Can the Fed Really Just Print Money? 17 comments
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Yesterday, the Fed reduced the overnight federal funds rate to 1% and the discount rate to 1.25%. There’s not much more room for rate reductions before the Fed needs to take more drastic actions to make credit available.
The Fed and the Treasury are determined and they will do whatever necessary to avoid deflation, short of paying people’s mortgages for them. Bernanke made this clear in his now famous speech from 2002:
I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief. …
The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
But is creating more dollars the same thing as creating more money, thus avoiding deflation? Will the Fed actually be able to generate higher spending and positive inflation as Bernanke says?
To answer this, we need to understand what money actually is. Modern money is credit, meaning a promise to pay a certain value as denominated in a currency. So how do we measure the amount of money in circulation? Should we determine the amount of credit money based on the nominal amount of currency, or based on the value of goods and services promised? A real measure of money would have to use the latter. In this case, if creating more dollars does not result in an increase in the amount of credit as determined by value in goods and services, then more money has not actually been created.
So it is possible that printing more dollars will not have the desired effect of creating more money and thus reflating the economy. It will just create more dollars which will be hoarded or used to pay off debt.
Real inflation is caused not only by the amount of money in existence, but also by its velocity, which is how quickly it moves from one person to the next. To get inflation, you need to get people to spend the new money and then to borrow more. You also need people willing to produce and sell things in exchange for this money.
In hyperinflation, nobody wants to hold onto money because they fear that it will be worth less tomorrow so they spend what they have as soon as they get it. This feeds on itself with increasing price rises causing increasing inflation expectations causing increasing velocity which causes prices to increase again, and so on. In deflation this works in the opposite way, and both cycles can be difficult to stop once they get going.
In the present economy people are less able and less willing to borrow and spend money into existence. So, to cause inflation, the Fed needs to replace the borrowing and spending “efforts” of hundreds of millions of people.
It’s not clear that Ben Bernanke’s printing press will be able to accomplish this before it destroys the value of the dollar. If the dollar stops having value as money, then it doesn’t matter how many trillion dollars you print into existence.
We live in a global economy where the dollar isn’t the only meaningful measure of value. We need to import from other countries and we need to pay the value of the goods we import, not a set nominal number of dollars. If people around the world feel that they will not be able to get something for dollars, they will eventually stop accepting them for their own goods, regardless of all the political reasons to take dollars.
The Fed can’t print money, it can only print dollars. For now this is essentially the same thing, but it doesn’t need to be.
How should we invest in this kind of environment? We are in uncharted waters, so there is no tried and true solution for how to profit from all this, but protecting your capital is the most important thing. You need to be able to preserve the value of your savings before you can make them grow. In the present environment it’s hard to see how to do either, but here are some defensive investments that make sense now:
- Government issued inflation linked bonds such as TIPS in the U.S or the equivalent in other countries. We hope that the interest makes up for the amount the government understates inflation, so we at least break even. There is an ETF with the symbol TIP that invests in these, or you can buy them directly from the U.S. Treasury here.
- Gold and silver have been a good store of value over the long term, though they can be very volatile in the short term. They can’t be printed and they can’t default, so they will always be worth something. GLD and SLV are ETFs that invest in gold and silver bullion respectively, though there are many other ways to invest in precious metals.
- Basic consumer products that will be consumed in any economic environment. Food is the most obvious of these. Here we want companies with recognized brands that give them some pricing power. Look for shares with dividends because they help support the share price and provide some income. Heinz (HNZ), General Mills (GIS) and Kraft (KFT) are some examples.
When the dust settles there will clearly be some excellent investment opportunities in many sectors, but you need to preserve your capital in order to take advantage of them.
Disclosure: The author is invested in gold, silver and inflation linked securities. He has no positions in the companies mentioned.
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1. when did this happen?
2. when will it be redefined?
3. what will be the 'new' definition?
4. who defines it?
5. what happens when the 'said' definer dies?
6. what is his definition?
really... credit is now money... credit crisis... there is NO money
if there were credit... it is in DEFAULT... leveraged 20:1 packaged and sold to the tune of 55 trillion
so... do I ask my clients to pay me with IOU's?
that actually may be worth more than our $'s at the end of this...
you may be on to something
The author's suggestions, on the other hand, would do best in an inflationary environment.
The government's policies are clearly inflationary, while the credit and mortgage crisis is clearly deflationary. Which side will win this tug of war is anyone's guess. The bloggers are certainly split about it. Meanwhile, judging from Bernanke's 2002 quote, he is confident that the government possesses the nuclear option that can be used against any deflationary foe. Fuel up the helicopters!
Yet I have to wonder... if it is that easy for a govt. to crush deflation and cause a healthy return of inflation, why was Japan unable to do so? Can anyone comment on this?
The US is in major problems. Yank Bush Jr.'s credit card. He maxed it out in 8 years and is threatening a default.
"So if the Treasury bails out banks by giving them credit and the banks turn around and buy Treasury bonds that have been used to generate the credit (in order to build up their capital), has anything been created or destroyed?"
If nothing was created or destroyed, then how has capital been built up? And if this is merely just an obvious accounting trick, then is it any wonder that banks don't trust each other?
We are running into the wall of reality: money must be based on something, otherwise it can just be created out of thin air; finally, when it is created out of thin air, even when we use clever accounting tricks, everyone knows it's not real. And since everyone knows it's not real, no one trusts anyone.
Isn't that exactly where we are now?
What the hell are they teaching in school nowadays?
Buy TIPS and short long bonds.
See what happens to the value of a dollar if the Treasury sends out wires to redeem a trillion, or two, or six, of debt. It won't be deflation!
Thank you.
At the basic level the economy is controlled by money and widgets. The government prints the money and everybody else builds widgets (hopefully those we want or need). Prices are determined by the ratio of money to widgets. If widgets go up prices go down, if money goes down prices go down. If widgets disappear prices go up, if new money is printed prices go up. Unless money disappears due to unnatural causes, (fire at a bank, a mattress full of cash, Al Capone’s Vault, etc) its normal life goes from printing to generating economic activity to returning to the government in the form of tax where it dies and is replaced by a clone and put back in circulation.
Inflation is an increase in the ratio of money to widgets. Deflation is an increase in the ratio of widgets to money. In a period of inflation the government can bring prices down by taking money out of circulation, everybody else can bring prices down by making more needed widgets or putting money in storage (bank deposits, mattress, a foreign country, etc). In a period of deflation, the government can bring prices up by printing new money and putting it in circulation; everybody else can bring prices up by consuming widgets or putting them in storage, or taking money out of storage.
In contrast, every dollar of credit created by commercial banks (the vast majority of the money supply) IS a debt owed by someone to someone else.
Congratulations to Josh for the following two sentences, which are spot on: “Real inflation is caused not only by the amount of money in existence, but also by its velocity, which is how quickly it moves from one person to the next. To get inflation, you need to get people to spend the new money and then to borrow more.” If more of those who comment on the money supply had tumbled to this one, we would save billions of tons of paper, ink and billions of man hours. David Hume in his essay “Of Money” written in 1752 made much the same point. He said in relation to money supply increases: “If the coin be locked up in chests, it is the same thing with regard to prices as if it were annihilated.”
I don’t agree with the following few sentences. “In the present economy people are less able and less willing to borrow and spend money into existence. So, to cause inflation, the Fed needs to replace the borrowing and spending “efforts” of hundreds of millions of people. It’s not clear that Ben Bernanke’s printing press will be able to accomplish this before it destroys the value of the dollar.”
This contradicts the above point where Josh effectively says that inflation will not take off till the increased money supply has raised demand to the point where the economy’s ability to supply cannot keep up with demand. (The “David Hume” point). I.e. the printing presses can roll away, but there will be no effect TILL there has been a significant increase in demand. But WHEN there has been a significant increase in demand (and hopefully not too much of an increase) the problem will have been solved. Employment will have risen. All those folk layed off will be back in work.
An absolutely beautiful example of this is taking place before our very eyes at the moment. The US monetary base has DOUBLED over the last quarter. This is totally unprecedented in the history of the Fed or any central bank as far as I know. And what is the result? Practically nothing. But if this money supply increase continues, the point will come where there is an effect.