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:
- 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?
- 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.
- 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:
- 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.
- 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.
- 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.