Sunday, August 15, 2010

Fiat money, part 3

(Follow-up to part 1 and part 2.)

Let’s clear up some potentially confusing points about fiat money on our island:

We said that when the government spends, it increases net dollar wealth, and that when it taxes, it decreases net dollar wealth.

So you can think of the total government debt as the “national savings account”. But it is important to note that when we say "savings", we are really referring to savings in the form of dollars (or Treasuries, which we’ll get to later).

If I chop up some wood and build a bird house for my pet woodpecker, I've created wealth and my net worth (assuming that other people are interested in buying the bird house) has gone up. But my dollar wealth is unchanged. Since the total number of dollars out there is the same but there are more goods it can buy (because that spectacular bird house has been built), overall prices might have to come down. So you could argue that the government has to issue more dollars to keep pace with the amount of “real wealth” that is created.

Where does the extra money "come from"? Is the government racking up a bunch of debt?

You might be confused at this point as to where the money used for deficit spending comes from. There are two possible answers: the government can "print" the money, or it can "borrow" the money.

Let’s start with borrowing, since that’s the case most familiar to a lot of us.

In order to borrow money, the government has to print up a bunch of IOUs and sell them. We'll call the island IOU's "Treasuries" to match the U.S. terminology. So the government prints some Treasuries and exchanges them for cash with "regular" civilians. For now, those civilians represent island citizens, but later we'll consider what happens if they are foreigners.

For instance, if the government collected $500,000 in taxes but wants to spend $520,000, it could issue $20,000 worth of Treasuries and sell them to island residents. In the process, the government has $20,000 worth of cash, and it can proceed to spend or give away the money. If Lenny the Lender purchased $100 worth of government Treasuries, then he's just as wealthy now as he was before. His cash has been reduced by $100 but he now has $100 worth of Treasuries.

So now when we refer to "dollar savings" we'll be referring to cash or Treasuries. Both are a form of dollars; the difference is the Treasuries are scheduled to "turn into" regular cash at a future date. Alternatively, you could say that cash is just a "zero maturity" Treasury, i.e. a Treasury that gets paid back by the government right now.

So how does “printing” money work?

Well, on the island, we can literally print it and spend it. It is our imaginary island after all.

But does the U.S. actually just print money and spend it?

This is a minor point, but the U.S. Treasury works slightly differently. (Thanks to ESM for spelling this out for me.) If the U.S. Treasury wants to "print money", the Treasury issues bonds to the Federal Reserve, and the Fed pays cash to the Treasury. Now the Treasury has cash to spend, and the Fed is holding onto a bunch of bonds. The Fed can either hold the bonds, sell them on the open market, or tear them up. In the last case (which is quite common), we can say that the Treasury effectively printed money, and for some reason, the amount that it printed is not added to the U.S. debt. This is horribly inconsistent, but it’s the way it is. It's as the government periodically get loans and the bank keeps forgetting to collect debt payments.


Anonymous said...

i would like to ask 1 question and have one point clarified. First the clarification.

You write:
"So you could argue that the government has to issue more dollars to keep pace with the amount of “real wealth” that is created."

I understand what you are saying, but do you mind elaborating on this? For example, is this really the goal of the goverment? If we did this, does this put our island goverment in the business of deciding what peoples work is worth? Is it necessary to do this - isn't this money relative and if someone makes something valuable, then other products will go down in price as you mention - but is that a bad thing? (i guess a better question is why doesnt the government keep the amounnt of money constant and your wealth is more a reflection of the % of that pie you own)

Then my question is regarding your last paragraph about how the fed and treasury tranact business. you write "the Treasury issues bonds to the Federal Reserve, and the Fed pays cash to the Treasury" - where does the Fed get the cash to buy the treasuries?

ESM said...


First there is the simple idea that as you have more wealth, more productive capacity, and more people, you need more money around to make the economy run smoothly. Obviously, if you have too few dollars people have to resort to start using a different kind of money for transactions (personal IOUs for example) or even resort to barter.

Leaving aside such an extreme case, you will also have a problem if the currency begins to appreciate in value relative to goods and services (which is what we call deflation). There are certain financial asymmetries which make moderate deflation worse for the economy than moderate inflation.

One asymmetry is that the nominal interest rate cannot go below zero. Therefore, if you have deflation, investors earn a real return from just hoarding cash. Certain investments which produce a positive real return in actual goods and services (consider a chicken farmer who starts with 100 chickens and ends the year with 103 chickens after paying for all of his labor and supplies with chickens) will not happen because investors will just sit on their cash.

A second asymmetry comes from creditworthiness. Inflation makes it easier for debtors to pay back their debts, but deflation makes it harder. A small amount of deflation can undermine creditworthiness throughout the system because when one debtor defaults, the person he defaults to may also become a bad credit as a consequence. When everybody is seen as a poor credit risk, loans simply will not happen. You might think, well, loans will happen at some interest rate. Bad credit people will just be charged a higher spread over the risk free rate. But that doesn't happen in the real world. Aside from the fact that we have usury laws, once the interest rate gets above 20%, the interest burden exacerbates credit risk more than the interest income can compensate. Rates above 20% just aren't feasible.

Finally, there is the sticky wage asymmetry. Workers are reluctant psychologically to accept a cut in nominal wages. Faced with the choice between cutting all worker salaries by 5% or cutting the workforce by 5%, many companies will actually choose the latter, which is obviously very inefficient.


ESM said...

Forgot about your second question. The Fed gets the cash from the same place that the scorekeeper gets the points in a basketball game. They're made up numbers. Just numbers placed into cells in an Excel spreadsheet. Say that cell F4 is the Treasury's federal reserve account. Somebody at the Fed just puts in "+1,000,000,000,000" into cell F4 and now there is a $1T in there.

Anonymous said...

Thanks ESM. The clairfication of why the goverment might want to create more money as wealth is created makes sense.

When I read the answer to my question (your last comment). It seems that the Fed has an absolutely enormous amount of power AND the residents of this country do not have any alternative cause we pay taxes in dollars. Is this correct? Say you knew ahead of time that a crazy guy was going to run the Fed, you would not have any alternative except to leave the country. Is there any legitimate type of check and balance to what the Fed decides?

ESM said...

It is a crazy system since there is really not much of a check on the Fed except for Congress basically voting to disband it I guess. The thing is the Fed was purposely set up to be independent of Congress and the Treasury because it was felt that only an entity that was apolitical could make the right decisions for the country with respect to monetary policy. The US (through the IMF) has enforced this central bank - Treasury separation on almost every country in the world. The problem is that much of what the Fed does is hidden from the public. In theory it isn't hidden, but the press does such a bad job of covering the Fed that nobody really scrutinizes what it does.

DWJ said...

ESM, how much damage can the Fed really do? They have no control over deficits/surpluses, so all they can do is "move money along the yield curve", right?

ESM said...


In theory, Ben Bernanke could just direct some of his minions to credit JP Morgan's reserve account with $10B for further credit to Ben Bernanke.

More realistically, the Fed could transfer wealth to favored institutions by buying their bonds or buying toxic assets from them at inflated prices. Although Fed managers could get in trouble if they outright transferred money to another entity as a grant rather than a loan or a purchase, making a loan which you know won't be paid back or purchasing something at an inflated price amounts to the same thing.

The Fed has plenty of power to do this, and in fact has been doing this for the last 2.5 years.


DWJ said...

ESM, great point. If the Fed couldn't do things like that, is there a lot of damage they could do with just regular monetary policy?