“Printing money” and the mass hysteria that comes with it

Let’s put ourselves, for a second, in the shoes of a person who has neither the interest nor the time required to understand the workings of modern monetary systems. Their fears are being fueled continuously by hyperinflationistas who keep yapping in the media about “printing money”, “debt monetization , “helicopter drops”, “zimbabwe”, etc. They’re understandably frightened by all the ruckus.

I think that for many, the root misconception is that fiat money is backed by little more than faith. For instance, the resident economist at about.com writes:

If we print more money, prices will rise such that we’re no better off than we were before. To see why [..] Let’s suppose the United States decides to increase the money supply by mailing every man, woman, and child an envelope full of money. What would people do with that money?

These people get comforted in their erroneous understanding when the media blasts quotes of Ben Bernanke, the very person they regard as the guardian of their currency, boasting that he can always prop up inflation by ordering helicopter drops of freshly printed cash.

“Helicopter Ben”, who probably understands the monetary system better than anyone, is quoted out of context by journalists who are well aware that, other than sex, nothing sells quite like fear. Under today’s institutional arrangements, a helicopter drop would be a fiscal operation that needs to be carried out by congress and financed by bonds, not by the central bank. (Of course, the central bank can help by purchasing the bonds, and there starts my grief with quantitative easing. But more on that in a minute).

In reality, money is backed by the assets owned by the central bank and by its willingness to sell them (effectively redeeming the money supply) if money’s value were to dip below a pre-announced threshold (inflation target). Further, if the value of the assets held by the central bank was insufficient to cover all the money redemptions, the fiscal government would top up the Fed with funds sourced through taxation or borrowing. (Yet another source of grief against risky asset purchases).

The inflation targeting regime further fuels the fear of the public because the central bank is effectively saying it wants more inflation, which the public perceives as bad. This is a marketing problem that was pointed out by Scott Sumner and is one more argument for “re-targeting the Fed” from inflation to nominal income.

Ultimately, the mass hysteria is a political affair, with the loudest whiners populating the ranks of the tea party. Markets seem to completely discount the issue, with implied future inflation trading at very low levels.

That being said, I think there is some room for improvement in the way the U.S. monetary system is run. Namely:

  1. Does the Federal Reserve really need to be purchasing risky assets to create reserves? QE is debt monetization (and I’m not quite sure why David Beckworth is saying otherwise). Arguing that a fiscal crisis might occur, or that the value of the risky assets might have declined by the time the Fed decides to “exit” QE is beyond the scope of this post. I think most will agree that there is some chance it might happen. Is it worth striking a blow to the monetary system when it does?
  2. Is it necessary for the Federal Reserve to bloat its balance sheet in order to “ease”? i.e. do we really need to change the amount of money we print in order to achieve our monetary goals.
  3. Further, do we need banks with government guaranteed deposits to purchase risky assets? Capital requirements are almost always distortive and can never really protect the taxpayer.

I believe we do not need any of that. In this theory section, I argue that:

  1. The Federal Reserve should stick to overnight loans collateralized by government bonds (which are as risk-free as it gets and have historically been the instrument of choice for open-market operation). Rates should be lowered in the negative range if needed to achieve the target.
  2. The amount of liquidity needed to carry out transactions shouldn’t vary all that much depending on the economic environment. The Fed can control the volume of the money supply by varying the spread between the interest it lends money at and the interest it pays on reserves, without affecting the price-level.
  3. The reserve ratio should be raised to 100%. Capital requirements and bank regulations would become irrelevant and the taxpayer would no longer be bearing the risk of a bank blowing up. The lending and investment activity currently carried out by banks can move to privately funded institutions or asset managers.

From a marketing standpoint, this means we are no longer “printing money”: the amount of money remains more or less stable as a fraction of GDP. We are no longer “monetizing debt”. And the “evil bankers” are no longer “gambling” with the taxpayer’s money.

On the flip side, even some smart people can’t seem to wrap their heads around negative nominal rates (they generally misconstrue it as a tax). Still, given that the demographic evolution of western societies keeps pushing the real equilibrium rates lower, this is a hurdle that we need to get over, or we’ll all end up in the same boat as Japan.

6 thoughts on ““Printing money” and the mass hysteria that comes with it

  1. Max

    I agree with everything except “…Capital requirements and bank regulations would become irrelevant.” Taxpayer risk is one thing, risk to the economy is another. Highly leveraged finance is like pollution, it affects everyone.

    Reply
    1. DOB Post author

      Very good point, and one I’ve also been thinking about. Let’s go over what happens when a financial institution blows up in a full reserve system with fixed velocity, negative rates, and NGDP targeting.

      The taxpayers and depositors would be safe as you said, so no intervention is required there. We would not experience massive unemployment as rates would drop however much they need to to sustain NGDP. However, it is possible that real growth would be affected by the disturbance in economic activity, and therefore be replaced by inflation to get to right level of NGDP.

      So everyone still has a job, they earn the same as before (in nominal term), but their standard of living has gone down because of the lower growth/higher inflation. This is already much, much better than where we are today in all the advanced economies.

      Can we do better by further regulating certain companies (who no longer enjoy an guarantees or special relationship with the government) to prevent them from blowing themselves up?

      I personally have a hard time getting there, as capital requirements and any other regulation a government can write is to be highly distortive at best, and most likely will not work. Today’s capital requirements practically caused the housing bubble. The loss of freedom that comes with these regulations also would really annoy the libertarian in me. (If you ever need to find the libertarian in you, I strongly recommend watching the Milton Friedman series called PBS Free to Choose on youtube :-))

      Since the government is no longer taking the downside, the private sector owning both the downside and the upside is already a big motivation for not blowing oneself up. The creditors, equity holders, and management should be wrestling one another to achieve an outcome that satisfies everyone’s risk tolerance. That includes protecting one’s institution against another blowing up (counterparty risk).

      I think the most useful thing we can do is to replace the lengthy and uncertain bankruptcy process which isn’t appropriate for today’s large financial institution by a speedy and streamlined one, as described in the second-to-last proposal. This way, when someone does blow up, by the next morning the institution is freshly capitalized by converting debt into equity.

      Reply
  2. Benjamin Cole

    I enjoy this blog post, and it is very intelligently done.

    however, I have no problem with the Fed monetizing debt, and aggressively, when appropriate.

    Japan did QE from 2001 through 2006, and still suffered deflation. They didn’t go in hard enough.

    The USA, same story. The Cleveland Fed is reporting the lowest inflationary expectations ever—hardly a sign of a “loose” monetary policy.

    Sheesh, monetize a lot more debt, start up inflation into the 5 percent range. We can develerage Anerica through QE and minor inflation.

    Some people seem to start from the premise that zero inflation is the goal (despite the fact that even measuring inflation is very difficult, and I could argue that with rapidly evolving goods and services inflation has become less and less measurable).

    Why genuflect to the Zero Inflation God? Monetary asceticists would rather have zero inflation and zero growth vs. five recent inflation and five percent real growth. It is nuts

    Relax about inflation and monetizing the debt, Both are good things in the right measures.

    Reply
    1. DOB Post author

      Thank you.

      Just to be clear, I have nothing against inflation. I’m all for an NGDP level target.

      I’m just proposing to achieve that target without having to expand the money supply to astronomical proportions. Without the Fed messing up the funding maturity of the U.S. government. And certainly without “fiscal stimulus” (in forms that destroy the taxpayer’s equity).

      I’m proposing that we achieve it with negative nominal interest rates (and these other ideas).

      If we’re not going to do that, then it becomes a game of picking the lesser evil. And yes, I agree that QE and even fiscal stimulus are better than letting the economy deflate itself into the ground. But as you said, policymakers do not seem to ever deploy those lesser evils in the sizes that would be needed in order to for them to work, so we don’t even get the result we want.

      Reply
  3. Benjamin Cole

    DOB-

    It is true that policymakers don’t do what we say.

    But the BoJ did practice QE in 2001-2006 and the Fed is doing QE now.

    So, it is a matter of degree, not ideology.

    We need only for the Fed to get more aggressive.

    I like your idea for negative interest rates.

    Also, if it were up to me, federal outlays would be capped at 15 percent of GDP and largely funded through a national sales tax, with extra taxes on recreational drugs, booze, cigarettes, and gasoline.

    Now I am really dreaming….

    Reply
    1. mikeclueby4

      QE really only goes to banks though, it doesn’t reach the everyday consumption-production circulation. You can talk about more aggressive QE all you like but it’s not helping the everyday economy. All it does is hold banks under the arms so they can buy yet more govt bonds.

      Unless of course you are talking about actual helicopter drops, in which case I could agree.

      Reply

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s