Economic Thoughts

Synopsis of this article: Despite what almost everyone thinks, we do not really have a paper money system in the United States. This fact has implications for our economic future. I don’t think we will have any inflation in the short to middle term future. Part of the reason I am writing this article is that my thinking has changed over the last two years. I used to be pretty sure we would eventually have inflation and maybe even hyperinflation. I don’t think so any more. It is possible that we still might, but the government would first have to act in a totally different manner than what they do now in order to make that happen.

Economists of all persuasions talk as if the U.S. has a paper money system. Federal Reserve Chairman Ben Bernanke said “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” [Speech at the National Economist’s Club, Washington, D.C., November 21, 2002] Economists who wish the U.S. had maintained the gold standard bemoan our paper currency, and think tanks like STRATFOR discuss the consequences of the U.S. “printing money.” The context of the discussion of paper money usually involves the idea that if we print too much money we will trigger inflation.

The problem is that we really don’t do this any more. In the past, say in the Civil War, the Union was short on money and began printing “greenbacks”, a paper dollar in addition to the use of gold and silver coins. Greenbacks were printed at the Treasury and paid directly into the hands of Union soldiers. This caused an increase in the money supply and inflation, even though the greenbacks were nominally tied to the value of gold. At the same time, the Confederate States lacked a gold supply and printed even more money, leading to much worse inflation. This really was a paper money system, and money really was created by use of a printing press. The Weimar Republic in Germany did the same thing. Many similar examples have occurred in U.S. and international history. But this is in the past; it doesn’t work like this any more (except for a few out of the way exceptions, like Zimbabwe). People talk about Ben Bernanke tossing money out of a helicopter, but he doesn’t do this. If he did it would be inflationary, but he doesn’t and so the analogy is flawed.

We might get a clue that our money is not paper-based by our own experience. In our recent family vacation to Florida, we spent about $2000 on plane fare, hotel, rental car, food and various fees, yet the amount of greenbacks we used was less than $10. All our other expenses were handled electronically. Furthermore, the money used was never really paper. It came out of a bank account, and I did not put green paper in the bank account. That was done electronically too. The total money supply in the U.S. is now more than ten times the total of all the green paper dollars that exist. The money supply isn’t really paper any more, it is electronic. The paper is just used as a temporary substitute to handle local transactions, especially in places where they can’t takes checks or don’t have card readers (like the coke machine).

Still, what we use for transactions (paper or electronic) is not as important to the economy as how money is created and destroyed. It is not done with a printing press -dollars from the printing press are just exchanged at a bank for electronic dollars to use as convenient small change. Money today is created by fractional reserve lending. See the article at http://en.wikipedia.org/wiki/Money_creation for a description if not familiar with the concept. The short version is that the Fed loans money out to banks which in turn loan out even more than they borrowed from the Fed, “creating” money. Since all economists know this, it is a bit strange that they still talk in terms of “printing money.”

Fractional reserve lending in most times has the power to significantly increase the money supply and lead to inflation. Can you imagine if interest rates in the 1980’s dropped to 1%? Everyone in the country would have borrowed money like crazy for all kinds of ventures, purchases, businesses, investments, etc.

However, I believe when debt beast gets too scary, fractional reserve lending and quantitative easing will not succeed in increasing the money supply, because commercial bank loans will just not be made. For example, when a middle class guy is a million dollars in debt and can’t make his payments, he is not going to borrow more money even if interest rates are less than 1%, because he knows he can’t afford it. Even if the guy thinks he can afford it, no commercial bank will lend to him at any interest rate because the bank knows he will not pay them back. Now it’s hard to pinpoint the exact level in an economy where this happens, but I think we are already there. The whole economy isn’t there of course; a bank can borrow at 1% and loan to IBM or AT&T for one year at 5% and still make a profit, but for most of the economy, it is no longer possible to expand the money supply with fractional lending.

Last March the Fed began a major operation of “Quantitative Easing,” in which they bought long term government bonds and also mortgage instruments, probably causing a reduction in long term interest and mortgage rates. They have now stopped after buying a little over a trillion dollars of such debt. However, this is still just an additional form of lending – just of a type the Fed had not done before. Therefore, for reasons mentioned in the previous paragraph I don’t think it will increase the money supply either. The guy in California who owes $600,000 on a house that he is trying to sell for $400,000 is not going to borrow money to buy a new home for $700,000 regardless of how low the Fed caused the mortgage interest rates to go.

Finally, the fact that the government is running a huge deficit is no longer inflationary either. The Treasury is not creating money. They are just spending money that is either (1) collected in taxes, or (2) Borrowed when they sell treasury bills or bonds. Eventually, the market will doubt our ability to pay it back, and our interest rates will go up, like what has happened in Greece. But that will not be inflationary either.

The bottom line is that since we don’t really have a paper money system, we are not in our current environment going to have significant inflation. We might even have deflation until the level of total debt in our country comes down to a much lower level.