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The ongoing

ing his tenure? Rather than averaging 2.5 per-

requirements and allowed banks to reclassify

cent annually, shouldn't prices have remained

many M1 checking accounts as M2 savings

spread of

constant or actually fallen? The answer relates

deposits. M2 and the broader measures

electronic funds

to the market's extraordinary capacity for

became quasi-deregulated aggregates with no

legal link to the size of the monetary base.11

transfers and

financial innovation. Because bank reserves in

the U.S. currently pay no interest (except for

A result, and one that Milton Friedman

assorted cashless

required clearing balances arising from the

noted in 2003, is that changes in the velocity of

payments are

Fed's check-clearing operations), banks have a

M2 were automatically offset by changes in the

strong incentive to economize on their use.

amount of M2. Interestingly, this is exactly

essentially replac-

They can figure out ways to do so even under

what monetary economists George A. Selgin

ing money with a

reserve requirements, as amply illustrated by

and Lawrence H. White predicted would hap-

sophisticated

the origins and growth of the Federal funds

pen under free banking, that is, a market-deter-

market, where banks regularly loan each other

mined monetary system without any govern-

network of

excess reserves. Financial deregulation gave the

ment involvement. They argued that free

computerized

process an additional boost. From December

banking would automatically adjust the quan-

barter.

1986 to December 2005, the same period dur-

tity of money to changes in velocity. If velocity

ing which aggregate reserves remained almost

rose, signaling a fall in money demand, market

constant, the aggregate, de facto reserve ratio

mechanisms would cause banks to reduce the

of the banking system as whole backing M2 fell

quantity of money they created. And if velocity

in half: from 2.52 percent to 1.23 percent. So

fell, signaling a rise in money demand, banks

the quantity of M2 deposits grew at a secular

would enlarge the quantity of money. The

rate of 4.6 percent, enough to generate mild,

response of M2 to changes in velocity in the

positive, sustained inflation. And the quantity

1990s offers stunning confirmation of this

of domestically held currency grew alongside at

claim. The result was that inflation was held in

check.12

an accommodating rate.14

Thus, during the dot-com boom of the 90s,

This steady, long-term decline of reserve

the velocity of M2 rose as people shifted into

ratios cannot easily be halted and confronts

stocks. But this was perfectly offset by the

government fiat money with a fatal long-run

declining growth rate of M2, which fell to near

problem. Retightening of reserve requirements

zero between 1994 and 1996. Assorted Fed

would only burden banks with an implicit tax

watchers reached opposite conclusions, depend-

not faced by other financial institutions,

ing on which variable they chose to focus on.

encouraging the development of new, highly

Some warned that Greenspan's policies were

liquid money substitutes that effectively evade

deflationary, while others looked at the higher

the requirements. Congress has, moreover,

growth rates of the base and M1, which remains

moved in the opposite direction, permitting the

more closely tied to the base and more distorted

Fed to eliminate all remaining reserve require-

by currency going abroad, and predicted higher

ments in 2011, thereby bringing the U.S. into

inflation. Both were wide of the mark, of course,

line with such countries as Australia, New

but not because of Greenspan's miraculous cen-

Zealand, Canada, the United Kingdom, and

tral-bank discretion. The result was a product of

Sweden, which have already done so. The same

market process, and when the collapse of the

act, the Financial Services Regulatory Relief Act

dot-com boom burst the M2 velocity bubble, it

of 2006, also authorizes the Fed, beginning in

induced a new spike in M2 growth.13

2011, to pay interest on bank reserves held as

deposits with the Fed. But any resulting

increase in the demand for bank reserves stems

Why Any Inflation?

from, in effect, transforming that portion of the

monetary base into Treasury securities.15

If Greenspan approximately froze total

In short, the ongoing spread of electronic

reserves, why was there any inflation at all dur-

funds transfers and assorted cashless pay-

5