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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 are Austrians Obsessed with Hyperinflation?

July 24, 2012 14 comments

In WordPress, next to your “top posts,” it tells you the top searches that led people to them.  Next to my recent post on monetary economics I noticed the following search: “why are Austrians obsessed with hyperinflation?”  So I tried that search to see what came up and guess who is number 1 (me)! However, the post that it links to is not all that enlightening by itself.  So I figured I would give the people what they want and just answer this question directly.

Austrians are obsessed with hyperinflation because they don’t get how money is created in this country.  And I am saying this as someone who is morally and philosophically sympathetic with them.  But they have a model of money creation in their minds which is not accurate.  They can only see a system where the government just prints money and spends it.  In this system, we would be in great danger of hyperinflation for exactly the reasons they say.  Namely, the tendency of the government to print and spend more and more money would cause the money supply to expand constantly driving the value of that money down until eventually people decide to flee the currency in anticipation of this drop in value and then the value starts to drop dramatically and this causes a rush for the exits and so on.  In this scenario, all the things they say are correct including the stuff about inflation being a stealth tax on people who hold money, and the notion that governments can “inflate away” their debt.  The problem is that this is not the system we actually have.

What we have is a central bank (the Federal Reserve) which prints money and lends it.  This is entirely different from just printing and spending.  Notice that they do buy things with the money but what they buy are government securities.  In other words, they buy debt, which is the same as lending it.  When the debt matures (or when they sell it) the money goes back to the Fed.  This is completely different from the system outlined above because every dollar created also creates a counterbalancing debt.  This means that the money they put out there isn’t just out there forever, it is like each dollar is really a boomerang which they throw out but eventually comes flying back to the Fed.

But since they lend it with interest, when it comes back, it is even bigger than when they threw it out in the first place.  And that additional money which comes back to them has to come from somewhere which means they have to constantly throw out more and more to keep the quantity out there large enough that it can flow back to them fast enough to retire the debt without upsetting the inflation expectations they have cultivated.  The way it breaks down is not with them printing too much money but rather with them not printing enough to keep this cycle going.  In other words, it ends with a deflationary spiral, not an inflationary spiral.  This is far worse because not only does it mean that we lose all our money but we actually lose all of our stuff which is collateralizing all of these loans.  Or to put it another way (emphasis added):

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property – until their children wake-up homeless on the continent their fathers conquered.

–Thomas Jefferson 1802

The Power of the Printing Press

I said recently that the Fed has the ability to buy whatever they want.  I just want to explain that for people who may not have noticed this fact.  Regardless of what you think about the economic implications of monetary policy, this much is basically indisputable.  When you give some entity the power to print money you hand over control of essentially all of the real assets in the economy to that entity.  The reason for this is simple.  That entity can buy whatever they want.  There is no budget constraint for a printer of money.  If they want your house they can print money and buy it from you, just name your price.  They don’t have to create anything of equal value to trade.

Given this fact, the position of most “practical” people seems to be that for some reason we can trust them to only use this power in ways that benefit all of us, and that such a way exists.  My point is that even if such a way exists (and I don’t think it does), it’s irresponsible to just give this power to a private institution (or a public one for that matter) and hope that they don’t use it to screw us over.  That argument I think is pretty simple and it’s astonishing how reluctant people who believe, seemingly for no particular reason, that bankers acting in a free market with no special powers are evil and will surely fleece the public are to admit that giving a handful of the most powerful of these evil bankers special monopoly power to print money and buy whatever they want and to regulate all of their competition is a bad idea.

But it’s even worse than that.  The system works in a way that leaves us begging for them to print money and buy our stuff.  To keep inflation going at expected (promised) levels the money supply must continue to grow.  The normal way you grow the money supply is to expand credit by lending to banks who then lend to the public.  Unfortunately there is a limit to how much the public is willing to borrow (this is a topic of debate despite the obvious  evidence).  When this happens the government can borrow.  But what if the public gets fed up with constantly increasing government deficits?  You have to get the money out there somehow.  Well you can always just start buying things.  But don’t call it that, it might give people the wrong (read: “right”) idea.  Give it a name that most people won’t really understand like “quantitative easing….”

 

Monetizing the Debt

My editor tells me I need to make these shorter so I’m gonna try to take some small bites at this thing.  We can’t monetize the debt.  This notion is another mistake frequently made by friends of liberty when talking about monetary policy.  Monetizing the debt means one of two things (which basically amount to the same thing in practice): the government causes inflation in order to reduce the real value of their existing debt or the government prints money to pay its debts (causing inflation in the process).  But this isn’t how our monetary system works.  The government doesn’t just print money.  The Fed creates money and it injects the money into the system in exchange for–guess what…….debt!  This means that creating those dollars requires the creation of debt–usually government debt.  So in order to print money and cause inflation (or stave off deflation) the government must go ever deeper into debt.  This is why we’re so deep in debt.  Someone please tell Sarah Palin and Glenn Beck.

“Fiat Money” or “I’m Back Baby”

July 9, 2011 1 comment

If you are a regular reader of this blog, then hi mom!….(how do you type a rimshot?)  Ok if you’re a regular reader of this blog you’ve probably noticed that I haven’t been blogging for a while.  I’m trying to get back in the habit so I’m going to restart with the most important thing I have to say.  Even though I’ve sort of been over this ground before, it is a difficult concept and I don’t think I’ve nailed it yet so I’m just going to keep trying until I do.

Among libertarians, there is a lot of uneasiness about our system of fiat money.  For that matter, among leftists there is a lot of uneasiness about our system of fiat money (although they would usually like to replace it with a more centralized fiat money system rather than a decentralized hard money system).   However, I don’t think many people on my side really grasp the true nature of the system we have now.  If they did they would be even more horrified by it than they already are.

The misunderstanding centers on the idea that the currency is not backed by anything.  This is not correct, and it leads to the notion that the government/Federal Reserve can endlessly debase the currency imposing a stealth tax on us and potentially leading to hyperinflation.  While the first part of this is true to some extent, it is not hyperinflation that we should be concerned about it is precisely the opposite phenomenon.  To understand this we must first understand the fundamental difference between the monetary/banking system with a gold standard vs. without.

In both systems money represents debt.  When you have a gold standard and a fractional reserve banking system, you take 100 oz. of  gold to the bank and the bank hands you a piece of paper signifying a debt from the bank to you for 100 oz of gold.  This paper can then be traded as though it were gold because anyone can take it to the bank at any time and exchange it for gold.  When they do this the Bank’s balance sheet will look like this (assuming no additional fees or interest in either direction):

Assets                                         Liabilities

Gold:   100                                Accounts Payable (cash outstanding):  100

Banks can inflate economic bubbles in this case.  When an investor comes in asking for a loan, the bank can write an IOU for 100 oz. of gold without receiving the gold up front.  In this case the bank trades debt for debt.  They give an IOU for gold payable at any time and receive an IOU for gold payable at some specific time in the future.  If they charge interest, the debt they receive will be larger than the one they give up.  The bank’s  balance sheet will then look like this:

Assets                                                   Liabilities

Gold:                               100              Accounts Payable (cash outstanding)    200

Accounts receivable     100

By doing this the bank has doubled the amount of cash supported by the original 100 oz. of gold.  In the process they have made a profit of 10 oz.  However, because of the difference in maturity of their assets and liabilities they have made themselves technically insolvent.  As long as the cash, representing their promise to pay gold at any time, continues to circulate in the economy rather than being redeemed for gold until their loan becomes due they will be fine.  However, if the people holding this cash show up demanding gold before that 110 oz. comes in from the repayment of the loan to the investor, then they will not have enough gold to pay their debts and they will go bankrupt.  This is the dreaded bank run.  I have already discussed how a bank run could be managed in a free market economy so I won’t get into that here but the key point is that the bank goes bankrupt in the event of a bank run.  This is because the debt which backs the currency is a debt from the bank to the public.  This is convenient because the bank is the one determining how much to inflate the money supply and they destroy themself if they inflate it too much (the more money they create in this way, the more incentive there is for people to exchange it for gold).  In other words there is a natural incentive for banks not to get too carried away with the creation of money.

Now consider a central bank with fiat money.  Here I will speak of a central bank which represents the banking system as a whole.  This should not be confused with an individual bank within that system which is confronted by different issues.  The distinction is very important.  Money no longer represents a debt payable by the bank in the form of gold to the bearer of the money.  This leads many smart people to proclaim that our money is not backed by anything.  However, this is not the case.  The money is in fact backed by real assets and this distinction is the key to understanding the system.  The money is backed by the goods that collateralize the debt which calls it into existence.  To see what I mean, consider a homeowner who takes out a mortgage.  When this happens the bank “prints” (though the actual printing is largely circumvented these days) money and gives it to the homeowner.  The homeowner promises to pay the money back at some time in the future and if he is unable to, the bank gets the house.

The homeowner takes the money and uses it to buy the house from a builder.  Now the builder has the money.  But the builder cannot redeem the money for anything at the bank.  It is no longer backed by gold.  This eliminates the potential for a bank run.  So why does the builder want the money?  Because he can exchange it for other goods and services of course.  But why is he able to do this?  Most people seem to think this is just some kind of magic or “animal spirits,” driving people to always keep accepting something that is ultimately guaranteed by no real assets in the hope that someone else will accept it in the future.   The real reason is that it is contractually guaranteed to be redeemable for real assets.  To see how consider the homeowner again.

When we talk about a mortgage we typically say that the homeowner takes out a loan and buys the house and then must pay back the loan or the bank takes the house.  Another way of saying the same thing is that the bank buys the house (and lets the borrower live there) and promises to sell the house to the homeowner at a later date for a specified amount of money.  Either way, the homeowner must pay dollars back to the bank in the future to keep the house.  The dollars are guaranteed by the house!  The homeowner we considered can borrow freshly printed dollars to buy a house because the builder can use those dollars to buy groceries because the grocer has a mortgage which he must pay with those dollars in order to keep his house.

In this system, the amount of money the borrower promises to pay in the future is larger than the amount created when he takes out the loan.  This means that in order for him to be able to pay off his loan, even more money will have to be created in the future.  Every dollar created requires more than a dollar to be destroyed (paid back to the bank) in the future.  This means that in the future more money will have to be created to replace the money coming out, otherwise there will not be enough money for everyone to pay their debts and they will scramble to get the existing dollars to avoid losing their homes and other collateralized property.  This will cause the value of the dollar to rise (price deflation)!  It will also cause a wave of defaults.  As people default on their loans, real property is accumulated by the central bank and money leaks out into the economy (the money not used to pay back the loan).  This process will continue until enough money has leaked out to stabilize the system.  Sound familiar?

So here is the difference.  With a gold standard, if the banks inflate the money supply too much, they cause a bubble.  When the bubble collapses they go bankrupt and the real wealth remains in the hands of the people (though there is likely to be some “collateral damage”…I really have to figure out that rimshot thing).  With fiat money, when the central bank inflates the money supply it causes a bubble.  When the bubble bursts we go bankrupt and the property ends up in the hands of the bank (remember this is not your local savings and loan we’re talking about, they go bankrupt too and their property goes to the Fed.)  This is because when there is a gold standard money is created by a debt from the bank to the public.  With fiat money, money is created by a debt from the public to the bank.

So now the important question is this:  Why in the world would we think that going from a system in which the banks lose from blowing up monetary bubbles to one with a single centralized bank which gains from this process will result in fewer monetary bubbles?  Maybe more fundamentally, how can we claim to love liberty and fear tyrants when we grant a group of private bankers the right to buy whatever of our property they wish just by printing money and literally print laws requiring us to indebt ourselves to these men?  How is it that we find the idea of free money more frightening than this scenario?

 

The Anatomy of a Bubble

April 14, 2011 2 comments

 Keynesians and progressives (along with Marxists) hold some combination of the beliefs that interest is immoral and lower interest is better for the economy because it increases investment.  Recall the words of Keynes.

Interest to-day rewards no genuine sacrifice, any more than does the rent of land.  the owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce.  but whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant….

The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save.  But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.

This highlights a key difference between them and us.  A classical economist would tend to observe a positive price for something (like the lending of capital) and take this to indicate that there must be some “genuine sacrifice which could only be called forth by the offer of a reward.”  Keynes, on the other hand, assumes that there is no such sacrifice and therefore that it would be beneficial to create a giant quasi-governmental organization with the power to manipulate the entire economy in order to eradicate this seemingly inexplicable phenomenon.  Of course he is confusing capital with money.  It’s true that it is possible to print money until the money rate of interest is zero.  The problem for Keynesians is that this does not necessarily cause the rate of interest on capital to become zero. 

This is because creating money does not create more capital, it creates a higher demand for capital at a given price.  To see what I mean imagine you own a business and you borrow money to invest in producing some good.  You will do this until the marginal return on investment is equal to the interest rate (both in money terms).   This means that when interest rates are lower, you will invest more because there will be some projects that are productive enough to pay the lower rate of interest but not the higher one as long as you hold all other things equal.  So the Keynesians would like to “stimulate” investment by lowering the interest rate.  The problem is that all other things do not remain equal.

When you see the lower interest rate, you borrow more money (the money supply increases) and you use it to invest in your business.  But the “capital” that you invest consists of real goods which you buy with the money you borrow.  And these real goods have alternate uses.  The reduction in nominal interest rates doesn’t make anyone else any more willing to forego the other uses of those real goods (if it did, this would lower the real interest rate) so when you use this borrowed money to purchase capital it drives the price of these real goods up.  Furthermore, if you actually expanded investment you would produce more in the future and if everyone produced more in the future, the price of your output would be lower.  In other words, you would see short-run inflation, then long-run deflation and if everyone predicted this accurately, the equilibrium amount of deflation would bring the Fisher equation into balance with the new lower nominal rate and the same real rate as before.  Because, the real rate wouldn’t change, investment wouldn’t change, and this policy would have no effect on production (although the bankers would end up with some wealth that they didn’t have to begin with).  This is the same phenomenon I have been trying to describe for a while now.

So if they are going to “stimulate” investment, they have to do something to drive the expected real interest rate down, not just the nominal rate.  The way they go about this is quite simple: they just come out and tell us that they will keep prices steadily rising.  “Trust us, we know what we’re doing” they say.  Now you’re a producer and you believe that inflation will be 2% and you are looking at a nominal interest rate of 2% and you say “wow I can borrow at a real rate of 0%, Keynes’ dream has finally been realized, we’ve overthrown the rentier class at last.”  So you undertake all projects that you expect to yield a positive real return.  In your rush to borrow more and increase investment you drive prices up for a while which fulfills the Fed’s promise of inflation.

After a little while, though, the loans come due and you have to find some money to pay them back.  Your plan was to sell the resulting produce of your investment to get this money but lots of other people borrowed back then to invest and produce goods and their loans are now coming due as well so there are a lot of goods out there chasing that money and prices are in danger of falling.  If this were to happen you would not be able to pay back your loan and a wave of defaults would sweep the economy.  But have no fear, the Fed will prevent this from happening by lowering the interest rate some more which will cause more borrowing, investment, and inflation keeping prices high enough for you to carry on.  Let’s say they lower it to 1%.

So as interest rates keep going down prices keep going up and everyone manages to pay off their loans and life is good.  But wait a minute!  Now nominal interest rates are 1% and you are expecting 2% inflation…. This means that you don’t even have to produce anything to make money.  You can take out a loan and just buy something and hold on to it, then sell it when the loan becomes due and you will have some money left over because its price will increase at a greater rate than the rate you have to pay on the loan.  All you need to do is find a durable good and someone to give you a loan.  So what could you buy…?  I know, how about stocks?  Or you could buy real estate, there are lots of government programs to help you get a loan for that.  And there’s always gold….

So did you ever wonder what was going on at the Fed in 1928-29?  Well according to Milton Friedman’s authoritative account:

The stock market boom produced severe disagreement within the System on policy, generally oversimplified as a difference between the Federal Reserve Board and the Federal Reserve Bank of New york.  The question at issue between the Board and the New york Bank in 1928-29 had provoked controversy as far back as late 1919, when the Bord, at the Treasury’s behest, refused to sanction increases in the discount rate and instead urged the Banks to use “direct pressure–in the language of the 1929 and later annual reports–to prevent overborrowing by member banks.  The question arose again in October 1925, when Walter W. Stewart, surprisingly in view of his presumed authorship of the Tenth Annual Report (for 1923), seems to have recommended direct pressure.  Governor Strong disagreed, pointing out that direct pressure could not succeed in New York unless the Federal Reserve Bank refused to discount for banks carrying speculative loans, and that it would mean rationing of credit, “which would be disastrous.”  in May 1928, Adolph Miller, the economist on the Board, demanded that the presidents of the large New York banks be assembled and warned that speculative activity must be reduced, although a few months later, he was no longer in favor of such a warning.

Both the Board and the Federal Reserve Bank of New York agreed that security speculation was cause for concern.  The difference was about the desirability of “qualitative” techniques of control designed to induce banks to discriminate against loans for speculative purposes.  The Tenth Annual Report section on “guides to credit policy” had emphasized the impossibility of controlling the ultimate use of Reserve credit, and other reports had repeatedly noted the same point.  Nevertheless, the view attributed to the board was that direct pressure was a feasible means of restricting the availability of credit for speculative purposes without unduly restricting its availability for productive purposes, whereas rises in discount rates or open market sales sufficiently severe to curb speculation would be too severe for business in general.  The Board’s unwillingness to approve a rise in discount rates was partly, no doubt, a reaction to the severe criticism the System had suffered for the 1920-21 deflation.  The board’s view prevailed until August 1929, when it finally permitted the New York Bank to raise its discount rate.  Bu then the New York Bank believed the time might have passed for such action.

The collapse of 1920 (remember the Fed was created in 1913) was caused largely by a commodity bubble.  They knew the same thing was happening again in the stock market.  Their problem was that the obvious solution to this (raising rates) would have burst the bubble so they were trying to use the approach that progressives always turn to once their distortion of a market starts to cause unintended consequences: “direct pressure.”  They tried to ration credit by arbitrarily deciding who could get loans and who could not (death panels anyone?) 

So of course, this bubble can’t go on forever because, just as before, eventually the loans that people used to drive the prices of these goods up have to be paid back.  At that point, the borrowers have to liquidate their positions and the prices collapse.  In 1920 the bubble was in commodities, it was the stock market in 1929 and again in 2001.  In 2008 it was housing and here are quotes from two different stories in the Wall Street Journal on April 11, 2011

The task has become even more daunting recently because companies and individuals [in China] have been hoarding commodities of all types–from cotton and copper to cooking oil–betting that prices will rise.  With little insight into the stockpiles, analysts tend to overestimate China’s real strength of consumption.In China’s three dozen largest cities, prices have shot up by about 50% over the past two years, according to Dragonomics Research, a Beijing consulting firm.  Ordinary Chinese have become real-estate speculators, figuring that real-estate prices can only go up.  State-owned industries are also big speculators, using loans they received from state-owned banks in late 2008 to fight the global recession to invest in urban real estate.

Here is what gold has been doing over the last 5 years.

Oh, if only there were some way that we could set the interest rates to simultaneously prevent unwanted speculation and also coordinate saving and investing in such a way as to achieve the efficient amount of each and not blow up these inflationary bubbles that eventually burst and harm the poor working class……

History shows again and again how markets point out the folly of men.  Godzilla!

Monetary Theory: A Fisher Equation Approach

March 31, 2011 1 comment

Here is a different way of approaching this monetary thing which focusses on interest rates and inflation.  This requires a discussion of what money is and how it comes about in a natural economy.  This is kind of complicated so be warned.

Money comes about in a natural economy to serve two purposes: to act as a medium of exchange and as a store of value.  The first of these is well-recognized but the second is often overlooked and it is the second which is primary and makes the first possible.  Since a barter economy requires the coincidence of wants for trade to take place it is much more efficient if there is some good which people can keep on hand for the purpose of trading.  But this is only possible if there is a good which everyone expects to be able to trade freely for the things that they want in the future.  In other words it is only possible if the medium of exchange is expected to hold its value. 

To see what I mean notice that people hold wealth in a number of forms.  At any point in time a typical person may own a house, a car, some quantity of food, furniture, clothes, stocks, bonds, cash etc.  These things all represent wealth in a different form.  Now to simplify the model consider a person who can hold wealth in one of two forms: chickens or gold.  Each of these has two possible uses.  Each can be consumed directly or traded for other consumption goods and each has different characteristics which affect their value in each use.  A person of sufficient wealth would likely choose to consume some quantity of each directly along with some other goods.  For our purposes we will focus on their value in exchange. 

If one were to hold their wealth entirely in the form of chickens, they would be faced with some difficulties.  For one thing, chickens eventually die.  This has a couple of important implications.  One is that if you hold them to long they will become worthless.  Another is that if the person with whom you want to trade does not want to consume the chicken immediately but rather to hold it and potentially exchange it with someone else for another good later, you cannot divide it up.  So what do you do if you lose a button on your shirt and need a new one?  You have to either find someone who wants to eat chicken right away or trade a whole chicken for it.  Neither of these scenarios are very desirable.  Second, chickens require maintenance.  They have to be fed, they take up a lot of space, and they make a mess.  In other words, it’s costly to hold them as wealth.

On the other hand, gold takes up very little space for its value.  It doesn’t eat or poop, it just sits there.  It can be infinitely divided with no loss of value.  And finally, it doesn’t degrade over time.  All these characteristics make it more convenient to hold as a store of value.  But this is only the case because it is possible to rely on it being valuable in the future and it is possible to rely on this because it has value in consumption to somebody somewhere.  Because of this people will know that they can take it in exchange for whatever they have to sell and be able to trade it for whatever they want to buy in the future.  What all of this adds up to is that people would rather hold some goods as a store of wealth than others.  This is basically what Keynes called “liquidity preference.” 

There is another difference between chickens and gold that must be accounted for.  Unlike gold, chickens produce more chickens.  This means that by foregoing the consumption of a chicken today (and attending to the costs mentioned above) you can potentially have more chickens in the future.  Let’s assume that the stock of chickens grows at 10% per year.  So if you have 10 chickens now and you refrain from eating them for a year you will have 11.  Meanwhile, if you hold 10 oz. of gold for one year you will still have 10 oz.  In this case the real interest rate will be 10%.  This represents the additional amount of real goods (chickens) you can get for giving up some consumption of real goods today. 

So now your decision is between holding gold and holding chickens.  If all markets are in equilibrium it must be true that the benefit to holding each asset is the same.  How can this be when chickens multiply and gold doesn’t?  To see the answer first assume there is no liquidity preference so chickens are just as easy to keep and exchange as gold.  In this case the amount of goods that you can get in the future by holding gold must be the same as the amount of goods you can get by holding chickens.  This means that prices in terms of gold must fall.  Or to put it another way, the same amount of gold must get 10% more valuable.  And this is a phenomenon which is not just left up to chance, competition will make this happen. 

As an illustration of this process, assume for the sake of simplicity that you know the price of chickens in terms of gold 1 year from now will be 10.  If the price of chickens now were 10 (and there were no liquidity preference) then nobody would want to hold gold.  This would mean anyone who had gold would try to buy chickens because they have a higher rate of return.  This would bid the price of chickens today up.  People would keep bidding the price up until the fall in prices were just enough to make it worth it to hold the gold (about 11).  In this way the market would equate the rate of return on all assets. 

Alright, now we must turn to a slightly more realistic world where some people raise chickens and finance this activity by borrowing money.  Assume that 10% is the real return from this activity net of any expenses involved.  The chicken farmers will borrow money and offer IOUs for some amount of money 1 period in the future.  The price of this borrowing is the real interest rate and they will bid it up to 10%.  That is to say that for lending 1 unit of gold you would receive an IOU for the amount of gold expected to purchase 1.1 chickens in the next period.  Again, if there is no preference for one of these securities (gold vs. IOUs) then they will have to generate the same rate of return in equilibrium.  This will mean that 1 unit of gold will buy an IOU for 1 unit of gold in the future.  In other words the nominal rate of interest will be 0% and again, prices will have to fall by about 10% to equate the return on gold and IOUs with the return on chickens.  Notice that the Fisher equation holds.

nominal interest rate (0)=real interest rate (.10) + inflation rate (-.10)

The situation gets a little more complicated if you add liquidity preference back in.  Liquidity preference in this case is any reason people may prefer holding gold over holding IOUs.  This is likely to be the case because an IOU will not be as easy to trade to meet some need that may come up between now and 1 year from now (such as a broken button) as gold.  Alternatively, there may be some risk of the IOU not being paid back.  But even in the absence of this risk, there is still some benefit to holding gold due to its being more useful for satisfying any consumption desires which might come up in the meantime.   This means that if gold and IOUs have the same rate of return, people would prefer to just hold gold.  Because of this, competition will drive a wedge between the rate of return on IOUs and gold. 

Let’s say that because of liquidity preference, people are only willing to trade .96 units of gold today for an IOU worth 1 unit a year from now.  This return of about 4% will be the nominal interest rate or the price paid to have money (gold) now rather than money later.  The real  rate–the price of having goods (chickens) now rather than goods later–will remain unchanged since this has nothing to do with the rate at which chickens reproduce.  So the change in prices required to bring the economy to equilibrium will now be smaller (only about 6%).  The Fisher equation in this case will be:

nominal rate (.04)=real rate (.10) + inflation rate (-.06)

In this natural economy, markets will efficiently allocate all resources across time.  This is possible only because of the relative stability of the money supply (by stability I don’t mean that it has to be constant just that it has to be exogenously determined).   If the money supply is growing at a slower rate than the real interest rate, then there will be deflation.  There would be nothing wrong with this.  More importantly, the real rate would be determined by real factors (production possibilities and time preference) and the nominal rate and inflation rate would be determined by liquidity preference.  This is nothing like the system we now have!

The system we now have is one where the Federal Reserves sets the nominal rate (sort of) and lets the money supply expand or contract to bring the market into equilibrium.  This alone wouldn’t actually be that disruptive.  If you imposed a lower nominal rate on the economy, it would not change the real rate, it would cause people to borrow and drive up prices today, causing inflation in the short run.  But the system would be brought into equilibrium by the inflation rate falling (even more deflation).  In other words, the dollars drawn into the economy would be sucked back out with interest in the next period and prices would be even lower than otherwise. 

Again assume that in a natural economy, everyone knew the price of a chicken in 1 year would be 10 units of gold.  Also assume, as above, that the nominal rate would be 4%, the real rate 10% and the inflation rate 6%.  So people would bid the price of a chicken today up to about 9.4.  Now imagine a central bank that can print and lend as much “gold” as they want.  And imagine that they offer to lend it at an interest rate of 2%.  At this rate people will want to borrow “gold” and use it to buy chickens.  This will inflate the money supply and drive the price of chickens up today.  But in a year all that money will have to be paid back to the central bank with interest which will make the  money supply contract.  The inflation and contraction of the money supply and resulting increase in price of chickens today and decrease in price of chickens tomorrow will be just enough to make the rate of deflation equal to 8% or in other words to fill the gap between the real interest rate and the (now artificial) nominal interest rate in the Fisher equation.

nominal rate (.02)=real rate (.10) + inflation rate (-.08)

But even this is not what happens today.  Today, the Fed has convinced us that they can keep nominal rates low and also keep inflation rates high.  By doing this they are degrading one of the most important characteristics of money: it’s ability to hold value.  When people believe this, they will be willing to borrow much more and leverage most of their property since they will expect the value of it to be increasing.  For instance, if the nominal interest rate were 1% and you expected 2% inflation (because that is what the Fed told you their target was), you would want to borrow as much money as you could and use it to buy real goods just to hold until next period.  Then you could sell them at the new high prices, pay back your loans and have money left over.  But obviously everyone cannot do this (it is not consistent with the Fisher equation).  If everyone rushes out to get a loan and buy some real good, let’s say housing.  They will drive the prices of housing up today and when they all try to sell them in the future to pay their loans the price will plummet and they will all end up defaulting on their loans.  In other words the expected price increase will not materialize because it is not consistent in the long run with the real interest rate and the artificial nominal rate set by the central bank.  Sound familiar……?

The result of this will be that people don’t really own any of the things that would have made up their wealth in a natural economy.  Their house will be mortgaged, their car will be financed, their clothes and food will be bought on credit, etc.  But the greater the money supply and the price level are inflated in this way, the greater the tendency for them to contract will become.  Eventually there will not be enough room to lower interest rates or enough property to mortgage to hold off the deflation.  Once inflation expectations break down the bubble will burst, the money supply will contract, prices will fall, they will default on their loans, the banks will foreclose on their property and they will wake up homeless on the continent their fathers conquered.