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Steve,

What happens if the Fed has no buyers for the junk assets it has purchased such as those quirky credit default swaps (assuming it purchased them)?

Also, would you care to comment on the implications going forward of the demise of traditional investment banks? More specifically, what are the risks associated with another "too big to fail" scenario in which a Bank of America, for example, gets in trouble?

To play devil's advocate - how this article explain the '95% purchasing power of the U.S. dollar since 1913'? If inflation and deflation should reasonably cancel each other then should general prices stay more or less even? Similarly what is the breakdown in the system that causes hyperinflation in other countries such that 'yes others in charge of other money supplies do increase the supply to enrich themselves at others' expense'?

Wow. Great explanation. Thanks!

Bob,

First, the Fed is trying to be very careful about the safety of the unusual portfolio of assets it started purchasing (...historically, they would only purchase shorter-term Treasuries, but that has changed). In the unexpected event that the Fed can't break even when it sells back some of those assets, they will have to use other tactics to avert inflation. One would be to sell back more Treasury securities; when it runs out of those, the Fed could maneuver with the Treasury to (in effect) transform the excess money (inflationary) into additional federal debt (not inflationary, up to a point we haven't reached yet). In fact, I believe that maneuver is already being employed to a degree: Treasury sells securities to the public, but leaves the proceeds on deposit with the Fed instead of spending it back into the public -- thereby avoiding the risk of it becoming money-in-motion.

Regarding banks going forward: in my judgment, the recent lesson has been learned well by the entities still standing. Risk *will* be assessed far more accurately and expeditiously by financial firms, and failures *will* be compartmentalized such that one falling domino can no longer bring down the system. My judgment, based on what I've been reading and hearing.

Gil,

Without going into a lengthy explanation, central banks target a low, steady rate of inflation, usually around 2%, so that they have a cushion between that and zero. "Inflation" per se is not the problem, it is *unanticipated* inflation that is the problem.

Given that, let's say a perfect central bank achieves its target of 2%, year in and year out. Result: the purchasing power of the wages paid for an hour of labor remains constant, because both wages and prices inflate at the same 2% rate.

Great piece!

Steve,

Let's say that, starting tomorrow, all of the world's coffee drinkers buy an extra cup of coffee per day for $5 from a relative. Will this increase in the level of transactions require an increase in the supply of money?

Not at all. The increased number of transactions don't consume or destroy money, but simply transfer its ownership from the buyer to the seller. The total supply of money is the same after each transaction, but is slightly differently distributed. Only if the coffee seller were to eat or destroy the $5 would the total supply of money change. If the buyers and sellers were not relatives, the only difference would be who ends up with the $5, but it will still not be destroyed.

This incorrect, but widespread, belief that increased transactions MUST be supported by an increase in the supply of money is likely the basis of many monetary fallacies.

Regards, Don



1) You are conflating falling prices with deflation. An actual deflation occurs when the money supply shrinks. This happened in the Great Depression when bank failures caused billions of dollars in fiduciary media (checking deposits) to simply vanish.

But even that sort of deflation does not have to leave us "poorer". If wages and prices are allowed to fall accordingly, everyone's net purchasing power will remain the same. The problem in the Great Depression was that first Hoover, and then Roosevelt, took steps to prevent wages from falling. Roosevelt also took steps to prevent product prices from falling. These were disastrous moves that brought unemployment to the 20% level and kept it above 15% for almost the entire decade.

Falling prices that are the result of falling demand -- not from a fall in the money supply, but because of economic conditions -- do not leave us poorer, they leave us RICHER. For instance, the fall in gasoline prices has added billions to American's disposable income (just as the previous rise in gas prices subtracted that amount).

Nor has that fall in gasoline prices set of any sort of “spiral”; nor has it caused our economy to “shrink”. Your alleged “deflationary spiral” does not exist.

2) You are confusing cause and effect when you blame our economic problems on “money at rest”. The current economic problems were not caused because people *saved too much* -- they were caused by people that *borrowed too much*. The Fed’s expansion of credit, along with the CRA, the secondary market created by the GSEs, etc, combined to create an unsustainable boom in the housing industry. Essentially, many people who would otherwise be renters were enticed into purchasing a home.

So for a period of several years, the housing industry saw a strong growth in demand for its products. This translated into strong growth in demand for all the products that go into the construction of a home: lumber, nails, sheetrock, windows, doors, appliances, HVAC systems, plumbing pipes, shingles, etc. So a whole range of businesses -- not just home builders -- experienced an increase in demand, which lead, no doubt, to increases in employment and production capacity in numerous industries supplying the housing market.

However, that increase in demand was not sustainable; there are only so many additional home buyers -- above and beyond the normal level -- that can be enticed into the market; once that pool of additional buyers is exhausted, demand must fall back to its prior level; consequently, employment in all those industries that expanded must fall back to its prior level. Hence, a recession and an increase in unemployment.

Now that we have a recession, it is normal and natural for people to increase their savings. That increase is thus an *effect* of the recession, not a cause of it.

3) You are wildly naïve if you think the Fed is going to successfully pull enough money out of the economy to avoid inflation. There is a reason why the value of the dollar has been crushed by 95% since the creation of the Fed: the Fed is nothing more than an attempt at economic central planning of the money supply. Economic central planning doesn’t work; see the history of the U.S.S.R or any other centrally planned economy.

Central planning for our money supply hasn’t worked either, as witness the relentless inflation we’ve experienced, along with one asset bubble after another (S&L crises, dot.com bubble, housing bubble), recessions, stagflation, etc. The Fed’s track record is terrible and there is no reason to think it will get any better.

Asset bubbles: we've blamed Greenspan, interest rates, China, regulations, but what if the real problem is simpler? What if it's just wealth? The world's population is getting wealthier, millions more have money to save for the future rather than just spend on survival. What do they do with it? Answer in boom times: put it where the payoff looks best, which means into whatever asset is currently performing well. Isn't that enough to create an asset bubble?

Steve --
Thanks for this. How does it relate to the "MV=PT" equation that I've heard other economists bat around? It seems to me that you're just making a special case, where "V" (the "velocity of money") is made up of some money moving at its normal speed, and some money not moving at all, leading to a lower average "V". If so, two comments:

1. If the money is at rest, where is it? A lot of press would make it seem like it's money that the Fed has given/lent to banks, but is just sitting in their vaults, since they are unwilling to lend it out. Is this correct?

2. One problem with the MV=PT equation is that the graph is asymptotic -- if V slows down a little (from 1 to, say, .9), it can be offset by a slight increase in M (by ~0.1, from 1 to 1.1). But, if V slows down again (from .9 to .8), you need a bigger increase in M to offset it (now, by ~0.15, from 1.1 to 1.25) and so on. The Fed need increasing amounts of money in order to offset small changes in the performance of the economy.

Here's my concern: if that money is "at rest" in a small number of banks, then those banks, collectively, are capable of putting it back into motion very quickly.*** And, that means that the Fed will have to pull a HUGE amount of money out of the economy in fairly short order to prevent massive inflation.

***As we've seen recently, "herd mentality" among banks is very common.

I don't think the gold standard folks have a better idea, I just think that maybe the right answer is to avoid printing so much that it can't be drawn back in quickly. Sure, that would be painful, but the alternative is worse.

"The increased number of transactions don't consume or destroy money, but simply transfer its ownership from the buyer to the seller. The total supply of money is the same after each transaction, but is slightly differently distributed."

The quantity of transactions certainly does affect the quantity of the money supply. If transactions slow the money supply can decrease, indeed plunge, due to the fall, indeed *collapse*, of the money multiplier.

For a picture of the recent collapse, see the first chart here:

http://www.scrivener.net/2008/12/mvpq-in-pictures.html

"Steve -- Thanks for this. How does it relate to the "MV=PT""

To see how it has in the last year, see all three charts at the link above.

"Here's my concern: if that money is "at rest" in a small number of banks, then those banks, collectively, are capable of putting it back into motion very quickly.*** And, that means that the Fed will have to pull a HUGE amount of money out of the economy in fairly short order to prevent massive inflation."

True enough, and a real concern. But as changes in the money supply typically take a year or 18 months to feed into inflation, the Fed thinks it will have ample time to pull back on the money supply should the multiplier recover and the money supply start shooting up.

Anyhow, it's a problem the Fed would love to have -- it would mean Depression II averted, with the Fed back on the familiar ground of taming inflation, which it knows how to do. It is deflationary deleveraging potentially causing systemic widespread financial-system failures, as in Depression I, that it has no experience handling, and which is giving it nightmares. The Fed is saying: "Inflation, please!"

Hi, Steve,

I do like what I read on and about your blog! And I LOVE your graphics about economics!

But it seems that you don't distinguish between Cash and Credit. It doesn't seem to matter to you whether money is interest-free as printed note or minted coin (interest-free from governments) or interest-bearing credit from banks.

I.e. there is a difference between governments 'printing money' and central banks doing the same. In Weimar it was the Government!

Anyway, I'm a mathematician and system analyst who used to diagnose software at CERN where the web was born. I'm German and thus thorough and half Slavic and thus rather passionate.

So I thought I'd let you know some of the results of my conclusion.

With best wishes for more power to your blogging elbows,
Sabine
http://moneyasdebt.wordpress.com


Jim,

"The quantity of transactions certainly does affect the quantity of the money supply. If transactions slow the money supply can decrease, indeed plunge, due to the fall, indeed *collapse*, of the money multiplier."

This argument has no obvious logical connection to the problem at hand.

Starting at the beginning, Steve claims that an increase in the level of transactions must be supported by an increase in the supply of money. This can be falsified if you can find or imagine a case where the level of transactions has increased while the supply of money has not increased. My coffee example is just such a falsification for at least a cash economy. But since a cash economy is a proper subset of a fractional reserve credit economy, Steve's claim is also falsified for a fractional reserve credit economy as well.

Regards, Don


"Jim ...[Your] argument has no obvious logical connection to the problem at hand.

"Starting at the beginning, Steve claims that an increase in the level of transactions must be supported by an increase in the supply of money. This can be falsified if you can find or imagine a case where the level of transactions has increased while the supply of money has not increased. My coffee example is just such a falsification..."
~~

Don: As far as I am concerned the problem at hand is making the right policy decisions in today's real-world financial crisis, not trying to imagine if in theory in some other situation A could exist with B.

The problem at hand in the real world today -- just as in the 1930s -- is that the demand for money has surged, causing the money multiplier to collapse (first chart at the link I provided) ... which by itself causes a collapse in the higher measures of money (M2, etc.) relative to base money ... which if uncountered would cause a collapse in transactions, the economy, which indeed it did in the 1930s.

To prevent such a collapse in transactions and maintain the level of economic activity in the face of such an event it is necessary to increase the level of money from what it would be without intervention -- by exploding the monetary base by an amount sufficient to offset the collapse in the multiplier (second chart at the link), and thus keeping M2, etc., from falling as they otherwise would have.

So in the real world today it *is* necessary to support a given level of transactions by increasing the money suppply. Steve is right.

I mean, c'mon: Look at those two charts -- if the collapse in the first one hadn't been countered by the increase in the monetary base shown in the second one, what do you imagine would be happening to the "the level of transactions" today? Pretty much what happened in 1931 and 1932.

The key here is that "supply and demand" applies to determine the price of money (in terms of goods and services) just as it does to determine the price of everything else (in terms of money).

A conceptual mistake made by many -- especially fans of a gold standard -- is that while they are aware of the effect of the "supply" side of money (too much money supply causes inflation; a gold standard that restricts money growth and so prevents inflation) they neglect the "demand" side effects of money (with money supply *fixed*, decrease in demand for money raises prices, increase in demand for it causes deflation, like the in 1930s).

Can transactions increase without any increase in the money supply? Sure -- that's the world in which demand for money decreases. People desire to hold less of it so they spend it faster.

Your coffee example has the fault of considering only one good (it doesn't indicate what happens to the total money supply any more than the price of coffee shows what has happens to inflation) but that's OK -- expand it to include all the goods and services in the economy.

It then reflects what happens assuming one specific change in the demand for money -- demand for money falls, so people use it quicker, velocity rises, giving more transactions per dollar per year. But it neglects what happens when demand for money goes the other way and rises -- the opposite.

We're in that opposite world today.

Don-
You seem to be missing an important aspect of Steve's argument.

He didn't say that an "increase in the level of transactions must be supported by an increase in the supply of money". He said that an increase in the level of transactions must be supported by an increase in the supply of money IN MOTION.

If I buy a $5 cup of coffee from a relative and they take 2 of those dollar bills and stuff them under the mattress because they don't want to spend them, they don't have enough to buy a $5 cup of coffee from their relatives unless they increase their supply of money in motion by taking $2 from somewhere else.

And we aren't exactly hoping to keep exchanging the same amount of goods and services without any growth. If I want to start buying 2 cups of coffee instead of 1, I'll need another $5 to buy it, and that will give my relative an extra $5 to spend as they wish.

Michael Smith:

We disagree on several key points; I hardly know where to begin.

"If wages and prices are allowed to fall accordingly, everyone's net purchasing power will remain the same."

The problem here is the difference between the normative economy you describe (how you say it *should* work) versus the positive one we live in (the way it works *in reality*). Income earners in your normative world must willingly accept falling wages and salaries. In our real world, they don't, and won't, do that. Therefore, because wages per full-time-equivalent employee won't fall as you say they should, wage reductions must be accomplished by a reduction in the number of full-time-equivalent employees (i.e., in an increase in unemployment). In our real world, unacceptably high unemployment causes the populace to vote in more socialistic governments — or, in the extreme, to install totalitarians — thereby moving the entire system even further away from your normative ideal.

"Your alleged 'deflationary spiral' does not exist."
Not in your normative world, anyway. But it is undeniably at play in the real world.

"The current economic problems were not caused because people *saved too much* -- they were caused by people that *borrowed too much*."

I never said people saved too much. I advocate saving, but saving that's deposited in reliable financial institutions, not in mattresses. Banks are merely brokers who connect savers with borrowers. Borrowing (usually) means investing. Saving by some is a necessary condition for investing by others, but not a sufficient condition. If many are willing to save, but others are unwilling to invest, the bank becomes more of a mattress than a brokerage house connecting savers to investors.

"Central planning for our money supply hasn’t worked..."

Compared with what? Surely you don't prefer the boom/bust cycles of the period during which we had no central bank(?). Nobody is saying the central bank is perfect, but as Hamilton said: "If the abuses of a beneficial thing are to determine its condemnation, there is scarcely a source of public prosperity which will not be speedily closed."

Don,

Let's say I drink $5 of coffee a day, and I work in a coffee shop 30 minutes a day at minimum wage to earn that $5. The coffee shop pays me once a month; my paycheck is $150 ($5 x 30 days), and with the economy humming, I'm willing to spend all $150 on coffee, $5 at a time.

But then the headlines tell me the economy is slowing, and I get more cautious, thereby deciding to save $50 of my $150. Because banks are failing, I stuff that $50 into a mattress, and I cut back my coffee consumption by 1/3. Those dollars-at-rest, created by my heightened liquidity preference, reduce the coffee shop's production and sales. The minimum wage law prevents the manager from cutting my wage rate, so she cuts my hours. Fixed costs at the coffee shop also prevent prices from declining at the same rate my pay is declining. I earn less per month, and buy less coffee. It becomes a recursive spiral that (1) puts me out of work at the coffee shop, and (2) sooner or later reduces the shop's variable profits to a point less than its fixed costs, at which time the shop folds.

The first domino in that deflationary spiral was my shift towards a higher preference for liquidity.

Sabine,

Thank you for your comment. You are correct about the difference between cash and credit.

Currency is non-interest-bearing, and so are (correction, *were*) bank reserves deposited at the Fed. Currency + reserves equal base money, which is created and destroyed by the Fed, as the Fed deems necessary in the fractional reserve system. ("Reserves" of fiat money are analogous to "reserves" of gold the banks were required to hold under that fractional reserve system -- the difference being that gold reserves were more difficult to increase/decrease to prevent deflation/inflation in response to swings in economic activity.)

Bank (credit) money is created by banks making loans, and earns interest for the banks -- unless the borrower defaults, in which case the loan doesn't even earn its principal back, let alone any interest.

Alexander Hamilton knew that politicians elected by the people could not be trusted with the power to print money; that's why he advocated a central bank separated from the politicians. Back then, the "reserves" were gold and silver, but the central bank's control of money-creation rules was the same basic idea.

Very enlightening Steve. I love the graphics.

"The current economic problems were not caused because people *saved too much* -- they were caused by people that *borrowed too much*." - Michael Smith

The doom and gloom of anti-Fedders like Michael Smith is getting rather annoying. They actually believe that there is a difference between money at rest and too much borrowing. I hope you address Michael's types of arguments, either in a future blog post or right here in this comment thread (though I hope it's in a future blog post). I don't think people like Mr. Smith realize that debt to one person is savings to another. Their arguments amount to what you mentioned in another blog post, single entry accounting in disguise.

"Economic central planning doesn’t work; see the history of the U.S.S.R or any other centrally planned economy." - Michael Smith

McCarthyism-lite that anti-Fedders throw (I wonder how these people justify the existence of the Federal government at all.)

Optimist123,

I am largely in agreement with your reply concerning your work in the coffee shop. My only reservation is, that for the economy as a whole, the effects of individuals in marginal jobs choosing to cut back spending are likely far smaller than the effects of medium and large firms having to layoff 15% of their workforce to reduce variable capacity to match unit demand.

The demand for money is always a demand to hold. It's not money which ultimately allows purchases but the ability to acquire money, whether as job earnings or investment income or asset sale or counterfeiting, with the new money either printed in your basement or supplied by the FED.

Money coordinates income and purchases over time and place, allowing the two to be unlinked.

The key point about money is that a dollar that I own cannot be owned by anyone else at the same time. The total money supply is the sum of the amounts held by all individuals and other entities, and which is also the demand for money if the demand is allowed to be satisfied.

It is unbelievable how sensitive the demand for money is to what seem like small changes. In your coffee shop example, you stress the money supply to the extent of your average $75 holding, starting at $150 and working down o $0 over a month. Your average holding would be reduced by the same factor as your payday interval. If you were paid weekly instead of monthly, you average money holding would fall by a factor of four to about $19.

Simarly, the relative timing of a $1000 monthly rent payment with respect to paydate can make the average money holding vary by up to 30:1, depending on by how many days come between pay and rent payment.

Regards, Don

"I don't think people like Mr. Smith realize that debt to one person is savings to another."

Indeed, but the savings in this case was being done to a large extent outside of the US.

But the problem was not too much borrowing, as Michael says, since on paper, borrowing money to buy an asset that is appreciating faster than your interest rate is a smart thing. The problem was no understanding or leadership in real estate investment risk management.

But then I'd sooner expect a large, well-lit billboard just outside Las Vegas city limits reading: "YOU WILL LOSE MOST OF YOUR MONEY HERE EVENTUALLY."

"I wonder how these people justify the existence of the Federal government at all"

Most of the anti-Fedders are advocates of the Austrian school of economics...and they, by nature, want the Federal Reserve and, basically, the "State" out of everything.

This is precisely why I find this blog and, this discussion in particular, so fascinating and informative...I get to read posts from both the Keynesian and Austrian point of view.


Steve, Monday's Lex column in the FT titled "Money surprise" claims that the US monetary base, M0, doubled in '08. "As the Fed has shovelled money to the banks, excess reserves at the central bank has surged. Curiously, currency has fallen from 90% of M0 to about half. Banks' fright has meant that they are taking handounts and merely redepositing them at the FRB for safe-keeping rather than lending to the public.....Still, the fact that M0 exceeded M1 in December is unusual and may reflect this bottleneck.....The pace of growth of M1 hit double digits in November for the first time since the early 1990s. Broad money growth, meanwhile, remains stable. It's acceleration could be one sign that the Fed's easing is taking effect. It will also be the cue for inflation...."
Seems to me this confirms your views.

@Optimist123
[b]The first domino in that deflationary spiral was my shift towards a higher preference for liquidity.[/b]

The domino could not work if, before all, there was no minimum wage. If the prices go down, then the wages can go down so there is a positive profit level for the employer. Then people could keep their jobs because would be profitable to hire them again and they could continue to be profitable.

The point of "minimum wages" are wrong because wages are not "independent variables" (like they were called in Italy in the '70). Private wages can and must fluctuate inside a limited zone where they could work like independent variables, but as soon as the wages go out of the proper fluctuation zone, two things will happen:
1) Wages too low - employees will stop working and will look for another job
2) Wages too high - employers will stop hiring and will look for a different ways to make money and not lose it.

Money is a commodity that is more valued as a mean of exchange than for direct consumption. A good property of a commodity to be used as "money" is durability.
Printing money and inflation reduce the "durability" property.
More you keep it, more you lose.

The problem of "hoarders" is fallacious, because:

1) People need to consume in order to survive and live. So they can not hoard all they earn.

2) People hoarding, for the law of diminishing return, will value the last saved unit of money less as the quantity of money hoarded grow.

3) As soon as the hoarder drain the money from the market, the value of the money in the hands of other actors will raise so they will have incentives to use it and not hold it

Point 2 and 3 show that the incentive to hoard money will reduce for the hoarder and will grow for the not hoarder. And the incentive to use the money hold will grow for the hoarder more than for the not hoarder.

The only exceptions for this will be psychiatric cases that hoard compulsively. But they are exceptions.

Point 4 is this:_
if there is not enough "money" to support the exchanges (not enough gold, for example), the market will start to use something other as money (silver for example) or copper.

I remember, when I was younger, that public phones tokens ("gettoni" http://en.wikipedia.org/wiki/Gettone ) were informally used as money like the legal tender.

So, there is and never will be an absolute scarcity of money, as soon as the volume will be not enough to support the exchanges of other goods, the market will start to adopt another "money" in substitution or parallel with the first one.

painlord2k:

"The point of "minimum wages" are wrong because wages are not "independent variables""

Depends on what you think is the point. You are missing an alternative between work and not work -- retrain, or school. That's what people do for the first 20 years of their life anyway. If one of society's goals is to have a highly educated workforce, the minimum wage does its job by preventing people from working in absolutely awful jobs that cannot support a decent lifestyle. You may not agree with this, but all first world nations have a minimum wage so the burden of proof is on you.

"So, there is and never will be an absolute scarcity of money, as soon as the volume will be not enough to support the exchanges of other goods, the market will start to adopt another "money" in substitution or parallel with the first one."

You are looking at it one way. The other way to look at it that makes less assumptions is that the money in motion assumes more value. This is the way that Steve explains it and if you want an additional assumption (using phone tokens of all things) the burden of proof is on you.

Thank you, Steve, for your clarification!

True, currency is non-interest-bearing. But how do you describe the effect of it being traded?

I just feel that money has TOTALLY lost its purpose of a 'medium of exchange' and it is losing value as it is being used to fight over 'real resources'.

But I shall not get too pessimistic on your blog! :)

Sabine
http://forumforstablecurrencies.org.uk

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