance.

In a fractional reserve banking system, any move to currency in the system as a whole is wildly deflationary: a reduction of money by 98% in today's world of 2% reserves. When new monetary reserves are added by the FED, the multipler is inflationary. When currency is being withdrawn from the banking system, the multiplier becomes a divisor. Commercial banks must sell assets to fund the surrender of currency to depositors. That's a lot of selling!

To avoid this divisor-based deflation, the central bank will loan the currency to hard-pressed commercial banks. The rate of interest for these currency-replacement loans will be above the normal overnight rate. Thus, the total money supply will not drop, since the newly issued currency will pass from the central bank through the commercial bank to the depositor (ex-depositor). But the move to currency will reduce the velocity of money.

The real deflationary threat is not the shift to currency, although this will reduce the velocity of money. The central bank could buy more financial assets (T-bills or anything else) by creating electronic money in order to compensate for the reduction in velocity. The real threat is cascading cross defaults: the destruction of bank-to-bank payments. That would lead to the destruction of all digital money.

Deflation? Like nothing seen in man's history. We could see a 20-to-one appreciation of currency's purchasing power -- all nicely tax-free. (They tax us on rising money income, not rising purchasing power.)

The control over money by central banks rests on one assumption: bank computers will work, so banks will be able to settle transactions with each other. Remove this assumption, and the era of central banking is called into question. The day that banks cannot settle accounts with each other, the digital capital markets will shut down, all over the world. Overnight, currency will replace digital money. The free market will replace central banking. The monopoly over money will end.

Anyone who says this scenario cannot happen has a responsibility to identify the world's compliant money center banks. Or at least one. They have worked since 1996 to get compliant. Not one has announced its compliant status. It's September, 1999.

Faith? You have to a lot of it to believe that digital money will survive.

Bankers can beg us, "Please, don't take currency out of our banks." But whether we do or don't, the bankers' #1 problem is cascading cross defaults. That is not the depositors' responsibility to fix. It's the international banking system's. So far, they haven't fixed it. Depositors have nothing to do with this problem.

Depositors will not destroy the banks in 2000. That honor will go to the programmers.

Four words will end the 300-year experiment in central banking: "Our computer is down."

Banking is a system. It uses one huge computer system. This system is not compliant if any computer in the system is not compliant, unless they can isolate that computer from the system. Do this enough times, and there is no more system. So, when banker A says "our computer is down" to banker B, Banker B will say it to banker C. On that day, you had better have currency in hand. Otherwise, some teller will be saying it to you.

Bankers keep saying, "I am confident that my bank's computer will work. That's because we have been working on it really hard." But none of them says, "I am confident that the computers of all of banks on earth will work." Which ones won't? He doesn't know. Then which ones will the system have to screen out? No one knows. Then how will they keep bad data out of the system, assuming the system stays up? No one knows.

What are you going to do about this? I hope you don't reply, "I don't know."

-- Andy (2000EOD@prodigy.net), September 13, 1999

Answers

I figure that greenbacks will increase in value relative to goods for a while once the banks close/restrict withdrawals late this year, but will then move toward worthlessness as owners of survival goods (including food) begin to refuse ANY amount of paper for their property. I for one will not accept paper in exchange for sm stored food in 2000. Michael Hyatt's preparation book gives a nice summary of how this might transpire.

www.y2ksafeminnesota.com

-- MinnesotaSmith (y2ksafeminnesota@hotmail.com), September 13, 1999.

Andy: Should you not credit the author of your post ?

-- Just Browsing (IKnewIreadit@someothersite.com), September 13, 1999.

Yes sorry I forgot - Gary North from the 10th.

BTW it's now 7am Central time, and the Dollar is getting murdered by the Yen, currently down to 106 Yen to the Dollar, the Euro is also lookiing like going to parity... interesting times...

-- Andy (2000EOD@prodigy.net), September 13, 1999.

If y2k is really bad and a central banking system remains intact, we will have delation.

If y2k is really bad and all central banking crashes, hyperinflation is more possible.

-- coprolith (coprolith@rocketship.com), September 13, 1999.

Andy, Is the right answer, "I'm buying gold"? (I am, too, not because I know what's going to happen, but because I think gold has an even chance of retaining some value.)

-- Mara Wayne (MaraWayne@aol.com), September 13, 1999.

I think the government is not recycling bills so fast anymore- i handle cash in my business- and I have never before seen so many old worn bills. Hardly ever see a new crisp one anymore- am even seeing 2 dollar bills and Susie B's- a lot of my customers come to the market straight from the ATM - and these bills are all worn out too.....

-- farmer (hillsidefarm@drbs.net), September 13, 1999.

I agree with farmer. The bills are just getting awful.

Which reminds me. Why do all the bills- from 5's to 20's- have dates on them from 1990 to 1995. I have yet to come across a $5 bill that was dated later than 1995 and the same with old 20's. Now, maybe they just have run the old plates for a few years without changing them, or maybe they are stockpiling the new bills for release later. I just think its odd that even $1 bills have dates generally on or before 1995, considering the published life expectancy for $1 bills is 18 months. Any thoughts?

-- Jim the Window Washer (Rational@man.com), September 13, 1999.

Andy, I always thought that during deflationary times, gold lost, or at best maintained it's value while during deflation, cash was king. Considering the goldbug you are, I'm surprised you contributed an article on deflation, or am I missing something here?

-- Richard (trubeliever@webtv.net), September 13, 1999.