MODERN MONETARY THEORY & THE CONCEPT OF VERTICAL AND HORIZONTAL MONEY CREATION
There has been a great deal of confusion here in recent weeks in reference to several posts I have written about the solvency of the U.S. (see here), the credit worthiness of the U.S. and the actual way a non-convertible floating exchange rate currency system works. I have found that the overwhelming majority of investors believe our government is revenue constrained and effectively believe we are living in a convertible currency system akin to the gold standard or a commodity linked currency system. That couldn’t be farther from the truth. There are very important implications here in terms of what the government can do and how it will impact the future rate of inflation and the solvency of the United States. Warren Mosler was nice enough to forward this brief summary of the concept of vertical and horizontal money creation:
When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.
When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.
Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.
The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.
Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.
Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”).
When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.
Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.
These principles are then applied to Y+C+I+G+NX to balance nominal aggregate demand with real output capacity in order to achieve full capacity utilization, hence, full employment, along with price stability. This is based not on theory requiring assumptions but on operational reality that can be represented using data, standard accounting identities, and stock-flow consistent macro models.
Perhaps most important in all of this is that it is not “theory” at all. This is actually how the banking system works in a non-convertible floating exchange rate system. The United States government is never revenue constrained. We do not “fund” our spending via taxes and debt issuance. China is not our banker. The fear mongering over government deficits and the issuance of government “debt” is built on a mountain of falsehoods by people who don’t understand how the monetary system works.
Of course, I don’t believe that this gives the United States a ticket to spend (or print or “button press” or whatever you want to call it) at will. That couldn’t be farther from the truth. Spending has very real repercussions (though they’re misconstrued by most). I have maintained and continue to maintain that government spending is not the solution to all of our country’s problems. We have a private sector that remains deeply indebted, a banking system that is highly unregulated, a flawed Central Bank and a government that continues to promote a supposedly Capitalist economy where the losers never lose.
While the private sector continues to de-leverage let’s hope that the government will play their role in helping to properly regulate the banking system in a fashion that ensures the U.S. public can never be held hostage by the big banks again. Unfortunately, it looks like that day could be a long way off. In the meantime, the misconceptions about the U.S. being Greece or Weimar or Argentina will hopefully cease….
so you believe in the power of free markets…yet believe that the bond market….which is unnecessary in the world view you espouse… is a creation which has no practical use. Effectively saying the bond market is a miscalculation by millions of minds worldwide at once who do not understand monetary systems. Because if they did…they would realize the bond market is essentially useless.
Therefore that means the free market is useless since it has created an entire ecosystem that has no use.
This doesn’t says the bond market is useless. It just means the US government doesn’t sell bonds in order to finance spending.
No one is saying that. In fact, the low interest rate environment in Japan and the US is telling us exactly that free markets work – hence why interest rates are low.
The free market works? what kind of free market are you talking about? In Japan the rates are zero because the BOJ dropped short term rates to zero and kept buying government bonds (the so-called quantitative easing) for years to keep long term rates low, and there are no expectations of higher rates in the foreseeable future. There are no real “market forces” are work here except the artificial intervention/manipulation of the central bank. I am surprised by your comment TPC.
Are you saying that corporations and foreign banks are not buying long-term bonds? Obviously the short-term rate is being held low, but investors appear to have no problem buying bonds around 3.5%-4% for the last few years.
Or are you in the conspiracy theory crowd that thinks inflation is running much higher than the almighty bond market would have us all think?
TPC, I was talking about Japan so the rates you are talking about are only in the range 1.5%-2% (2.3% for 30 years) – cf http://www.bloomberg.com/markets/rates/japan.html.
To answer your comment, of course corporations and banks are buying government bonds, I never said the contrary, but it doesn’t mean that the market is free, like you said. Without a central bank and market expectation of interest rates change by the central bank, where do you think the long-term rates would be in a REAL free market in a country with debt-to-GDP at about 200%? So now it depends to what degree you think a market is free, but to me it seems like it does not exist in our monetary/government system. That was my only point.
I see.
There is no inflation in Japan, however. So what should their rates be in a world where they don’t fund their spending via bond issuance? Technically, it can be whatever they want it to be. Japan is exactly like the USA in that it is a sovereign issuer of the currency. This is different from the Euro system.
You could demand high interest rates from Japan, but they will tell you you are silly to demand higher rates from a nation that cannot technically default. It’s no different than buying CDS on the USA. It’s crazy. With no foreign denominated debt they are not at risk of default.
Life in such a nation which just prints and spends is a different story. They effectively tax or inflate their citizenry with inefficient government spending, but that’s a bit of a different story.
But this gives the impression we can just spend and spend in an environment like this (deflationary) without consequence. If that is the case, why did it fail so miserably in Japan?
That is a long and complex answer, but I would argue that Japan’s policies have failed because they allowed zombie corporations to exist and didn’t allocate spending efficiently. Richard Koo argues that Japan avoided a depression which was actually an enormous success.
… “they allowed zombie corporations to exist” …
… “didn’t allocate spending efficiently” …
Let’s see …
Fannie, Freddie, Citi …
Cash for clunkers, TARP, HAMP …
Mmm … US exceptionalism at its finest.
japan would be vietnam now if it wasn’t for their own tightwad saving people buying their own bonds.
or mabe obozo or his buddies will put all our ira’s into gov’t bonds like it or not.
And no, I specifically said that spending is not the end all. At some point, the private sector MUST drive real demand.
Inflation is low? How can anyone who buys gas or groceries say such a thing? Does your nanny do all your grocery buying TPC? Methinks you need to step out of your economics office once and now and see how the real America is living.
Are we really that much worse off than our parents were? I am not so certain I agree with the argument that the government has printed away the value of the dollar:
http://www.american.com/archive/2008/july-august-magazine-contents/how-are-we-doing
I generally find it to be a contradiction when people say consumers have spent too much (because we are too rich and financially complacent) and then claim that there is crippling inflation that is hurting our ability to spend. Isn’t that a bit of a contradiction? American’s are pretty well off compared to the rest of the world despite this “crippling” inflation that has occurred ever since we left the gold standard….
That “unbiased” American Enterprise Institute analysis conveniently and glaringly completely excludes real wage/income growth (or lack thereof) of the last 25 years. Consumers can purchase more because of unprecedented access to credit, not because of increases in earnings. Real income is less than it was a generation ago. In addition, a significant cost that is approx. 16% of household income that is totally excluded from AEI’s analysis is healthcare! The corresponding to decrease in real wages and increase in healthcare costs is what is known as the “middle class squeeze”
But, according to the AEI, we’re doing great! Everyone is much better off than their parents if you simply ignore income and healthcare….
Dont you feel better already?
Oh, and I buy my own groceries though I’ll admit I am generally dragged there….More so for my ability to carry many bags of groceries than anything else.
You lost me after the first paragraph. Can you dumb this down??
Thanks for the question. The govt is not a household. They do not finance spending via revenues. The govt, as a monopoly supplier of currency simply spends. Allow me to regurgitate an old comment to clarify:
I would highly recommend that most of you read the following:
We do not finance our spending via the bond market. Taxes do not finance spending either. We issue bonds as a form of controlling the Fed Funds rate. It’s a pure monetary operation. Not a fiscal financing operation. We issue bonds to maintain the Fed funds target rate and control excess reserves. People think this is govt debt because that’s how the system works in Europe and under the gold standard. This thinking has never changed despite the dramatic changes in the monetary system after the Nixon shock. I am quite certain that Bernanke understands this (or at least partially), but I am also quite certain that most other people in power do not.
Let’s understand a few things first:
1. foreigners do not fund our spending. That is a fact.
2. The bond market is a monetary tool. NOT a fiscal financing tool.
3. We tax in order to create demand for the currency. In addition, it controls aggregate demand or effectively, the money supply.
I’ll use the example I often use. Please excuse the simplicity, but this can be a mind bending concept if you are textbook taught (trust me, I know the feeling) so I will keep it simple:
I start a productive economy/country and invite my 5 friends to become citizens. Rather than forcing all of us to trade with heavy gold I issue TPC notes. Now, in order to create real demand for these notes I create a tax. This makes you beholden to me via the TPC notes. You MUST have them in your account on April 15th of every year. I’ve created instant demand. This is what the US government does. In return, they spend money on public works, create jobs, supposedly spend money on furthering our nations prosperity (in theory at least) and protection of the nation (a military).
How do I enforce your use of the TPC notes? I create jobs via a military and a police force and pay them well. Don’t want to pay your taxes? Say hello to officer Joe. A group doesn’t want to pay their taxes? You can protest, but if you get out of control I will introduce you to 500 men wearing body armor holding M4 carbines. In other words, don’t question the currency or else….As long an economy is productive, the sovereign nation can enforce the use of said currency, and as long as we don’t issue excessive currency there should always be demand for it. In other words, trust in the national currency is safe as long as the rule of law is maintained, corporations are productive and I maintain my ability to tax you.
I do not borrow from governments or tax to spend as I would if my currency were backed by gold. Interestingly, I can’t TAX you until I’ve credited your accounts with TPC notes. There is no money to be taxed otherwise. So, in effect, I have to SPEND in order to TAX (counter-intuitive to what you have been taught). Taxing debits your accounts (saps liquidity) and crediting is government spending. On my island, I am never revenue constrained. If you don’t pay your taxes I will throw you in jail and confiscate your money. But that doesn’t mean I can spend more when I tax. What do I care if you send me your TPC notes? I can just press a button and credit my “spending” account right after I shred your tattered looking cash. This is what the government actually does. Taxation is essentially a form of maintaining control of private sector spending. Pay your taxes in cold hard cash. The IRS will shred those dollar. They don’t put them in a bag and mail them to the Treasury so they can’t go “spend” it. The only reason they might keep the dollars is if they are pretty and in good condition so they can go back out into circulation.
So what’s the bogey here? What’s the catch? The bogey here is inflation which is constantly moving up and down with the amount of money in the system based on my tax rate, spending, etc. Thus, govt cannot just spend and spend and spend or the extra dollars in the system will chase too few goods and drive up prices. Thus, it’s important to understand that govt cannot just spend recklessly.
In terms of the bond market, the issuance of bonds does not serve the same purpose it did under the gold standard. We actually issued bonds because we were revenue constrained (not enough gold reserves at all times to fund spending without creating massive inflation). Today, we effectively control the value of money in the banking system via bond issuance (a pure monetary operation to control the Fed Funds Target Rate). It can also be thought of as another form of government spending because a treasury bond is basically a savings account. Contrary to popular opinion, QE is actually a deflationary event because it takes an interest bearing instrument out of the private sector’s hands and replaces it with a non-interest bearing deposit. QE is a term that used by people who want to scare you into thinking that the govt is being reckless with their money. The reality is that QE is just an asset swap. Nothing more. Debt monetization is another tool of the fear mongerers who don’t understand that debt monetization is actually impossible so long as the Fed has a target rate. It’s operationally impossible.
The US government is never revenue constrained. They are not like a household or state government. We don’t need China to buy our bonds in order to spend. China gets pieces of paper with old dead white men on them in exchange for real goods and services. They can either hold that money in a checking account at the Fed OR they can do what they wisely do and invest those pieces of paper in what is actually a savings account at the Fed. We also don’t need taxes to spend. The budget deficit is in direct inverse correlation to private sector savings. TO THE PENNY.
This by no means says that the government can just recklessly spend. But it’s imperative that the government spend SOME money otherwise they are simply debiting the system each year via taxation without ever crediting accounts. Just ask yourself what would happen if the govt imposed a one time 100% asset tax?
Many financial theorists actually believe the Great Recession (and the Great Depression) was caused by account SURPLUS. You’ll notice that both events were preceded by great periods of “fiscal competence”, ie, budget surpluses. In reality, the govt had debited too many accounts and forced investors to use too few dollars to chase too many goods. This results in full blown deflation and excessive debt levels (because you borrow what you can’t actually get your hands on). I think the cause is a bit more complex than that but the fact that we are grossly overtaxed and the govt spends very inefficiently is a large contributing factor.
Still confused? Read this: http://pragcap.com/talking-ourselves-off-the-edge-of-the-cliff
And this: http://pragcap.com/jeff-gundlach-says-the-usa-will-default
And this: http://pragcap.com/when-will-the-bond-auctions-begin-to-fail
And this: http://pragcap.com/a-fearsome-herd-of-tyrannosaurus-rex-approaches
Head spinning? Read the links in each. It will spin more….Everything you’ve learned in school is wrong….Well, most of it….
“This by no means says that the government can just recklessly spend”
Then everything you said is complete gobbledegook. It is no more correct than me saying:
Since I always get my steaks at the store, and
Since I NEVER get steaks from an actual animal,
Therefore the store must creates its own meat, and
We have no use for actual animals.
It is complete nonsense and it means absolutely nothing, except that it makes you stupider for even trying to analyze it. If this government’s reckless attempt to consume 30% of the economy continues to the point that rioting destroys what little private sector GDP is remaining, I can assure you it damn well WILL matter when the government tries to go and spend even more money (and we all know is exactly what they would do if there were riots).
Again, you’re assuming that all government spending is inherently bad. That is incorrect. Government is not a household. I am not sure how many more times I can say this or create examples. Please read all the comments before making ad hominem attacks.
We do not “fund” our spending via taxes and debt issuance. China is not our banker.
TPC, you got me totally confused now! I am not as qualified as you in these topics, can you explain:
1. how you fund your spending then if not by taxes & debt?
2. why are you issuing debt (government bonds) for then?
3. why are your officials (recently Geithner) going to China to beg them to keep buying GBs if not because you need someone to keep lending you money?
I won’t go into your free market assertions until you tell me what is a free market…
Thanks for your posts & comments.
See above for more details.
Our leaders don’t understand the system. Why do you think it almost came crashing down on our heads under the leadership of Geithner, Bernanke, etc.? Do you think they know what they’re doing just because they have good resumes and work for the government? Does that make them omnipotent and omniscient? Think again.
They understand the system too well. The system was designed by the moneyed class to extract rent (interest) from the peasants (most of us).
The government is a willing accomplice because politicians need money to act out their ideologies: universal health care, cold war, etc.
As a matter of fact, they are not omniscient (nor benevolent) but they are certainly omnipotent, according to the definitions below:
1. able to do anything that is logically possible for it to do.
2. able to do anything that it chooses to do.
3. able to do anything that is in accord with its own nature.
4. able to do anything that corresponds with its world plan.
5. able to do absolutely anything, even the logically impossible.
IMO, that fits quite well Geithner, Bernanke, GS & Co.
But that was not my question anyway. When you say that you don’t need taxes & debt to fund your spending, you are technically correct. In a fiat money system, you can “print” as much money as you want/need so you don’t really need taxes (why there are taxes is another long debate). But we don’t live in a theoretical world. You need a certain level of debt to spend, you can’t PRACTICALLY print 100% of your deficit with new money, especially when the deficit/debt is already high, without running the risk of very high inflation along the way. At some stage you need to REALLY borrow the money hence the need of debt to fund your spending. That was my point.
Again thanks for your time and all the debate your posts are generating.
Thanks Fayce! Glad to get people thinking if nothing else….
TPC, you gonna have to start thinking about cloning yourself if you start this kind of debate everyday LOL. cheers.
Amen to that. I don’t have the time just to answer all the questions!
Why are there taxes?
Simple. To give legal power to the fiat currency. The IRS will only accept USD, not gold, not silver, for the payment of taxes.
Say your tax bill is $1,000 and you send the IRS an ounce of gold. From their standpoint you still haven’t paid your taxes even though at today’s price they got more than you owe them. If you argue and refuse to pay your $1,000 in USD, they could, if they so choose, put you in jail.
Printing money = Cheating on someone’s productivity.
Pure and simple.
I don’t think you guys understand. If the government were to never print, the private sector would never have any money to spend.
Regardless, it’s very hard to make the argument that all spending is bad. Military? Infrastructure? Social security? Etc.
So, what happened at a time when humans all bartered? Two people exchanging goods or services constitute the basic unit of a private sector.
Am I missing something?
There was no currency. Totally different monetary system.
One that worked without money, despite its restrictive nature.
Well it didn’t work, that’s why it had to be changed. For one, two private products/services weren’t easy to match quantitatively (even if both wanted the what the other was offering). But moreover, its nearly impossible to keep track of.
Currencies have been around for thousands of years. Whether it was gold coins, shrunken heads, or beads – they’ve existed for a long time. However, they seem to always fall into the same inflationary trap. Take a $1000 at the beginning of human civilization, compound it at 3% annually and figure out why no one on Earth has that amount of money.
Currencies evolved naturally from a bartering system as society became more complex.
The root cause of inflation, which is everywhere and always a monetary phenomenon, are:
1. Human dishonesty – I promise you something at an agreed upon value that you can claim in the future in exchange for obtaining something from you today. I later break my promise and give you something of lesser value than I had promised (money printing).
2. Our limited ability to predict the future – You gave me a prune today and wanted me to give you an orange. I ate the prune as soon as you gave it to me. It was sweet. I went back and randomly picked an orange from my tree and gave it to you as promised. You ate it, it was sour. I got better enjoyment (value) out of your prune than you did my orange, even though I was honest and kept my promise.
the CPI has been changed 10 times since 1996 to keep social security checks low. it doesn’t include food or fuel……90% of what i spend.
if gov’t debt doesn’t matter, why all the hub-bub about social security insolvence?
i guess a budget is irrelevant since we can print whatever we need.though you say eventually thats bad.
No one ever said debt doesn’t matter.
This may also help – from the Fed:
http://www.scribd.com/doc/7581471/Modern-Money-Mechanics
TPC
You say spending by government is NOT a problem. Then you say that we shouldnt spend so much. You also say that we dont fund govt spending with taxes and revenues.
With all do respect it is this type of thinking that creates problems, not solves them. My good god man can you hear yourself:
“Moreover, government debt is not true debt either”
“That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.”
What?
By this explanation then we could just give every citizen in the US a million dollars to solve all of their finanical problems and while we are at it print up another 12.7 trillion and pay off all of our “pretend” debt and call it a day.
This is the problem with all theoretical economists, the numbers add up but the reality does not.
In the end they always forget one thing, A Government and its currency serve at the behest of the peoples confidence. And as of yet no one has truly found a way to measure when the confidence of a people breaks, although Rogoff and Reinhart have come close.
Keep it up TPC just dont forget to apply a little logic to those economic theories.
Amen. Magical thinking. Amazing.
I’m really seriously thinking about moving to Zimbabwe.
Again, I specifically said you cannot just spend and spend. Did you guys actually read the article?
I guess what you’re saying is:
Not all cheating is bad. Cheating a little is OK.
If China dropped a nuke on NY City and the US government hired workers to rebuild NY would you say – sorry NY, but that’s the free market for ya? Or would you think that was a good form of spending worth the investment?
The government can spend the money but it will have to be paid back through future and/or someone elses productivity.
Google “The Broken Window Fallacy”
I wonder why don’t they teach that in business school. Instead they teach us to read financial statements ( which a lie anyway due to off balance sheet accounting) and do sueless DCFs ad infinitum.
Even in the MS of finance classes I remember pieces of this here and there but never a complete picture.
Anyway, now that it all comes together ion this article – iof Treasurieas are for draining reserves, why sell them to foreigners? US banks loan money primarily to US residents but reserves are drained from foreigners? Is it because US residents spend their money on foreign goods and this is where the money ends up as we can see from teh trade deficit? So, it is a closed circuit then. I remember that reasoning – foreigners have to buy our Treasuries because they need to recycle USDs in the end.
Buw where does the government spending comes in? Let’s see consider this: government hired a census worker and paid him 20K. Now it has 20K credit at Treasury. The worker spent 5K on chinese goods. Now China has 5K surplus and buys Treasuries with it, which pay 2-3%. Wow, what a deal. Now what abotu the rest of 15k? it went to US vendors rtent, groceries, gas, car loan etc. So that money – 15K is now in circulation within US. Treasury needs to sell another 15K to US residents to drain that money. But US resident shave too much debt, they don’t want to buy Treasuries. So, where the 15K is going to come from? can it simply stay as an open line for a while? So, essentially 15K went to plug the debt whole? How does Treasury/ FED decide how much debt to sell?
TPC,
I don’t think anyone is pursuing the “revenue constraint” argument. I think, instead, most of us understand that crediting credit from nothing to service costs (operational or otherwise) or to stimulate an economy is not a real solution (something which you’ve agreed with). This seems to be an argument of syntax rather than semantics.
The more currency “printed” by the us to remain “revenue unconstrained” is directly related (I won’t say proportionally, because its not) to the decrease in confidence of said currency (as it’s back by nothing but confidence). This has been hidden from view for two reasons:
1. The government has increasingly hidden the amount of money it prints (M1-M4 numbers)
2. The growth in the USD as a reserve currency has largely overcome the amount of inflation is has undergone.
Regardless, and as you point out, this is no way to run a government – its how you run a Banana Republic and will inevitably face the same fate. Even a completely uneducated individual understands what inflation is when you say “Every 100 dollars you have is now worth 1″ (North Korea).
This seems to be the great myth of the day though. Where is all of this inflation everyone is referring to? How are we really doing?
http://www.american.com/archive/2008/july-august-magazine-contents/how-are-we-doing
The real problem in America is that there is a massive gap between the haves and the have nots. It feels like there is growing inflation in the middle class because they pay a disproportionate tax rate compared to the upper class. I am not saying this is right or wrong, but the value of a millionaire’s dollar at 40% tax rate is greater than the value of a lower class citizens dollar at 20% (or whatever the lowest income tax rate is today). At least in their mind….
I think most people have trouble wrapping their head around this because they equate the government to a household – which is entirely wrong. That’s how a currency system works under the gold standard. But that’s just not how the monetary system works.
I agree to some effect. However, just like housing prices, the curve becomes much more flattened when you look at an overall average (and even this neglects the fact that the calculation of inflation changes year to year – for example, at one point a component may be a “steak dinner”, 5 years later when the cost of steak jumps, this is changed to a “chicken dinner” – eventually this component may become “a amino acid carbohydrate mash”.) But in fact, “inflation” is also compounded by the effects of “supply and demand”. Here in midtown NYC, you can get an freshly made Bacon, Egg and Cheese on a Roll with a coffee (to go) and expect to pay at least $7. In South Dakota, I bet you could have the entire meal served to you and $7 would cover it plus the tip. So, a dollar for a millionaire in NYC really does buy less than a dollar from a sub-living wage individual from South Dakota (FYI, I’ve never been to SD so I’ve just made up those numbers) – yet the tax brackets aren’t adjusted to account for such.
I know the Gold vs Dow argument quite well and have used it myself many times. The problem with it is twofold:
1. The comparison against gold as the determinant of inflation
2. The timeframe you look over
Gold is a problem because it’s essentially useless. To quote a famous Hedgefund Manager “We dig it up, aggregate it together, then put it back in the ground (ie. bank vault). There’s no reason why a rich individual necessarily needs/wants to purchase Gold – why not something more expensive and rare like platinum or even plutonium? It’s a fairly useless metal these days, so a supply glut or a decrease in demand will offset the price changes. However, even if you choose this – look at the Gold price from peak to trough between July 2007 to Feb 2009. This period the market shed over 50% while Gold remained relatively flat. That leads into the second point where the time frame you choose to observe has a very large impact on the perception of inflation. An even better comparison would be against Oil (a commodity consumed by EVERYONE) or even the current inflation numbers vs the inflation numbers when using the inputs from 1979. A very different picture arises.
I certainly do believe that growth has outperformed inflation and that a fiat monetary policy is really the only way for a government to function. However, these are very generalized and qualitative statements and the gap becomes much narrower when you use quantitative numbers along with some selective data sets. But in a way that everyone can realize (which isn’t fair but I use exaggeration to make the point) – between Oct 2008 and March 2009 the government created $1.4trln dollars of money out of thin air; however, both rich and poor literally cut off all spending during a period of deflation (or perceived deflation). Meanwhile, I didn’t see a single price decrease in the essentials for living – food, water, shelter. Yes these fluctuate very much, but then again they are the most basic goods for survival. I did see prices dip down at Tiffany’s and perhaps you could pick up a Rolex at face value (instead of a regular 10% markup) but is that what really matters?
PS – To argue in your favor, those who have voiced the greatest complaint in North Korea are those who actually managed to amass an equivalent “fortune” over there….by trading through the black market.
This post is not theory. It is actually how our monetary system works. For some reason the overwhelming majority of investors and citizens believe the current monetary system is no different from a gold standard world in terms of monetary ops. I went to a real estate presentation this weekend and bit my fist for an hour as a real estate broker lectured me on the dollar being backed by gold….Luckily for him, I was playing the role of the dumb American consumer itching to invest in real estate as opposed to the economist who actually understands our monetary system. This is what people really believe. They really believe the US can go bankrupt. They really believe that money printed is automatically inflationary. That we borrow from China. That taxes are spent. That is all wrong.
I’m not certain that inflation won’t pick up. In fact, it’s starting to look like the economy is picking up which means Bernanke is starting to get very worried. But that doesn’t change what I’ve described above in terms of how the monetary system works. I’m just trying to clear up the misconceptions that persist. That’s all….
I’m not disagreeing with the facts of our monetary system. Rather, I’m alluding to the fact that its intertwined relationship with our debt issuance (or rather, that both are performed in the same currency) means that we can “technically” default on debt – this is at the point when no one recognizes the legitimacy of our currency so printing and issuing it would be no different than plucking and issuing feathers as a replacement. Now can this happen? Perhaps, though highly improbable, especially in the short to medium term. Could China dump its treasury holdings and cause “issues” that would put pressure on our markets? Yes, though this is equally as unlikely if not more so. However, I will say this – the misconception of how our monetary policy works is a large part of the reason that it works. The rest is political jockeying between two sides of the same party – neither of which has any intention of fixing things, thus leaving it to fester and grow as a problem.
The only question I have is: why would one equate the level of monetary inflation with the price of goods when one could simply observe the net amount of credit vs. debt issued? Wouldn’t that yield true “currency inflation” rather than “price inflation”? Why were there so many moans and groans about bailouts yet hardly a peep about the fact that the Banks borrow at 0% and lend out at 29%? After all, that’s how they’re making all their money back… Why isn’t anyone complaining any more that the same banks which issue credit are issuing interest rates based on averages of the numbers which they willingly submit?
There’s a lot more ignorance of finance than simply Monetary Policy. However, I think the uproar is the fact that many people are catching on to the fact that we’re printing out money by the boatload (or the button press as you refer to it), yet they’re not seeing any of it. After all, I’m fairly certain the Central Bank and the Treasury didn’t somehow overcome the physics principles of Conservation of Mass/Energy…
Banker,
With all due respect – you’re thinking in a gold standard world. China is not our banker. We do not issue debt that “funds” spending. China can’t dump our bonds and topple the US economy.
Bond issuance is a monetary operation. Not a source of funding. This is vitally important in understanding this whole discussion.
The US can’t default because it has no foreign denominated debt. We could choose to default, but that would be unnecessary. An alchemist never runs out of gold unless he chooses to run out of gold. The US government never has nor doesn’t have money. They are never revenue constrained.
You’re assuming the US government as sovereign issuer is equivalent to a household, but that is entirely false. Government just spends and taxes to control money supply.
The bogey here is inflation, not potential default. Could we technically default by inflating ourselves to death? Yes, but in order for hyperinflation to occur our economy would have to go seriously haywire. With that said, I see no signs of inflation.
Of course, I would argue that parts of this spending have been highly inefficient and will result in mal-investment which is why it’s important to understand that government spending is not some magic pill. Quite the contrary.
“The US can’t default because it has no foreign denominated debt.”
That’s because of hegemony of the dollar being the “reserve” currency.
See what happens if OPEC demand to be paid in gold or any currency other than the USD.
The USD is not backed by gold, but by the willingness of the US to start wars to defend the reserve currency status.
Ah yes, the old, “the world doesn’t want our dollars anymore” argument. Don’t want your dollars? Send them to me. I’ll take them. And so will Opec when they demand gold and we tell them to shove it.
See what I’m talking about. Telling them to shove it, starting wars. Do you have a mirror at home?
You’re changing the focus of the argument. I don’t think you’re grasping this concept. Read my island example above. The governments spends in order to tax. The private sector doesn’t have money if the government never spends it. Your Austrian argument that all government spending is bad is inherently bad is wrong because it displays a gross misunderstanding of the monetary system in the USA.
I’m not changing the focus, just using your own points against you.
Nevertheless, I don’t mean to get personal and I don’t believe you do either.
My point is simply that government spending has to be paid back by its citizens’ productivity, i.e. robbing Peter to pay Paul. Government spending only redistributes wealth, not generate it.
I understand how money is created as an accounting unit in the US, but it is not an abstraction. It has real impact on real lives. That’s exactly why it has to be an honest system; humans have a tendency to cheat. I agree it doesn’t have to be backed by gold, but it has to be honest.
I think we can both agree on that. Thanks ATP.
TPC,
I’m not disagreeing with you. I fully understand what you’re saying. The inflation bogey, though, is quite a bogey!
You’re only thinking one step in advance, ie. issues non-liable credit (ie. prints money, inflates the money supply, etc). However, tell me what is one of the first signs of inflation (well before the CPI/PPI numbers)? Could soaring bond yields be an indication? How do bond yields begin to soar?
Ok, so let’s follow this imaginary scenario where China decides to flip us the finger and dump half their holdings – $500 billion face value, onto the open market. This supply flood overwhelms aggregate demand (let’s say they time it with a gov auction) and yields start to soar – 5, 6, 7 – 15%. Now there is “perceived” inflation. They’ve effectively flooded the market with paper and are asking for dollars. Sure, this can be zeroed out by printing $500bln dollars and saying “Here ya go China, now blow off”. But there’s now a big problem on our hands – the perception of high inflation and a fairly large monetary inflation move that cannot simply be withdrawn (as could be with a $300bln in quant easing, or $700bln in TARP, or as any of the other tools the FED uses). This is because the Fed was pumping dollars into what they believed was a black hole, but now the black hole starts spitting those dollars back. Effects would ripple – the price of oil would skyrocket (as its largely denominated in dollars). Obviously, China making such a move would be for reason of not wanting those dollars (worthless pieces of paper) so at the same time they do a USD/Gold swap with the banks of the world, or some other complex derivative transaction. Could this happen? Well, yes, I guess – but realistically no. The Chinese would kill themselves on this trade and legging into it would never go unnoticed. But similar scenarios HAVE played out. Remember the July 2007 tippy top? Remember when USTs went over 5% (psych barrier) and coasted to 5.30%? Market started cavetating and ultimately started collapsing (despite some “large buyer” swooping in and grabbing tons of those 5.3% bonds). At the same time, remember when oil was coasting to $150 bbl? OPEC was essentially using their dollars to buy back oil on the open market because they didnt like their worthless pieces of paper. At the same time, they started accepting Euros. These events were actually mitigated by the Great Recession – which may or may not be a coincidence. However, the point being – you can’t look at monetary policy in a vacuum…it simply doesn’t work that way in the real world.
I don’t think inflation is “out of control” but its definitely an ugly view from where I stand. In my relatively short life time, I’ve seen prices of items multiple by 5 (pizza, soda, water, cigarettes, movie tickets, etc). This is not at all a scientific assessment but at the same time, I can do basic math well enough to know how much more it costs to obtain certain things than it did years ago.
In Banking,
What inflation? This is history’s era of “great plenty”. There is nothing you could want today that you can’t have on a “normal low middle class salary” if you put on your 1980′s glasses. I just cooked three meals worth of BBQ spare ribs for <$3/lb. I make my bread for $0.45/loaf and enjoy the best and healthiest breakfast of steel cut oats and a banana for <$0.30. Food is cheap, stop eating out and stop eating the engineered processed food that didn't exist 25 years ago.
Is petrol too expensive. Try GotoMeeting and avoid the $1,000 travel fees to fly to NYC…screw those dealmakers who insist they see you face to face everytime they want to threaten you.
Are cars too expensive? Don't buy a new one. Just fix the incredibly reliable one you have.
Is your house too expensive? Is it twice the size of your parents? Geeshh! Sell it and rent one…it is far cheaper and the nation has plenty to select from.
Peak oil. Climate change. Food shortage.
Not sure of your points???
Peak Oil, if meaningful, is manageable. Primarily with higher fuel prices and associated efficiency improvements. This is exactly what we are seeing today and if transitioned to smoothly shouldn’t lead to higher individual costs.
Climate change is the sad evidence of man’s wastefulness not a statement that leads to inflation. We must deal with our destruction. How we begin to take real responsibility for our destructive nature is the question. My suggestion is everybody stop running around and read a book or two….a used one at that.
I suppose you believe a Food Shortage is imminent. I just don’t see it. Genetic engineering is rolling out some unbelievable traits. Expect food prices to mirror petroleum costs due to high fertilizer inputs needs. But this really is no problem. While the cost of prepared foods will rise, the cost of the basic ingredient will remain at generational lows. Look, I go through 10# of flour and 4 lbs of rice and 3lbs of steel cut oats per week at home. That costs about $10/week and provides most of the caloric energy needs for my family of 5. All the other foods we eat are for micronutritional needs and to fend off boredom, i.e. luxury spending
You can think what you think but neither you nor I have control over food and oil prices.
I think (hope?) this is a joke.
Here’s some real prices for you (in NYC):
Movie tickets: $18
Bottle of water: $2-5 (bar or club $5-10)
1 bedroom apt rental (400 sq ft non-converted): $1800/month + security deposit + application fee + background check fee + broker fee = $1900/month
Slice of Pizza: $2-3
Pack of 8 Mach Fusion Razors: $32
Starting Cab Fare (before moving): $2.75 + 0.50 per mile (or 5 minutes)
Pint of Beer: $7-10
Hero Sandwich: $7.50
16 oz. Fresh Fruit Shake: $6.48
12 oz. Coffee: $2.00
Bagle with cream cheese or butter: $1.50
Subway fare: $2.50
Express Bus fare: $5.50
Brooklyn Battery Tunnel Toll (each way): $5.00
Ok, yes, this is one of the most expensive cities in the world – I know that. However, it’s also a place of opportunity…and a very large lower class/lower middle class population. However, I don’t have the luxury of time to do many of the cost saving things that I could do. Beside working 12+ hrs a day, the lines at grocery stores are incredible and well, I do like to occasionally sleep.
But hey, I’m not really complaining all that much. I know a slower pace/cheaper life could certainly be had if I wanted such. I just figure there will be no healthcare and no social security by the time I retire (if I’m ever allowed to), so I’ll bust my hump now and hopefully make enough to atleast insure I survive in the future…and maybe even thrive if I get lucky
PS – I will never have time to bake bread and its not worth it. 3 racks of ribs from Costco are $35 + membership fee. And I dont even eat breakfast and usually skip coffee. I don’t own a car and pay the lowest rent you can find (at the sacrifice of a longer commute and longer work day). My biggest expenses according to my year-end credit card bill are food and beverage.
If you like to get ripped off in NYC then you shouldn’t complain. I just moved from Los Angeles to exurban Minneapolis and realized significant benefits. I now enjoy three times the house for half the price and half the property tax for quadruple the public school value. With three kids that means much.
Also, after I adopted this new lifestyle 18 months ago, I only go to a grocery store once a month just for ingredients not available at Sams or Costco. This new frugal behavior saves time. However, the transition to it is not without some serious commitment. My wife stills thinks I have lost it a little. Wait till she learns of the beer making outfit I have been accumulating in the basement.
Look, if you really want to save money, get a roommate or better yet get married to a good person. Stop drinking beer and get a crock pot with timer to make your steel cut oats and take it with you in a cup in the morning as I do (takes 3 minutes every night) Buy a used breadmaker on Craigslist for $5. After you get your ingredients (buy them bulk at Costco) a loaf takes <5minutes to assemble at night and nothing smells better than fresh cooked bread in the morning…that is a true luxury that costs almost nothing.
You must switch back to the 2 bladed razor, they work fine and are 1/3 the cost. Get yourself a thermos and bring your coffee with you…it is still hot at lunch time.
I am not trying to preach because I may have been leading a very similar lifestyle as you 3 years ago. My recommendations are all things I currently do and probably changed from similar items you listed. These changes added up to over $2200/month for me. Most people do not realize they spend so much on food and other consumables every month.
My latest addition to frugality? A home ice cream maker. Yummy and cheap and no real extra cost…just another bowl to wash.
With regard to China “dumping” their Treasuries, remember how they got them in the first place. The US holds NO debt denominated in foreign currency.
The Chinese received dollars by sending us stuff. Now, they could either spend the dollars in the global economy (eventually circulating back to the US, generating demand), or choose to save them and earn interest by buying Treasuries.
BTW, if they decided to spend them, that would drive up the foreign exchange rate of the RMB, so there is also an FX impact here (see how the Treasuries being bought and the “manipulated” FX rate are inter-related?).
So, if they “dump” the Treasuries, they end up with non-interest bearing cash and they still need to figure out what to do with it. They can buy US assets or goods and services denominated in dollars (like oil) – but if they don’t have any dollars that they earned they cannot buy Treasuries.
They do not “fund” our debt – the US does not accept RMB in exchange for Treasuries, only dollars (and the Chinese can’t print USD, yet).
They don’t need to spend, they can swap – and they can do it for any currency and just about any commodity. The dollars only circulate back to the US when something of value produced from the US is desired. For now, the lion share of that demand is generated by the service based industries (and financial services holds the majority of that sector – which everyone wants to regulate and inevitably shrink).
So they dump the treasuries and get USD cash (which again, is not necessarily how it has to be done, but regardless), then do USD/Gold, USD/Oil, USD/Steel, USD/Coal swaps or futures (financial/physical) and then what? They have real things instead of pieces of paper and a bunch of “bag holders” are standing around with dollars which can’t really buy so much these days.
Now, yes – I’ve already said this is a near impossibility (despite the political posturing that goes on). First, we’re they’re biggest customer and so they really can’t just cut off their blood supply. Second, as you pointed out, they’d lose their currency peg (though AFAIK, RMB isn’t “officially” traded on any market, so swapping dollars for Euros wouldn’t have an effect on RMB unless of course they decided to start accepting Euros instead of dollars going forward). However, if you’re earning 4% interest and the US government is inflating at 10%, what exactly do they have to gain? Perhaps this is the a partial hint to their massive commodities consumption (beyond the obvious infrastructure needed to serve their population).
The chinese aren’t dumb. They know they’re getting the raw end of the stick and they have no real choice but to play along – for now. But meanwhile, they are diversifying into other assets that have real value (and others which they’ve lost on as well). Luckily, the Euro is looking pretty crappy these days so that leaves commodities and land. Let’s all hope they’re overheating (as it appears to many) because they can definitely continue climbing if they play their hands right.
This “Nuts and Bolts” of the Treasury/Fed/Banking system is tedious.
The Fed/Treasury can “Create Money” at will
The Government then spends/mispends this “created money” to make up for the lack of aggregate demand—-”Keynes Model”
This “Deficit Spending” by the Government has consequences.
These consequences of the “Deficit”" “Fear mongering” — is the point many of you are making.
I believe the noted “Economist” John Taylor recently opined that it could take and Increase in Taxes by 60% or an Increase in Inflation by 100 times to pay for the Deficit at this point in time.
Of course– getting to “Full Employment”—Expanding private sector industry and REDUCING public/Government spending would reduce/alter the above numbers.
Moslers and TPC’s point–Deficits dont matter–its just a bookkeeping entry.
Consider this:
If your in the middle of the ocean with a hole in your Boat you will do any thing to stay afloat–TPC and Mosler
On the other hand when you have a “Sturdy Boat” it is foolish to put a hole in it.
This requires a “definition” of a Sturdy Boat.
“Richard Koo argues that Japan avoided a depression which was actually an enormous success.”
It never ceases to amaze me how dumb economists can be…particularly when they focus on aggregates and make broad statements like this.
Yes, Japan avoided a depression. That is a success if you were one of those who benefited from the bubble and didn’t want to go bust. However, if you steered clear of the bubble or are young in Japan you can look forward to the following: 1) assets which remain artifically inflated (good luck buying a house or earning any return on your savings), 2) a stagnant economy (because the old-school remained in charge and countless zombies were created), 3) a heavily indebted government, which makes the risk of a future crisis quite high. How exactly does one get wealthy in Japan today – hope you had parents who stayed wealthy thanks to the “depression avoidance policy.”
On of the functions of crashes is to transfer wealth from those who participated to those who did not. Another is to get rid of useless segments of the economy to make way for the next several decades of innovation. Another is to push asset values below their true value to bring back risk-taking among those who were smart enough to remain solvent. None of these happened in Japan and are also not happening in the US. And yes, this may require a period of negative growth. So be it. The reason so many Americans between the ages of 50-70 are so wealthy is not because of some genius insight. Rather, they followed a depression and played a role in rebuilding an economy that had gotten out of whack. They rode asset values back up.
Those under 40 in the US today have no such hope. You must simply pray you have wealthy parents b/c the government is throwing all its resources at making sure their assets dont fall. What we will get is a stagnant economy and a huge debt burden. I say bring on the depression.
I would agree to a large extent. I am in no way arguing that government spending is a magic potion. But the hysteria over deficits, default, the AAA rating of the USA, etc is all misguided.
Misguided until when? The time of reckoning?
Ah yes, the dreaded day of reckoning when China sells all of our bonds (to whom?) and the world stops accepting our dollars (though we are the world’s largest consumer). Hmm, that all appears to contradict doesn’t it?
You’re fear mongering based on total misconceptions. The point of my article is to eliminate your style of thinking through rational thought and education. I am sincerely trying to help….You’re simply not willing to even explore the possibility of the things I discuss….
The day of reckoning is not when China sells all our bonds. It is when the savers of the world are no longer comfortable in financial assets and seek to diversify into physical assets (particularly those that are non-leverged). Today very little wealth is allocated to such assets. At some point, the “spend because money is an illusion” path we’re on will change people’s minds. And then we will have inflation AND an output gap. The shift in mindset could well cause massive capital shifts. $150 oil anyone? Why not – all it would take would be for Bill Gates to shift 10% of his wealth into oil because he fears debasement.
Warren called up Bill in the 90s and mentioned that JPM was dumping a lot of silver and it was a good time to get in. Each of them bought somewhere around 100 million ounces, around $4.00. Both of them have highly secure and climate controlled facilities to house these investments. At $17+ these days, those turned out to be very valuable investments. However, the market didn’t care less.
$150 oil is a very likely possibility but not necessarily a scary one. We do have the world’s largest coal and nat gas supplies right within our borders. In fact, the sooner oil gets to 150, the better – at least it will push forward necessary alternatives.
Forget about China.
The day of reckoning would be when Americans realize they’ve been conned by their government and the hard earned money they stashed away is not sufficient to give them the standard of living they believe they had saved up for.
Remember, the endgame is always political, and it’s in your backyard.
TPC,
Congratulations on a great piece. It looks like few of your readers understand the concepts you describe here. Keep at it. People will get it with time.
A lie told a thousand times becomes the truth? Are you with Goldman?
How is any of it a lie? What TPC has described is reality. And I highly doubt Goldman Sachs wants you to understand this. Keeping the public poorly informed about the inner workings of the monetary system does not really help Goldman’s cause.
As long as there is something, be it oil, food, minerals, etc. that people in the US (or any country for that matter) need for survival but do not have enough of on American soil, it has to be obtained either by brute force (war) or by trade. If we accept the notion that the USD is money used in trade, then it should serve 3 functions:
1. It is a medium of exchange.
2. It is an accounting unit.
3. It serves to store value.
The third function is based on the notion of honoring ones promise. Imagine getting a coupon from, say, the owner of a video store that’s good for 5 movie rentals. You know the owner and he agreed to give you the coupon if you would work for him for 8 hours. You did that and he gave you the coupon. One month later, you went to store to rent some movies but the guy said you could only rent 3 movies with the coupon because he printed and sold too many of them relative to the number of videos they have in possession. How would you feel? One month earlier your 8 hours of labor was worth 5 movie rentals but now it’s only worth 3. He broke his promise; he cheated on you.
The problem with TPC’s point is that the monetary system he describes is one that only serves functions number 1 and 2. In his monetary system, credibility doesn’t matter and the “owner” of that system (US government, Fed) can break promises at will.
Now go back to the beginning of my comments. Only a fool would hand over oil or whatever in exchange for TPC’s money, not knowing what it will be worth in the future. How would you and TPC feel if I sell you some oil that I know will turn into water in a week but did not reveal the truth to you?
If the US is an isolated, self-sufficient nation whose citizens don’t mind cheating one another all the time, then the rest of the world probably wouldn’t care less.
The problem with money as a store of value is the trust issue. The gold standard was basically a no-trust currency system – if the money IS gold then it is an asset, not a liability/promise to pay. If the money is convertible to gold, then it is still a liability, as there is a promise implied to convert.
But the question is what reduces the trust in government or the national economy? People trust in the productive power of an economy, that there is the ability to efficiently produce goods and services. Governments lie and always have and always will – people still work and produce things other people want.
First you need to get your head around what ideas are being discussed and not jump to political conclusions. You will find that corruption and dishonesty exists in all monetary systems to date – not that this one is particularly evil. Corruption has to be dealt with, but the monetary system isn’t the solution – the legal system and people demanding that the laws be enforced is a start.
Ironically, the trust in the USD today is based on the trust of a corrupt political system that will bail out and protect the rich at all cost. In other words, some believe the USD to be “too big to fail”.
Totally agree with you ATP.
This isn’t my world. This is the actual monetary system we reside in. And yes, fools accept our dollars every day in exchange for real goods. Just look at China….Despite your claims, the USD is still in very high demand and arguably the most trusted currency on the planet.
Lets hope that continues.
A good piece indeed.
TPC, said “We do not “fund” our spending via taxes and debt issuance?”
Then why does our government tax and issue debt or what purpose does this serve?
Are these just tools to control the quantity of money?
Yes.
As I responded to an earlier comment:
Why are there taxes?
Simple. To give legal power to the fiat currency. The IRS will only accept USD, not gold, not silver, for the payment of taxes.
Say your tax bill is $1,000 and you send the IRS an ounce of gold. From their standpoint you still haven’t paid your taxes even though at today’s price they got more than you owe them. If you argue and refuse to pay your $1,000 in USD, they could, if they so choose, put you in jail.
TPC is 100% correct. The US government never has nor doesn’t have dollars. The government credits accounts via spending and debits accounts via taxation. This is how the government controls inflation. Over time, your taxes have increased in order to offset the increase in spending (inflation).
As TPC has said, this doesn’t mean all government spending is good or necessary, but it’s important distinction when discussing the gold standard myths, myths of insolvency and government spending. What most here fail to grasp is that government MUST spend in order for private sector to spend.
Exactly! Government spends in order to tax. Not vice versa!
Not to mention the fact that an understanding of this allows us to more accurately portray the reality around us.
Half the reason I write these kinds of articles is because it sickens me to see the misinformation in this world and the fear that is struck into investors by people who have no clue what they’re talking about.
do not stop writing these articles.
maybe i dissagree because i don’t understand it.
i might be hard headed but i’ll be a dead man when i stop listening.
if i didn’t respect your opinion, i wouldn’t read it in the first place.
The Keynesians were right in their day about pump-priming as an effective way for navigating a nation out from under an economic slump. The economics of a nation with reserve country status present infinitely more alternatives for fiscal manoeuvre than those available to any given family. However, since the US no longer actually produces much in the way of exchangable goods, any stimulus must ultimately be directed to supporting consumption. But since we now consume more than we produce, we must depend upon the kindness of foreign lenders to keep our juggling act going.
So, the problem is not whether our Dear Uncle is now or ever will be impecunious. He will always have dollars. The really nasty game will be played out in the exchange value of the dollar, how badly inflation hits import prices, and the political influence accruing to holders of our vast debt. The end game is well under way, as a burgeoning, service-based economy finds it can no longer earn foreign reserves to pay for its necessary imports – all o’ them do-LARS and no takers!
TPC,
“The fear mongering over government deficits and the issuance of government “debt” is built on a mountain of falsehoods by people who don’t understand how the monetary system works.”
I understand about the vertical & horizontal money creation, but I am confused by this comment and want to clarify.
As far as inflation, I have to agree with the some of the other posts. This year my state automobile fees doubled, my property tax goes up every year, food, gas & energy have increased, my daughter’s school tuition has increased, iTunes have increased (from .99 to 1.29), the .99 Wendy’s value meal has gone from .99 to 1.19. However, my salary has not increased….not just now, but for a decade. The only reason that I have savings (assets) is because I am sneaky-smart with my money. I rarely pay for services and I am cheap & miserly. Also, I understand about the island TPC Dollars; however, it is not just one government entity on the take, it is multiple layers of government thieves forcing the dollars from my hands.
Our government runs a fiscal deficit (www.usdebtclock.org). At some point, I anticipate that I will be called upon to produce my share of the deficit pay-back via taxation.
If I am called upon to pay my portion and balance the budget, we are in trouble because it will take about eight years of tax collection to get the $41k that I owe, and God knows how much more the government will run up within those eight years.
I think that’s where the dollar devaluation comes in. Over my lifetime, I have experienced multiple price increases (inflation). But I have never experienced a real wage increase that would compensate for living increases. Therefore, it is much easier for me to believe that the government will “inflate” away my share of the deficit burden by devaluing the dollar.
My intangible assets are denominated in dollars (CDs, savings & stocks) and then there are the real/tangible assets like land and commodities. I believe that the real/tangible assets will eventually be inflated (again) like everything else. This is my reasoning for preferring real/physical assets (commodities) that I can control and hold. But also why I believe that the government prefers the US to be in an inflationary state while denying that inflation exists. To deny inflation exists is to keep the masses struggling and focused on the income side of their household equation….”If I could just make more money, I’d be okay” syndrome.
The government may create “bookkeeping” entries, but I anticipate that those entries will cost me real dollars (wealth) in the future.
Agreed. Also they “cook” the inflation numbers because some benefits like pensions are indexed to inflation. In fact, wages are influenced by inflation as well.
Crash Course: Chapter 8 – The Fed & Money Creation by Chris Martenson
http://www.youtube.com/watch?v=p3_Q1SiRN-A&NR=1
TPC,
I understood how the government is not constrained financially. However, Karl Denninger has an excellent take called “A Sobering View of Macro Economic Reality” written on 4/4/10. IMHO he is right on the money as to where the government ( or Fed) has positioned our countries financial future. I expect to see this article referenced by others soon as has happened before when KD has produced an exceptional article. I would really like to hear your take on it. And yes I like KD, but you are also on my five must read daily list. I have learned a lot from you in the last year.
Hi Bill,
I think KD and I reach similar conclusions though I would argue he reaches it for different (and incorrect) reasons. He says:
“we’re spending nearly 12% of GDP in borrowed money that we don’t have.”
But this is just not true. The US never has nor doesn’t have dollars. We aren’t borrowing this money.
Where KD is absolutely right though is when he says that all the “printing” is funneling money into malinvestment and papering over the real problem in the economy. Just look at how the banks have speculated in the equity markets for the last 12 months. Or how real estate investors are crowding the court house steps again. We are giving people incentives to continue with these forms of malinvestment.
Of course, it’s important to realize that this can continue to for quite a long time, but it’s hard to imagine that the US consumer’s true weakness won’t again be exposed.
The point here is not that government spending is always good, but that fears of insolvency, borrowing from China, etc are all misguided. That’s just not how the monetary system works….
TPC,
I think I follow your argument fairly well. You make the point that government spending is not revenue constrained but also that government spending is not a “magic potion.” Can you clarify when government spending is appropriate and when it is not?
It entirely depends on the situation. Remember, I am opportunistically Keynesian (and Austrian). Giving bankers money when bank lending is not reserve constrained – waste. Spending on healthcare when nearly 20% of the country is unemployed – waste.
I would generally argue that much of the infrastructure and defense spending in recent years has been productive. But government spending is not a long-term or consistent buffer for the economy. At some point real productivity MUST come from the private sector. Unfortunately, we are promoting much of the malinvestment that got us here to begin with and that means the private sector is not actually generating a sustainable recovery as of yet….Not to mention the consumer balance sheet is in tatters.
I believe the reason were not having much inflation is that Mr. Market is destroying money faster than the Fed is printing it. Since borrowing is way down the normal growth of the money supply has been retarded. Milton Friedman thought the best solution to money growth was to keep it at 4% per year. (This was before the massive growth of the shadow banking system) This goes along with the idea that money creation by the Fed is only a bookkeeping entry which supplies liquidity. It can be loaned out and can be multiplied by the banking system without having adverse effects of over stimulating demand and creating inflation. (Too much money chasing too few goods). Mr. Market has recently given the Fed a free ride. As long as Mr. Market has trust in the Fed and US dollar inflation will be controllable. When trust is lost Mr. market will dump dollars for tangibles and require a greater interest rate for perceived risk. That I believe is now starting to happen.
Government issues debt to assist the central bank in hitting its overnight rate target, not to acquire funds to spend. Government spending in excess of taxation adds system reserves, and puts downward pressure on the rate on reserves, while govt borrowing offsets this by withdrawing system reserves.
Govt debt issuance is thus properly a monetary operation, not a fiscal operation.
@TPC:
I don’t know whether you’re a liberal or a conservative but still a very good article. But I think (after having read your supporting comments above) you are underestimating the power of inflation. Whenever, in the future, private spending and consumption gathers steam and real asset values head north we will see the current glut of money turn to excess demand, which in turn will push up the interest rates and consequently crowd out investment spending for the private sector. That’s what happened in 1982, when Reagan found out that too much monetary policy can have absolutely no effect on inflation and yet suppress growth significantly. He had to expand his fiscal policy to kick-start growth and thus began the advent of the greatest debt accumulation in American history. (Trust me I like everything about the Washington Consensus except the debt part) Plus, I didn’t read anything in the article about the affect on the dollar. Surely you can’t expect the dollar to hang in there for too long in the current scenario. Yes people seek the safety of the dollar in recessions and a weak dollar at this stage will benefit exporters of goods and services, but what will happen when we emerge from the recession? Do you actually believe that investors will stay faithful to the dollar if the debt keeps on inching higher?
America going the Greek way might not be happening tomorrow, but it can certainly happen in the near future.
TPC, read this article and a prior one and most comments on this topic, thanks for the discussion. One thing that I have not seen addressed are long term treasuries. Most of the description presented discusses the use of treasuries to allow the Fed to target interest rates and not fund our deficits. This is fine for short term treasuries but that does not explain long term treasuries (10 year, 30 year). The Fed has acknowledged in the past that it cannot effectively control those rates (free market forces), so how does that fit into the system you’re describing?
BTW, is there a book or original source where you derived this conclusion of how our monetary system really works. I’m still on the fence with one foot on the other side. Having troubles concluding that taxes and bond sales do not fund our deficits – even though we can theoretically just print money.
View it this way, I may use a credit card to buy goods, but later on my salary allows me to pay back what I borrowed. One could could argue that my salary was not required to buy the good (true statement), but my salary was required to pay back my credit card. If I did not pay back my credit card and kept on racking up more debt, then at some point my credit worthiness would be called into question. There is no free lunch.
One problem we are facing is that state and localities cannot print legal tender yet they require taxes to continue thier wastful operations (wastful because they were encouraged by previous keynesian spending boondoggles). So now we face a dilema where the Federal gov’t can print to support these operations and bail-out states and localities, and continue the game, or they can not support them and force them to tighten thier own budgets (or increase taxation–very unproductive). If states choose to tighten budgets this becomes very disinflationary (layoffs, curtailed project spending, Very Angry People, ect.). So the Keynesian crap eventually does come back to bite the hand that feeds it. Encouraging malinvestment has a price, but you are right, it can take a long time before it must be paid.
Sentence #2 in attached explanation:
“Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank.”
How does the US Treasury obtain cash to finance the account balance at the Fed? By raising taxes and selling bonds… no?
TPC,
I obviously learnt something new and like your blogs a lot.
I have couple of questions for you.
So, US can print all they want but due to fear of inflation, they try to drain money through taxes and issuance of debt. Is that correct?
If so, even though they can print unlimited amount of money, they are responsible enough to balance it (by issuing debt – even though they don’t have to).
Due to that responsibility of balance, we have to make sure our deficits stay small – isn’t it?
I like the concept of AAA etc., as it tells the world if we are honest in the balancing process or not. Don’t you agree?
TPC, I appreciated your thoughtful article and the slew of commentary it generated. It makes me really miss the gold standard.
I am not as convinced as you are that inflation in US is benign. We’ve got too many of the greenbacks out there. The dollar has retreated substantially over the recent years against the CA, EU, AUS currencies. It is also why it takes a lot more green paper to buy almost ANY commodity today then it did 100 years ago.
Whatever the gimmickry of the current monetary system, government spending that is not paid for through taxes by private citizens and corporations (thereby trading REAL GOODS for them) leads, with a small lag, to debauching of the currency. Which, in turn, penalizes saving and destroys the outcome of people’s life-long work. I say we get those pickforks out before our life savings are only enough to buy one lunch … which, incidentlly, is exactly what happened to many people’s savings in Eastern Europe in the 90s.
TPC,
Thanks for this piece. I have been reading about economics now for about 18 months, and have visited your site often. Between you, Denninger, Mish and a host of other bloggers I feel that I am starting to grasp some elements of economics. Maybe, one day, it will even help me to be wealthier, but for now the knowledge alone is enriching.
However, if I have understood this correctly, then it raises a number of questions (good analysis always should). I also would like to begin with a comment.
1. Given that high inflation is the detrimental outcome of too much deficit spending coupled with too little taxation or bond issuance (the means of withdrawing liquidity) then it isn’t strictly true to say that sovereign governments are not spending-constrained. They are not currency-constrained, but they are still spending-constrained if the goal is to avoid high inflation. It’s just that they are not constrained by their ability to borrow or tax, as these operations are not the source of the sovereign government’s ability to spend.
2. Most governments, however, cannot simply press the button. State, provincial (I’m Canadian) and municipal governments cannot print dollars (real or digital). Deficit spending at these levels of government are intrinsically different. Apart from matters of misallocation of the deficits, how do these non-sovereign government deficits impact the economy? Do they actually ‘matter’
3. If a central bank can print money money to buy up bonds to keep the interest rate of a particular issuance period (2, 5, 7 etc) down, then why have interest rates been rising anyway, albeit slowly? Is there a point at which the central bank/sovereign government loses control?
Thanks for all the work you put into this site.
Mathew,
Thanks for the kind words. I am trying to help though I know it might not always come off like that so your compliments are meaningful.
1) The govt is not REVENUE constrained. If they want to spend more they’ll just tax you more. If they wanted to spend 100 gazillion dollars the tax rate would simply soar. The point is, government never has nor doesn’t have money. They can spend as much as they want in theory. This isn’t to imply that they should or that deficit spending doesn’t have consequences (it certainly does), but for realistic purposes a sovereign govt with a non-convertible floating exchange rate currency system can theoretically spend as much as they want. Are they spending constrained? Yes. They can’t just print forever without consequence. But it’s all a matter of balancing spending with taxation and monetary ops.
2) Only a country in a floating exchange system with monopoly control over the currency can press the print button. This is my beef with the Euro system. They are not their own bankers. They can’t print. It’s a system that is destined for failure. States are the same way. They are like households. They do not print. They rely on the government for currency. I would think of states and provinces in almost exactly the same way you think of an individual. They are revenue constrained and actually need to raise money, invest, spend, etc.
3) I think rates are ticking higher because the economy is strengthening. Part of this is a re-allocation of funds and part of this is increased inflation fears. Inflation is still benign in my opinion, but mal-investment is beginning to run hot. We’re in a classic boom/bust cycle again and the boom is on the upswing….When it busts is anyone’s guess….I don’t think true inflation (textbook) ever becomes a concern, but like we saw in 2003-2007 there will be mal-investment again as too many dollars seek too few productive sources.
Hope that helps.