Fetters of Gold and Paper

We describe in this essay why the gold standard and the euro are extreme forms of fixed exchange rates, and how these policies had their most potent effects in the worst peaceful economic periods in modern times.  While we are lucky to have avoided another catastrophe like the Great Depression in 2008-9, mainly by virtue of policy makers’ aggressive use of monetary and fiscal stimuli (wintercow emphasis added), the world economy still is experiencing many difficulties.  As in the Great Depression, this second round of problems stems from the prevalence of fixed exchange rates.  Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad.

Two quick points:

1. I read the abstract and knew who must have been a coauthor without even looking at who it was. Is that science? This author, it seems to me, is an idea in search of a theory and a theory in search of an application.
2. Read the sentence I highlighted. That is not science. It is certainly not up to the standards of what one would expect in a (soon to be) published academic economics paper. The above paper is not based on research which proves that monetary and fiscal policy staved off the Great Depression 2.0. The paper itself does nothing to demonstrate that aggressive monetary and fiscal policy staved off the Great Depression. But hey, the policymakers in DC are all my friends, so they must have gotten it right. This article from Greg Mankiw is well worth the read if for the only reason to understand economic epistemology.

I’d love to be able to parse this out empirically – but remember one reason why we have organized and other crime – black market activity. When market activities are pushed underground, people with a comparative advantage in protection and violence tend to be involved in the production and distribution of the goods. Think about the difference in having a loan called in from a loan shark versus from a bank – the latter is a far more “civil” affair. If there are factors which push borrowing and lending activities into black markets, then you would expect the incidence of crime to be higher than if we lived in a world where borrowing and lending in the formal sector was easier.

Thus, despite the millions of rotten loans that were made by fly-by-night mortgage originators, despite the bad incentives created from low-interest rate policies, despite the flood of capital via Fannie and Freddie into the lending markets, might we only be focusing on the easy to see negative effects of these things? Could it not be the case that millions of people used these formal institutions rather than the informal institutions of the past? If this is the case, then the amount of crime, particularly in the areas where loan sharking and money collection are involved, could very well have been lower than otherwise would be the case because of this easy credit policy.

I am not saying this is true, but what I am saying is that it is entirely possible – and if someone were to take a purely utilitarian approach to social policy, before rejecting easy credit out of hand, perhaps a study or ten could be employed?

(1)   What is money? It is not even clear what the money supply is in the US (or any) economy. Is it M1? Is it M2? Is it something in between? How do we even know what should fall into each aggregate? Even if we decide what goes into each, is it reasonable to believe that we can measure those things with any degree of accuracy? And if so, can we capture how these change from day to day?

(2)   The supply of money: the Fed, at best, has the ability to change the amount of base money in an economy. How much those changes translate into changes into the amount of purchasing media in the economy is subject to factors beyond the Fed’s control, and beyond their ability to measure. Two such factors are how banks are going to respond to changes in base money and how consumers’ demands for currency change over time. Not only are these hard to predict, but they are extremely hard to measure.

(3)  The demand for money: remember that the Fed does not operate in a vacuum. Even if it had a perfect ability to measure the amount of money and even if it had perfect control over the supply of money – the price level in the economy is a function of supply AND demand.  Now you can make arguments that the Fed can influence the demand for money (perhaps by instilling confidence) it ultimately has little control over the many factors which affect Md. For example, the Fed cannot predict the pace of financial innovation, it cannot impact real interest rates, etc.

Any one of those factors ought to make readers skeptical about the ability of the Fed to conduct monetary policy. However, when taken together, asking the Fed to run effective monetary policy is like driving a truck at night with beer goggles on. You might be able to stay on the pavement, but you are likely to wipe out a few little old ladies driving Ford Fiestas along the way …

In future posts, we will explore each of these factors in more detail, along with the other things that the Fed is asked to do.

Myth #1: The government should balance its books like a private household.
Reality: Our federal government is the issuer of the currency, which makes its budget fundamentally different than the average citizen’s.Discussion of government budget deficits often begins with an analogy to a household’s budget. People say: “No household can continually spend more than its income, and neither can the federal government”. But there are big differences between a household and the federal government. You don’t have the ability to print money in your living room, do you? Well, the government does. So how it finances its own debt and spending is different from the way you do.

A government is the issuer of the currency. The household, on the other hand, is the user. Households are restricted by the need to somehow get money into their bank accounts, or their checks will bounce. The federal government, by contrast, doesn’t “have” or “not have” dollars. There is no vault or lock box where it “keeps” its money. In fact, it makes all of its payments simply by electronically crediting private bank accounts and there is no practical limit to which it can change those numbers up. Spending by the federal government always creates new money in the system, while taxation destroys it. When households and firms pay taxes, the money does not go anywhere; the government simply debits those private bank accounts by electronically reducing the amount of reserves they hold, i.e., by changing the numbers in those bank accounts down.

Government is constrained only by the inflation it can create by over-spending, but its ability to spend is numerically unlimited. Households are constrained by their ability to get dollars from some form income and from borrowing, and both of those have real limits.

~Pavlina R. Tcherneva, Assistant Professor, Franklin and Marshall College

Well, take Franklin and Marshall off the list of schools my kid will be thinking about attending. Now, I’m not of the belief that government needs to balance its books – that is nonsense. Lots of time, debt makes sense. Particularly if you expect to be richer in the future (that would have been unthinkable for generations living 200 years ago, hence less debt back then (at least one reason)), then incurring debt today can very well be prudent. What I do have a problem with is running a balanced budget while spending 50% of GDP on government. That is not only a serious violation of my property rights (as if small violations are any less of a violation) but it is a serious drain on economic growth. I’d much favor a world where we ran infinite budget deficits but that spending was only 5% of GDP. Our dear professor doesn’t say much about these differences.

But more to the point, what she is saying is that technically, the US can be Zimbabwe, so the issue of budget deficits is overblown. I don’t even need to say more than that, but let’s see exactly what kind of inflation we would have to deal with in order to “solve” our current debt “crisis.” By the way, if we solved it, that would just clean the slate for another spending orgy to be solved by our kids … so I am not entirely sure I favor solving any of the current problems either (sort of like learning that someone invented low-cal donuts, you may end up fatter in that world than in a world with high cal donuts).

Anyway, regardless of your beliefs about whether the money market is in equilibrium or not, this equation, which is an identity, is a useful way to think about money market dynamics. Milton Friedman’s license plate in fact had it printed on it. What did it say?

MV = Py

That is known as the “Equation of Exchange.” All it is saying is that the amount of money in an economy is equal to a fraction of the amount of income in an economy. If people like to hold a large share of their income as money (as opposed to other financial or other assets), then the amount of money in circulation will be large as compared to the amount of goods and services produced in an entire year (V stands for “velocity” where velocity is a convoluted way to write the inverse of people’s interest in holding money balances as a share of their total income, so V would be low here). If people like to hold a small share of their income as money, then the amount of money in the economy would be small (V is large).

Now, let’s think about the implications of Dr. Tcherneva’s worldview. Right now, the U.S. government is expected to run annual deficits of $1.5 trillion. Let us examine the economics of this view from two perspectives. First, let us ask what would happen to inflation if the government turned into Greece and was unable to borrow any money to finance beyond its spending (that assumes we can still tax to the tune of $2.5 trillion per year, hardly a realistic assumption). As of this writing, M2 is about $8.5 trillion while M1 is about $1.7 trillion. The actual amount of purchasing media in the economy is likely somewhere in between. For argument’s sake, let’s call it $4 trillion.

If we write the equation of exchange in growth form, it becomes this:

The percentage change in M + the percentage change in V = The percentage change in P + the percentage change in Y

Rearranging and reinterpreting, you would see that:

The rate of inflation = the increase in the money supply + the change in people’s preferences for holding money – the real rate of economic growth (p = m + v – y)

So, to monetize all of the current year’s excessive spending (and each year for the infinite future) we would be creating some inflation. How much? Let us make some assumptions, each of them generous. Let us assume that people’s money holding preferences do not change over time.  If you believe that as a country enters into an inflationary period that people would wish to hold less and less of that country’s money, then the rate of change of V, what I call v, would be positive (in other words, the share of our income we hold as money would fall, and since V is the inverse of that, V would rise). Similarly, let us make the very generous assumption that real economic growth would be 3% per year, for every year going forward. Note that the US has rarely sustained that level of growth (and funnily enough, the Obama Administration is assuming larger growth numbers than that in order to say he would reduce the primary budget deficit after he is re-elected). Adding $1.5 trillion to the money stock each year, when the current money stock is $4 trillion, would appear to be a 37.5% increase in M (so little m is 37.5%). That number is larger if you think M1 is a more appropriate measure of money and that number is smaller if you think M2 is a more appropriate measure of money. What would happen to prices each year in this world?

p = 37.5% + 0% – 3%

p = 34.5%

In other words, if the Administration wants to keep up its spending party and monetize it each year, then we would see annual inflation of 34.5%. While that is not Zimbabwe level inflation, it is far more serious than any inflation level we have ever seen. Savings would be devastated. The poor would be devastated. Retirees on fixed incomes would be devastated.

Second, let us examine what would have to happen for the United States to pay for all of its accumulated deficits – in other words, if it had to deliver on its entire existing national debt, PLUS the entire amount is owes via unfunded entitlement programs (Medicare, Social Security, Public Sector Pensions). Estimates of its outstanding obligations range from $50 trillion to $100 trillion. I’ll be kind and say it is only $50 trillion. In other words, that is the total amount of money we need to come up with in order to pay everybody the goodies that we promised them. And again, since Dr. Tcherneva’s seems to think we can just print up some dollars to pay for this, let us think about the implications. We could try to pay it all off in one year. But that would be extremely hard to do. Or, we could try to form a “5 year plan” or probably something like a 20 year plan to pay it all off. If we make the assumption (heroic) that nothing would be added to these debt obligations over 20 years, then on top of financing the $1.5 trillion in annual government budget deficits, we would have to “pay off” $2.5 trillion more each year to take care of those nasty little unfunded liabilities (or $5 trillion if you price those obligations more realistically). Returning to our equation of exchange, we would be printing an additional $4 trillion of money, on top of the existing $4 trillion. So money growth would be 100% (in the first year … the money growth rate would be smaller each year, but then again, y would fall and v would increase, so I simply hold them constant for now). Our dynamic equation of exchange would suggest we’d face inflation rates not 2% per year as we have seen for the last 30 years, and not even 34.5% like we would see if we simply monetized our deficits each year, but we’d see 100% + 0% – 3% = 97% increase in the level of prices each year. In other words, we could “pay off” all of our debts if prices doubled every single year.

So, Dr. Tcherneva’s is certainly correct that technically it is possible to print lots of money. But in the real world, that is like saying, “technically, it is possible for Rizzo to safely strap himself to a rocket and fly around the earth and land back where he started, safely …”

In a future post, we will examine would 97% annual price level increases would do to an economy – and who would benefit and who would lose.

Not too much “fishy” stuff – this was at the tail end of the Latin American debt crisis, the S&L Crisis had largely passed and the trouble in Asia had yet to start brewing. My only few comments for the benefit of the readers are these:

1. Notice how much larger the Fed’s balance sheet is today than it was 15 years ago. The size of the Fed’s balance sheet is a proximate picture of how much high powered money is floating around out there.
2. How does it get so large? Well, the Fed simply creates short-term liabilities out of thin air. Whereas a private bank would only be able to create deposits (or back in the State Banking era print banknotes) if it received assets or gold from its customers, the Fed in fact prints the FRN or creates deposits on its member bank balance sheets out of thin air.
3. Why all the weird stuff on the current balance sheet? In fact, much of this was because the Fed was unwilling (because it might exacerbate a panic) or unable (by law) to use its discount window to help out troubled firms. The classical lender of last resort role for a central bank, and one justification for the existence of the Fed was to make emergency liquidity available to solvent banks via discount window loans at penalty (e.e. above market) rates. This would prevent otherwise healthy firms from using the window as a low cost way of borrowing (like the Fed allowed banks to do to fuel the inflation of the late 19-teens and the 1920s via “rediscounting of commercial paper” and would be a way to ensure that healthy banks would pay back the emergency loans quickly when the panic passed. So, all of those bizarre facilities it set up were either (1) ways to legally get around the fact that some firms are not permitted by law to make use of the discount window or (2) prevent firms from having to use the discount window for fear that it would signal to investors and customers that the bank is, in fact, in trouble. All I will say about point (2) would be that by not allowing discount window use by anyone, the Fed in fact exacerbates the information problem and leaves investors and customers guessing that all firms must be in trouble (perhaps we can write down a model to show this in a future post). And as a way to prevent this information problem from causing an even worse panic, the government actually mandated that certain firms have to take part in these liquidity auctions.

Anyway, I hope you enjoy comparing the two. My fear used to be that today’s balance sheet would have lots of poorly performing assets on it so that the taxpayers would have to bail out the Fed … now it is … I am worried that these things will turn out to be good investments. And before you know it, the Fed will turn into nothing different than a giant hedge fund – the very thing it is supposed to (at least in the new la la legislation world) be monitoring, not engaging in.

Why? Because the profits of the Fed are plowed right back into the Treasury. Thankfully, we spend so much freakin’ money as a Congress that even if the Fed generates $50 billion per year in “profits” (from its monopoly position) that is a little more than 1% of the $4 trillion that the accountants in DC spend each and every year. Countries that rely on central bank profits for a larger portion of their fiscal spending (I hope this puts aside the notion that the Fed is an independent branch of government) are at a much larger risk of severe inflations than we are.