In case you haven't heard, the Federal Reserve has been flooding the banking system with additional reserves (i.e., "printing money") in recent months. Take a look at the 12-month change in the Fed's balance sheet (3rd column on this page): a $1.35 trillion increase in reserves—more than a doubling—in 2008. That's the amount of money the Fed created "out of thin air" to purchase assets from the private sector.
Here's a diagram showing how the Fed creates new money:
That "thin air" thing infuriates some people, such as Ron Paul and his supporters. To them, "fiat money" is the dirtiest word of all, and "printing money" is the economic equivalent of skewering our grandkids and roasting them over red-hot charcoal. I personally wish Ron Paul would stick to the real goods and services side of the economy and stay away from monetary economics, because printing truckloads of new money in this economic environment is exactly what we need to be doing. For several months, I have been shuddering at the mental image of our economy plummeting into oblivion under Ron Paul's preferred gold standard, the economic equivalent of the iron maiden torture device pictured at this link.
Why is there such a disconnect about what the Fed is doing? Why do most economists agree that pumping large quantities of new money into the economy is just what we need these days, while a small contingent of Ron Paul supporters protests loudly that it's absolutely the wrong thing to do? Well, a good place to start would be a diagram of what typically happens to new money when it's injected into our economy.
Money in motion
Under normal conditions, most of the new money enters the transaction stream, where it's used as a "medium of exchange" by the public for consuming and investing in real goods and services.
Money at rest
However, not all of the new money becomes transaction money; some of it is used as a "store of value"—and takes several forms, such as currency sitting in safe deposit boxes or stuffed in mattresses, money sitting dormant in bank deposit accounts, or currency circulating overseas (in areas where it's perceived as safer to hold than the local currency).
If there's just enough money-in-motion to satisfy the economy's production of real goods and services, there is no price or wage inflation. A corollary: If the production of real goods and services grows, the money supply must grow at the same rate (or slightly more) to achieve price/wage stability.
To illustrate, here are two diagrams. The first is a balancing scale showing the stable price/wage condition achieved when money-in-motion matches the production of real goods and services. The second shows the inflation condition driven by the imbalance of too much money for the real goods and services.
It's easy to assume that the typically-running economy is all we ever have to worry about; and once we make that comfortable, naive assumption, we can spend the rest of our lives arguing our own pet opinions on what causes and what prevents unanticipated inflation. But the typically-running economy is not the only one we ever have to worry about. The dysfunctional economy is one we have to face every now and then, and guess what: the head-in-sand approach is not the way to handle it.
Specifically, there are conditions that can throw the scale out of balance in the other direction, with consequences arguably more severe than inflation. An economy can become dysfunctional in several ways; ours became dysfunctional because of a sudden shift in the public's preference towards money as a "store of value" instead of a "medium of exchange." [By the way, I've never heard Ron Paul address this condition.] Here's a diagram depicting the dramatic shrinkage of money-in-motion, due to the public's sudden preference for liquidity (money at rest). It also depicts why the flood of new money is not causing inflation; the Fed's attempt to stimulate money-in-motion has been largely diverted into mattresses and balance sheet "cash" accounts. The public hasn't been spending, borrowing, lending, and investing; it would rather avoid those risks by sitting tight on its most liquid asset—and that is what the textbooks call a "liquidity trap."
What happens when money-in-motion shrinks rapidly? It throws the scale out of balance in the other direction, towards deflation. Insufficient money-in-motion fails to support the production of real goods and services, as depicted below.
The result is price/wage deflation pressure, and it causes the real economy to shrink in compensation. If the money-in-motion side keeps shrinking (for whatever reason), the real economy keeps shrinking, too. That's called a deflationary spiral, and it is NOT pretty. At best, it means high unemployment and misery; at worst, it leads to the overthrow of governments. In any case, it eventually bottoms out at a much smaller level of economic activity.
Oh, I suppose the Ron Paul crowd would be popping champagne corks at each other, celebrating the fact that "inflation" had been defeated. Nonetheless, when the deflationary spiral finally hit bottom, we'd all be a lot poorer. And, sadly, so would our grandkids' generation: we would bequeath to them a shrunken, stagnant economy—if we chose today to ignore the dangers of deflation. That's what the Fed is currently fighting against, and that's why all that "money from thin air" has not even come close to generating wage/price inflation.
Can the Fed pull it off?
Let's say the Fed succeeds in challenge number one, preventing a deflationary spiral. In that scenario, the public gains its confidence back, and the huge stock of "money at rest" starts to tranform into "money in motion." Well, at that point we'd better leave the champagne sitting on ice for a while, because we wouldn't be finished yet—not by a longshot. The Fed would be facing challenge number two: recapturing enough money (making it disappear into "thin air") at a pace sufficient to prevent subsequent high inflation. Why? Because there is no way the real economy could grow fast enough, all of a sudden, in order to balance the vast quantity of money-at-rest if most of it were to become money-in-motion. The Fed would have to throw its Open Market Operations into reverse, and sell back a substantial portion of the assets it bought, in order to keep the scale in balance.
As the diagram below depicts, that is the process of making fiat money disappear into "thin air"—a scenario that presumably sends the Ron Paul crowd into blissful ecstasy.
I'm not sure the Fed will get its timing just right, on either of the two challenges. It might not blunt the deflationary pressures as effectively as it could, and it might not blunt the subsequent inflationary pressures with perfect timing.
But one thing is for sure: I thank my lucky stars that the Fed is there for us, wielding its weapons as effectively as it knows how. The alternative of a gold standard Iron Maiden would be Great Depression II, if not a total collapse. I'm glad we are dependent on our own Federal Reserve, and not on Russian and South African gold mine owners, to manage our money supply ups and downs on short notice. Aren't you?
If you'll excuse me now, the night sky is clear. I think I'll go out and thank my lucky stars one more time.
The total money supply is equal to base money created "out of thin air" by the Fed, plus bank money created "out of thin air" whenever any bank makes a loan. It sounds complex, and it is — but it boils down to this: the Fed and banks create fiat money. The supply of fiat money is able to expand and contract with more flexibility than the supply of gold coins would be able to (under a gold standard). The Fed's job is to expand and contract the base money supply to support its target interest rate, which in turn is set periodically to control inflation and deflation, i.e., to achieve the goal of a steady, predictable aggregate price level.