A real Y2K threat

I received a number of e-mails expressing thanks for my attempt last week to put the relationship between money supply, interest rates, and inflation into some semblance of readable economics (an oxymoron).

Some folks asked if it’s really true that banks don’t have enough cash to cover all the deposits. One asked if Fort Knox (where the government stashes its gold hoard) isn’t the place where all the money is kept that “backs up” bank deposits.

Well, as crazy as it sounds, real money, the stuff we can put into piggy banks and wallets–a fancy word is currency–is just about 10 percent of the total money supply (depending on how you measure money supply, which is comprised of currency plus various measures of bank deposits and similar stuff).

In the United States, most money is basically digits in computers, which is created by bank loans.

Along with my email about this topic, I noticed the snowballing amount of paranoid Y2K email from the United States. I always “bah, humbug” all this jabbering Chicken Little the-sky-is- falling talk. There is, however, an interesting angle to the Y2K bug and it’s probably worth considering.

The standard worries about Y2K are pretty much straightforward (even if they are just hysterical gibberish), such as banks goofing on your account balance, credit cards sending you a bill for $11 trillion, and so on. This strikes me a potential inconvenience, but hardly enough to shake the world from its foundations.

Lurking here, however, is something I haven’t yet seen in the Y2K scare literature (perhaps because I stopped reading it a long time ago, and any email concerning it goes straight to delete- land). Since money is created by banks making loans, could the money supply hiccup if banks get snarled in a Y2K mess?

That’s a legitimate question, and more than a matter of mere record keeping. If banks can’t process loans, then the entire money supply in the United States will be screwy. If you were to draw a worst case scenario, you would have to assume that loan activity would substantially decline, and along with it the creation of money.

Under this scare-scenario, we’d see deflationary pressures, as a money supply crunch pushes prices down. In deflationary times, people holding cash are the ones who benefit, since they’ve got more spending power as prices fall. People who are in debt, by contrast, lose the game, since they have to pay off loans with more “valuable” dollars.

These positions are reversed during inflationary times, by the way, in which debtors are the winners, and creditors the losers, since the loans are being repaid in weaker dollars as time goes on.

I can’t see how Y2K could create any kind of wild boost in the money supply, so it would seem that the big risk is towards the deflationary side. Cash is king during deflation, so if you’ve been squirreling away your money instead of living the high life on credit, you might emerge a winner if any of the Y2K stuff really hits.