Tuesday, April 17, 2012

Eventually, there is no alternative

When I first got on the internet I ran across an innocent-sounding statement. Someone had distinguished between greenback dollars and account-entry dollars, and thought greenback dollars rare and therefore valuable. The account-entry dollars, they thought, would continue to grow and increase and inflate away, while the greenback dollars would only grow in value.

It was a unique idea -- I've probably presented it badly -- and fascinating.

Immediately, some cowboy misunderstood the innocent statement and with Austrian bravado blew it out of the water. Naturally. But the idea stuck with me, and woke me up this morning.

After the gold standard had failed one time too many, people invented the Federal Reserve to provide a more flexible monetary system. Eventually, the printed dollar became a replacement for gold.

But if you mentally equate olden-day gold with modern-day central bank money, the old and the new face an identical challenge. That challenge is the creation of credit-money by private banks.

Under the gold standard, no central authority had control over the quantity of money. FDR's devaluation of the dollar to $32/ounce was an attempt at centralized control. But it came late, it worked only temporarily, and FDR has still not been forgiven for doing it.

Today, the central bank has control over the quantity of money but the solution (as with FDR) is always to inflate. The problem now, as then, is that the quantity of money (be it gold or central bank issue) becomes insufficient to support the quantity of private bank credit -- because of the growth of private bank credit.

Given the option to inflate, we inflate. When private issues overwhelm central bank money the economy is hindered, and the central bank responds by inflating the quantity of money.

To the extent that it outpaces the growth of private credit issue, inflation of the base money can reduce the hindrance. But the result is price inflation.

That is what happened during the 1960s and '70s. Then in the 1980s a new policy was established, which controlled prices by undermining demand, while still celebrating finance. But it is not wise to mess with the forces of supply and demand. And interest rates over the next thirty years worked their way down to zero, whence they could fall no more.

And now the only solution our central banks can see, to correct the imbalance between central bank money and private bank credit, is to issue more central bank money. Thus, quantitative easing.

Both the problem and the solution today are just as they have always been: the growth of private credit use and private debt.

The Federal Reserve will ultimately realize that increasing base money does nothing to restore economic vigor but only increases inflation and the threat of inflation. At that point, they will stop.


A commercial bank that maintains a reserve account with the Federal Reserve can obtain notes from the Federal Reserve Bank in its district whenever it wishes.

Eventually, the Fed will refuse to issue greenbacks in exchange for account-entry dollars. Eventually, they will fail to honor their obligation to convert reserves into currency on demand. Eventually, they will have no choice.

At that point, the cowboy will be proved wrong, and the innocent proved right. But by then, it will not matter. It will be too late.


jim said...

Hi Art,

I don't understand the basis for your dire predictions.

I think without the $1.3 tn annual federal deficit you would not be seeing much inflation. Without the federal deficit there would be spiraling deflation as described by Irving Fisher. It wouldn't matter much what the FED tried to do to counter it. The simple fact is the private sector is underspending it's income by some 8%-9%
Without some entity to borrow that surplus and spend it back into the economy, there will be a feedback loop of decreasing incomes and production.

The Arthurian said...

This was an "impulse" post. I woke up with an interesting thought and I ran with it. As a rule I don't make predictions & I don't give much weight to the predictions of others. I'm sort of trying to create an image here.

The central point is that "the old and the new face an identical challenge. That challenge is the creation of credit-money by private banks."

The denouement is that the central bank will ultimately respond exactly the same way private banks responded when they got in trouble: by taking a holiday, to avoid a run on the bank.

For the central bank, which can get money from an empty cardboard box in the janitor's closet, quantitative easing is like the beginning of a run on the bank. Printing Federal Reserve notes (like paying out gold to depositors) is the next step. I think at some point the Fed may choose not to do that, and take a holiday instead. Here's imagery for ya: Banks withdrawing $1.5 trillion in excess reserves, in $20 bills.

Jim, I usually use the word "inflation" only to mean a general increase in the level of prices. This time, somehow, the old meaning slipped in: an increase in the quantity of money.

But this is what it must come to, it seems: When private money expands until the economy can no longer function, there are only two ways out: Either the private money contracts, or the government money increases. Deflation, or inflation.

jim said...

I think you experienced every member of the federal reserve board's worst nightmare. but there is no evidence that i can see that would indicate there is any possibility of a bank run coming true. The public has slightly increased it's preference to hold 20 dollar bills since 2008, but I don't understand what connection that has with inflation.