Saturday, June 11, 2011

The Fed and the Money Supply

In order to remove the political motivations that may otherwise manipulate the money supply arbitrarily, the powers to do so are granted to a private entity known as The Federal Reserve, or as it is sometimes called “The Fed”. Although it is technically a private institution and not officially part of the government, the Fed acts as the policy arm of the US treasury. The board of the Fed is appointed by the president and approved by congress. The actions of the Fed are also overseen by congress, although not directly regulated by them. In other words, the Fed doesn’t need to ask permission to act, but if its actions are perceived to be devious by congress, it has the power to revoke the Fed’s authority. The Fed is the US central bank, of which all other private banks throughout the country must be a member, and it is tasked by congress with two main objectives: maintaining high employment and low inflation. It attempts to accomplish these goals primarily through adjusting the money supply to meet demand. Theoretically, if the supply of money is kept in balance with demand, then employment will remain high, and prices will remain stable. As was discussed in the last post, the operations of the Fed become necessary because the government needs some leeway when it comes to the budget. It is just not practical to adjust the money supply completely by government spending and taxation alone.

In order to create a buffer in which the money supply can be adjusted, we operate under the fractional reserve banking system. This means that banks are allowed to lend a portion of the funds deposited with them, and still allow those funds to be demanded for withdrawal by depositors at any time. As long as not too much of the money is demanded for withdrawal on any given day, the bank has enough funds on reserve to pay out normal requests for withdrawals. When too many withdrawals are requested at once, it is called a run on the bank. Usually, a bank run is driven by the fear that the bank will fail. People flock to pull out their money, and thus failure becomes a self fulfilling prophecy when the amount of withdrawals demanded becomes greater than the reserves held. In order to quell fear and prevent bank runs, the federal government created an insurance program called the FDIC, which insures accounts up to a certain dollar amount (currently $250,000). When bank failures occur, and they still do, the government steps in to take over the bank temporarily and pays out its creditors while insuring that depositors are kept whole up to the insured amount. This creates a stable banking environment where your average consumer no longer needs to worry about bank failures, since their money is safe even if the bank itself does go under.

Fractional reserve banking creates a buffer in the money supply known as “bank money”, or the “private money supply”. The Fed can use interest rates and reserve requirements in order to influence the size of this buffer to try and balance the demand for money. To understand how this works, we’ll take an example of someone depositing $100 in their local bank. The current reserve requirement for US banks is currently 10%. This means that when person A deposits $100, the Fed requires that the bank keep at least $10 in reserve on account with the Fed. The bank is then free to lend the other $90 as it wishes. So, the bank then lends $90 to person B, who turns around and buys something from person C. Person C then deposits that $90 in another bank. That bank must keep $9 in reserve, but then lends out the remaining $81. You can see that if this keeps on going with each bank lending out the maximum allowed, by the time the last person deposits the proceeds of the last loan there is $1000 total in deposits at various banks. Only when all the loans are eventually paid back does the money supply shrink back down to the original $100. You can see that because the supply of money can be influenced to grow up to 1/R times, where R is the percentage of reserve requirement, it becomes a powerful tool for managing the supply of the currency.

Ok, so what does all of this have to do with government debt? When the government creates more currency from spending than it removes in taxes, it is required to create treasury bonds in the amount of the difference. While this wouldn’t technically be required by the rules of a floating exchange currency, it does make congress feel all warm and fuzzy that the deficit is accounted for somehow. The creation of federal debt also serves some other important functional purposes. It gives people, businesses, and foreign investors somewhere safe to store the currency where it will be protected against inflation. Also, federal debt is the means by which the Fed is able to institute monetary policy. The issuance of government bonds allows the Fed to buy and sell them on the open market in order to target interest rates, which in turn influences the bank money supply. When the economy is hot, and the demand for money is low, the Fed can move to shrink the money supply by selling government debt that it holds. The increase in the supply of privately held bonds puts upward pressure on the interest rates demanded in order to hold those bonds. That pressure directly impacts the “overnight rate”, or the rate at which banks are willing to loan to each other in order to satisfy their reserve requirement with the Fed. Say that on a given day, a bank has lent out more than 90% of all the deposits they hold. In order to satisfy the reserve requirement, that bank has to borrow the difference from a bank that has more reserves than required. The lending bank would only choose to lend its excess reserves if the interest rate was slightly better than it could otherwise get from holding treasury bonds. That bank in turn will be incentivized to offer higher rates for deposits, and will have to charge higher rates to the borrowing public to make it worth the risk. So, if interest rates are rising, that then influences the public to pay down debt, which shrinks the private money supply, thereby bring the total supply of money back down to meet demand so that inflation does not occur. That is how the Fed looks to prevent inflation. By targeting interest rates which in turn influence the private money supply it can adjust for the demand of currency, hence stabilizing prices. It can only do this because of the existence of government debt. The system is supposed to work pretty much the same way in reverse, but it turns out that attempting to control unemployment by influencing the growth of private money is a little bit trickier. That fact is evidenced by what we are currently seeing with the present state of the economy, and is what we’ll explore in the next post.

Sunday, June 5, 2011

The National Debt Can Never be Repaid

Recently, democrats and republicans have been arguing over how to reduce the deficit and, eventually, the national debt. They differ on exactly how this should be done and how quickly this should be done. However, they both agree that the deficit should be reduced, and that the national debt should eventually be brought down. They argue that America is going deeply into debt that we will never be able to repay and that we are in danger of bankrupting America. The problem is, however, they are all wrong. It is impossible for the US to go bankrupt, and the national debt, is in fact, not really even debt, at least not in the way individuals or businesses have debt. Not only that, but paying down the debt will cause recession.

In the last forty years, since the US left the gold standard, we have been using a monetary system never before seen in history. The current system was a necessary consequence of modern economic development. For much of prior economic history, using gold as currency was a relatively stable system because there was always more of it being discovered. The rising supply of gold was enough to cover the rise in demand for currency from the growing productivity of the industrial revolution. However, right around the time of the Great Depression, a number of factors including the slowing rise in the gold supply, as well as poor policy decisions by the newly created Federal Reserve, caused a constriction in the money supply relative to demand. In fact, many economists today accept the conclusion of the famous economist Milton Friedman that if a constricted money supply wasn’t the main cause of the Great Depression, it surely contributed to the depth and length of it. Even though temporarily leaving the gold standard was credited in part with finally lifting the world economy out of depression, we still couldn’t see past the desire to return to it. Eventually, due to war expenditures, the US was forced to finally leave the gold standard once and for all in 1971. Instead, the money supply would now be entirely regulated by government spending and by the open market operations of the central bank, the Federal Reserve (or just, the Fed). The value of the dollar would now “float” freely, determined by the free market as it bought and sold the currency in exchange for the currencies of other nations. When this happened, it also meant that the actual value of the national debt, which is denominated in dollars, also freely floats, and is determined by the free market.

Our currency is now established by government fiat. This simply means that the currency is created by decree of law. Its value lies in the trust people have that our nation will continue to exist and be able to defend itself, and its interests, militarily. Our stable system of government and our military strength are what make the dollar so trusted around the world, so much so that it has been used as the international reserve currency since WWII. As discussed in previous posts, this makes the dollar just as valuable, and just as “real”, as any other form of currency, including gold.

Instead of maintaining a set supply of money according to how much gold happens to exist in the world, we are able to adjust the supply of dollars in order to meet demand, thus maintaining price stability and a healthy economy. This is the main job given to the Federal Reserve. Its stated mission is to maintain low inflation and high employment by manipulating the money supply. It is given this power mainly to remove the political motivations that could otherwise influence policy decisions if it was handled by congress or the executive branch.

Imagine if a new country with our current system was created today, and a new currency was created called the “armchair”. The citizens of this country may hold other foreign currency, or commodities, but none of them would have any armchair, because none had been printed yet. How would the new government get armchair into the hands of its citizens? It would have spend them into existence. In a system of fiat currency with floating exchange rates, this is the only way to create new base money. Now, this is not to say that the government would be creating wealth out of nothing, rather, it is stimulating the creation of wealth by offering the new currency as payment. So, the government would print of a bunch of armchair and hand them out to citizens in exchange for goods and services to be placed into public use. Once there was enough currency in circulation, the citizens would begin to exchange it amongst themselves, and eventually everyone in the economy would be producing something and being paid for it in armchair. So, why would the citizens of the country accept armchair as payment in the first place? First, the currency is legal tender. This means that when courts enforce contract law, a debt is considered paid when an offer of the appropriate amount of legal currency is offered. A party must accept an amount of currency equal in value to whatever payment is described in the contract for it to be enforced. Also, to establish its value, the government must create a tax payable only in the currency. If you have to pay a percentage of your income to the government in its currency, then you either need to buy some of it, or be paid with it in at least the amount owed in tax. This establishes a market for the currency where people will buy and sell it. There is also a second reason a tax needs to be established. Once the economy is at full employment, the government needs to begin removing some of the currency from circulation to offset some of the new spending it does. However, it couldn’t remove all of the currency created in a given year due to the demand placed on the new currency by productivity growth. Otherwise, as we’ve seen, the economy would experience deflation. In a perfectly balanced system, the government would leave only the amount of new currency in circulation as was demanded. In our real world economy, we call the difference between the amount of currency created, and the amount of currency removed by taxes, a budget deficit. The accumulation of deficits from year to year is called the national debt. So, you can see that in any given year, it is necessary to run a deficit, and in fact grow the national debt, in order to keep the economy healthy. This is not money that ever needs to be paid back, and in fact it cannot be paid back, because if it was there wouldn’t be any currency left in existence. Likewise, if you try to pay down the national debt at a time where the demand for money is already higher than the supply (as is currently being proposed), you will create or worsen a recession because the money will simply not exist in order to spur demand. People and banks will hoard their cash and cause higher unemployment. Though the desire to pay off debt during hard times is understandable from an emotional perspective because it is rational for a person, a business, or a state to do so, it is exactly the opposite of what needs to be done at the federal level where the currency is created.

So, why does the government even issue public debt in the first place? Couldn’t we just create a surplus of new currency over what is taken out from taxes in order to meet demand without having to issue bonds to someone? Theoretically yes, however, in real world practice there are a couple of challenges to that. First, it is very difficult to measure or predict the amount of demand for currency there will be in any given year. Also, it would be difficult for the government to spend only and exactly the amount required. The government needs to be able to make some long term promises in spending, and it would not be practical for the budget to change dramatically every year completely based only on the demand for currency. So, another control on the money supply is needed. This is where the fractional reserve banking system and the central bank come into play. This will be the subject of the next post.

Thursday, June 2, 2011

The Gold Standard, Destroyer of Worlds

As was discussed in the last post, gold has served as a basis for currency for thousands of years, and up until 1971, it was explicitly used to back the US dollar. This meant that a $1 bill technically represented a promise by the treasury to pay the holder of the note a fixed amount of gold. Prior to the great depression, the US used a mix of gold and silver standards over the years, occasionally changing the exchange rate during times of crisis. During the great depression, the US temporarily left the gold standard by suspending convertibility in an attempt to turn the economy around. In fact, the year in which countries around the world left the gold standard, and the year in which they exited recession are closely correlated. An international agreement formed after the Great Depression which created the system known as “Bretton Woods” basically said that the treasury would offer convertibility of gold to governments and central banks at a rate of $35 per ounce. The basic idea that every dollar represented a fixed amount of gold in the treasury was restored. This system persisted until, in 1971, President Nixon abruptly ended the agreement and suspended convertibility into gold permanently. The reason President Nixon “closed the gold window” was simple, we were broke. In order to fund the war effort in Vietnam, the US was printing more dollars than there was gold in the treasury. The amount of gold the treasury owned relative to the number of dollars printed went from about 55% to 22% during 1970, meaning that if every dollar in existence was turned into the treasury in exchange for gold, only about 22% of the dollars would have gotten paid out. This spooked international investors and central banks around the world quickly moved to make the US live up to its “promise to pay”, requesting gold reserves in exchange for the dollars they were holding. Realizing we didn’t have enough gold to cover the debt, Nixon abruptly ended the fixed exchange rate system and stopped paying out gold. This event came to be known as the “Nixon Shock”, because the decision was made without consulting congress and without notification in order to avoid an all out raid of the treasury. While this was considered radical at the time, and did cause some temporary economic instability, it was a necessary move, and we have never looked back.

You will sometimes hear politicians (such as Ron Paul) advocate that the US return to a true gold standard. The theory behind this is that it prevents the government from printing more dollars that it can pay out in gold, thus fixing the money supply to the amount of gold in the treasury. They argue that in the current system, the government is allowed to steal value away from those who hold the currency by simply printing more of it. When that devaluation causes prices to rise, it is called inflation. A true gold standard, by definition, prevents inflation by limiting the amount of dollars that can be printed. It is also argued that a gold standard would prevent long term trade deficits and surpluses by automatically adjusting the money supply of the deficit or surplus country. Both of these things are true, except that these benefits come at a terrible cost, the total and utter collapse of the economy.

Price stability is essential for an economy because it promotes predictability. If the price of something you buy stays relatively stable over time, you don’t worry about exchanging your money for it. In contrast, if the price of something you buy is going up too quickly you will want to stockpile it, while if price is going down you would want to hold out on purchasing it. The problem with fixing the supply of money to any static amount of physical good is that the supply and demand of that good then affects the price of everything in the economy. This creates price uncertainty and thus dramatic swings in the economy, which is completely avoidable and unnecessary. For example, say that the entire supply of gold in a country made up of four people was $100. Let’s say everyone in the economy starts out with $25. The four people exchange their respective goods and services so that, at the end of a given year, everyone is back to having their original $25. Now, say the next year the farmer is able to produce twice as much food than he did the year before (this is called productivity growth). He goes to the market to sell twice the food, but the other 3 people only have the same amount of money as they did the year before, so they can only buy the same amount as the previous year. In order to sell all the food he produced, the farmer has to decrease the price of food because there is only so much money in the economy to buy it. Well, noticing that food prices are falling, one of the other people decides that he can hold out on his food purchase, and decides to wait until food prices are even lower. Instead, he stockpiles his money and doesn’t spend on anything. This compounds the problem, because now instead of $100 in the economy, there is effectively only $75. This leads to further price cuts, and eventually, everyone is unemployed because everyone else refuses to spend money (which is going up in value) on goods and services (which are going down in value). This is called a deflationary spiral, and is a simplified version of what was happening around the world during the Great Depression. A similar thing happens when a country begins a trade deficit with another country. The outflow of money from the nation in deficit shrinks the money supply of that country. Conversely, the money supply of the exporting nation grows. This creates deflation in the importing country and inflation in the exporting nation. When the domestic price of goods in the importing nation fall below the price paid for the imported goods, the deficit will naturally reverse itself. Though, as we’ve seen, this natural balancing comes at the cost of high unemployment in the importing country during the deflationary period.

The gold standard is an unnecessary relic. If an individual is worried about inflation of their currency, they are perfectly free to buy gold or other stable currencies on the open market. There is absolutely no need to base a sovereign currency on some artificial limit such as the amount of gold in existence. The gold standard has been replaced by a better system of floating exchange rates, where each country can adjust monetary policy to fit the needs of the time. The new system allows the necessary creation of new money to meet the demand caused by productivity growth. Admittedly, while the necessary powers granted to governments and central banks in the floating exchange are to foster growth, they can also be used to cause damage if wielded improperly. For this reason, it becomes increasingly important for the voting public to understand the mechanisms of the monetary system. These mechanisms will be the focus of coming posts.

Wednesday, June 1, 2011

Is Gold the Only “Real” Money?

In order to have a discussion of our modern monetary system, it is helpful to define what it is we are discussing in the first place. So, what really is it we are referring to when we talk about money? Money is simply a medium of exchange. The function of money is to act as a non-perishable store of real value. It is a promise agreed to by the majority of a society that allows members to freely exchange goods and services of varying value in an efficient manner. Civilizations throughout history have used all sorts of different material objects to represent this concept, from seashells to giant stones.

The actual object being used as currency is really just a symbol. In reality, you don’t actually need a physical object to represent value at all. There is an island in the Pacific named Yap, in which the inhabitants began to import large carved stones, some as large as a small car, from a neighboring island. The stones first became valued as art, but eventually came to be traded as currency for large transactions. Since it was not practical to keep moving these large stones around every time someone wanted to trade them, people just publicly started keeping track of who owned these stones at any given time. One day, a resident of the island was transporting a new stone onto the island by boat when a storm hit, and the stone was lost to the bottom of the sea. However, since the islander was trusted in the community, he was still able to trade the lost stone as if it had not been lost at all. The islanders continued to trade the stone at the bottom of the sea, and as long as everyone accepted it as payment, it was just as good as any other stone. At this point, it didn’t even matter if the stone was real; it only mattered that other people in the community would accept ownership of it as payment. This story illustrates that the real value of a currency is in the level of trust people have that they themselves will be able to exchange it for the same relative amount of value they exchanged away to obtain it. Of course, in general, people tend to trust money more if they can actually hold it in their hands.

So then, what sorts of qualities are desirable for something to be used as money? Well, first, you want something where the physical amount of it that is generally available allows it to carry a value that makes it practical to exchange in amounts easily handled by people. For example, you wouldn’t want to use gravel as money because you would need truckloads of it in order to buy anything. Second, you want a material which is chemically stable and that doesn’t deteriorate easily. The reason for this is obvious, you want to be able to store and save value without the medium itself being destroyed. Next, it is important that the material is easily testable and identifiable. The harder it is to counterfeit, the more useful it is as money. It turns out that out of all the materials available on Earth, gold fits all of these requirements better than pretty much any other substance. Gold is rare, but not too rare that everyone cannot own a reasonable amount of it. It is easily identifiable and very difficult to counterfeit, even with modern technology. A simple acid test will quickly and accurately verify a material as real gold. Gold is also extremely chemically stable and does not even tarnish. Lastly, given its relatively low melting point, gold is easily manipulated into a form, such as coins, that makes it very practical in everyday use. Thus, gold has been used as money by many civilizations, and is still valued as currency today. There is an important distinction here though; gold is only valuable because people have been convinced to accept it as a currency, not the other way around. In other words, “we use gold as money, therefore it has value”, NOT “gold has value, therefore we use it as money”. You may occasionally hear people or even politicians say something like, “We should use real money like gold and not some artificial money like paper dollars”. This is a straw man argument. People designate something as money or not, and therefore paper money that people trust is just as real as gold. There is a quote often attributed to Warren Buffett that goes something like “We dig gold out of the ground, melt it down, dig another hole, and put it back in the ground where we pay people to guard it. It has no utility. Anyone watching from Mars would be scratching their head”.

So, if gold does have qualities that make it ideal for use as currency, why don’t we still use it? Well, up until 1971, most currency around the world was still based on gold. This idea is generally referred to as “The Gold Standard”. The reason we left the gold standard is because gold does have one important drawback if you are looking to supply a large modern economy with currency: you cannot make any more of it. Now, the argument for going back to the gold standard is actually because of that very same fact. However, not being able to adjust the supply of a currency to meet demand has devastating consequences. I’ll explore why in the next post.