What is money, how does it relate to wealth, what causes inflation and how does the Fed try to control it and stimulate investment?
Money is a medium of exchange and a store of wealth. Suppose you have horses and I have sheep.
- If our animals have offspring every year, our wealth will grow.
- There will be no change in total wealth if we trade our horses and sheep
- But there is additional wealth if I trade you a sheep for an IOU because I still have the equivalent of the sheep and you have the sheep itself.
Your IOU promising to return the full value of a sheep is money, a medium of exchange and a store of value but a limited medium of exchange because I may be unable to exchange it with anyone else. That’s why we have currencies, they’re safer to trust than an IOU from someone you don’t know. Your IOU may or may not be a perfect store of wealth. Right now, I expect you will return me the full value of a sheep but maybe you’ll have a problem and I’ll begin to have doubts.
It’s the same with dollars, people must stay confident they will hold their value. It is the Fed’s job is to maintain that confidence in the dollar as a store of wealth. That is a challenge at this time because Treasury’s borrowing is high and growing fast. Will the US ever be able to repay that debt?
A terminally over-indebted nation controlling its own currency has two options. It can refuse to pay, or repay with currency of less value. Lenders demand higher interest when they suspect either possibility. They may not get all their money back and/or it may not have as much value.
Despite our high and growing debt, the US is not currently expected to default in that way but there is concern the Fed’s very large expansion of the money supply could trigger high inflation. If concern turns into worry, lenders will require higher interest rates for longer term loans. What can the Fed do to avert such worries?
Recall that the Fed kept interest rates and bank reserve requirements low to stimulate economic growth via increased lending and when the economy stalled, they directed extraordinarily large amounts of new money to commercial banks hoping to stimulate more lending. But as the following chart shows, shortage of cash was not what stopped investment. Business leaders did not invest in new production facilities because they did not expect demand to increase any time soon. Consumers were too indebted to borrow more and/or were risk averse on new borrowing. Consequently, much of the Fed’s newly created money stayed at the banks.
Fear of inflation was growing because the greatly expanded money supply had not been matched by corresponding economic growth, so last September the Fed announced a Maturity Extension Program “to sell $400 billion of shorter-term Treasury securities … and use the proceeds to buy longer-term Treasury securities” “By reducing the supply of longer-term Treasury securities in the market” they explained, “this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities.”
The following charts show the results. Because Treasury issued a small amount of long duration relative to short term securities, the Fed needed to buy only a relatively small amount to set their price (interest rate). The crisis in Europe helped by making the dollar feel safer than the Euro. The Fed hopes this will work until the economy gains enough strength and spending is balanced with revenue.
But could the Fed try too hard to manage longer term inflation expectations and trigger hyperinflation? Inflation is an increase in the money supply without a corresponding increase in real output that leads to an increase in general price levels. Hyperinflation is when a money supply increases so fast that people trade it immediately for what they hope will retain value and their currency loses value extremely fast relative to other currencies. The following charts suggest no large economy is approaching hyperinflation because while central banks everywhere are greatly expanding their money supply, they are all doing it at around the same rate. The first chart shows what we typically think of as money, banknotes in circulation in the USA, Japan, the Eurozone, China and , all other nations.
The next chart shows all forms of money. M0 is base money issued by central banks. M1 is currency plus demand deposits, e.g., checking accounts, M2 adds in savings accounts and time deposits under $100K, M3 includes larger time deposits and institutional accounts. M1 is the most liquid form of money, M3 the least liquid.
The charts suggest central banks around the world are coordinating the expansion of money supplies well enough so no government can inflate away its debts to overseas investors. On the other hand, because all developed economies are highly indebted and none has a demonstrably effective program to stop borrowing yet more, perhaps we’re heading for a global economic collapse.
The Fed is hoping that by keeping interest rates very low and inflation expectations a little higher, they can push our large amount of idle cash into investments with higher potential return to stimulate creation of accelerating intrinsic value.