What is money? That seems like a simple question. It’s mainly the green stuff in your pocket that you want more of, but it leads to all sorts of confusion in the economic world, with harmful results. It is the type of question that economics should define as easily as a core component of any other field of study, i.e. what is a meter? But the economic world is not a hard science, it’s a behavioral science that meshes less definable certainties with undefined behavioral qualities. In our current climate of commanded central bank intervention far beyond its legislated intent, these confusions become multiplied.
Traditional Fed Operations 1913 – 2008
Money is cash and reserves created by the Federal Reserve, known as base money. The Fed creates base money out of thin air. It does this with its “magic checkbook” given to it by Congress. The legislation that created the Fed in 1913 gave the Fed monopoly power over the issuance of currency, the dollar. The era of free banking prior to the creation of the Fed, when individual banks created money and credit, became unwieldy and inefficient with the complexity of the rapidly expanding economy. Treasury’s ability to manage its relationship with chartered national banks was becoming increasingly archaic. The Panic of 1907 illuminated the need for a lender of last resort. Congress created the Fed to manage the dollar on the gold standard and act as lender of last resort. Nothing is more important for the world economy than the Fed returning to its original legislated role.
The Fed traditionally creates base money by exchanging (monetizing), in open market operations via its magic checkbook, non-interest bearing debt for government debt. Corporate debt, sovereign debt of foreign governments, foreign exchange, or agency debt are the obvious choices if there are no more Treasury bonds or bills. Prior to 1934 the Fed mainly monetized private debt at its discount window. The Fed handed out cash and reserves for eligible commercial debt. However, as Bernanke proved, the Fed can buy or sell anything at all, including a bankrupt shopping mall in Oklahoma City. When the Fed buys or sells, it creates or extinguishes base money, non-interest bearing debt. Non-interest bearing debt is cash and reserves, that fraction of the national debt that citizens desire to hold, in place of interest bearing debt, for circulating medium. This is money. The only money is base money. Confusion arises from some terms that are interchangeable and others that seem interchangeable. Terms used to define money may include the dollar, base money, cash, currency, reserves, liquidity, the money supply, demand deposits, savings accounts, time deposits, money market mutual funds, monetary aggregates, fractional reserve banking, and credit. Each have specific meaning that one must understand in relation to how the Fed and private banks operate.
Interchangeable terms for money are cash, currency, reserves, the dollar, base money, and liquidity. In general it doesn’t matter which term defines base money as long as one understands the concept of base money. The Fed creates, “prints”, base money and completely controls it. All other terms—the money supply, demand deposits, time deposits, savings accounts, money market mutual funds, monetary aggregates, fractional reserve banking—are not money. They are credit denominated in dollars, the unit of account. Money is mutually accepted as payment while credit, a loan or a bond, is not. You can’t buy your groceries with a treasury bond or by offering a relative amount of your checking account. They are bonds or loans that must be exchanged for cash in order to purchase something. Credit is built upon base money, but it has no effect on inflation or deflation. Only error in the Fed’s creation of base money is responsible for inflation or deflation. The price of credit is interest rates, whereas the price of money is its purchasing power. Purchasing power derives from the unit of account, the standard of reference for the value of money.
The money supply is the most confusing. The Federal Reserve defines the money supply as M1 and M2. From the Fed website:
“The narrowest measure, M1, is restricted to the most liquid forms of money; it consists of currency in the hands of the public; travelers checks; demand deposits, and other deposits against which checks can be written. M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.”
The Fed’s definition of the money supply includes money and credit. When the two definitions become conflated, monetary chaos ensues. Milton Friedman advocated for the end of the Bretton Woods gold standard in favor of monetarism. Monetarism targets a consistent rise in the money supply based on M aggregates that combine money and credit. Friedman’s brief monetarism experiment, for which he eventually offered a mea culpa, blew up the world economy in the 70s, the era of the great inflation and stagflation. The Fed only controls base money. It doesn’t control credit. By targeting monetary aggregates that include base money and credit, the Fed lost control of base money. The price of gold signals error in Fed maintenance of base money. During Friedman’s monetarism experiment, the POG went from $35/oz to $850/oz before eventually settling at $350/oz. That’s a lot of error. There were other flaws in monetarism, such as assuming the velocity of money is constant, but they are related to confusion between money and credit while ignoring the POG, the monetary standard of reference.
One way to think of credit is in terms of barter. When one purchases a home, the buyer agrees to exchange their future production over the life of the mortgage for the home builder’s current production. A bank acts as the intermediary to facilitate the trade. At the end of mortgage, the builder has the initial monetary value of the home less his costs, the buyer has a home, the bank has a profit from acting as the intermediary, and the dollars disappear. The trade creates no new money, and there are no inflationary consequences as there is no permanent excess in the supply of liquidity. The mortgage was a credit contract denominated in dollars, created by a private bank, that has no direct connection with base money.
The indirect effect on base money derives from the economic activity resulting from the trade. To the extent that the mortgage purchase was the result of expanding economic activity, then the Fed must increase the supply of base money to meet new demand. Despite all the misplaced mumbo jumbo about Fed Maestro, omnipotence, Man of the Year, and PhD busybodies, this is the Fed’s only real function; to match the supply of base money to demand such that there is no inflation or deflation. This makes trade efficient, removes risk premia, enables new trades that otherwise would be uneconomical, and promotes growth. The only possible way for the Fed to accomplish it without error is to have a monetary reference that is stable in value. That reference is gold.
Next: Money and Credit Post 2008