Home > Macro/Monetary Theory > Why Hyperinflation is Not a Threat Part I: Fed Accounting (yawn…)

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

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.



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