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Money doesn't multiply.
If you take $1m of $20 bills, and put it in a briefcase, and you opened it
ten years later, there would still be $1m of $20 bills. Excepting
counterfeiters, only the Fed can create base money. "Base money" is
our word for money -- other forms of so-called "money" are really
forms of credit.
Money is pretty simple.
It has a value, which represents the balance of supply and demand for the
currency. The Fed (or whatever entity is managing the currency, if you don't
like the Fed) can adjust supply at will to properly balance it with demand.
That's about it. As long as the value is stable, there really isn't much more
to worry about, with the possible caveat of liquidity-shortage type events,
which represent a short-term increase in demand for money.
Historically, there has
been an idea of the "money multiplier," which is the notion that
banks "multiply" money through various forms of credit. This
remains a common idea among economists today, although they are not as
fixated on the idea as they were twenty years ago, I think. In my copy of the
textbook Economics: private and public choice (2003) the
"money multiplier" is described on pages 299-301. John Hussman, the economics professor turned asset manager,
has written extensively about the idea of the "money multiplier,"
and how it doesn't exist in real life.
http://www.hussmanfunds.com/wmc/wmc070917.htm
The gist of the
"money multiplier" is that an increase of base money leads to
"multiplication" of this base money by the banking system, which
leads to credit growth, and thus a flush and healthy economy. When (as is so
often the case), this process doesn't work, we start to hear about the
"broken transmission mechanism." This was a popular phrase
regarding Japan in the 1990s. I suppose this "money multiplier"
idea has roots as one of those concepts that was repopularized
in the 1930s. The notion that the world economy could be saved from itself
via central bank manipulation seized the minds of generations of economists,
including our current Fed chairman Ben Bernanke, who based his career on the
notion that a bit of Fed nonsense would have averted the Great Depression.
The reason that the
"transmission mechanism" so often seems "broken" is that
it doesn't exist in the first place. Think about it. Why does a bank lend
money? Why does an entity borrow money from a bank? It takes two to tango. If
you put a hundred bankers in a room, and asked them, "why did you make
your last loan?" not one of them would say, "I was multiplying
money in response to the Fed's increase in base money." Indeed, in
practice it most often works the other way around: two parties decide to
enter a credit contract, and if, for whatever reason, the creation of this
credit contract results in a greater need for base money to undertake the
transaction, then this greater demand would, if things are working properly,
be met with greater supply by the central bank. So the transmission mechanism
is really the other way around -- the supply of a properly managed currency
will adjust in response to changes in demand for currency, which arise through
all the transactions of the economy including credit transactions.
This is not to say, as Hussman sometimes argues, that a central bank has no
effect on credit conditions. It most certainly does. However, those effects
are primarily a) regulatory/moral suasion, b) changes in the value of money,
and c) changes in interest rates as a result of central bank policy. Here's a
concept:
Credit is just people
making deals.
People enter into credit
contracts, both borrowers and lenders, voluntarily. It is a "free
market." It's just people making deals. Nothing unusual there. However,
their decision to enter into a contract, and the terms of the contract, can
certainly be affected by the three avenues of central bank influence listed
above.
The central bank manipulators
are much enamored of the "money multiplier" concept, as it lies at
the root of their theories of government manipulation of the economy.
However, the more libertarian types are also equally confused about the
"money multiplier," leading to the excessive fascination with
credit today. To take one example, former Fed chairman Greenspan is often
blamed today for the US housing bubble and associated lending silliness.
Although people rarely mention a "money multiplier" explicitly in
this case, the basic concept it the same -- namely the idea that hundreds of
independent financial institutions, and millions of freely-acting borrowers,
entered into certain transactions due to some sort of centralized control.
Actually, the Fed's influence was limited to a) regulatory/moral suasion
(they didn't say don't do it), b) changes in the value of money (generally
reflationary in 2002-2005), and c) changes in interest rates (low, in
response to the deflation of 1997-2002). This was certainly influential, but
not really in the way that many people imply.
Another place the
libertarian types stumble is regarding the "money multiplier's"
effect on monetary value. After all, if banks "multiply" money, and
"too much money" leads to inflation, then banks and the "money
multiplier" must cause inflation, right? This "too much money"
that causes inflation is not credit, but base money, and the only entity that
creates base money today is the central bank. Commercial banks did create
base money in the past, in other words they printed their own currencies.
However, since the currencies were redeemable for gold, and the banks
adjusted their supply of currencies appropriately, this was generally not a
problem. If the central bank today creates too much base money, then the value
of the currency (as noted in the exchange rate with gold and other
currencies) will decline. This is inflation. If banks create credit, in any
amount, but the central bank manages base money supply and currency value
appropriately so that the value of the currency is stable (against gold),
then there will be no inflation. It is possible that you could have entirely
too much credit, possibly accompanied by a certain unsustainable economic
frenzy or an asset bubble. But you won't have inflation.
The concern among
libertarian types about banks' supposedly inflationary "money
multiplier" leads to their somewhat hysteric denunciation of
"fractional reserve banking," supposedly a great horror. When
banks' real role is understood, this "fractional reserve banking"
fascination dissipates. I think this is somewhat irrational emotional residue
that remains over many bad experiences with banks over the years. Before the
advent of deposit insurance in the 1930s, in very many instances small-scale
savers who thought they had "money in the bank" were shocked to
find out that the money wasn't really there. In fact they were making loans
to the bank, and the bank, going bankrupt, was unable to pay them back. Also,
on a more sophisticated note, the presence of so many levered lenders (as
opposed to direct, asset-based lending) does create pressure on currency
managers to "do something" in the event of widespread default, and
that "something" often amounts to some sort of money
printing/currency devaluation.
So, I think we can see
that there is no "money multiplier," and banks/credit creation is
really no inherent threat to the stability of currencies. Currencies are
managed by adjusting supply in response to demand, to maintain a stable
value. Banks are just another form of business -- they do what they do. The
whole process is a lot simpler than most people think.
* * *
Martin Feldstein popped
up in the FT last week, espousing on the wonderful advantages of a declining
dollar.
http://www.ft.com/cms/s/0/dd0a0840-7ab8-11dc-9bee-0000779fd2ac.html
Feldstein, a professor at
Harvard who was chairman of the Council of Economic Advisors under Reagan
(and who was also short-listed as Alan Greenspan's replacement), leads with
the idea that a lower dollar would help reduce the U.S.'s current account
deficit, now running about 6% of GDP. This is a disastrously bad idea, and
the fact that Feldstein is out in public flogging it at this time suggests
that perhaps some Administration types are thinking the same way. Well, they
might get the results they expect -- a smaller "current account
deficit" -- but not in the way they think.
A "current account
deficit" is really a measure of imported capital. It is matched with net
importation of goods and services because capital is, actually, goods and
services. The paper part is just a contract saying who gets paid what in
return for the capital (goods and services) imported.
In an economy, there are
generators of capital ("savers") and recipients of capital. On a cashflow basis, the "savers" are cashflow-positive and the recipients are cashflow-negative. These recipients of capital could be
making sound investments. On average, the corporate sphere, which is normally
a capital-user, makes productive investments. Other potential recipients of
capital include the government and the consumers. The corporate sector
normally generates positive cashflow from operations,
but invests an amount greater than that in capex,
leading to a net demand for additional capital. You could say that the
corporation is running a "current account deficit." Consumers are
normally capital generators ("savers") in aggregate, although that
is not the case today. The government is normally a cashflow-generator
when it is running a surplus, and a cashflow-user
when it is running a deficit.
The world is basically an
open market, so when the cashflow-generators in an
economy (normally the citizens) look for places to invest their capital, they
can potentially look worldwide. When the cashflow-users
in an economy (normally the corporations and often the government) look for
sources of capital for their needs, they also look worldwide. Today, with a
low savings rate (often negative) and large government deficits, on balance
there is much more demand for capital than there is creation of capital in
the U.S. The result, of course, is that the demand for capital is satisfied
in some part by foreign capital, producing a "current account
deficit."
This is all fairly
mundane, conventional economics. You'll notice, however, that there is NO
mention of currency value in the above description. Thus, we can also see
that WHATEVER THE CURRENCY DOES, the "current account balance" will
reflect the relative balance of the supply and demand of domestic capital.
Rather, the currency
value affects this system in other ways. For example, if the U.S. dollar
tanks (as it is doing now), then foreign investors may be unwilling to export
capital to the U.S. and accept U.S. dollar debt in return. What would happen
if all foreign investment stopped, as appears to be indicated in the most
recent TIC data? Then, of course, U.S. capital creation and capital use must
balance. The U.S. consumer savings rate would most likely go up, corporate
capital use might go down, and the government budget deficit might go down
too (in this case forced by higher interest rates). We are likely to see the
consumer savings rate go up soon, as the primary use of capital among
consumers (home equity loans) is shutting down rapidly. This is likely to
lead to a falloff in consumption, which doesn't inspire corporations to
invest much. The government will do what it does. In the end, markets clear
via price, and price in this instance is primarily interest rates. Higher
interest rates tend to encourage savers and discourage borrowers. With higher
rates, foreigners might become interested again.
Thus, if there is a
correlation between a sinking currency and a shrinking current account
deficit, it is not necessarily because of "trade" but rather
because of the deteriorating investment environment in a country experiencing
devaluation and inflation. At some point nobody would want to invest there
(foreign or domestic), in which case all capital would be exported to more
promising locales, and the country would run a current account surplus!
Likewise, countries that have exceptionally good conditions for growth
(typically among emerging markets) will often run very large current account
deficits as capital is imported. This hasn't been the case so much recently,
because emerging markets (particularly China) have also had very high savings
rates recently, so the great demand for capital has been satisfied by
domestic sources, on balance.
However, whenever foreign
capital is employed, there are currency issues involved. The U.S. doesn't
have this so much because entities typically issue debt in dollars. We'll
talk more about that some other day.
* * *
Thanks to Jim Puplava for offering to interview me for his wonderful
Financial Sense radio program and website. Jim and his guests are very
sophisticated, and it was an honor to be on the show. Here's the recording of
the interview. I'm afraid I was a bit of a rambler for the show -- Jim was
asking questions of a sort I haven't been asked before, so I didn't have my
answers worked out. (Also, we had some technical problems which impaired our
ability to chit-chat.) Jim read my book (not necessarily so common among
interviewers) and I can tell he was really able to appreciate what I was
getting at. Thanks again Jim!
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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