Friday, September 21, 2012

Money: It's all made up!


This post will be more colloquial in style than most of my posts. Apologies in advance.

It's just made up money

The main thing that differentiates the Federal Reserve Bank from other banks is that it can create money from nothing. This bothers a lot of people. Mitt Romney is apparently one of those people.
We're just making it up. The Federal Reserve is taking it and saying, "Here, we're giving it." It's just made up money, and this does not augur well for our economic future. (Source)
The candidate seems troubled by the notion that the Fed buys Treasury securities by simply creating the money it needs to pay for them. Romney has exceptional business experience and probably a pretty good grasp of economics. He has two degrees from Harvard and has been a governor. But he doesn't get monetary economics. That's understandable--business experience doesn't necessarily teach a person a lot about monetary economics, which is a very macro-level thing and can be pretty counterintuitive. But I think the general public is capable of grasping this, so here goes.

The key point that Romney is missing is this: it's all made up! The money floating around the US economy was all conjured out of thin air at some point. This isn't unique to Fed purchases of Treasury debt; every time a central bank does anything, it is either creating money from nothing or magically eliminating it from the world.

A common response to this revelation--that it's all made up--is something like, that's what you get when you have "fiat" money instead of tying money to something which has "inherent value" (gold is a common suggestion). But guess what: A gold standard would still have the government creating money out of thin air!

Suppose we abolish the Fed and replace it with a gold standard. Our wise Republican leaders decide that the dollar should be worth 1/1500th of an ounce of gold (i.e., gold is worth $1500/oz). This isn't some free marketeer's paradise. The gold standard is implemented by having the government promise to buy or sell gold at $1500 per ounce in unlimited quantities. The government is fixing the price of gold rather than letting the market decide what it should be. What does this mean? Well, if I dig a hole and discover an ounce of new gold, I can take it to Uncle Sam and get $1500 for it. In simple terms, this means Uncle Sam will fire up the presses, print up a fresh batch of Benjamins, and hand them to me in exchange for my gold. Thanks, Uncle Sam.

So it's all made up! Uncle Sam conjured that money out of thin air! And by the way, the event I just described may cause inflation (yes, you can still get inflation under a gold standard).

Paul Ryan has said we need "honest money." I have no idea what that means, but I know that a gold standard, or whatever, isn't any more "honest" than our current policy.*

The key point is this: if the government is going to be in the business of controlling money--whether through a central bank which targets inflation, as most developed countries have, or through a central bank which sets a gold standard, or a silver standard, or a commodity-basket standard, or a Junior Bacon Cheeseburger standard--if the government is going to control money, it is going to be conjuring it out of thin air some of the time. Gandalf would have made a great central banker (but not Dumbledore**). The only alternative to this is free banking--getting government out of the currency business entirely and leaving money up to private actors. That's not going to happen any time soon, and indeed Romney has not advocated it.

It's all made up, folks. That's how central banking works.

But does it not "augur well for our economic future"? That depends on the stance of monetary policy. By that I mean, is money too tight, or is it too loose? Romney seems to be implying that it's too loose, and the Fed is making it looser, so bad things are going to happen. People fall into the trap of thinking money creation, or the current level of the money supply, or even the nominal interest rate, are indicators of the stance of monetary policy. In Mitt Romney's mind, the fact that the Fed has created trillions of dollars means that money must be too loose.

But the money supply is a bad indicator of the stance of monetary policy. If I told you that tomorrow Wendy's is going to make 1 million Junior Bacon Cheeseburgers, would you say that Wendy's is making too many or too few JBCs? I have no idea. I need to know how many people are going to want a JBC tomorrow. If only 100 people want one, Wendy's made too many. If 10 million people want one, Wendy's made too few (but if they're smart, they'll raise the price until only 1 million people want one).

Money is no different. You can't just look at the money supply, or the rate of growth of the money supply, and think you have measured the stance of monetary policy. The best way to measure the stance of monetary policy is to look at inflation (or expected inflation) and growth in nominal GDP (or expected growth in nominal GDP). As Scott Sumner frequently points out, lately money has been tighter than at any time since Herbert Hoover! And indeed, even after the Fed announced QE3, market indicators of inflation expectations did not indicate excessive monetary looseness.

Sure, all these asset purchases by the Fed may lead to somewhat higher inflation. But it's very unlikely that it will get so high or unmanageable that the economy will be at risk.

But they're monetizing the debt!

It's true that recent and current Fed actions have involved creating money to purchase Treasury securities, and other stuff. Romney, after talking to one expert and ignoring the broader consensus of economists, complains (same source as above):
The former head of Goldman Sachs, John Whitehead, was also the former head of the New York Federal Reserve. And I met with him... You know, we borrow this extra trillion a year, we wonder who's loaning us the trillion? The Chinese aren't loaning us anymore. The Russians are loaning it to us anymore. So who's giving us the trillion? And the answer is we're just making it up.
First of all, who cares if Whitehead used to work at the Fed? His opinion obviously does not represent the views of people who are, you know, actually running the Fed. Regardless, I'm not so sure about Romney's claim about who is willing to lend to us. Like everyone in politics, Romney dramatically overstates the importance of China for financing US deficits; of course, China matters a lot, but China only holds about $1.1 trillion out of the total $16 trillion national debt. But that has gone up over the last 5 years--Chinese appetite for US debt hasn't disappeared.

More importantly, should it bother us that the Fed buys lots of US debt? In a word, no. Not right now. Not when inflation is averaging below 2 percent. Setting aside concerns about availability of safe assets for collateral and risk aversion, if the Fed can buy US debt without causing lots of inflation and effectively forgive that debt (since the Fed returns all profits to the Treasury), why not do it? It's about as close as you can get to a free lunch. Reduce the burden on future generations while simultaneously stimulating the economy. What's not to like?

The common response--which Romney gives--is that once the Fed quits buying assets, interest rates will have to go up. Sure. They'll eventually go up. Markets don't seem to be counting on rates going up dramatically in the future, but maybe they're wrong. Regardless, why should we care? Who cares*** if eventually rates go back up after we were able to spend several years borrowing for almost nothing and having the Fed cancel a bunch of our debt?

When inflation is low and unemployment is high, it's a perfect time for the Fed to monetize some debt.

I don't mean to suggest that monetary policy has no costs or tradeoffs; when we get a real recovery I'll be as hawkish on inflation as anyone. I'm just saying that in the current environment, the benefits probably exceed the costs (in expectation).

*Someone might argue that since the bank notes created are redeemable for gold, they are somehow more honest, or cannot be said to have been created out of thin air or something. This is not relevant to my point as long as dollars have purchasing power; and it's fairly obvious that dollars can have purchasing power even without gold backing. If you don't believe me, let me know when I can stop by and take all your dollars off your hands. Also, if history is any guide, under a gold standard there's still no reason to believe your banknotes will always be redeemable for gold.
**Okay, so maybe he would. I'm not being entirely precise here.
***This is abstracting from elasticities of government spending to interest rates. I'm sure those matter, but I think they're second-order here.

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