23.01.13 - Understanding Money Mechanics

	A	B	C
1
2		Understanding Money Mechanics
3		By Robert P. Murphy
4		----------------------------------------------
5		Amazon: Link
6
7		#	Highlights
8		1	To be sure, those readers interested in a more detailed treatment of the theory and history of central banking from an Austrian perspective should pursue the topic, starting with the seminal works of Murray Rothbard.1 The Chicago Federal Reserve’s book “Modern Money Mechanics” is also a useful guide.2 The present book is not intended as a substitute for the more detailed treatment of Rothbard and others.
9		2	However, if society were limited to direct exchange—in which individuals only accept items in trade that they plan on using personally—then people would miss out on many advantageous transactions. Let’s consider a simplistic example. Suppose there are three individuals: a farmer, a butcher, and a cobbler. The farmer starts out with some eggs that he’s just taken from his hens. He would like to trade his eggs in order to get his tattered shoes repaired. The problem, though, is that the cobbler doesn’t want any eggs—but he would be willing to repair the shoes for bacon. Unfortunately, the farmer doesn’t currently have bacon. However, his neighbor the butcher does have bacon. Yet the butcher doesn’t want to trade with the cobbler, because the butcher’s shoes are just fine. What the butcher would really like are some eggs. Yet, the farmer himself doesn’t like the taste of bacon, and would rather eat his own eggs. In a world limited to direct exchange, these men are at an impasse, because no single transaction would benefit any pair of them. Yet all of them could improve their situation with a rearrangement of the goods.
10		3	The solution is to introduce indirect exchange, in which at least one person accepts an item in trade that he doesn’t plan on using himself but holds merely to trade away again in the future. In our example, suppose that the farmer has an epiphany: Even though he personally dislikes its taste, he trades his eggs to the butcher to obtain the bacon. Then he takes the bacon to the cobbler, who accepts it as payment for fixing his tattered shoes. After these two trades, all three individuals are better off than they were originally. Remember, though, that the solution relied on the farmer accepting an item in trade—in this case the bacon—that he didn’t plan on using himself. Economists call such a good a medium of exchange. Just as air is a “medium” through which sound waves travel, the bacon served as a medium through which the farmer’s ultimate exchange was effected—namely giving up his eggs in order to receive shoe-repair services.
11		4	As individuals in the community seek to trade away their less marketable (or less liquid) goods in exchange for more marketable (or more liquid) goods, a snowball process is set in motion: those goods that started out with a wide appeal based on their intrinsic qualities see a boost in their popularity simply because they are so popular. (For a more modern example, the prisoners in a World War II POW camp would gladly trade away their rations in exchange for cigarettes even if they were nonsmokers, because enough of the other prisoners were smokers.2) Eventually, one or two commodities become so popular that just about everyone in the community would be willing to accept them in trade. At that point, money has been born. A formal definition for money is that it’s a universally accepted medium of exchange. Menger’s explanation showed how such a commodity could emerge from its peers merely through voluntary transactions and without any individual seeing the big picture or trying to “invent” money.
12		5	What would make a community gravitate toward some commodities but not others? Besides having a wide marketability, an individual would want a medium of exchange to possess the following qualities: ease of transport, durability, divisibility, homogeneity, and convenient size and weight for the intended transactions.
13		6	In our fable above, although bacon served as the medium of exchange, it would be ill-suited to serve this purpose generally, as bacon is perishable. Like-wise, a shotgun might be very valuable in certain communities, but it’s not divisible; you can’t cut it in half to “make change.” Diamonds might seem like a great candidate for a medium of exchange, but they aren’t homogeneous: one giant diamond is more valuable than five smaller diamonds that (combined) weigh the same amount. These types of considerations help explain why eventually gold and silver emerged as the market’s commodity monies of choice. These precious metals satisfied all of the criteria of what makes a convenient medium of exchange, and once the community generally agreed, they were money.
14		7	The emergence of money meant that a single commodity was on one side of every transaction. This greatly reduced the calculations required to navigate the marketplace. For example, consider a merchant whose business required him to closely follow twenty different goods. In a world of pure barter—where each good traded directly against every other good—in principle he would have to keep track of 190 separate barter “prices”4 (meaning the ratios at which one good traded for another). But if one of those twenty goods also serves as the monetary good—maybe it’s silver—then the merchant only needs to keep track of nineteen different prices (all quoted in silver), because each of the other goods is always being bought and sold against silver.
15		8	In addition to striking full-bodied coins (meaning they contain the legally defined amount of gold or silver), another possible solution is for reputable outlets to issue token coins, which represent redemption claims on the issuer for a specified amount of the actual money commodity. Note that to perform their function well, even token coins would need to be recognizable in the community and difficult to counterfeit. For a modern example, consider the plastic chips issued by casinos: A Las Vegas casino needs to have chips that are distinctive and “authentic”-looking, and which can’t be easy for outsiders to replicate. Because such chips will be instantly redeemed by the casino, within its walls (and even perhaps in the surrounding neighborhood) they are “as good as money.” But a gambler who travels back home wouldn’t be able to buy groceries with chips issued from a Las Vegas casino.
16		9	In this intolerable situation, Thomas Williams, the principal owner of the giant Parys copper mine, hit upon the bright idea of installing a commercial-scale mint on the premises. He then struck (token) coins out of the copper with instructions on where they could be redeemed for money, and paid his workers—the ones actually mining the copper—with these token coins. Soon afterward Matthew Boulton, famous for his collaboration with James Watt in the refinement of the modern steam engine, followed suit with the privately owned Soho Mint, where he was the first to implement a process of using steam power to mass-produce exquisite coinage. The following photos exhibit the remarkable craftmanship of the privately struck coins and tokens from this era.
17		10	The reason a book on the mechanics of money must also cover banking is that—to put it bluntly—banks enjoy the legal ability to create money. In chapter 4 we will explain this process in much greater detail, but for now let us quote the Chicago Federal Reserve on the historical origins (at least in England) of this practice: [B]anks can build up deposits by increasing loans and investments so long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency. This unique attribute of the banking business was discovered many centuries ago.
18		11	It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their “deposit receipts” whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker and exchange them for metallic money. Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment [emphasis added].
19		12	Once the banker (such as the goldsmith) realized that his deposit receipts (“notes”) were treated by at least some members of the community as being “as good as money,” he could lend out some of the coins that his customers had deposited with him, even though the customers still held paper receipts entitling them to immediate redemption. The whole operation was viable so long as the banker always had enough coins on hand to satisfy whoever might show up to demand their deposits back.
20		13	However, when the deposited items are fungible goods, such as wheat or oil, then the relationship is more nuanced. With such an “irregular deposit,” the depositor isn’t entitled to the specific physical items that were handed over for safekeeping, but instead merely expects to receive comparable items back. In the typical scenario, this is the type of deposit applicable to money; the people handing over coins to the goldsmith didn’t care about receiving back those particular coins, they merely wanted to be assured of obtaining the same number of comparable coins when they redeemed their deposit receipts (i.e., banknotes).
21		14	It is crucial for today’s readers to understand that from the inception of the modern (i.e., post-Constitution) United States in the late 1780s through the eve of the Civil War in 1861, the federal government issued currency only in the form of gold and silver coins. (The one borderline exception were the limited issues of Treasury Notes first used in the War of 1812, which were short-term debt instruments that earned interest and did not enjoy legal tender status, but of which the small denominations of the 1815 issues did serve as a form of paper quasi money among some Americans.
22		15	In the Coinage Act of 1792, the US dollar was defined as either 371.25 grains of pure silver or 24.75 grains of pure gold, which officially established a gold-silver ratio of exactly 15 to 1. Part of the rationale for this policy of “bimetallism”—in which new coins (of various denominations of dollars) could be minted from either of the precious metals—was that silver coins were convenient for small denominations (including fractions such as a half dollar, quarter dollar, dime, etc.), while gold coins were preferable for larger denominations (such as $10 and $20 pieces).
23		16	The classical gold standard refers to the period beginning in the late nineteenth century when a growing number of countries tied their currencies to gold. Because the process was gradual, it is difficult to state precisely when the period began: “In 1873 there were some nine countries on the gold standard; in 1890, 22 countries; in 1900, 29 countries; and in 1912, 49 countries.”
24		17	Although many modern economists scoff at the gold standard, in its “classical” heyday it was a quite remarkable achievement. Economic historian Carl Wiegand writes: “The decades preceding the First World War were characterized by a degree of economic and personal freedom rarely, if ever, experienced in the history of mankind.” He goes on to explain, “An essential part of this system was the gold standard.”
25		18	If the beginning of the classical gold standard is up for scholarly dispute, everyone agrees that it ended with World War I. Indeed, the Great War was only possible because the major governments abandoned their commitment to gold. As Melchior Palyi explains: “This war cannot last longer than a few months” was a widely held conviction at the outset of World War I. All involved would go “bankrupt” shortly and be forced to come to terms, perhaps without a decision on the battle fields. The belligerents would simply cease to be credit-worthy. Such was the frame of the European mind in 1914; the idea that credit and the printing press might be substituted for genuine savings was “unthinkable.” “Sound money” ruled supreme, supported by the logic of the free market. (bold added)
26		19	To say that World War I would have been “unaffordable” on the classical gold standard really just means that the citizens of the countries involved wouldn’t have tolerated the huge increases in explicit taxation and/or regular debt issue to pay for the conflict. Instead, to finance such unprecedented expenditures, their governments had to resort to the hidden tax of inflation, where the transfer of purchasing power from their peoples would be cloaked in rising prices that could be blamed on speculators, trade unions, profiteers, and other villains, rather than the government’s profligacy. This is why Ludwig von Mises said that inflationary finance of a war was “essentially antidemocratic.”
27		20	After the wartime experience, the “traditional gold standard had ceased to be ‘sacrosanct,’” in the words of Palyi. “Events proved, supposedly, that mankind could prosper without it.”22 After all, if the gold standard could be violated and central banks could use their discretionary powers to help with the war effort, why not do the same for other important social goals, like promoting economic growth and reducing inequality?
28		21	FDR would issue an even more draconian executive order on April 5, 1933, which required all citizens to turn in virtually all holdings of gold coin, bullion, and certificates in exchange for Federal Reserve notes, under penalty of a $10,000 fine and up to ten years in prison. Although US citizens couldn’t buy gold, foreigners still traded in the world market, and there the US dollar now fluctuated against the metal, the $20.67 anchor having been severed. The Roosevelt administration in 1934 officially devalued the currency some 41 percent by locking in a new definition of the dollar that implied a gold price of $35 per troy ounce. However, this redemption privilege was only offered to foreign central banks; American citizens were still barred from holding gold, and even from writing contracts using the international price of gold as a benchmark.
29		22	As the Allied victory in World War II became more certain, the Western powers hammered out the postwar monetary arrangements in the famous Bretton Woods Conference, a nineteen-day affair held at a New Hampshire hotel which led to the creation of the International Monetary Fund (IMF) and the World Bank. Following the war, the global financial system would rest on a refined gold exchange standard in which the US dollar—rather than physical gold—displaced sterling and became the sole reserve asset held by central banks around the world.
30		23	Under the Bretton Woods system, other countries could still hold gold reserves, but they typically defined their currencies with respect to the US dollar and dealt with trade imbalances by accumulating dollar assets, rather than draining gold from countries with overvalued currencies. In theory the Federal Reserve kept the whole system tied to gold by pledging to redeem for central banks dollars for gold at the new $35/ounce rate, but in practice even central banks were discouraged from invoking this option. Furthermore, governments only gradually lifted restrictions on international transactions following the war, so that the Bretton Woods gold exchange framework—tepid as it was— was really only fully operational by the late 1950s.
31		24	Eventually the weight became too much to bear, and President Richard Nixon formally suspended the dollar’s convertibility on August 15, 1971. Along with other interventions in the economy (such as wage and price controls), this official closing of the gold window has been dubbed the “Nixon shock.”
32		25	As Warburg’s discussion indicates, the original justification for the creation of another central bank—one with more power than the Second Bank of the United States had had—did not allude to the modern goals of “full employment” and “price stability.” Rather, the pleas of the time called for an “elastic currency” that would expand or contract according to the “needs of trade.” Some nine months after Warburg’s essay appeared, a failed bid by speculators triggered a run on depository institutions and eventually swelled into the Panic of 1907. Insolvent banks collapsed, while solvent yet illiquid banks had to go hat in hand to private lenders such as J.P. Morgan. The experience bolstered calls for the creation of a publicly run “lender of last resort,” and conventional histories cite this episode as pivotal in building support for the creation of a new central bank.5 However, dissenting scholars argue that a group of powerful financial interests had been agitating for a US central bank for years—and Warburg’s essay indirectly confirms this.
33		26	It is important to understand that originally each of the twelve Reserve Banks exercised considerable autonomy: each Reserve Bank, under the leadership of its respective governor, set its own policies. In contrast to our day, there was no such thing as “the Fed’s” discount rate but instead the discount rate charged by, say, the Reserve Bank of St. Louis or of Dallas.13 This would all change in 1935, as we will explain in the next section.
34		27	Although sweeping legislation affecting the American banking system was passed in 1932 and 1933—including the famous Banking Act of 1933 (commonly known as Glass-Steagall)—the most significant changes to the structure of the Federal Reserve System itself came in the Banking Act of 1935. This new legislation strengthened the overall power of the Federal Reserve System and consolidated it in Washington, DC, away from the Fed’s own Reserve Banks. However, the Banking Act of 1935 also served to make the Fed more autonomous from the federal government.
35		28	And thus, through the 1935 legislation, the United States created a truly “modern” central bank patterned after the European model. Setting aside the question of the merits of this consolidation of power in Washington, it is safe to say that this version of the Federal Reserve would not have been approved politically back in late 1913. Indeed, the very term federal had been picked in order to assure Americans that this would be a relatively decentralized network of autonomous banks.
36		29	The other major reform we will discuss is the aptly titled Federal Reserve Reform Act of 1977. If the legislation of 1935 gave the Fed more autonomy from the federal government, the 1977 act arguably tightened the leash. The biggest takeaway from the 1977 legislation is its explicit assignment of what is commonly referred to as the Fed’s “dual mandate.”
37		30	As the name suggests, the seven-member Board of Governors is the overarching authority over Federal Reserve actions. However, the specific component of monetary policy known as “open market operations” (analyzed in detail in chapter 4) is handled by the twelve-member Federal Open Market Committee (FOMC). The seven members of the Board of Governors are always on the FOMC, and the remaining five members are presidents of the Reserve Banks: one is always the president of the New York bank, while the remaining four are drawn from the other eleven districts, serving one-year terms on a rotating basis.
38	X	31	As we explained in chapter 1, a standard definition of money is that it’s a medium of exchange that is (nearly) universally accepted in trade among a given community of people. However, in practice there are different ways of applying this definition, because of the special economic nature of claims on money.
39		32	M0: The narrowest definition of money, M0 refers to the actual physical items, such as $20 bills and coins. (Note that some classifications consider M0 equivalent to the monetary base.)
40		33	Monetary Base: The monetary base includes paper currency and coins, as well as commercial banks’ (electronic) deposits at the Federal Reserve.
41		34	The intuition behind this classification is that M1 measures the amount of money and “very close money substitutes” held by the general public. A money substitute, as the name suggests, is an immediately redeemable claim on actual money that everyone in the market expects to be honored at par.
42		35	even though shares of corporate stock (especially those listed on major exchanges) are very liquid, we don’t include them in the definition of money. This is because a share of stock is a claim on ownership of the corporation, not a claim on a certain amount of dollars.
43		36	Incidentally, we should point out that 100 percent reserve banking is possible, whether or not one thinks that it is desirable. Banks can charge a fee for the warehousing of their customers’ money, just as the owners of storage units manage to stay in business even though they don’t rent out their clients’ furniture. Furthermore, remember that we are here talking about demand deposits (think checking accounts), where the depositors believe they are entitled to obtain their money upon demand. If instead a customer buys (say) a one-year bank certificate of deposit (CD), the bank can lend that money out to a borrower even while practicing 100 percent reserve banking, because the CD is not a promise for immediate redemption.
44		37	In our current fiat money system, the Federal Reserve creates new base money when it buys assets by writing checks on itself. Going the other way, the Federal Reserve destroys base money by selling assets (or by letting its assets mature and refraining from rolling over the proceeds). These actions do not require a literal printing press, as they can be achieved through electronic operations.
45		38	When the Fed injects new base money into the system, it will often be deposited into commercial banks, where it will add to reserves. Under fractional reserve banking, the new reserves give the commercial banks the ability to pyramid new money (as measured by M1, M2, etc.) on the system through the process of granting new loans. Going the other way, when the commercial banks restrict their loan portfolios or the public withdraws base money from the banks, it causes the broader aggregates (M1, M2, etc.) to shrink.
46	X	39	The term Eurodollar actually refers to any US dollar-denominated deposit held at a financial institution outside of the United States, or even a USD deposit held by a foreign bank within the US. It thus has nothing to do with the euro currency, and is not restricted to dollars held in Europe; they are dollar deposits that are not subject to the same regulations as US dollars held by American banks, nor are they guaranteed by FDIC (Federal Deposit Insurance Corporation) protection (and hence they tend to earn a higher rate of return).
47		40	By its nature, the Eurodollar market is harder to quantify than the more conventional US-based market. However, one study estimated that at its peak before the 2008 financial crisis, the size of the Eurodollar market was 87 percent of the US banking system.
48		41	A repurchase agreement (or “repo”) is a convenient method for market participants to trade short-term collateralized loans. If a firm holds liquid assets, such as US Treasury securities, but needs a quick infusion of cash, it can sell its Treasurys along with a contractual obligation to repurchase them in the near future, at a slightly higher price. Conceptually, this arrangement is equivalent to borrowing money and agreeing to repay the principal plus interest, while pledging the Treasurys as collateral in case of default.
49		42	After the final collapse of the Bretton Woods system in 1971 (which we briefly discussed in chapter 2), the central bankers of the major powers wanted a new framework for regulating global finance. Consequently the BIS formed what is now called the Basel Committee on Bank Supervision (BCBS) in 1974, with the stated aim of enhancing “financial stability by improving supervisory knowhow and the quality of banking supervision worldwide.”
50		43	For example, economists believe that it was sometime in the 1980s that the Fed moved away from targeting the total amount of money and/or bank reserves, and instead began to use its powers to target interest rates.1 Specifically, from the 1980s until the eve of the 2008 financial crisis, the Fed’s official announcements of policy decisions concerned its target for the so-called federal funds rate.
51		44	For the purposes of an introductory text, the important thing to note is that when the Fed (tries to) push down interest rates through open market operations, the Fed is NOT directly lending new reserves to the banks. Instead, it is paying newly created reserves over to the sellers of financial assets in exchange for their property. When those new reserves are deposited into the banking system, the recipient banks lend them out to other banks and thereby (tend to) push down the fed funds rate.
52		45	At the other end of the cycle, when the Fed began “normalizing” its policy stance and finally began raising its target for the federal funds rate in December 2015, it did not do so by selling off some of its assets (and thereby draining reserves out of the banking system), as the textbook description of monetary policy would have it. Instead, the Fed maintained its outstanding stock of assets and caused the fed funds rate to increase by raising the interest rate that it paid to banks on their reserves kept at the Fed. In this way, the Fed could raise interest rates without selling off its large holdings of Treasury bonds and mortgage-backed securities, actions that may have jeopardized the still fragile recovery in financial markets. To sum up, among other implications,7 the new policy begun in October 2008 of paying interest on reserves allowed the Fed to decouple its asset purchases from its desired target for the market-clearing federal funds rate.
53		46	When justifying the new powers that it took after the financial crisis struck, Fed officials typically appealed to the section of the Federal Reserve Act giving it liberal powers to lend money to financial institutions. In practice, the Fed lent money to newly created Limited Liability Corporations (LLCs) named “Maiden Lane”—referring to the street in New York’s financial district—that would then use the money borrowed from the Fed to purchase the desired assets.
54		47	As Figure 1 indicates, the explosion in Fed asset purchases since March 2020 dwarfs even the three rounds of QE (quantitative easing) following the 2008 financial crisis. Indeed, from March 4, 2020, through March 3, 2021, the Fed increased its assets from $4.2 trillion to $7.6 trillion, an incredible one-year jump of $3.3 trillion (or 78 percent). Furthermore, as the graph reveals, the upward trajectory continues as of this writing.
55		48	As the figure indicates, there was a massive spike in the official M1 measure in May 2020, largely (though not entirely) reflecting the reclassification of savings deposits as part of M1. However, note that M2 also rose sharply at exactly this time, reflecting a genuine increase in money held by the public because of the coronavirus panic and Fed policy. (Also remember that the M1 chart shown in chapter 13 was made based on the original M1 numbers, before the retroactive reclassification occurred. The chart in chapter 13 shows that M1, even according to the old definition, truly did spike in the spring of 2020.)
56		49	Before the August 2020 change, the Fed had adopted a constant (price) inflation target, which reset anew each period. For example, if the Fed wanted inflation (in the Personal Consumption Expenditure index) to average 2 percent in 2020, but in actuality the desired inflation measure came in at only 1 percent, then under the old system, the Fed in 2021 would try again to hit 2 percent. But under the new system, the Fed might shoot for inflation of 2.5 percent for both 2021 and 2022 to make up for the initial undershooting of the target back in 2020.
57		50	Although Carl Menger founded the Austrian school in 1871 with his book Principles of Economics, in the twentieth century the acknowledged leader of the Austrians was Ludwig von Mises. Most modern fans associate him with his magnum opus, Human Action (first published in 1949), but Mises’s pathbreaking work on money, banking, and the business cycle was contained in his 1912 German book, translated as The Theory of Money and Credit.
58		51	In a loan involving commodity credit, someone lends (say) 100 barrels of oil today in exchange for a promise of 110 barrels of oil delivered in a year’s time. This credit transaction involves the renunciation of the oil for twelve months by the lender; he can’t simultaneously lend it out and still have the oil. Like-wise, it would also be an example of commodity credit if someone lent $100 in currency to a borrower who promised to pay back $110 in a year. Because the lender would no longer physically possess the currency, this would be a genuine deprivation, a sacrifice of present goods for the hope of obtaining a greater number of future goods, and hence would be considered commodity credit. However, under the practice of “fractional reserve banking” (which we explained in detail in chapters 4 and 6), there is a sense in which a lender can lend out his funds while still enjoying the benefits of holding the money. For example, when a man deposits $100 in his checking account, upon which he earns interest because the bank then lends out $90 to a new borrower, even though this is a credit transaction, the original depositor still thinks that he has $100 in the bank. This is what Mises has in mind when he says that there are credit transactions in which the renunciation of the lender “results for him in no reduction of satisfaction.” Thus, to the extent that bank loans involve unbacked claims to money, where the total customer deposits exceed the total reserves of actual money in the vaults, the loans constitute circulation credit in the Misesian framework.
59		52	In the preceding section we laid out the essence of Mises’s theory of the business cycle. Yet in order to understand its implications, one of the most useful analogies was created by Mises himself. When responding to the claim that his was an “overinvestment” theory, Mises explained in Human Action: The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not over-investment, but an inappropriate employment of the means at his disposal. [Mises [1949] 1998, p. 557, bold added.] And thus we see that Mises doesn’t say that the banks’ injection of new money into the loan market causes overinvestment. Rather, he says that their policies cause malinvestment.
60		53	In the Austrian view, paradoxically, the boom period is actually harmful, while the bust period, though unpleasant, is a healthy return to reality. According to Mises, the only way to permanently cure recessions is to stop letting banks foster the preceding artificial booms.
61		54	Although it is important to recognize that massive price inflation is always the result of massive monetary inflation, there isn’t a stable relationship between the two; it’s not the case that, say, a 50 percent increase in the quantity of money necessarily leads to a 50 percent increase in prices.
62		55	Nowadays when the media or government officials discuss “inflation” they mean “the increase in consumer prices.” However, originally the term referred to an increase in the quantity of money (including bank credit).
63	X	56	Milton Friedman is often quoted as saying, “Inflation is always and every-where a monetary phenomenon.” To give more context, that quotation goes on to say “in the sense that [price inflation] is and can be produced only by a more rapid increase in the quantity of money than in output.”2 Although economists have debated the accuracy of Friedman’s famous assertion, the historical record shows that episodes of rapid price inflation (almost) always go hand in hand with rapid monetary inflation.3 In other words, if there is a genuine hyperinflation, then the government printing press is always involved. In this section we cover three famous historical examples.
64		57	Strictly speaking, the equation of exchange is a tautology or an identity; given the definitions of the four variables, it is necessarily true. In practice, however, it is often used as a way of illustrating the so-called quantity theory of money, which—as the name suggests—is a theory that might be wrong. There are different formulations of the quantity theory of money, but one simple version says that changes in the quantity of money go hand in hand proportionally with changes in the level of prices. To illustrate this statement using the equation of exchange, we could say, “If M doubles while V and Q stay the same, then P must also double.”
65		58	Putting aside Cantillon effects, there is no reason for monetary inflation to necessarily have the same proportional impact on even the average index of prices. As Mises observed, once a hyperinflation is underway, injections of new money may lead to greater than proportional increases in “the price level” (if such a concept made sense), as the community seeks to rid itself of the cash as quickly as possible in exchange for other goods.15 For example, once a hyperinflation is underway, if the government doubles the quantity of money, then this action may result in more than a doubling of the typical price of a consumer good.
66	X	59	Although the term “inflation” nowadays refers to rising consumer prices, historically it referred to increases in the quantity of money. There is a tight connection between monetary inflation and price inflation. Specifically, all examples of hyperinflation in prices involved comparable increases in the money stock. However, there are examples of large increases in the quantity of money that have not (thus far) resulted in comparable consumer price hikes. The equation of exchange, MV = PQ, is an identity and therefore must be true. Yet it invites a mechanistic view of the economy, rather than explaining prices on the basis of individual decisions to hold cash balances of a particular size.
67		60	So although any individual bank can go to the federal funds market and borrow enough reserves to satisfy its individual requirements, the banking system as a whole can’t create new reserves. If Acme Bank borrows $4 million in the federal funds market to replenish the $4 million in reserves that it lost in our story above, those reserves must have come from other banks that had excess reserves. When the commercial banks lend money among themselves, these actions don’t have the power to alter the total amount of paper currency or bank deposits with the Fed itself. In other words, only the Fed (in conjunction with the Treasury) has the legal power to create US dollars as part of the monetary base.
68		61	According to both Keynesians and proponents of MMT (modern monetary theory), increased government spending—even if financed by monetary inflation—won’t generate large increases in consumer prices so long as the economy is operating below its capacity. In more technical terms, they argue that so long as real GDP is below potential GDP, increases in nominal spending serve to boost real output rather than prices. The intuitive idea is that the unemployed and other idle resources will absorb new spending first, before tightening labor and resource markets cause wages and other prices to begin rising.
69		62	After the fact, because we didn’t observe an unusual drop in the purchasing power of the US dollar from 2008 onward, we can confidently say that the demand to hold US dollars increased to offset the increase in US dollars orchestrated by the Federal Reserve. This is necessarily true. However, the downside of this explanation is that we can only be sure to apply it correctly in hindsight. If we want to assess what will happen to the path of price inflation in the future, we need to forecast changes on both the supply and demand sides, and of course we might be wrong about our forecasts. This becomes especially problematic if changes in the supply of money directly cause an increase in the demand to hold it, a possibility we discuss in the next section.
70		63	The introduction of interest payments was indeed an important innovation in Fed policy, giving the central bank a means of divorcing its open market operations from interest rate targets. (For example, when the Fed began raising its policy interest rate in late 2015, its balance sheet remained constant for about two years thereafter. The Fed steadily raised rates during this period by hiking the interest rate paid on reserves, not by selling off Fed assets.)
71		64	The danger in this type of explanation is that it often misconstrues what actually happens when new money is injected into the economy. In reality, it is not the case that some money is “in” the stock market, while other portions of the money stock are “in” consumer goods. At any given time, all units of physical currency are held in cash balances, located in people’s wallets (or home safes), or inside of commercial bank vaults. If someone buys one hundred shares of a stock at $10 per share, it’s not that money “goes into the stock market.” Rather, what typically happens is that $1,000 is debited from the checking account of the buyer, while an equal amount is credited to the checking account of the seller. If the buyer and seller are clients of different banks, their transaction might cause some reserves to transfer from one bank to the other, but nobody looking at the money after the fact would be able to tell that it “had gone into the stock market.”
72		65	In contrast to the Austrians, Keynes viewed depressions as something that could naturally plague market economies when total spending (“aggregate demand”) was insufficient to support full employment. Keynes argued that markets didn’t possess a self-correcting mechanism and that left to their own devices, markets could be mired in depression for years on end. Only with wise oversight by central banks and government officials could we hope to achieve steady economic growth. This chapter will summarize the Keynesian view and then challenge it from an Austrian perspective.
73		66	It would have been presumptuous and provoked defensiveness for Keynes to argue that his predecessors were complete buffoons and totally wrong. Instead, as the introductory chapter explains, Keynes argued that their “classical” approach was correct under certain conditions (namely, when the economy is at full employment) but that in general those conditions might not be fulfilled. In that case—such as the world faced in 1936—Keynes proposed a more general theory that could handle all possible scenarios.
74		67	The above excerpt is a good distillation of the entire enterprise of The General Theory. Rather than viewing the economy from the perspective of an individual household or firm—where we start each time period with a particular level of income out of which consumption and investment are financed— Keynes reversed causality. Individual and business decisions to consume or invest, driven by psychological considerations, determine the level of income in the community.
75		68	“Bitcoin” encompasses two related but distinct concepts. First, individual bitcoins (lowercase b) are units of (fiat)3 digital currency. Second, the Bitcoin protocol (uppercase B) governs the decentralized network through which thousands of computers across the globe maintain a “public ledger”—known as the blockchain—that keeps a fully transparent record of every authenticated transfer of bitcoins from the moment the system became operational in early 2009. In short, Bitcoin encompasses both (1) an unbacked digital currency and (2) a decentralized online payment system.
76		69	At this point in its history, Bitcoin is no doubt a medium of exchange; there are thousands of people around the globe, who trade away valuable goods and services in exchange for receiving public acknowledgement—codified in the blockchain— that they control certain (fractions of) bitcoins. The reason these sellers accept bitcoins, of course, isn’t because they intend on eating them or using them to produce mousetraps. Rather, people accept bitcoins in trade because they expect them to have purchasing power in the future; they want the ability to trade the bitcoins away for other goods and services, down the road.
77		70	However, even though bitcoins clearly count as media of exchange for some people, we are currently nowhere near the point at which they are universally accepted in any economically relevant community (unless we cheat by defining the relevant community as “those people who are happy to receive bitcoins in trade”). Thus far, then, Bitcoin doesn’t count as money, though in principle Bitcoin—or some other cryptocurrency that surpasses it in popularity—could achieve this status in the future.
78		71	But when it came to explaining the market value—or purchasing power— of money itself, Menger’s subjective value theory seemed like a dead end, because the only reason you value money is that it allows you to buy things in the market. Thus it seemed as if the economist had to argue that people value money because people value money. This was a circular argument, and that’s why most economists used Menger’s subjective value theory to explain the market value of all goods and services except money. Yet in his 1912 work Mises showed the way out of this logjam. The solution was to introduce the time element. Specifically, when people accept money in trade right now, it’s because they expect the money to have purchasing power in the future. And their expectations of this purchasing power are based on their observations of money’s ability to fetch goods and services in the immediate past. To put it succinctly: people value money today because they expect money to have a certain value tomorrow, and this in turn is based on their memory of its value yesterday.
79		72	Because Mises had to cite the emergence of money from a state of direct exchange in order to satisfactorily explain its current market value, he made some pretty definitive statements about the type of past that money necessarily had to have. Here are two examples from Mises’s classic work, Human Action: [N]o good can be employed for the function of a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments. (Mises 1998, p. 407) and A medium of exchange without a past is unthinkable. Nothing can enter into the function of a medium of exchange which was not already previously an economic good and to which people assigned exchange value already before it was demanded as such a medium. (Mises 1998, p. 423) In light of Mises’s sweeping claims, we can quickly see why so many fans of the Austrian school have a major problem with Bitcoin: Since Bitcoin was born to be a currency—rather than first serving as a regular commodity—doesn’t that mean it can’t be money? Or, going the other way, if Bitcoin ever did become money, wouldn’t that mean that Mises must have been wrong? At the risk of being evasive, we are not here going to explore the fascinating question of whether the case of Bitcoin violates the regression theorem, or whether its unorthodox features can be made compatible with Mises’s monetary framework (which he obviously conceived with tangible goods in mind). Other economists familiar with the Austrian school and Bitcoin have weighed in on this intriguing issue.
80		73	To sum up: whether Bitcoin becomes a bona fide money is still an open empirical question, but at this point—since Bitcoin is already a medium of exchange—Mises’s regression theorem doesn’t have any bearing on the out-come.
81		74	So why is this bad news? Because Kelton’s concrete policy proposals would be an absolute disaster. Her message can be boiled down into two sentences (and these are my words, not an exact quotation): Because the Federal Reserve has the legal ability to print an unlimited number of dollars, we should stop worrying about how the government will “pay for” the various spending programs the public desires. If they print too much money, we will experience high inflation, but Uncle Sam doesn’t need to worry about “finding the money” the same way a household or business does.
82		75	Kelton and other MMT theorists argue that inflation isn’t a problem right now in the US and other advanced economies, and so we don’t need to be shy about cranking up the printing press. But whether or not the Consumer Price Index is rising at an “unacceptably” high rate, it is a simple fact that when the government prints an extra $1 million to finance spending, then prices (quoted in US dollars) are higher than they otherwise would have been, and people holding dollar-denominated assets are poorer than they otherwise would have been. Suppose that prices would have fallen in the absence of government money-printing. Then in this case, everybody holding dollar assets would have seen their real wealth go up because of the price deflation. If the government merely prints enough new dollars to keep prices stable, it is still the case that those original dollar-holders end up poorer relative to what otherwise would have happened. Now to be sure, Kelton and other MMT theorists would object at this point in my argument. They claim that if there is still some “slack” in the economy, in the sense of unemployed workers and factories operating below capacity, then a burst of monetary inflation can put those idle resources to work. Even though the rising prices lead to redistribution, if total output is higher, then per capita output must be higher too. So on average, the people still benefit from the inflation, right? On this score, we simply have a disagreement about how the economy works, and in this dispute I think the Austrians are right while the MMTers are wrong. According to Mises’s theory of the business cycle,4 the existence of “idle capacity” in the economy doesn’t just fall out of the sky, but is instead the result of the malinvestments made during the preceding boom. So if we follow Kelton’s advice and crank up the printing press in an attempt to put those unemployed resources back to work, it will simply set in motion another unsustainable boom/bust cycle. In any event, in the real world, government projects financed by inflation will not merely draw on resources that are currently idle, but will also siphon at least some workers and raw materials out of other, private-sector outlets, as I elaborate elsewhere.
83		76	In summary, the fundamental “insight” of MMT—namely, that governments issuing fiat currencies need only fear price inflation, not insolvency—is something that other economists have acknowledged for decades. Where the MMTers do say something different is when they claim that printing money only carries an opportunity cost when the economy is at full employment. But on this point, the MMTers—like their more orthodox cousins, the Keynesians—are simply wrong.
84		77	Now that we’ve covered this basic terrain, I have a follow-up question for the MMT camp: What would it take for a government to lose its monetary sovereignty? In other words, of those governments that are currently monetary sovereigns, what would have to happen in order for the governments to start borrowing on foreign currencies, or tie their own currency to a redemption pledge, or even to abandon their own currency and embrace one issued by a foreign entity? Here again the answer is clear: A government that engaged too recklessly in monetary inflation—thus leading investors to shun that particular “sovereign” currency—would be forced to pursue one or more of these concessions in order to remain part of the global financial community. Ironically, current monetary sovereigns would run the risk of forfeiting their coveted status if they actually followed Stephanie Kelton’s policy advice.
85		78	The MMTers take it for granted that if the Treasury ever actually tried to spend more than it contained in its Fed checking account balance, that the Fed would honor the request. Maybe it would, and maybe it wouldn’t; CNBC’s John Carney (who moderated the debate at Columbia University between MMT godfather Warren Mosler and me [Modern Money Network 2013]) thinks it’s an open question in terms of the actual legal requirements, though Carney believes in practice the Fed would go ahead and cash the check.
86		79	Whenever I argue the merits of MMT, I debate whether or not to bring up this particular quibble. In practice, it would be very naïve to think the Fed actually enjoys “independence” from the federal government that grants the central bank its power. And I for one think that the various rounds of quantitative easing (QE) were not merely driven by a desire to minimize the output gap, but instead were necessary to help monetize the boatload of debt incurred during the Obama years. (Of course Trump and Powell are doing a similar dance.) Even so, I think it is important for the public to realize that the heroes of MMT are misleading them when they claim there is something unique to Uncle Sam in the way he interacts with his banker. So far, this is technically not the case. Even when the Fed has clearly been monetizing new debt issuance—such as during the world wars—all of the players involved technically went through the motions of having the Treasury first float bonds in order to fill its coffers with borrowed funds, and only then spending the money. The innocent reader wouldn’t know this if he or she relied on the standard MMT accounts of how the world works.
87		80	I have included these lengthy quotations to be sure the reader understands the superficial appeal of MMT. Isn’t that intriguing—Mosler argues that the government funds the taxpayers! And when you think through his simple point about debits and credits, it seems that he isn’t just probably correct, but that he must be correct. Again, it’s a tidy little demonstration; the only problem is that it’s demonstrably false. It is simply not true that dollars were invented when some autocratic ruler out of the blue imposed taxes on a subject population, payable only in this new unit called “dollar.” The MMT explanation of where money comes from doesn’t apply to the dollar, the euro, the yen, the pound…Come to think of it, I don’t believe the MMT explanation applies even to a single currency issued by a monetary sovereign. All of the countries that currently enjoy monetary sovereignty have built their economic strength and goodwill with investors by relying on a history of hard money.
88		81	Stephanie Kelton’s new book The Deficit Myth does a very good job explaining MMT to new readers. I must admit that I was pleasantly surprised at how many different topics Kelton could discuss from a new view, in a manner that was simultaneously absurd and yet apparently compelling. The problem is that Kelton’s fun book is utterly wrong. The boring suits with their standard accounting are correct: It actually costs something when the government spends money. The fact that since 1971 we have had an unfettered printing press doesn’t give us more options. It merely gives the Fed greater license to cause boom/bust cycles and redistribute wealth to politically connected insiders.
89
90
91
92
93
94
95
96
97
98
99
100