Supply Side University Lesson #17
Memo To: Website Students
From: Jude Wanniski
Re: Reviewing monetary basics
In this penultimate week of the fall semester, I thought it would be useful to discuss the most basic aspects of money, especially what it is and how it is created and destroyed. It may surprise you to learn that there are very few members of Congress who understand the basics of money, including the members of the Senate and House banking committees. As I proceed with this lesson, I'll try to explain why this is so. In a way, I will even try to direct this lesson to the chairmen of these two powerful committees, Rep. Jim Leach of Iowa and Senator Phil Gramm of Texas, hoping I might be able to help them understand what has been going on around them. Senator Gramm has a Ph.D. in economics and professed at the University of Texas before he came to Congress, but he learned money and banking in a demand-side paradigm. By this I mean he has a different perspective at even the most basic level. Like Milton Friedman, he tends to be a quantity theorist, which the classical economists were not. He would say "Inflation is too much money chasing too few goods," while we say "Inflation is a decline of the monetary standard," which is characterized by an increase in the money price of gold and then other commodities. I also will address the world around us, as we most recently have been observing the dollar deflation in the United States as it has affected commodity prices at home, and the finances of Brazil, one of the biggest economies in the world. I'm sure this will lead to many questions, which I will take up next week in the final lesson -- and then move on to a spring semester on tax and budget policies.
At the most basic level, we learn about money as nickels and dimes and dollars when we are children, but most people live their entire lives without realizing this form of money represents the debt of the United States government. In other words, a physical dollar bill is part of the national debt, which we hold in our wallets and purses and cookie jars as non-interest-bearing debt of the federal government. This of course means that if there were no debt, there could be no money as we know it. In my early days of learning about money from Bob Mundell and Art Laffer, I was confused when they discussed "the demand for money." I thought we all demand money, as much as possible. It was only when I realized money is non-interest-bearing debt of the government that I understood the "demand for money" is limited because if there is too much debt that pays no interest, those who hold it will demand interest-bearing debt, which is not "money," but "bonds."
It was then I realized the job of the monetary authority, the central bank, in this case the Federal Reserve, is to figure out on a day-to-day basis how much money is being demanded, so they can supply it with some precision. To be exact, the Fed directly cannot create cash money. It only has the power to increase bank reserves. It does this by "buying" a government bond held by the bank in its reserves with a check on an account that has no money in it. Because it is the central bank of the government that writes this check, it does not bounce. The process is called "the monetization" of the debt, by which interest-bearing bonds are turned into non-interest-bearing reserves. To become "cash," the reserves have to be loaned to the bank's customers, who first observe their loan in their bank accounts. The customer can turn the funds in his or her account into cash, of course. That "money" comes from the Treasury Department, under which the U.S. Mint operates. So you see how the cash is created indirectly. If the Fed creates reserves, but the banks choose not to make loans, instead holding them as reserves that pay no interest, they do not become cash money, i.e., currency.
When people demand "money," it means they are willing to hold U.S. debt that pays no interest, rather than hold debt that pays interest. Now that makes sense, doesn't it? Why do people want "money"? It is because they wish to use it for transaction purposes — to pay cash for the groceries or a haircut or a meal. They also might wish to use currency for illicit purposes, so there is no record that the government can find when the commerce is in drugs. In the last 30 years, because so many currencies in other countries have become worth less through devaluations, the U.S. dollar has become a global currency, held for transactions and as a store of value. That is, instead of "the demand for dollars" arising out of the need to get a haircut, it may be a Russian citizen living in Moscow or St. Petersburg who prefers to hold a stack of $100 bills under his mattress even though they pay no interest. In this case, dollar "money" is not so much a "medium of exchange" as much as a "store of value," more trusted by Russians than ruble debt of their government that pays high rates of interest. These two uses of money are joined by a third and most important use of money, which classical economists believed was the most important of all, i.e., money as a "unit of account."
The first two uses of money are real uses in that money is palpable. Money as a "unit of account" is not real or palpable, but conceptual. Smith can imagine his dog is worth $100 and Jones can imagine his cats are worth $50 each. If they wish to do so, they can trade the dog for the cats without having any real money. In the course of a day, a human being reaches for his wallet or her purse only a few times, but the concept of a dollar runs through their head dozens of times each day, as they read the papers, listen to the radio, think about their finances, their needs, their wants.
Karl Marx, who was a classical economist as well as an innovative political philosopher, highlighted the importance of the unit of account in a way I could understand when I first read Capital in college. He pointed out that Europeans peasants would price goods in their marketplace in terms of ounces of gold even though no gold existed in their villages. The stability of the dollar as an accounting unit enables commerce to go forward even where the local currency has been destroyed, as in Russia over the past decade. [Four rubles would buy a dollar in the black market in 1989. Today it takes 20,000 of the equivalent rubles to exchange for a dollar.]
Now that we understand the three chief uses of government non-interest-bearing debt as "money," we can begin to see how interest rates bear very little relationship to the national debt. In his testimony before the House Ways&Means Committee last Wednesday, Federal Reserve Chairman Alan Greenspan argued that the federal budget surplus be used to reduce the national debt — and this would expand the economy by lowering interest rates. President Bill Clinton believes this and so do all members of the U.S. Congress, Republicans and Democrats, liberals and conservatives. They are all dead wrong, but because they all believe something that isn't true, the news media reflect that profound error, and it is conventional wisdom in every corner of the nation.
Why is it dead wrong? Ask yourself: Suppose the national debt of the United States were $1 trillion instead of $5.5 trillion. Would interest rates be lower? Suppose the debt were $500 million? Would interest rates be lower? If Greenspan were asked that question by a committee of Congress, he would not be able to give a straight answer. If he were not prepared for it, he would stammer and stutter and throw clouds of gobbledegook at the committee. Here is why: If the people are demanding $100 million in non-interest-bearing debt and the national debt is $1 trillion, the economy will function best if the Fed supplies exactly $100 million. If the national debt is $5 trillion, and the people need only $100 million in "money," the economy will function best if the Fed supplies exactly $100 million. If it supplies more than is being demanded, the surplus will cause the unit of account to be diminished through inflation. If it supplies less than is being demanded, the unit of account will be diminished through deflation. The size of the national debt only comes into play if it becomes so large that the marketplace questions the ability of the government to manage the debt without raising tax rates to a point that undermines the ability of the debt to be serviced.
As a perfect example, the national debt of the United States in 1940 was less than $50 billion and government bonds yielded 2%. World War II required the issuance of another $220 billion in bonds, and yet the interest rate of government bonds in the marketplace remained 2%. This example is extremely embarrassing to modern Ph.D. economists, including the Nobel Prize-winners, but they have agreed among themselves that the reason interest rates remained low was that there was an accord between the Treasury and the Fed to keep interest rates at 2%. The explanation has always struck me as being ridiculous, but it is the best the profession can do. Ask why the Treasury and the Fed could not finance the debt at 2% when interest rates on long-term government bonds climbed to 15% in 1982, the economists can only mumble that we were at war in the 1940s and people saved their wages because there was nothing to buy with the money. (What happened to their idea that inflation is caused by too much money chasing too few goods?) For a journalist to ridicule a Nobel Prize-winner for making such silly arguments would brand him/her as a fringe radical. The real reason the debt could go from $10 billion to $350 billion without a change in interest rates was that the government continued to define a dollar in terms of gold, at $35 per ounce, and increased the amount of non-interest-bearing debt just enough to meet demand, and no more.
Examples of how inflation and national debt are disconnected abound. Japan today has falling prices and negligible interest rates while its national debt continues to climb and now is twice that of the United States in per capita terms. In 1980, Mexico had almost no national debt, after years of inflating it away, but interest rates were in the 50% range and monetary inflation was everywhere in evidence. All the demand-side economists can do to explain these departures from their textbooks is talk fast, at times even suggesting that Japanese people and Mexican people behave differently than we do.
The classical, supply-side model has no such trouble explaining developments in the economy, which is why I decided to become a supply-sider. Because supply-side economists knew that the Reagan tax cuts would produce more than enough revenue to service the increased debt, for example, there was no apprehension about the tax cuts. We believed the economy would function far more efficiently with top tax rates on income closer to 25% than to 70%, which is where it had been in 1980, even though the deficit might rise in the near term, before the expanding economy would throw off more revenues. At the time the Reagan tax cuts passed in 1981, the Keynesian economists insisted they would do little good because they would not increase the deficit enough to matter, and would only enrich the rich. After the fact, the same economists blamed the high budget deficits on the tax cuts. But they could never explain why interest rates on government bonds fell during the process and why the stock market rose. This is because the demand model in which they believe does not allow this combination of events. The supply model answer is that the tax cuts were on rates so high that they were holding back production. Lowering them increased the demand for money, which made it easy for the Federal Reserve to supply fresh liquidity without supplying too much to cause an inflation.
It is critical if you are to understand what is going on in the world today that the size of the national debt has almost nothing to do with a country's currency. Brazil is now in crisis because it tried to defend its currency, the real, by raising interest rates to attract investors to buy its debt. There was so much doubt in the market that it could defend its exchange rate in this fashion that the interest rate had to be very high, in excess of 50%. To go back to the WWII example, why couldn't there have been an accord between Brazil's central bank and its finance ministry to keep interest rates at 2%? Indeed, a rate much closer to 2% than 50% could keep the real tied to the dollar by advising the market that the central bank would exchange bonds that paid interest for non-interest bearing debt. If the bank reduces the supply of liquidity that is being demanded, it automatically increases the demand for it. The market no longer worries that the currency will lose value through a policy decision to devalue and as the risk comes out of the currency the market rate of interest declines. The market is willing to hold that debt at lower interest rates.
Now let us return to the discussion about the Federal Reserve's job of deciding how much "money" the people want at any given moment. At present, the Fed never considers that question as being relevant to its function in society. When Greenspan meets every several weeks with his Federal Open Market Committee, the question about "the demand for money" never arises. They sit around and talk about how fast the economy is growing in one federal reserve district or another. They talk about the stock market. They talk about foreign currencies. They talk about the overall strength of the economy as measured by various government statistics. They talk about the money supply as measured by various definitions of money and calibrated as M-l, M-2, M-3, and so forth. But they never, ever talk about the demand for money, because they have no way of measuring it — unless they use the price of gold as the key to that information.
When the Bank of England — then a private bank — went on a gold standard in 1717, it used the sterling price of gold as its day-to-day signal of how much non-interest-bearing debt the public wished to hold. If it issued the slightest amount of money paying no interest, someone would show up at the Bank with so many pounds sterling and ask for gold. The Bank would then know it had erred slightly on the side of inflation, and would issue interest-bearing debt to take in the surplus liquidity. It was all automatic and nobody really had to think about it anymore. At the close of every business day, the Bank would either increase the amount of liquid debt or decrease it by the sale of a bond to someone who showed up and asked for gold — but would take an interest-bearing bond instead. This process proved so successful that most of the world joined in fixing their currency to gold in the same manner.
When England went to war with Napoleon at the end of the 18th century, the automatic convertibility of paper to gold was suspended briefly, but resumed after the war at the pre-war price. There it remained until World War I, when convertibility was suspended again, because of having to finance the war with more and more bonded indebtedness. The Bank returned to gold in 1925, again at the pre-war parity, and there was a mild deflation as the sterling price of gold came down, pulling commodity prices down with it, increasing unemployment and forcing a decline in wages. The point to this history is that by keeping the sterling price of gold at the same rate from 1717 to 1933, when convertibility was suspended yet again, the general price level was at the same level at the end of the 216 year period as it was at the beginning.
If the United States had resumed convertibility of the dollar to gold as the Clinton administration began in 1993, when the price was about $350 per ounce, the world economy would have developed much more differently in the years since then. The 1993 tax increase would have decreased the demand for liquidity and weakened the economy, but the gold price would not have drifted up to $385 as a result. The Fed would have had no choice but to automatically sell bonds to withdraw the surplus liquidity. The inflation that the higher gold price signaled would not have taken place and all the countries in the world that had linked their currencies to the dollar would have remained stable instead of inflating with the United States. There would have been no Mexican devaluation in 1994 and no Asian crisis in 1997-98. Brazil and Argentina would not have had to put their debtors through a wringer to maintain currency links with a floating, deflating dollar. Japan would not be in a long recession because it would not have had to deflate with the dollar. China, Hong Kong and Singapore would be thriving instead of walking a tightrope to maintain their dollar links.
Because the Federal Reserve is not on a gold standard, it is not able to use the dollar gold price as a signal to accommodate the demand for money. It is either too stingy when tax cuts spur an increase in demand for liquidity, or it is too generous in allowing surplus liquidity in the system when the demand declines, particularly in response to an unnecessary tax increase. If Greenspan should now desire to lift the gold price from $287 to $350, to relieve the commodity deflation, there is no way it can do so. Its operating mechanism will not permit it to add more liquidity than is being demanded given the current tax-rate structure. If the government suddenly increased tax rates to throw a monkey wrench into the economy, there would be a decline in the demand for liquidity and the gold price would rise. But that's hardly a good thing for the government to be doing.
The Fed is now stuck with its overnight interest-rate operating mechanism. If Greenspan were to make an impassioned speech at the next FOMC meeting on a need to end the commodity deflation, all he could do would be to ask for a lower interest rate on overnight funds that the banks use to lend to each other at the end of every business day to get their reserve requirements into balance. If Greenspan gets an agreement to lower that Fed funds rate, the Fed's open-market desk in New York is then instructed to adjust its purchases of government bonds in order to hit the lower rate. But because the lower rate changes the demand for fresh liquidity, the adjustment by the open-market desk does not cause the price of gold to budge. The fresh supply of liquidity exactly equals the new demand. The operating mechanism does not permit a purposely induced inflation to offset the inadvertent deflation. Of course, it easily could be done if the Fed changes from an interest-rate target to a gold target — and has the support of the government. In the current circumstance, this practically requires a President and the Congress to agree to fix the dollar/gold exchange rate. Opposition to doing this comes from the professional economists who prefer to manipulate interest rates and those who desire to use the money supply to regulate the national economy. If the gold price is fixed, the unit of account is unshakable, interest rates fall to an optimum level, and monetary risks to capital formation decline sharply. The big losers are those in high places who can play the markets based on information about monetary policy that leaks from the Fed hour by hour and those who believe they can gain advantage over their competitors by using inflation to reduce their debt burden.
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Here are some numbers to contemplate:
In 1970, when gold was $35, the national debt was $382 billion, of which the public held $285 billion. The difference is the amount of debt on the books of the federal government itself, chiefly for Social Security trust funds. Of the $285 billion in bonds, $74 billion does not pay interest, and of the $74 billion, $50 billion is in currency. The rest is held by banks as reserves against deposits.
In 1999, with gold at $287, the national debt is $5.5 trillion. Publicly held debt is $3.7 trillion. The amount that does not bear interest is $530 billion, of which $462 billion is currency and the remainder, $68 billion, is in bank reserves.
You can see in these numbers that since the dollar was cut loose from gold, the amount of dollars held by the public has increased dramatically as a percentage of the total, but most of that is in dollars held by foreigners. The amount of publicly-held debt has fallen as a percentage of the whole, but that is because of the giant Social Security surpluses, which are held in government trusts.