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Why Hyperinflation is Not a Threat II: Debt and Anti-Debt

January 16, 2013 5 comments

Last time I told you that money does not represent a debt from the Federal Reserve and that even if it did, it would not serve as an anchor for the real value of a dollar because the assets of the Fed are also denominated in dollars.  So what does money really represent and what does anchor the real value of a dollar?

In the past, paper money was created by banks.  You could take gold or silver or something of the sort to a bank and they would give you a bank-note which could be redeemed at any time for some quantity of gold or silver or the like in the future.   As long as people generally trusted the health of the bank, they could trade the notes instead of the gold or silver which was somewhat more convenient and also allowed for an “elastic” money supply (I’ll postpone a discussion of that topic).  Originally, the government got involved in money essentially by assuming the same job as a bank.  They would trade dollars for gold and gold for dollars at a given rate.  In this scenario, money represents a debt from the bank or the government to the holder of the note.  The gold or silver or other real good which backed the money is a sort of “anti-debt.”  It is the means by which these debts can be extinguished.

Today, money is not backed by gold or silver or anything in this manner.  The process of money creation is of an altogether different nature. There are a few different ways it is done but they amount to essentially the same thing.

If you buy a government bond, that represents a debt from the government to you.  It is redeemable at a fixed time for a fixed amount of dollars.  The dollars you use to buy the bond do not represent a debt from you to the government.  They represent the means by which the government can extinguish its debt to you.  At the appointed time, the government must produce the requisite amount of dollars to retire your bond or else default on its debt.  The number of dollars required to do this at that time does not depend on variables such as the price level, rate of inflation, real interest rates, GDP, etc..

If you sell a government bond to the Federal reserve, the debt which the government owed you is transferred to the Federal Reserve.  The dollars which the Fed prints and gives to you represent the means by which that debt can be extinguished.  The Fed doesn’t owe you anything, the government owes the dollars to the Fed.  When the bond comes due, the government must either get dollars from taxes or issuing more bonds in order to retire that bond, or, as they normally do, just issue another bond and give it to the Fed, which cuts out the middleman (you).

Alternatively, the Fed can loan to a bank.  When a bank borrows dollars from the Fed, it’s not the Fed that owes the bank, it is the bank that owes the Fed.  The dollars, again, represent the means with which the bank is able to extinguish this debt.  The principle is the same, in either case, the dollar is created and traded for debt.  In both cases, the debt is from someone else to the Fed and the dollar is not the debt but the “anti-debt.”  This is an important distinction between modern fiat money and traditional bank-notes which, at one time were backed by gold or silver.

To see how this provides an anchor for the value of a dollar, we must go a step farther.  If the Fed loans to a bank, that money becomes part of the bank’s reserves.  If you sell a government bond to the Fed, you most likely deposit the money which you get in return in the bank and it becomes part of bank reserves.  Alternatively, you may spend it on something else, but in this case the person to whom you pay the money most likely deposits it and it becomes part of bank reserves.  I can drag this out through as many steps as you please, but the point is that most of this base money will end up as bank reserves.

The money which the Fed creates and which is able to extinguish Federal Reserve debt is the money base.  Some of this ends up in people’s wallets but most of it ends up in bank vaults (or accounts with the Fed which amount to the same thing).  The base money that ends up in bank vaults acts exactly like gold did in the old system.  It is anti-debt.  The banks then issue bank credit on top of this which is debt.  This bank credit takes the form of checking accounts, saving accounts, certificates of deposits and so forth.  If you deposit a $20 bill in the bank and they add $20 to your checking account balance, this is a modern form of bank credit.  It is redeemable at any time at the bank for $20 in cash.  Again, the cash is the anti-debt into which this bank credit is convertible.

And just like people could use bank-notes to transact, we now can use this modern bank credit.  You can go to the store, buy a gallon of milk and pay with a check or a debit card.  At the end of the day, the store will deposit the check with their bank and their bank will settle any balance that arises with your bank by transferring cash, just like in previous times banks would have settled by transferring gold.  So what we typically call “money” and what we use to buy things is made up of both base money (currency) and bank credit.  The bank credit represents a debt of base money from the bank.  The base money is anti-debt opposing some debt with the Federal Reserve.

But not all bank credit is created from depositing currency.  The majority of it is created in opposition to a new debt to the bank.  This process is just like the one described above when the Fed creates base money.  Someone goes to the bank and wants a loan.  The bank may give them a loan in the form of bank credit. Alternatively, the story often goes that the bank lends cash and the borrower spends it and the then whoever they gave it to puts it in their bank and their bank lends some of it as cash and this process continues.  It makes no difference which story you tell.  The result is that bank credit increases the quantity of what we call money beyond the quantity of base money created by the Fed.

This increase in money comes with an increase in debt.  This is the key.  The debt is nominally denominated. In order to pay it off, someone must produce a fixed quantity of dollars.  If they don’t pay their debts, there are usually undesirable consequences.  Usually those consequences involve the loss of some real property.  If you don’t pay your mortgage, the bank takes your house.  If you don’t pay your car loan, they take your car.  If a business doesn’t pay their debts, they go bankrupt and the creditors take their assets.  It is all of these assets securitizing all of the debt which is created in the process of creating our money that provides a real anchor for the value of a dollar.

Maintaining a stable value for the dollar depends on maintaining a balance between the quantity of money and the quantity of debt.  The reason that the hyperinflation scenario described by many Austrians and conservatives, in which people lose confidence in the dollar and stop accepting it and the value plummets, never happens is because people with debt need those dollars to pay off their debt.  They won’t just decide not to take them.  If some people suddenly lost confidence in the dollar and decided not to hold any, those people with debt would be happy to take them off of their hands.  In fact they would compete over those unwanted dollars.  If someone owed $10,000 on their car, and not paying would result in the loss of the car, then they would be willing to trade any possession they own which they value less than the car for $10,000, including some quantity of their labor (or the car for any amount of dollars greater than $10,000).  In this way, all of those assets–the houses, cars, boats, businesses, etc.–which secure all of our debt are “backing” the dollar.  Dollars are convertible into these assets at a fixed rate.  It’s just that this rate varies from person to person, there’s no “car standard” or “house standard” so it’s not obvious to people.

What’s more, the process by which money is created, destroys money when reversed.  In other words, when people pay off their debt, the money supply decreases.  Now here’s the kicker.  Here is M2 (base money plus most forms of bank credit).  Here is total credit market debt owed.  Notice that total debt is about five times the size of M2.  Now consider what would happen if people did the opposite–that is, if people decided that they didn’t want to hold debt any more.  They start deleveraging and the money supply starts to contract.  As this happens the price level starts to fall.  There are different ways to explain it but they amount to the same thing, people compete for the dollars that they need to pay down their debt by offering other goods and services at a more favorable rate.  As the money supply contracts, it gets harder and harder to get the dollars required to pay off debt.  The prices of goods fall but the value of debt remains the same since it is nominally denominated.  Since there is more debt than money, it is impossible for everyone to get out of debt, some people will have to default.  This can result in a mad scramble to get the limited quantity of dollars so as not to be left bankrupt and with no real assets.

This is a deflationary scenario and this is the true danger which constantly hangs over our economy.  This is exactly what started to happen in 2008.  Notice in the graph of total debt, that it begins falling short of the trend right before the recession.  This is why the government stepped in and started throwing borrowed money at the economy to stop the bleeding.  When the private sector isn’t willing to borrow enough to keep the money supply growing fast enough to keep up with (artificial) inflation expectations and hold off this contraction, the government has to do it.  I’m not saying this is desirable or natural or unavoidable.  It’s an artificial problem we have brought on ourselves but if we really want to have any chance of fixing it, we have to understand what’s really going on.  We can’t just complain about the debt and ignore the system that makes it necessary.  If conservatives every got into power and actually tried to balance the budget without completely reforming the monetary and financial system, it would cause a recession that would discredit conservatives and free-market economics for a generation (at least) and probably destroy the Republican party.

Why Hyperinflation is Not a Threat Part I: Fed Accounting (yawn…)

January 12, 2013 5 comments

Part two will be a bit more exciting, but I want to provide some background first.  I know I’ve been over this before but it’s been a while and this is probably the most widespread misunderstanding among conservatives and libertarians.  And it’s not just about inflation, if the movement would start to think about money in this way, a lot of other things which are currently misunderstood would start to become clear I think.

The standard view of money is that it’s just paper that is out there circulating, backed by nothing.  We take it because we expect other people to take it.  They take it because they expect others to take it and so on.  Somehow, because we all keep expecting each other to continue taking it, it just keeps circulating.  This is essentially what they say in introductory economics textbooks (I don’t have one handy or I would quote it).  This logic, quite frankly, is economic nonsense.  But many on the right, sensing that this doesn’t seem like a stable situation, come to the conclusion that we are in constant danger of “losing confidence” in the money.  If a few people become unwilling to hold money, or if the Fed expands the money supply too much, the value of the dollar will go down and others will decide not to hold money and this will drive the value down further and eventually everybody would be trying to get out of their dollars and their value would plummet.

This is exactly what would happen if that story were true, that system would have broken down the moment the government tried to get it started.  A slightly more sophisticated, though also misguided, approach is to say that money is “backed” by the assets of the Federal Reserve.  Here is an example. 

What backs the money in the present irredeemable paper system?  Start by considering this brief anecdote.  Joe buys some equipment from John, to be paid Net 30.  We say that Joe owes John $10,000.  Next month, Joe comes back and gives the money to John.  Joe is out of debt, but has the debt been extinguished? No.  The debt has been transferred.  Now the Federal Reserve owes John the money.

But this is not true.  If you hold a $20 bill, the Fed doesn’t owe you $20.  The Fed doesn’t owe you anything.  The story goes that the dollars represent a debt from the Fed to you which is backed by the assets of the Fed which are mainly government securities.  Now to some extent, dollars are convertible into government securities because there is a market for them and the Fed, to some extent, supports this market by standing ready to buy or sell securities if the price moves outside of some range.  But this is not a debt.  The Fed is not legally obligated to trade you government securities for your dollars.

What’s more, this theory does not establish any anchor for the real value of a dollar since the securities held by the Fed are denominated in dollars.  So even if $20 in cash were legally convertible into a $20 treasury bill, this would not do anything to fix the value of a dollar.  If people did suddenly decide not to hold dollars the value of the T-bill would plummet along with the value of the cash.

I think part of the confusion surrounding the nature of money is due to the way the accounting is done.  In accounting, every debit must be offset by an equivalent credit.  When the Fed prints a hundred dollars and uses them to buy a $100 T-bill, they debit the asset “T-bills.”  This must be offset by a credit.  The way they choose to account for this is to credit a liability account representing notes outstanding.  We call this a liability because in accounting terms, this account behaves just like a liability.  A credit to this account offsets an increase in other assets caused by increasing the amount of notes outstanding and debiting it offsets a decrease in assets caused by decreasing the notes outstanding (selling assets and retiring the money).  But legally they do not represent a liability in the sense that we usually think about one.  There is no obligation to redeem these notes.

Alternatively, imagine I ran a counterfeiting ring and kept diligent accounting records (I’m not trying to make a moral connecting between the Fed and counterfeiting, just an accounting connection).  I print $1000 and buy a big-screen TV.  I account for this by debiting the asset account “consumer electronics” $1000 and crediting the revenue account “counterfeiting revenue.”  When I prepare my income statement at the end of the quarter, this revenue will become profit which will increase (credit) “owner’s equity” by $1000.  Now, of course, I could sell the TV.  Let’s say I can still sell it for $1000.  If I do this and burn the money that I get, I would have to credit “consumer electronics,” and debit some expense account, let’s call it “burning money expense.”  Then at the end of the quarter, this would be treated as a loss and would decrease (credit) owner’s equity.

The Fed doesn’t account for money creation in this way, I presume for a few reasons.  By calling the notes outstanding a liability, they do not get converted to profit periodically, they remain on the balance sheet.  My hypothetical counterfeiting operation was for the purpose of generating profit.  I (hypothetically) don’t really care how many of my notes are circulating.  The purpose of the Fed’s operations, at least partially, is to manage the money supply.  So they need to keep track of how much money is out there, so it doesn’t make sense to close out that account periodically.  Furthermore, the Fed may, theoretically, at any time need to reduce the amount of money in order to achieve their goals, whatever those may be.  This means that they must remain in a position to do so at all times.  Calling their asset accumulation profit and remitting it to the treasury would not allow them to remain in a position to contract the money supply whenever they wished.  Also, it would probably look worse to have to tell people the actual amount of real wealth that the Fed is channeling to the Federal Government.  (Though in our current perpetual “fiscal cliff” environment, there may be many who sort of wish people would notice as this profit generated by the Fed could essentially wipe out the national debt, if we wanted to.  More on that later.)

But just like I am not obligated to sell my TV back and burn the money, the Fed is under no obligation to redeem dollars for treasuries or any other asset.  And even if they were, it would not establish a “real anchor” for the value of the dollar.  So what does provide such an anchor?  More on that in the next post.