Professional Documents
Culture Documents
Naked Money
Naked Money
CJ
Contents
Acknowledgments
Introduction
PART I:
WHAT IT IS
1
What Is Money?
2
Inflation and Deflation
3
The Science, Art, Politics, and Psychology of Prices
4
Credit and Crashes
5
Central Banking
6
Exchange Rates and the Global Financial System
7
Gold
PART II:
WHY IT MATTERS
8
A Quick Tour of American Monetary History
9
1929 and 2008
10
Japan
11
The Euro
12
The United States and China
13
The Future of Money
14
Doing Central Banking Better
Notes
Index
naked money
Introduction
Take a $20 bill out of your wallet and look at it closely. It’s nice paper—a
high-fiber content so it can go through the wash and come out okay—but still
just paper. The engraving is nice, but nothing that approaches fine art. Perhaps
most important, there is nothing on that bill promising you something in return
—no gold, no silver, nothing. It is a piece of paper with no intrinsic value. If you
took it to the Federal Reserve, the institution responsible for issuing American
currency (which is then printed by the Treasury), the officials there would offer
you nothing. Some of the Federal Reserve Banks, such as Chicago, have a nice
little museum, but if you wave your $20 (or even a $100) around in the lobby
and demand something tangible in return, you will get a strange look and maybe
an escort out of the building.
So what is it worth? Not nothing. It’s worth about $20. That’s not a silly
statement, or at least not as silly as it seems. If you take a $20 to a sandwich
shop, you’ll get a nice lunch for two. At a grocery store, you’ll get three pounds
of chicken breast or a good bottle of pinot noir. Nearly everyone in the United
States, and many people elsewhere in the world, have a very refined sense of
what that piece of paper is worth. They would be only too happy to pick up your
$20 should it fall out of your pocket—which is not something you can say about
every small piece of paper blowing down the street.
This is a book about money—about how those pieces of paper in your pocket
have acquired such value, and how a bizarre convention, swapping seemingly
useless pieces of paper for real goods, is so fundamental to a modern economy.
Of course, while we’re at it, we’ll look at the even more bizarre notion that you
can write a check, wave a phone, or hand someone a rectangular piece of plastic
and walk away with new furniture, office supplies, or even a car.
In fact, you can use someone else’s money to do all of that. Money is not just
about the bills in your wallet. Our whole financial system is built around a
simple but powerful idea: credit. Banks, and the many institutions that function
like banks, are intermediaries that match lenders and borrowers (taking a fee, of
course, for the service). In that lending process, something remarkable happens:
financial institutions create credit, which expands the supply of money. Think
about this simple example:
Wow. That is the power of credit. Of course, the fact that you are spending
money that technically still belongs to me is a source of both economic strength
and instability. The good news: credit is what allows students to attend college,
families to buy homes, and entrepreneurs to launch new businesses. The banking
sector makes it possible for us to make productive use of other people’s capital.
The bad news: when credit goes wrong (as in 2008), the results can be
devastating for the whole economy. We have a problem when I suddenly want
my money and you are not in a position to pay it back, perhaps because you have
used it to buy a house or a car or a restaurant.
The history of finance is also a history of financial panics. If lenders want
their money back, and borrowers cannot readily produce it, the institution
brokering the deal can fail. And when financial institutions are at risk of failing,
more lenders rush to get their money—virtually ensuring that failure. We learned
in 2008 that some very fancy-sounding components of the financial sector (the
repurchase market, the commercial paper market, et cetera) are vulnerable to
runs when people get nervous, just like banks were during the Great Depression.
When the system works well, money and credit lubricate it and empower
human ingenuity. When the system breaks down, as it did in 2008, the financial
edifice implodes at huge human cost. This is a book about that, too.
A central bank, whether it is the U.S. Federal Reserve or the Bank of England or
the European Central Bank, is the institution with primary responsibility for
managing all this. Central banks are charged with maintaining the value of the
currency and protecting the stability of the financial system. (In the United
States, the Federal Reserve has the added mandate of using its powers to
promote full employment.) These institutions are vested with remarkable
powers, including the exclusive right to create new money.
Yes, the U.S. Federal Reserve can just make new money. And yes, that is a
power that requires enormous discretion. Since 2008, central bankers have taken
on oversized importance. More Americans can probably name the recent Fed
chairs (Yellen, Bernanke, Greenspan, and Volcker) than the most recent four
chief justices of the Supreme Court (Roberts, Rehnquist, Burger, and Warren).
Ever since the financial crisis, there has been a political battle in the United
States over whether the Federal Reserve is doing too little to help the economy
recover, or too much. Low interest rates help to put more Americans back to
work and raise the wages of others. On the other hand, low interest rates punish
savers and can, if they are too low for too long, cause inflation. During the 2012
presidential election, Republican candidate Rick Perry described Fed Chair Ben
Bernanke’s aggressive response to the financial crisis as treasonous. (For the
record, this was an absurd and inappropriate statement, but it certainly gives one
a sense of the politics.)
There is nothing new about that, by the way. Perhaps you remember from
history class William Jennings Bryan and his famous 1896 “Cross of Gold”
speech at the Democratic National Convention. The Federal Reserve had not yet
been created at that point, but Bryan argued that high interest rates were
punishing indebted American farmers and the solution was more money
(specifically, money backed by silver in addition to gold).
To connect the dots, Rick Perry wanted less new money. William Jennings
Bryan wanted more. I don’t think they would have liked each other. To the
larger point, this is a book that explains what the Fed does, how it does it, and
why it matters.
America is not alone in any of this. Other countries also have small pieces of
paper you can use to buy things. The money in those places causes political
battles, too. Across the Atlantic, the Germans and the Greeks have been
bickering for years like a seventy-year-old couple trapped in a loveless marriage.
These two countries, along with seventeen others in the European Union (and a
handful outside it), have adopted a common currency, the euro. The single
currency was launched nearly two decades ago with high expectations for
bringing the nations of the continent together, politically and economically. The
luster has been fading from that grand experiment. Under the euro, some of the
least productive economies on the continent—Greece, but also Italy, Spain, and
Portugal—have struggled. Specifically, they have lost some of the most
important macroeconomic tools that come with having one’s own national
currency rather than sharing one with an economic powerhouse like Germany
(e.g., setting interest rates and managing the value of the currency). The future of
the euro is still in question.
Yes, this is a book about all of that, too.
Across the Pacific, the Chinese government has been managing its currency,
the yuan, the same way it manages everything else in the economy: with a lot of
government oversight. For more than a decade many observers, ranging from
members of Congress to officials at the International Monetary Fund, have
accused the Chinese government of deliberately undervaluing the yuan. The
effect of this alleged nefarious activity is to make Chinese goods cheaper in the
United States and elsewhere, thereby bolstering Chinese exports and keeping
workers employed. When Beijing depreciated the yuan by 2 percent in the
summer of 2015 in response to a plunge in the Chinese stock market, U.S.
politicians from both political parties blasted the move as an unfair trade practice
and “further proof China cannot be trusted on currency policy.” 1
There are a couple of strange things about this. First, lawmakers are
condemning China for selling goods to us more cheaply than they should—not a
common complaint in capitalist countries. And second, the foregoing presents a
conundrum:
When countries share a currency (as with the euro), the result has been
currency-related friction.
And when countries have their own currencies (such as the dollar and the
yuan), the result has been currency-related friction.
This is a book about currencies, exchange rates, and the frictions that arise
when different countries use different pieces of paper as money—and the
separate set of challenges that arise when countries try to share money.
But it gets weirder. In Japan, Prime Minister Shinzo Abe was elected, and
then reelected, on a promise to create inflation. Yes, you read that correctly.
After more than twenty years of falling prices (deflation) and economic malaise,
Japan’s leader has vowed to end deflation as one tool toward restoring the
economy to health. For any reader who lived through America’s inflation in the
1970s, or has read about that stretch, it must be ironic that a responsible
government has promised more inflation (and has been judged harshly for failing
to deliver!). This is a book about inflation, deflation, and whatever the heck has
been happening in Japan for two decades.
Back in the United States, when members of Congress are not criticizing China
for selling us things too cheaply, they have been crafting new regulations for
banks and other financial institutions in response to the 2008 financial crisis. The
public is still angry about bailouts, the catch-all term that has come to
characterize the response to the crisis. The government made money on many of
its interventions, but that is a detail lost on voters who are rightfully angry about
spending tax money to fix the mistakes of reckless lenders and borrowers. The
lingering question is whether regulators have made the financial system safer or
merely laid the groundwork for a different kind of financial panic next time
around. Plenty of smart people are worried about the latter.
This is a book about financial crises, including those of 1929 and 2008.
(Spoiler alert: I will argue that we did a lot of things right this time that
prevented another Great Depression.)
All the while, one of the most intriguing monetary developments has been
unfolding on the Internet, with very little oversight from Congress or any other
government: the creation of “cryptocurrencies” like bitcoin. Just when you
thought nothing could get stranger than paper money—pieces of paper with no
intrinsic value issued by governments—along comes money without even the
paper or the government! Bitcoins are “mined” by computer users who solve
complex algorithms and are awarded bitcoins for doing so. Remarkably, those
bitcoins can be used to buy real goods and services. Stranger still, the bitcoin
computer program was written by a mysterious man (or woman, or group of
programmers working under a pseudonym) who has never stepped forward to
take credit for his creation. This book will explain bitcoin, to the extent it makes
any sense at all.
What do the phenomena I have described have in common? Money. Or more
broadly: money, banking, and central banking—three interlinked institutions at
the core of the modern economy. Money is a tool that we use to conduct
transactions: bags of salt in Roman times; pouches of mackerel in prison;
bitcoins when buying illegal drugs or weapons on the Internet; and, of course,
dollars, euros, yen, and other government currencies for just about everything
else.
To be clear, this is a book about money, not wealth. They are not the same.
Warren Buffett has a lot more wealth than I do; he may or may not have more
money. As the book will discuss, money typically refers to assets that can be
used immediately to make purchases. Cash is money. So are deposits held in
checking accounts or other accounts with check-writing privileges because you
can use them to buy things now. On the other hand, a fancy car and a big house
are not considered “money”; both have great value and are therefore sources of
wealth, but neither is frequently used to conduct commerce.
Spanish gold coins held in your safety deposit box might have been money
in a different era, but they would not currently be defined as such. Even stocks
and bonds are not money. They are assets that one sells for money, which can
then be used to buy things. Thus, all money is wealth, but not all wealth is
money. This is how I can safely assert that Warren Buffett may not have more
money than I do. Sure, he has billions in stocks and bonds, plus a plane and
maybe some hotels. But does he keep more money in his wallet and checking
account than I do? Maybe, maybe not.
In the same vein, now is a good time to make an important distinction
between “currency” and “money.” Currency technically comprises the paper
notes and coins that circulate—the dollars in your wallet, the coins on your
dresser, and so on. Money is a broader concept that includes currency but also
other assets that can be used to make purchases or quickly converted to currency,
such as checking account deposits. All currency is money, but not all money is
currency.
That said, a nation’s currency, such as the Japanese yen or the Chinese yuan,
typically refers to all its money, not just the bills and coins. The language in this
regard has evolved in a sloppy way, but context usually makes it clearer.
Finally, “cash” is usually synonymous with currency—but not always. When
we say that drug dealers conduct transactions in cash, we really do mean wads of
currency. But when a newspaper reports that investors have sold stocks and are
holding cash, the story is not suggesting that investors have suitcases full of
$100 bills. Instead, the point is that they are holding lots of “liquid” assets, such
as deposits in a money market account. Liquidity, a term that will come up
throughout the book, is a measure of how quickly an asset can be turned into
cash at a predictable price. Treasury bonds are highly liquid; Vincent van Gogh
paintings are not.
The nomenclature should not get in the way of the big picture. Money and
banking (broadly construed) make a modern economy work. They underlie
every important transaction we make. In turn, central banks make money and
banking work.
When all of this is functioning well, nobody takes particular notice. Most of
us don’t spend much time inspecting the twenties in our wallets. They’re just
pieces of paper with Andrew Jackson on the front—but pieces of paper that
empower a modern economy in an almost miraculous way. When the system
breaks down—when “money” goes bad—the results can be disastrous.
Obviously everyone prefers the former to the latter. This is a book about why
monetary policy is so hard, and why getting it right matters so much.
PART I
what it is
CHAPTER 1
What Is Money?
What is the nature of those little disks or documents, which in themselves seem to serve no useful
purpose, and which nevertheless, in contradiction to the rest of experience, pass from one hand to
another in exchange for the most useful commodities, nay, for which every one is so eagerly bent on
surrendering his wares.
—Carl Menger, founder of the Austrian School of economics, 18921
In 2009, North Korea did something unusual, even by North Korean standards.
The nation issued a new currency that lopped two zeroes off all the bills. Thus
one won of the new currency was declared equivalent to 100 won of the old
currency.2 This is not a particularly new trick; assorted countries in the past have
issued new currencies with fewer zeroes as a tool for fighting inflation. In 1994,
Brazil created an entirely new currency, the real, to replace the inflation-battered
cruzeiro real. The government announced that each shiny new real would be
worth 2750 cruzeiro reais. (Reais is the plural of real.)
None of this is inherently good or bad for consumers, as long as the old
currency can be freely swapped for the new currency. Imagine if the United
States had no dollar bill but instead priced everything in pennies. One day the
government announced that pennies would no longer be accepted as legal tender.
Instead, one hundred pennies could be swapped for a new currency, the dollar,
after which all prices would be quoted in dollars. A product that used to cost two
hundred would now cost two. In terms of purchasing power, nothing would
change. People who had lots of pennies before would now have lots of dollars.
Bank accounts would be even easier to convert; every account would just lose
two digits. Prices would look lower (hence the tool for fighting inflation), but in
terms of accumulated wealth, rich people would still be rich and poor people
would still be poor, only in dollars rather than pennies.
Anyone over the age of six recognizes that five dollars is no different than
five hundred pennies. (And even the six-year-olds can only be fooled a few
times.) We would all just have to carry fewer coins in our pockets. Stores would
no longer accept pennies, but if you happened to discover three hundred of them
under the cushions of your couch, you could always take them to a bank and
swap them for dollars. Brazilians had nearly a year to convert their old cruzeiro
reais for the new reais. Some European nations, such as Germany, have said that
they will forever exchange old coins and notes (the deutsche mark) for euros,
even though the country gave up the deutsche mark for the euro more than a
decade and a half ago.
But North Korea is not like other countries. When North Korea engineered
its currency reform, the government announced that only a limited amount of the
old currency could be swapped for the new currency—about $690 at the official
exchange rate (and only $35 at the black market rate).* Anyone holding large
amounts of old currency would see much of their accumulated wealth destroyed.
That was exactly the point. The North Korean government had become
increasingly intolerant of black market activities outside of the country’s official
ration-based economy. Black market traders were sitting on large stashes of
cash. With the stroke of a government pen (or whatever Korea’s Supreme
Leader does to promulgate legislation), the government confiscated most of that
illicitly accumulated wealth.
Of course, many ordinary North Koreans hoping to avoid starvation during
the winter and spring had also accumulated stocks of cash. After the
announcement of the currency reform, the sparse news that leaked out of North
Korea made reference to “chaos in markets and rail stations” as savers rushed
home to swap old money for new.3 North Koreans had only twenty-four hours to
convert their allotted quota of old currency to new currency. A defector told
Barbara Demick, a writer for The New Yorker, “In one day, all your money was
lost. People were taken to the hospital in shock.” 4
The North Korean government had taken money with value and rendered it
worthless. This is a curious power.
It is even more curious when juxtaposed against what was happening in the
United States at exactly the same time. In response to the 2008 financial crisis,
the Federal Reserve was aggressively “injecting liquidity” into the financial
system. The concept of liquidity will be explored in greater depth later in the
book. For now, the basic point is that the Federal Reserve was doing everything
in its power to lower interest rates so that struggling banks, businesses, and
consumers would have easier access to credit after the real estate bust. Here is
the part that is almost North Korean in its weirdness: the Federal Reserve
accomplished its task by creating new money. From nowhere. There is a
windowless room at the Federal Reserve Bank of New York where traders
literally created new electronic money and used it to buy billions of dollars of
financial assets. Between January 2008 and January 2014, the Fed injected
roughly $3 trillion of new money into the American economy.5
One minute the money did not exist; the next minute a trader acting at the
behest of the Fed bought bonds belonging to assorted private financial
institutions and paid for those securities by transferring electronic funds to the
accounts of the selling firms. New money. Money that did not exist just seconds
earlier. Click. That is the sound of a guy sitting at his computer in the New York
Fed creating a billion dollars and using it to buy assets from Citibank. Click,
click. That’s $2 billion more.
While North Korea’s Supreme Leader was taking money with value and
rendering it useless, the Fed was doing the opposite: creating money out of
nothing. Neither the North Korean won nor the United States dollar has any
intrinsic value. One cannot take either currency to the government that issued it
and demand something tangible in return, such as gold or rice or cooking oil
(although at least in the United States, you would not be sent to a labor camp for
asking). North Korea could wipe out money, and the United States could create
it, because money in both countries is just paper, or increasingly bits and bytes
on a computer screen.
And that brings us to the third wacky thing going on at roughly the same
time that North Korea was destroying money and the United States was creating
it: American prisoners were conducting many of their transactions using pouches
of mackerel. Yes, the oily fish.
Prison inmates in the United States are not allowed to possess cash. Instead,
they typically have accounts at a commissary where small items can be
purchased. With no cash circulating, the goods sold in the commissary can be
used as currency: books of stamps, PowerBars, and so on. As has been the case
throughout history, this kind of commerce becomes easier when there is informal
agreement on a single unit of account, such as cigarettes in prisoner-of-war
camps during World War II. The item that has emerged as the gold standard for
trade in American prisons since the federal smoking ban in 2004 is the pouch of
mackerel, or “the mack.” 6 (It comes in a pouch rather than a can so that
prisoners will not sharpen the container and use it to stab one another.) The
mackerel pouches are portable and storable. Curiously, mackerel has little appeal
outside of prison, even at discount retailers. But behind bars, mackerel outsells
tuna, crab, chicken, and oysters—in part because a pouch of mackerel happens
to sell for roughly a dollar in the canteen, so it’s relatively easy to think in terms
of dollars while using macks. Unlike the dollar or the won, the mackerel does
have some intrinsic value. You can always eat it.
In fact, if the North Korean or American economies ran on mackerel, neither
the Supreme Leader nor the Federal Reserve could have done what they did. The
Supreme Leader cannot go on television and declare that all mackerel is now
worthless. It’s still mackerel. You might get arrested if you try to trade it for a
winter coat, but you can always keep it in the basement and eat it for dinner
during the periodic famines. One cannot pronounce something worthless that has
worth. True, the government could try to confiscate all the mackerel, but that’s a
different and much more difficult task.
Similarly, the U.S. Federal Reserve cannot instantaneously generate millions
of pouches of mackerel where none previously existed. No one in a windowless
room at the Fed can push a button and have pouches of mackerel show up at
Citibank. Click, click, click. That is the sound of no mackerel being created.
How did money get so weird? The first and most important insight is that money
is not synonymous with wealth. A house is wealth. You can live in it or rent it
out. A bag of rice is also wealth. You can trade it, eat it, plant it, or store it to do
any of those things later. However, a bag of rice—unlike a house—is a relatively
uniform commodity, which gives it potential value as a medium of exchange.
You might accept a bag of rice as payment from someone even if you don’t
particularly like rice, just as inmates who don’t like oily fish are willing to settle
up with pouches of mackerel. Why? Because lots of other people like rice (or
mackerel). Rice has value to me in part because rice has value to other people.
This is a key feature of all commodities that have served as mediums of
exchange across cultures and throughout history: salt, gold, cigarettes, dolphin
teeth, wampum, animal pelts.
Now let’s expand the example slightly and say that you have ten fifty-pound
bags of rice in your basement. You would prefer not to carry them around while
conducting commerce. So you create ten elegant paper certificates, each with
your signature and a pledge to redeem said paper certificate for one fifty-pound
bag of rice. You give one certificate to the golf pro who gives you a putting
lesson. You explain to him that he, or anyone else bearing the certificate, can
come and claim a bag of rice from the basement anytime. You have now created
paper money, albeit paper money backed by a commodity (bags of rice).
And when the golf pro uses the rice certificate to pay the woman who walks
his dog, you’ve created a paper currency that circulates. Anyone holding a
certificate who decides they need rice will redeem it. Otherwise, the bags of rice
may sit in your basement for quite some time as people use the paper certificates
for commerce. Here is the irony: as long as the people using the rice certificates
are confident they can redeem them at any time, most will feel no urgency to do
so. But it’s also true that if there is even a whiff of doubt about the value of those
rice certificates—whether it is justified or not—you are going to have a mob of
certificate-wielding people banging on your door and demanding rice. This turns
out to be a potentially destabilizing feature not just of commodity-based money
but of the broader financial system. Even the most complex financial systems
can thrive or fail depending on whether people believe they will thrive or fail.
Second, modern money depends on confidence. Consider the curious case of
Indian rupees. According to the Reserve Bank of India, any soiled or torn rupee
note is legal tender as long as it has two intact serial numbers (as is policy for
U.S. currency).† If you present a crumpled, dirty, or torn note at an Indian bank,
the law states that the disfigured bill must be replaced with a nice crisp one. Yet
on the streets of Mumbai, you will find it very difficult to get anyone to accept a
torn or overly worn rupee note, even if the serial numbers are clearly visible and
intact. Not shopkeepers, not taxi drivers, not street vendors—and therefore no
one who expects to do business with shopkeepers, taxi drivers, or street vendors.
No one wants to be the sucker who has to schlep the soiled bill to a bank for
exchange. Of course, if people just accepted the soiled notes, no one would have
to schlep them to the bank. In the United States, I’ve accepted torn dollar bills,
crumpled dollar bills, dollar bills with pictures and phone numbers on them, bills
taped together, and even a dollar bill with George Washington’s face cut out. If
it’s got two serial numbers when the guy at Starbucks hands it to me, I’ll take it.
And so will everyone else (which is why I’ll take it).
Not in India. No one will accept torn rupees because no one will accept torn
rupees. Of course, when I travel to India, I refuse to accept rupees in bad
condition—thereby perpetuating the whole phenomenon.
In Somalia in the early 2000s, curiously, the opposite was happening: money
with no legal value was thriving. The currency of choice for small transactions
was the Somali shilling, which was not legal tender. (Dollars were typically used
for large transactions.) Due to a long-running civil war, the Central Bank of
Somalia had shut down. A transitional Federal Government was supposedly
responsible for monetary policy, but that entity’s authority barely extended past
the capital of Mogadishu. From a legal standpoint at the time, the Somali shilling
had roughly the same legitimacy as Monopoly money. The notes in circulation
had been issued two decades earlier by a government that no longer existed. As
the Economist noted, “Use of paper currency is normally taken to be an
expression of faith in the government that issues it.” 7 In the Somali case for
several decades,‡ there was effectively no government. Yet the currency—just
pieces of paper—marched steadily on. Why?
The short answer is that people accepted Somali shillings because people
accepted Somali shillings. If you poke a little harder, there were several reasons
for this. First, the shillings were useful as a medium of exchange for small
transactions. Just as prison inmates are accustomed to pricing and conducting
small transactions in macks, the Somalis were used to buying tea and bread with
shillings. Everyone had a pretty good idea how many shillings a small bar of
soap ought to cost. Second, Somalia has a strong clan and kinship system. In the
absence of a government, this system functioned as the strong social glue that
undergirded the faith in the currency. There was an expectation among members
of these networks that others in the network would accept shillings. As the
Economist explained at the time, “Paper currencies always need tacit consent
from their users that they will exchange bills for actual stuff. But in Somalia this
pact is rather stronger: an individual who flouts the system risks jeopardising
trust in both himself and his clan.” 8
Finally, the total absence of a functioning government was a good thing for
the value of paper money in this case. The supply of shillings was more or less
fixed because there was no government to print more of them. In contrast, quasi-
functioning governments often recklessly print currency as they struggle to stay
in power. (Take the Belarussian ruble, which was introduced in the 1990s and
became known as the bunny, partly because of the hare engraved on the note but
also for the currency’s remarkable ability to propagate.) The only growth in the
supply of Somali shillings during the civil war came from counterfeiters, and
even the number of high-quality fakes was limited because of the specialized
talent, equipment, and materials needed to make them. For this reason,
businesses and even Somali banks sometimes accepted high-quality counterfeit
bills, which created a certain mind-bending logic, as explained in one
contemporaneous news account: “An imitation of a thing which is already of
notional value turns out to be worth something.” 9 It’s like a bank willing to
accept counterfeit Monopoly money—not just fake money, but fake fake money.
But what is fake in this context anyway? The torn Indian rupees are real
money, yet you can’t use them to buy a cup of tea. The Somali shillings—and
certainly the counterfeit Somali shillings—were not real money, in the absence
of a government to declare them legal tender, except that you could use them to
buy a cup of tea. Here, the simple becomes the profound: If you can swap
something easily and predictably for goods and services, it’s money. If you
can’t, it’s not. There is even a continuum in between. Moneychangers across
Africa offer better rates for new American bills than for older ones. A $100 bill
signed by a current Treasury secretary gets a better rate than a $100 signed by
John Snow (Bush administration) or Robert Rubin (Clinton administration).
Clean, crisp bills get a better rate than old, dirty bills. And a single $100 bill is
more valuable than five $20s.10
None of this makes sense to people who use dollars in the United States, but
there is logic to the differential values in Africa. The Wall Street Journal
explains, “Some moneychangers and banks worry that big U.S. notes are
counterfeit. Some can’t be bothered to deal with small bills. Some don’t want to
take the risk that they won’t be able to pass old or damaged bills onto the next
person. And some just don’t like the looks of them.” 11 As always with money,
how people behave affects how people behave. The employees of an
international cruise ship with multiple ports of call in Africa began to complain
to their employers that they were being paid with too many old bills—too many
Robert Rubin $100s and not enough Henry Paulsons (Treasury secretary at the
time of their compensation revolt).
Once we appreciate the basic role of money, then it’s not hard to understand the
kinds of money that have evolved. Money tends to be portable, meaning that you
can carry it around while conducting commerce. Bags of rice do poorly on the
portability front, as twenty dollars of rice could easily weight ten pounds or
more. It turns out that the rice in the basement example is not as fanciful as it
may have seemed a few pages back; issuing paper certificates against a
commodity solves the portability problem. In 2010, after Haiti was recovering
from the horrible earthquake, the United Nations was working to distribute food
aid to the starving population. The distribution system was dangerous and
chaotic, in part because workers tossing bags of food from the backs of trucks
invited mayhem. Instead, the UN went to a system of coupons—a variation of
the rice certificate example. Each coupon could be redeemed for a fifty-five-
pound bag of rice. Consumers could store the coupons more safely than the rice;
aid agencies could distribute the coupons broadly while storing rice at a smaller
number of supervised distribution points. The coupons also became a currency
that could be traded for other scarce items.14
Money needs to be durable. You’d hate to have your retirement savings die,
melt, rot, rust, get eaten by rats, or otherwise disappear. Money also works best
when it is divisible, so that one can easily make change or conduct transactions
of different sizes. The $100s are nice for commerce; the $1s are handy, too. Gold
turns out to be too valuable for many small transactions; at present prices, a pack
of gum would cost about one twentieth of a gram of gold, which is smaller than
a grain of sand. Societies often come up with clever fixes for a lack of small
change. Zimbabwe eventually abandoned its own currency and adopted the U.S.
dollar as the currency of choice; U.S. bills circulate but there are few coins.
Vendors in Zimbabwe will sometimes take dollars and give change in candy,
matches, or even condoms.15
Most important, money needs to be scarce in a predictable way. Precious
metals have been desirable as money across the millennia not only because they
have intrinsic beauty but also because they exist in fixed quantities. Gold and
silver enter society at the rate at which they are discovered and mined; additional
precious metals cannot be produced, at least not cheaply. Commodities like rice
and tobacco can be grown, but that still takes time and resources. A dictator like
Zimbabwe’s Robert Mugabe could not order the government to produce 100
trillion tons of rice. He was able to produce and distribute trillions of new
Zimbabwe dollars, which is why they eventually became more valuable as toilet
paper than currency. At its peak in November 2008, the monthly rate of inflation
in Zimbabwe was reckoned to be somewhere on the order of 80 billion percent.16
________
* The official government exchange rate does not always reflect the market value of a currency, particularly
in a place like North Korea. Because the North Korean won is essentially worthless outside the country, the
rest of the world is not exactly clamoring to accumulate them. As a result, anyone looking to swap won for
a more useful international currency, such as dollars or Chinese yuan, is going to find that the won is worth
much less than the government says it is. For example, the official exchange rate between the dollar and the
won near the end of 2013 was 96 won to the dollar. The black market rate—the rate at which traders will
voluntarily give up dollars for won—was 8,000 won to the dollar.
James Pearson, “Black Market Gets Some Respect in North Korea,” New York Times, November 4, 2013.
† Any money declared legal tender by a government must be accepted within that country for all public and
private debts. The $20 in your wallet may have no intrinsic worth, but it is legal tender in the United States.
‡ The transitional government ended in 2012 and the Central Bank of Somalia was reopened.
§ The outhouse reference is not a glib throwaway. At the peak of Zimbabwe’s hyperinflation in the 1990s,
the Zimbabwe 1,000 dollar note had less value than a single piece of toilet paper, prompting businesses in
neighboring South Africa to post signs warning customers not to throw Zim dollars down the toilet.
Photo by Eugene Baron.
CHAPTER 2
Inflation or deflation, tell me if you can: Will we become Zimbabwe or will we be Japan?” 1
—Merle Hazard, self-described “first and only country artist to sing about central banking, mortgage-
backed securities, and physics”
All of this explains the most famous aphorism in monetary policy, Milton
Friedman’s observation “Inflation is always and everywhere a monetary
phenomenon.” 6 Friedman, winner of the 1976 Nobel Prize in Economics, spent
much of his career documenting the relationship between money supply and
prices. In a book called Money Mischief, he summarized his findings from
studying countries throughout modern history: “Inflation occurs when the
quantity of money rises appreciably more rapidly than output, and the more
rapid the rise in the quantity of money per unit of output, the greater the rate of
inflation. There is probably no other proposition in economics that is as well
established as this one.” 7
This phenomenon applies to all forms of money, not just paper. Commodity
money is prone to bouts of inflation or deflation for the same basic reasons: the
supply of a particular commodity does not necessarily rise or fall in sync with
the output of other goods and services. Let’s think mackerel again. Assume that
a special humanitarian shipment arrives and every prisoner in a particular
institution gets fifty additional pouches of mackerel. It’s not hard to see why the
price of haircuts in macks would go up; there are now more pouches of mackerel
and the same number of barbers. This is essentially what happened when the
Europeans discovered gold and silver in the New World. Beginning around
1500, the Spanish and Portuguese imported roughly 150 tons of silver from the
Americas, spending it on the same basic quantity of goods in Europe. The result
was a sixfold increase in prices over the next century and a half.8
For any given level of output in an economy, prices will rise and fall in
proportion to the money supply—with one crucial caveat. (Yes, there is always a
caveat.) The relationship between the money supply and prices is also affected
by the speed with which money circulates in the economy, or the “velocity” of
money. Velocity is prone to be higher—a single dollar will circulate quickly
through the economy—when consumers and firms have less need or desire to
hang on to cash (and assets that approximate cash, such as checking account
deposits).
To make this more intuitive, let’s revisit our prison mackerel example, just
after the Red Cross has lavished fifty new pouches of mackerel on each inmate.
We have no reason to believe that the velocity of mackerel would change
appreciably. Suppose each prisoner typically keeps two pouches under the bed to
satiate any midnight craving for oily fish and uses the rest for trade. We would
expect prison prices in macks to rise roughly in proportion to the increase in the
supply of mackerel induced by the humanitarian shipment. But what if there
have been several stabbings with shanks made out of sharpened toothbrushes
and the warden is threatening a lockdown? As a precaution against losing access
to the canteen, many of the prisoners might decide to keep more mackerel under
their beds. The speed at which macks circulated for trades would slow down as
pouches piled up under bunks. A doubling of the supply of macks in the prison
would not lead to a doubling of prices, since many of the new macks would be
out of circulation rather than chasing prison goods.
Velocity is the crucial link between money supply and prices. Anything that
causes individuals and institutions to hang on to money will slow velocity. For
example, economic uncertainty prompts banks, firms, and consumers to
stockpile cash (and other liquid assets†) because they fear less access to credit in
the future. On the other hand, financial innovations that make it easier to convert
assets to cash, such as home equity loans, speed up velocity because they enable
households to hold less money for a rainy day (or, more accurately, a hurricane
that blows off the roof). For all that, short-term fluctuations in velocity can still
be puzzling. As one prominent macroeconomist recently conceded to me as we
chatted about velocity while watching our daughters compete in a cross-country
race, “Yeah, we don’t really understand velocity.”‡ This turns out to be more
than an idle observation; changes in velocity make it hard to predict precisely
how increases or decreases in the money supply will affect prices, at least in the
short term.
The discussion so far might suggest that money has no significant impact on the
“real economy.” Velocity complicates things, but prices generally adjust to the
money supply and people generally adjust to changing prices. Nobody wants
hyperinflation, but what’s the big deal with 10 or 20 percent inflation (or
deflation) if we can all buy and sell the stuff that really matters, albeit at prices
that go up and down? No harm, no foul, right?
Up to a point, yes. If you knew that prices would rise 10 percent annually, or
even 100 percent, you could plan accordingly. You would expect your employer
to pay you 10 percent more every year to compensate for rising prices. Any real
raise, reflective of merit, would be on top of that. If you borrowed money from a
bank, and the bank demanded 4 percent as the “rental rate” for that capital, the
interest rate would be 14 percent: 4 percent “real” interest as the price of the
loan, plus 10 percent to compensate for the fact that the dollars you would be
paying back a year later would have 10 percent less purchasing power than the
dollars you borrowed. (Economists use the term “rental rate” because borrowing
money from a financial institution is like borrowing a car from Avis or power
tools from Home Depot; you pay for the privilege of using something that
belongs to someone else, even if you eventually give it back.)
Now is a good time for a short detour to reinforce the crucial distinction
between “nominal” figures, which are not adjusted to account for inflation, and
“real” figures, which are. In the above example, the nominal interest rate (the
price advertised in the bank window) would be 14 percent; the real rate (the true
cost of renting someone else’s capital) would be 4 percent. Any comparison
between prices over time ought to be adjusted for inflation. Hollywood studios
routinely ignore this elementary lesson. What are the top five highest-grossing
(domestic) films of all time?9
You may feel that list looks a little suspicious. These are successful films—
but The Avengers? Was that really a greater commercial success than Gone with
the Wind? The Godfather? Jaws? No, no, and no. Hollywood likes to make each
blockbuster look bigger and more successful than the last. One way to do that
would be to quote box office receipts in Zimbabwe dollars, which would inspire
headlines such as the following: “Hunger Games Breaks Box Office Record with
Weekend Receipts of $57 Million Trillion!” But even the most dim-witted
moviegoers would be suspicious of figures quoted in a hyperinflated currency.
Instead, Hollywood studios (and the journalists who report on them) use nominal
figures, which makes recent movies look successful largely because ticket prices
are higher now than they were ten, twenty, or fifty years ago. (When Gone with
the Wind was released in 1939, tickets cost around 50 cents.) The true measure
of commercial success is box office receipts adjusted for inflation. Earning $100
million in 1939 is a lot more impressive than earning $100 million in 2015. So
what are the top-grossing films in the United States of all time, adjusted for
inflation?10
In real terms, Avatar is number 14; The Avengers falls all the way to 29.
Similarly, programs that spend or collect money over time should be
adjusted, or “indexed,” to take inflation into account. The federal minimum
wage was 25 cents when it was established in 1938. Obviously getting paid a
quarter an hour is not going to take you very far in 2015, yet the minimum wage
is not automatically adjusted for inflation. Instead, Congress must change it by
law to account for rising prices. As a result, there have been long stretches in
which the minimum wage stayed constant while prices were rising (meaning that
the minimum wage was falling in real terms). The graph below, from the U.S.
Department of Labor, shows the difference between the nominal minimum wage
over time and the real purchasing power of that wage (measured in 2015
dollars).11 The real value of the minimum wage was actually higher in 1968
($10.97 when converted to 2015 dollars) than it is today ($7.25).
Source: U.S. Department of Labor, Wage & Hour Division, www.dol.gov/whd/minwage/chart.htm.
YOU: It’s true that prices are falling at 5 percent a year, but if we make
nominal rates negative 4 percent, the real rate will only be 1 percent and
some of our customers might start borrowing again.
BOSS: Who are you?
YOU: I sit in the cubicle right outside your office.
BOSS: You’re telling me that we should loan someone a million dollars at an
interest rate of negative 4 percent? They are going to pay us back less
than we loaned them?
YOU: Yes! But due to the current deflation, the money they pay back will
have gained 5 percent in purchasing power! We’ll still earn a positive
return on the loan in real terms!
BOSS: So you’re telling me that we should loan someone $1 million and ask
them to repay only $960,000 a year later?
YOU: Yes! In real terms, we still come out ahead.
BOSS: Okay, Einstein, wouldn’t it be better just to leave the $1 million in the
vault? Then at the end of the year, we’d have $1 million, not $960,000.
YOU: . . . True.
BOSS: Is $1 million more than $960,000?
YOU: Yes, it is.
BOSS: So what kind of dumbass loans money to people and asks them to pay
back less than they borrowed when we can make more money by doing
nothing?
The conversation might go on, but it would devolve to topics like cleaning
out your cubicle and meeting with human resources for your exit interview.
The effect of deflation on real interest rates presents a related challenge for
monetary policy. When an economy is operating below capacity, a central bank
like the U.S. Federal Reserve can push on the economic gas pedal by
manipulating the money supply to lower interest rates. However, central banks
face the same dilemma as commercial banks with regard to falling prices:
nominal rates can’t go negative. In central banking parlance, this is referred to as
the “zero bound.” If deflation is running at 4 percent a year, even a nominal rate
of zero would result in a real interest rate of 4 percent, which can be a steep cost
for borrowing during a time of economic distress. Deflation limits how far the
central bank can push on the accelerator—often when the economy needs the
most gas.
Now for the last monetary wrinkle: passing out pieces of paper with no
intrinsic value can change real economic activity in profound ways. Can we
make everyone richer in the long run by adding a zero to every denomination of
currency in the United States? Of course not. But in the short run, things are
more interesting—beginning with an insight from a famous babysitting
experiment. In 1977, the Journal of Money, Credit, and Banking published a
paper describing a Washington, DC, babysitting co-op in which members
exchanged babysitting time with one another by exchanging scrip.18 Each unit of
scrip was worth a half hour of babysitting; the scrip had no other worth. (As far
as I know, they were just fancy pieces of paper.) For technical reasons explained
in the journal article, the quantity of scrip in the co-op began to shrink. (The
money supply was falling.) More important, families began to conserve their
scrip because they worried that they would not have enough for future important
babysitting needs. (Velocity was falling, too.) This exacerbated the problem.
As economist Paul Krugman later explained in an essay for Slate, members
were hoarding in anticipation of future needs.19 But not everyone can hoard at
the same time. (Whose kids would they sit for, if everyone else is hoarding?)
Krugman explains, “As a result, most couples were anxious to add to their
reserves by babysitting, reluctant to run them down by going out. But one
couple’s decision to go out was another’s chance to babysit; so it became
difficult to earn coupons. Knowing this, couples became even more reluctant to
use their reserves except on special occasions, reducing babysitting opportunities
still further.” The babysitting co-op was experiencing the equivalent of a
recession. In the broader economy, one family’s rational response to a weak
economy (fewer dinners out, no new car this year) merely exacerbates the
economic problem as restaurants and car dealers lay off workers, who then
spend less and spread the economic malaise. As in the babysitting co-op, one
person’s thrift lowers another person’s income—a phenomenon popularized by
the twentieth-century economist John Maynard Keynes as the “paradox of
thrift.”
The Washington, DC, babysitting co-op attracted attention because of the
simple fix: give out more scrip. According to Krugman, “More coupons were
issued, couples became more willing to go out, opportunities to babysit
multiplied, and everyone was happy.” Remember those clicks on the keyboard at
the New York Fed creating money that previously did not exist? For all intents
and purposes, that was the Fed solving a problem similar to the babysitting co-op
recession. The Fed does not give out money; America’s central bank uses
monetary policy to lower interest rates and inject liquidity into the system, all of
which will be explained in chapter 5. Still, this should strike you as a bizarre
phenomenon: making paper with no intrinsic value more readily available
changes behavior—whether it is scrip for a babysitting co-op or dollars for the
world’s largest economy.
And so we conclude with the curious tension that characterizes modern
money. The American dollar is arguably the worst form of money one might
conceive. It has no intrinsic value or inherent scarcity. There is no physical limit
on the speed or degree to which the currency can be debased. History is replete
with examples of governments acting badly when given the opportunity to do so
by paper currencies, beginning in the American case with George Washington
and the Continental Congress. (During the American Revolution, the rebellious
colonies printed their own paper currency, the continental. The currency
depreciated to the point that the expression “not worth a continental” entered the
lexicon.) Even the Washington babysitting co-op went on to suffer a bout of
inflation; a surfeit of scrip created a situation in which too many people wanted
to go out and not enough wanted to babysit.20
At the same time, the U.S. dollar is the best form of currency one might
conceive. It is widely accepted and has a predictable purchasing power against a
broad basket of goods. In that respect, the dollar is better than gold or silver (or
mackerel) because it is less prone to swings in value, particularly deflation. A
responsible central bank can grow the money supply at whatever rate produces
stable prices. In times of economic distress, the right number of clicks on a
keyboard at the right time can save jobs and raise incomes.
Of course, there is a stunning complexity associated with determining the
right number of clicks and the right time. Fiat money has the potential to be
much better than commodity money, or much worse. In the timeless economic
classic Goldilocks and the Three Central Bankers, Zimbabwe creates money
recklessly and ruins the economy with runaway inflation. Japan allows prices to
drift downward for two decades and suffers economic malaise. Goldilocks
searches for a central banker who can deliver prices that are just right.
It turns out that nearly everything related to getting prices just right is far
harder than it would appear.
________
* According to recently declassified CIA documents, an underwater salvage operation in 2000 by
Oceaneering Technologies, the same outfit that located the Titanic, discovered wooden crates full of
counterfeit British pounds and American dollars on the bottom of Lake Toplitz in the Alps of western
Austria. The bills, perfectly preserved in the cold, oxygen-free depths, were sunk by the Nazis as the Allies
approached in 1945.
David Kohn, “Hitler’s Lake,” 60 Minutes, November 21, 2000, http://www.cbsnews.com/news/hitlers-lake-
21-11-2000/.
† Liquidity is a measure of how quickly an asset can be converted to cash at a predictable price. A Treasury
bond is more liquid than a Rembrandt painting, regardless of their respective values, because it can be sold
to a willing buyer at a predictable price on a moment’s notice. The Rembrandt painting may take months or
years to sell at an appropriate price because the market is small and specialized.
‡ Sadly, economists do talk about these kinds of things in social settings.
§ These are British sizes, but American clothes have undergone a similar sizing phenomenon.
¶ In the aftermath of the 2008 financial crisis, there were instances of nominal interest rates turning
negative. In particular, some banks began charging a small fee for holding large deposits. Thus depositors
were getting back less than they deposited—a negative nominal interest rate. In practice, this was akin to a
storage fee since large depositors had few other options for safely storing large amounts of money during
the post-2008 economic disruption and uncertainty.
CHAPTER 3
For all that, the CPI-U (hereafter referred to as the CPI) is a reasonable
approximation of the change in price for the things we tend to buy. As our
consumption patterns evolve, the basket of goods used to calculate the CPI
changes, too. Outdated items are dropped and new items are added. Automobiles
were added in 1935; air conditioners in 1964; cell phones in 1998.12 Meanwhile,
typewriters were gradually phased out as their share of the typical consumer’s
consumption bundle dwindled and eventually disappeared. Yet any mention of
cell phones (or televisions, computers, or automobiles) opens the door to yet
another methodological challenge: yes, the prices are changing, but these
products are also getting better, faster, smaller, and safer. My iPhone allows me
to watch Netflix on Wi-Fi; the phone I had a decade ago was five times larger
and did nothing other than make and receive calls (with relatively lousy
reception). On the other hand, the phone I had while growing up offered near
perfect sound quality; I went twenty-five years without ever saying, “Can you
hear me now?” Unfortunately that phone was tethered to the wall by a cord. As
the Economist has noted, “Your cotton shirts are wrinkle proof. Your clothes
dryer is clever enough to shut off automatically when it senses that your socks
are dry, and your television may allow you to watch two different channels at
once. All of this innovation surely makes life better—but just how much?” 13
Here we come to the part where measuring changes in price is as much art as
science. We know that a television in 2015 is not the same as a television in
2005, nor is a Toyota Camry. The relevant question for any price index is how
much of any price increase should be offset by improvements in quality. In
theory, if a car is 7 percent more expensive and also 7 percent “better” (safer or
more dependable or more comfortable), the price has not gone up. How exactly
does one quantify how much better a car is because it now has antilock brakes
and audio controls on the steering wheel? In what the Wall Street Journal has
described as “a warren of beige-walled cubicles at the Bureau of Labor
Statistics,” some forty commodity specialists make these determinations.
The analysts use a process called “hedonics” to break down the price of a
good into its component parts: memory, speed, functionality, durability, et
cetera.14 If a new model of toaster is deemed 20 percent better as evaluated by
this process, and it costs 20 percent more than the old toaster, there is no price
increase for purposes of measuring inflation. The improved toaster is essentially
treated as a new product at a new price rather than the old product at a higher
price. For example, BLS analysts determined that the value of quality changes
for a sample of new 2015 domestically produced automobiles was $45.78—not
$43 or $51, but $45.78. These 2015 cars are $45.78 better than the comparable
2014 models. Dealers are allowed a small markup on this quality improvement,
so for purposes of measuring inflation, $48.39 can be subtracted from any
model’s yearly price increase when calculating inflation.15
Hedonics, like any statistical process, can confuse precision for accuracy.
Statisticians are doing their best to account for quality changes when measuring
prices, but at the end of the day sensible judgment matters as much as good
math. Bureaucrats must measure not only whether the lords a-leaping cost more
than last year but also whether they have become better dancers. Still the basic
methodology behind measuring inflation should make sense. A modern economy
depends on sound money, and sound money depends on measuring changes in
prices as accurately as possible.
Sounds easy? Consider a seemingly arcane question that turns out to have
huge political and fiscal implications: How do consumers change their basket of
goods in response to changing prices? An example will help make the point.
Suppose the price of citrus fruit rises sharply because of frost in southern
Florida. The price of orange juice and related products would obviously go up.
But something else just as significant would happen: most of us would consume
less orange juice (and other citrus products) in response to the higher prices.
How should that be reflected as we measure inflation?
If our goal is to measure changes in the cost of living, obviously we have to
measure changes in prices—but also changes in consumption patterns induced
by those higher or lower prices. Yes, my Social Security check ought to get
bigger if the stuff I typically buy gets more expensive; however, that bigger
check ought to be offset somewhat if I buy less of the stuff that is getting more
expensive—fewer oranges and more bananas. Failure to take this behavioral
change into account will overstate the true rise in the cost of living. Perhaps you
have heard people at dinner parties or sporting events complaining about this
phenomenon, the dreaded “consumer substitution bias.” Okay, maybe not. (And
if so, you might want to explore new social options.)
The stats geeks* at the Bureau of Labor Statistics have a fix for consumer
substitution bias, too. In 2002, the BLS introduced the Chained CPI for All
Urban Consumers (C-CPI-U), described breathlessly as a “new, supplemental
measure of inflation.” Just as we can sample consumer behavior to derive an
appropriate basket of goods, we can also study how consumers substitute across
products when prices change. If consumers respond to a price increase by buying
less of something, for example, the weight of that item in the basket of goods is
reduced accordingly (and the weight of what they buy instead is increased). The
specifics approximate rocket science, but the intuition is simple: when the price
of apples goes up, people buy fewer apples; this minimizes the inflationary
impact of more expensive apples. As one would expect given the methodology,
the chained CPI typically produces a lower figure for inflation than the
traditional CPI. From 1999 to 2014, the average annual price increase in the
traditional CPI was 2.33 percent, while the average increase measured by the
chained CPI was 2.08 percent.16 More important, the chained CPI is designed to
more closely approximate changes in the cost of living than the traditional CPI.17
This sounds like stuff that policy wonks debate in windowless offices at the
Department of Labor. Technically, that’s true. But these seemingly academic
methodological matters also inspire vitriolic congressional battles. Why?
Because hundreds of billions of dollars are at stake. Some of the largest line
items in the federal budget are social programs that pay benefits with automatic
cost-of-living adjustments. If the government promises to pay Social Security
recipients or veterans $1,750 a month, the intent of the program is to keep the
purchasing power of that benefit constant over time. If we understate the true
rate of inflation, the beneficiaries of government programs will be shortchanged.
If we overstate inflation, taxpayers get a bill for programs that grow increasingly
generous rather than merely compensating for rising prices.
Something similar happens on the tax side. The United States has a
progressive income tax, meaning that people with higher incomes pay a higher
tax rate than those who earn less (e.g, 33 percent instead of 28 percent). We can
debate the merits of that system another time. For now, we should agree that a
household whose income has grown from $100,000 to $110,000 only because of
inflation should not pay a higher tax rate. In terms of purchasing power, they are
not any richer than they were before; the tax system should not treat them as if
they were. As a result, income tax brackets are indexed for inflation to prevent
“bracket creep,” a phenomenon in which households pay higher tax rates
because the numbers on their paychecks are bigger but the real value of those
paychecks has not grown. Each year the brackets are adjusted so that when we
soak the rich, we don’t soak people who just seem rich because of changing
prices. In 2013, individuals paid the Internal Revenue Service 39.6 percent on
any income over $400,000; in 2014, the tax tables were adjusted for inflation so
that individuals had to earn over $406,750 to be taxed at that rate.18
Who cares? Well, if we index the brackets in a way that overstates inflation,
Kim Kardashian will pay less in income taxes than the law intends. (After boring
you to tears with the Bureau of Labor Statistics, and then transitioning to the
IRS, I had to work Kim Kardashian into this paragraph.) It’s one thing to adjust
taxes and government checks for inflation; it’s another to do it wrong—and in a
way that costs the government staggering sums. Way back in 1995, one year
after Justin Bieber was born, the U.S. Senate created a panel of prominent
economists to evaluate the accuracy with which the BLS was measuring
inflation. The so-called Boskin Commission† concluded that the CPI
systematically overstated changes in the cost of living by 1.1 percentage points
per year. That may seem like chump change—it’s not. The commission pointed
out that the upward bias in the CPI was responsible for more government
spending than any federal program outside of Social Security, health care, and
defense, and if left uncorrected, this seemingly picayune methodological glitch
would add $1 trillion to the national debt between 1996 and 2008.
Specifically, the Boskin Commission identified a number of inaccuracies that
resulted from static assumptions about where and how consumers shop. The
report noted, “The strength of the CPI is in the underlying simplicity of its
concept: pricing a fixed (but representative) market basket of goods and services
over time. Its weakness follows from the same conception: the ‘fixed basket’
becomes less and less representative over time as consumers respond to price
changes and new choices.” 19 Consumers typically respond to rising prices in
three ways, all of which the CPI failed to capture fully. First, they find cheaper
places to buy the same product. (This was a particularly salient point because the
Boskin Commission report coincided with the spread of outlets and superstores.)
They also substitute across products (bananas for apples). And then they
substitute within product categories (Gala apples for Red Delicious). Meanwhile,
the CPI was criticized for understating quality improvements (particularly
household goods that had become more durable and dependable) and for being
too slow to incorporate new products. I mentioned earlier that cell phones were
added to the CPI in 1998. What I did not mention is that by then there were
already fifty-five million cell phone subscribers, and the cost of a phone and
service had fallen by 51 percent over the previous decade.20 The longer it takes
for new products to be adopted into the statistical basket of goods, the less their
price drops will be reflected in the broader price index.
The BLS subsequently made numerous methodological changes to address
issues raised by the Boskin Commission. (Broader use of hedonics to measure
quality changes was one of them.) The BLS also began publishing the chained
CPI (C-CPI-U), which more fully accounts for consumer substitution effects, as
noted earlier. But the chained CPI has never been adopted for purposes of
indexing federal taxes and benefits, a point that has come up in recent budget
negotiations. The 2010 Simpson-Bowles deficit reduction commission
recommended that the federal government switch to the chained CPI, as did a
similar debt reduction task force chaired by former senator Pete Domenici and
budget expert Alice Rivlin. Since inception, the chained CPI has grown by an
average of 0.3 percent less than the traditional CPI. To paraphrase Everett
Dirksen,‡ .3 percent here, .3 percent there, pretty soon you’re talking real
money. Like $220 billion in real money. That is what the Congressional Budget
Office estimated would be saved over ten years if the federal government
switched to the chained CPI for calculating cost-of-living increases.§21
Of course, that is $220 billion in benefits that people will not receive, which
has inspired arguments over whether this is a cut in Social Security benefits or
not. Both sides have logic on their side. Yes, Social Security checks would grow
more slowly if indexed using the chained CPI. That’s a cut. But it’s a cut that is
consistent with the original intent of the program, which was to adjust checks for
the real increase in the cost of living. To fiscal hawks, it is as if there was a
typographical error in the benefit formula decades ago and everyone has been
getting more than they were supposed to get ever since. Changing the cost-of-
living adjustment is not a benefit cut, it is a correction. If the subsequent benefits
are not sufficient, the programs ought to be reformed directly, rather than by
inflating checks through an inaccurate cost-of-living adjustment. Many groups
that advocate for adoption of the chained CPI have also called for revisions to
federal benefit programs to offset any undue hardship.
Suffice it to say that on America’s shuffleboard courts, the nuance of the
cost-of-living debate is often lost. A smaller check is a smaller check. As
economist Robert Gordon, a member of the Boskin Commission, reports, “The
suggestion that the bias had caused excessive growth in Social Security and
other benefits evoked a sharp and damning political reaction, as the AARP
(American Association of Retired Persons) sent its lobbyists scurrying through
the corridors of Congress to throw cold water on those senators and
representatives who had initially been sympathetic to reducing the budget deficit
by adjusting the indexation formula by some fraction of the Commission’s bias
estimate.” 22
I have described the CPI as a speedometer for measuring the purchasing power
of the dollar. Okay, now we know that there is really no single perfect measure
of changing prices, so it is more accurate to say there is a dashboard of tools that
can be used to measure inflation or deflation, including the various flavors of the
CPI. On the one hand, these indices are likely to be highly correlated. Even the
wacky PNC Christmas Price Index has done a decent job of tracking the CPI
over several decades. Since 1984, when a PNC economist came up with this
clever marketing ploy, the Christmas Price Index has climbed by 118 percent;
over the same stretch, the CPI has risen 127 percent. The average annual price
increase over this period for both indices is 2.8 percent. On the other hand, even
a fraction of a percentage point can make a huge difference over time, and we
probably don’t want to be adjusting veterans benefits using the Christmas Price
Index.
Which measure of inflation is best? That typically depends on who is asking
and why they care. For example, the Federal Reserve pays particular attention to
“underlying inflation” (previously called core inflation), a measure of changing
prices that excludes volatile categories of goods, such as food and energy. After
all, who needs gas or food? (A snarky headline in the New York Times once
proclaimed, “If You Don’t Eat or Drive, Inflation’s No Problem.”) But given the
Fed’s mission of delivering price stability, underlying inflation is a crucial gauge
on the dashboard. The food and energy sectors are prone to shocks—such as a
bad harvest in the Midwest or Russian president Vladmir Putin shutting down a
major natural gas pipeline to Europe—that are not representative of price
changes in the broader economy. If the goal is to understand systemic changes in
prices across the economy, especially the relationship between interest rates and
prices, a jump in petroleum prices caused by Putin’s pique could obscure rather
than inform the bigger picture. As officials from the Federal Reserve Bank of
San Francisco explain, “Although the prices of [food and energy] may frequently
increase or decrease at rapid rates, the price disturbances may not be related to a
trend change in the economy’s overall price level. Instead, changes in food and
energy prices often are more linked to temporary factors that may reverse
themselves later.” 23 Think of it like slamming on your brakes when you pass a
police car on the highway; yes, you are going slower, but not in a way that
accurately represents how fast you typically drive.¶
The Economist has created a McFlation Index that uses changes in the price
of a Big Mac in different countries as a simple back-of-the-envelope method for
capturing changes in the broader price level. The Big Mac is consistent across
countries; each one is its own basket of goods: beef (outside of India), wheat,
rent, wages, pickles, special sauce, and so on. How does the price of a Big Mac
change over time relative to official inflation statistics? That last clause—
relative to official inflation statistics—is what makes the McFlation Index more
than a humorous curiosity. While the United States is not likely to begin using
the price of Big Macs to index Social Security benefits, this simple tool is a good
way to detect when other countries are cooking the books—like Argentina,
where burger inflation between 2000 and 2010 was 19 percent annually
compared to an official inflation rate of just 10 percent.24 Why fudge the official
statistics? Governments often promise various cost-of-living adjustments, or in
the case of Argentina, interest rates on government debt that rise with inflation
(to ensure investors a fixed real rate of return). One way to minimize these costs
is by cheating on the official inflation numbers. The McFlation Index correctly
flagged Argentine perfidy. In 2013, the International Monetary Fund officially
censured the Argentine government for deliberately reporting inaccurate
inflation statistics.25
Another useful indicator on the price dashboard is future inflation. After all,
investors and businesses and labor unions often care more about price changes
next year than they do about last year. The challenge with measuring future price
changes is that, well, they have not happened yet. Until the Bureau of Labor
Statistics can figure out a way to send economic assistants into the future to
fondle lingerie, we would need some kind of crystal ball to figure out what
prices will be in 2020.
In a way, we have the crystal ball. The best predictor of what prices will be
next year is what people think prices will be next year—so-called expected
inflation.# Anyone making an agreement that involves payments over time will
build in some expectation about future inflation. When the U.S. Treasury sells a
bond that pays some annual rate of interest, say 3.2 percent, that interest rate
consists of two parts: a real rate of interest (the return one gets for loaning
money to the U.S. government) and some added amount to compensate for rising
prices over the term of the bond (an inflation premium). But anyone looking at
the nominal rate on a ten-year Treasury bond would not be able separate the two.
How much of the 3.2 percent is real interest and how much is expected inflation?
Maybe the real rate of interest is 3.2 percent and investors expect perfectly stable
prices. Or perhaps the real rate of interest is 2 percent and investors expect prices
to rise 1.2 percent each year over the next decade. Who knows?
We do, thanks to a simple but powerful kind of security introduced by the
U.S. government back in 1996: Treasury Inflation-Protected Securities, or TIPS.
Inflation-protected securities pay some fixed rate of interest every six months
plus an adjustment for inflation, as measured by the CPI-U. As I sit here writing
this chapter, the current annual yield on a ten-year TIP is 0.34 percent, not
including the nominal adjustment for inflation. Here is the cool part: we can
infer what the market believes about future inflation by comparing the yield on
TIPS to the yield on regular Treasury bonds that are not indexed for inflation.
The current yield on a regular ten-year Treasury bond is 1.93 percent.26 That tells
us that the market expects the annual inflation rate over the next ten years to be
1.59 percent (1.93 minus 0.34) because investors are indifferent to whether they
get a real rate of return of 0.34 percent plus the change in the CPI-U each year or
a nominal rate of 1.93 percent. As Taylor Swift’s business manager has probably
explained to her, the only way those bonds are the same is if our best guess for
the increase in the CPI-U each year is 1.59 percent. Inflation or deflation over
the next decade will almost certainly turn out to be different than what the
markets are predicting today, but the spread between regular Treasuries and
TIPS still gives us the best snapshot of current expectations.
There are more price indices on the dashboard, but I am going to stop describing
them. If you are aware of the inherent methodological challenges in measuring
changes in prices—getting the right data for the right goods and adjusting
appropriately for quality and consumer behavior—you can figure out the
strengths and weaknesses of different indices. For now, we can all agree that
measuring changing prices is much harder than it appears. Presumably we can
therefore also agree that everybody would be better served by perfectly stable
prices—neither rising nor falling for all eternity.
Right?
No, my naïve reader. No, no, no. Just as a tuberculosis epidemic is good for
people who sell antibiotics, inflation is good for some people, and deflation is
good for others. Let’s start with deflation, the most egregious form of changing
prices. After I described the Stephen Kingtype economic horror induced by
falling prices in the last chapter, no one can possibly think this is a good thing.
Wrong. For individuals living on a fixed nominal income (such as Japanese
pensioners), falling prices make every yen go farther. If prices are falling at 10
percent a year, the real value of that check is growing at 10 percent a year.
Lenders benefit as well, assuming the deflation was unexpected and borrowers
can still afford to pay off the loan. Every dollar or yen that gets paid back is
worth more than the dollars or yen that were loaned out. Yes, there is a general
consensus among economists that falling prices are bad for the economy overall.
There is also agreement that deflation should never have to happen, as every
modern economy has a fiat currency that can be printed on demand. Ben
Bernanke once famously suggested that falling prices in Japan could be fixed
easily by dropping money out of helicopters. (This was a metaphor, not a literal
policy suggestion.) Deflation is like a disease that can be cured by eating pizza
and ice cream while watching TV on the couch; we would not expect it to afflict
the country for a long time. Yet you are going to read a whole chapter on Japan’s
two-decade battle with deflation. This seeming contradiction can be explained as
much by politics as economics. Some powerful groups don’t mind falling prices
at all.
Other folks are quite keen on inflation. Debtors like rising prices because it
erodes the real value of their debts. (Again, this has to be unexpected inflation or
else the expected price increases would have been included in the nominal price
of the loan.) As you’ll see in chapter 8, some of the fiercest battles in U.S.
history were essentially battles over rising or falling prices. Perhaps you have a
dusty recollection from high school history of the populist presidential candidate
William Jennings Bryan. In his 1896 speech at the Democratic National
Convention in Chicago, he famously declared to America’s monied interests,
“You shall not crucify mankind upon a cross of gold.” 27 Bryan was arguing for
the free coinage of silver to supplement America’s gold standard. Metallurgy
aside, Bryan was arguing for expanding the money supply to create a burst of
inflation. Who wanted that? Farmers in the West, who were drowning in their
debts. Who despised such an idea? Bankers in the East, who wanted to be repaid
in dollars backed by gold, not in some depreciated silver-backed currency. For as
long as there have been creditors and debtors—which is a darn long time—
creditors have tried to protect the value of the currency and debtors have sought
to devalue it.
Governments tend to be huge borrowers; for that reason, they tend to benefit
from inflation, too, assuming their debts are not indexed for rising prices. The
United States borrows hundreds of billions from the rest of the world, in dollars.
China is one of America’s biggest foreign creditors—we owe the Chinese a
trillion dollars, give or take some billions. To put a finer point on it, these are the
same dollars that the Federal Reserve can create with a few computer clicks. As
will be explored in chapter 12, the danger for our Chinese creditors is not that
the United States will default on our debt. We would never have to do that.
Instead, Congress could order the Federal Reserve to print new dollars to repay
our debts, thereby devaluing all existing dollars, creating significant inflation,
and honoring our legal obligation to Chinese creditors while really paying them
back far less than we borrowed—a default in all but name.
It speaks well of the United States that international creditors are willing to
buy U.S. government bonds at extremely low nominal interest rates (implicitly
suggesting that the likelihood of the United States inflating away its debts is
negligible). Countries like Argentina do not have that luxury. One of the reasons
Argentina’s debt is indexed for inflation (prompting the bogus inflation statistics
referenced earlier) is that the government has a history of irresponsible monetary
policy, including hyperinflation. That brings us to the answer to the question that
you may have asked in the first couple of chapters: Why would Zimbabwe (and
the Weimar Republic in Germany, and Brazil, and Argentina, and many other
countries) inflict hyperinflation on themselves?
The answer is that governments have a lot to gain—in the short run—from
printing and spending new money, particularly when access to other forms of
revenue is limited or nonexistent. Printing new paper money is a surreptitious
way to tax citizens—an inflation tax.** Printing more money diminishes the
value of the money already in circulation, which is effectively a tax on that
currency. Economists refer to this phenomenon as “seignorage,” which reflects
the difference between the cost of producing money (essentially zero in the
modern era) and the value of that new money. Seignorage is like the host of the
poker game who reaches into the closet to get more plastic chips for himself
without putting any more cash in the shoebox. He gets richer at the expense of
everyone else holding chips.
It is no coincidence that countries at war or with particularly dysfunctional
governments are most prone to serious inflation. If the army is demanding to be
paid, printing new money does not require a functional tax system or willing
international lenders—just paper, ink, and some pliant bureaucrats over at the
mint. Yes, that describes Zimbabwe in the 1990s and Argentina in the 1980s, but
also George Washington and his revolutionary compatriots in the 1770s, who
printed those continentals to finance the Revolutionary War. The paper currency
allowed the Continental Congress to pay for the early years of the war without
any appreciable gold reserves or a national tax system. And yes, the inevitable
result was serious inflation. These historical examples and many others prove
that, to paraphrase Milton Friedman, inflation is everywhere and always a
political phenomenon.
But wait, money turns out to be psychological, too—and not just the fact that
we all want lots of it. Many of us act like small children when it comes to
separating out inflation from real changes in the value of money. Just as a three-
year-old might prefer five singles to a $5 bill, many adults seem to care about the
numbers on the bills more than their real worth. Here is a quick quiz. Which
would you prefer: (a) getting no raise when prices are unchanging, or (b) getting
a 5 percent annual raise when prices are rising at 5 percent a year? There is no
trick math here. The correct answer, at least to an economist, is that we should
be indifferent between those two scenarios. In the first case, all the numbers stay
the same from year to year; in the other, our check gets bigger but so do the price
tags on all the things we typically buy.
In fact, there is a human tendency to prefer getting a raise, even when
inflation eats away all the benefit. And we abhor getting a pay cut, even when
falling prices might compensate for some or all of the smaller check. Economists
describe this tendency to think in nominal terms, rather than real (inflation-
adjusted) terms, as “money illusion.”
A group of academics—both economists and behavioral psychologists—
documented this phenomenon by posing a series of hypothetical questions to a
large group of people, including both Princeton undergraduates and random
folks at Newark International Airport and in New Jersey shopping malls. (The
answers across the groups were not appreciably different.) For example, an
interviewer asked a respondent to compare the following scenarios: one person
receives a 2 percent raise when there is no inflation and a different person
receives a 5 percent raise when there is 4 percent inflation.
Most respondents correctly inferred that the first person is better off
financially, but a majority answered that the second person would be happier!
Similarly, respondents were asked to compare a hypothetical person, Carl, who
bought a house for $200,000 and sold it a year later for $246,000 at a time when
inflation was 25 percent, to Adam, who bought a house for $200,000 and sold it
a year later for $154,000 after prices had fallen by 25 percent. That’s a lot of
numbers, so let’s summarize:
Carl makes a 23 percent gain on paper, but prices have gone up 25 percent,
so in real terms he has suffered a 2 percent loss.
Adam has lost 23 percent on paper, but prices have fallen 25 percent, so he’s
made a 2 percent gain when deflation is taken into account.
Yet the most common answer is that Carl got the best deal. Apparently our
brains and our wallets are not always in sync.
The authors of the study conclude that “money illusion is a widespread
phenomenon in the United States today.” 28 They point to several social
phenomena that suggest a tendency by all of us to think in nominal rather than in
real terms. The first is “sticky prices,” which is the tendency of prices to be more
rigid in nominal terms than economic conditions warrant. For example, workers
are particularly averse to taking nominal pay cuts, even when the job market has
gone weak. Reducing wages, even temporarily, can save jobs when a business is
struggling, yet that is a surprisingly unusual arrangement.
Second, firms rarely enter into contracts that are indexed for changing prices,
even when history suggests that the value of a dollar or euro could change
appreciably over the duration of the contract. As one professor, a member of the
Stable Money Association, puzzled almost a hundred years ago, “We have
standardized every other unit in commerce except the most important and
universal unit of all, the unit of purchasing power. What business man would
consent for a moment to make a contract in terms of yards of cloth or tons of
coal, and leave the size of the yard or the ton to chance?” 29
Third, much of our common discourse, particularly news reports, confuses
nominal and real values. I gave the example of Hollywood box office receipts in
the last chapter, but the same is true with CEO compensation, philanthropic
gifts, government spending, and athletes’ salaries. A baseball player who
becomes the highest paid shortstop ever might really be fifteenth when inflation
is taken into account.
The psychology is complex. People are not oblivious to changing prices;
they often just find it easier to ignore them. The implications of this behavioral
quirk are enormous. For example, workers may resist a 3 percent pay cut when
prices are stable, as noted above but be willing to accept a 1 percent raise when
there is 4 percent inflation. (Both contracts leave workers 3 percent worse off in
real terms.) This phenomenon is more than a curious mental illusion; it suggests
that labor markets are likely to be more flexible when there is modest inflation
than they are when prices are stable or falling. Similarly, consumers follow
nominal price cues when making major decisions. A homeowner may resist
selling a house for less than he or she paid, regardless of the value of the deal in
real terms. Conversely, rising prices might induce an owner to sell “for a profit”
even if the deal is a loser when inflation is taken into account. Eldar Shafir, Peter
Diamond, and Amos Tversky, the academics who documented our curious
mental accounting using the data from the New Jersey survey respondents, write
in their study, “The implications of money illusion may be the most important
factor to consider when contrasting between zero and other low rates of
inflation.” 30
That brings us to an odd place. There are three strong arguments that a little
inflation is better than none at all. First, there is the economic lubrication
described above: because of money illusion, markets work more smoothly when
workers and consumers can take real losses disguised as nominal gains. (A guy
who gets a 1 percent pay increase when inflation is 3 percent can still tell his
drinking buddies that he got a raise.) Second, a low but positive level of inflation
protects against slipping into deflation, particularly during times of economic
weakness. And third, modest inflation gives the central bank more room to lower
real interest rates before bumping up against the zero bound. (Remember,
nominal interest rates cannot go negative, other than in the most extraordinary of
circumstances.) In 2013, as the United States was still recovering from the Great
Recession, the New York Times reported, “Inflation is widely reviled as a kind of
tax on modern life, but as Federal Reserve policymakers prepare to meet this
week, there is growing concern inside and outside the Fed that inflation is not
rising fast enough.” 31
Yes, not enough inflation. So let’s recap the first three chapters: Inflation is
bad. Deflation is worse. Hyperinflation is worst of all. Yet there are some
political actors who benefit from each. Meanwhile, the whole point of money is
to facilitate commerce, which is presumably best achieved by prices that don’t
change at all, except that commerce actually works more smoothly when prices
are rising gradually over time. Go figure.
So yes, getting prices just right is a challenge.
And I have not mentioned the bankers yet—you know, the folks who
brought you the 2008 financial crisis (with a lot of help from their friends). One
of the most important things we can do with money is lend it to other people.
Credit is the backbone of a modern economy. When we borrow money to go to
college, to buy a car, to start a business, or to speculate in Las Vegas real estate,
our lives get steadily better.
As long as we can pay it back. Speculating in Las Vegas real estate—with
someone else’s money—can turn out badly, as we saw in 2008. Money is a
tricky business, even without borrowing and lending. But once the banks get
involved (and other institutions that act like banks), things can get really crazy.
________
* Having written Naked Statistics, a book on the power and importance of statistics, I mean this in the very
best sense.
† Officially known as the U.S. Advisory Committee to Study the Consumer Price Index. Stanford
economist Michael Boskin was the chair.
‡ Senator Everett Dirksen is often credited with saying, “A billion here, a billion there, and pretty soon
you’re talking real money.” Apparently there is no record of him actually saying that.
§ The savings grow even larger over time because they compound—smaller increases are calculated on top
of smaller increases.
¶ PNC Bank also produces a Core Christmas Price Index that excludes swans, which tend to be the most
volatile gift in “The Twelve Days of Christmas.”
# Or sometimes “inflationary expectations.”
** A government can also devalue commodity-based money, such as gold or silver coins, by reducing the
content of the precious metal. If the army was due a fixed payment in gold francs, the king could make
those gold francs go farther by putting less gold in each of them. Still, there are physical limits to how much
a commodity can be debased. Hyperinflations are uniquely a phenomenon of paper currencies.
CHAPTER 4
Sometime in the next five years you may kick yourself for not reading and re-reading Kindleberger’s
Manias, Panics, and Crashes.
—Nobel laureate Paul Samuelson, in a promotional blurb for the book—three years before the 2008
global financial crisis
There are a lot of good books on the 2008 financial crisis. You might begin by
reading Ben Bernanke’s essays on the Great Depression, or his new memoir.
Bernanke is a scholar of the Great Depression; his views on that crisis informed
his response as chairman of the Federal Reserve while the financial crisis
unfolded on his watch. You can read the memoirs of participants like Hank
Paulson and Tim Geithner (Treasury secretaries under George W. Bush and
Barack Obama, respectively). You might also consult an old classic by Irving
Fisher, Booms & Depressions, which was originally published in 1932 but has
timeless insights into the causes and consequences of financial crises.2 If you
would like a summary of many different views, you could read Andrew Lo’s
article in the Journal of Economic Literature, “Reading about the Financial
Crisis: A Twenty-One-Book Review.” 3 Yes, he read all of those books so that
you do not have to.
Of course, you should read the final report of the Financial Crisis Inquiry
Commission, the ten-member panel appointed by Congress in 2009—while the
crisis was still under way—to “examine the causes, domestic and global, of the
current financial and economic crisis in the United States.” 4 The bad news: the
report is 632 pages, including dissenting views and endnotes. The good news: it
is available free online. You might also peruse The Squam Lake Report: Fixing
the Financial System, a report prepared by fifteen of the world’s most prominent
economists who came together in the fall of 2008 for a retreat (on Squam Lake
in New Hampshire) to make recommendations for improving the long-term
stability of the financial system.5
Or you could just watch It’s a Wonderful Life. Yes, the film with Jimmy
Stewart and Donna Reed. It’s a Wonderful Life is not just a timeless holiday
classic; it is also the most accessible way to understand the inherent
vulnerabilities of a modern financial system. If you understand the bank run
scene, when depositors are queued up outside the Bailey Bros. Building & Loan
demanding their money and George Bailey saves the day by dipping into his
honeymoon fund to pay off the anxious depositors, then you can understand the
2008 financial crisis, the Great Depression, the periodic bank panics in the
United States in the nineteenth and twentieth centuries, and the future financial
crises that are still likely to happen. The rest is just detail.
Banks—and institutions that act like banks, regardless of what the name says on
the door—are the heart of the financial system. Banks (and the like) match
savers with borrowers, putting capital in the hands of entrepreneurs,
homebuyers, and other parties who can make productive use of someone else’s
money. People like me, who are saving for the staggering cost of our children’s
higher education, earn a return on the money we set aside. (In economics
equations, the letter that represents the interest rate is r, rather than i, because it
represents the rental rate on capital.) People like my former students who need
money to start businesses or to attend graduate school can “rent” my savings to
do things that will presumably make them better off, even after paying the
interest on the loan. I don’t loan money directly to students; instead, a bank takes
a cut for acting as the intermediary—paying interest to me for my savings and
then loaning those funds out at a slightly higher rate to borrowers. When all of
this works well, society benefits and financiers earn a tidy profit in the process.
A modern economy cannot function without a vibrant and profitable banking
sector.
But when things go bad . . . Well, let’s go back to George Bailey in Bedford
Falls. For those who have never seen It’s a Wonderful Life, or have not
previously thought of it as the greatest teaching tool on financial panics ever
made, George Bailey (played by the young, likable Jimmy Stewart) runs the
Bailey Bros. Building & Loan Association, a small town bank (in the broad
sense of the word) that makes home loans in the town of Bedford Falls.* A
series of events in the film creates a run on the Building and Loan. Customers
fearing for its solvency are lined up outside the door, trying to get their money
out before it’s too late. The script describes the scene:
An iron grill blocks the street entrance to the Building and Loan. It has been locked. A crowd of
men and women are waiting around the grill. They are simply-dressed people, to whom their
savings are a matter of life and death.6
These simply dressed people want their money, which is not an unreasonable
request. The finances of the Bailey Building and Loan are ostensibly sound,
meaning the bank’s assets exceed its liabilities—but that does not mean there is
enough cash in the vault to honor the demands of all the depositors who want
their money now. George Bailey’s problem in that moment is timeless and
instructive. Financial institutions often “borrow short and lend long,” meaning
that if a high proportion of depositors (or other investors) suddenly want their
money back, the funds are likely to be tied up in loans or other investments that
cannot easily be converted to cash. The funds may be safe in the sense that the
bank has not made a bad loan. Still the money is not in the vault, nor can it be
retrieved quickly. If enough investors show up demanding payment, they cannot
all get it. Worse, when word gets out that an institution cannot fully honor its
obligations, others will rush to be paid before it’s too late, thereby exacerbating
the crisis. It is a classic bank run, and when there is a rush for the exit, even a
healthy institution can collapse.
George Bailey implores the customers crowding the teller’s window to
understand all this. When the first depositor demands all the money in his
account, George explains, “You’re thinking of this place all wrong. As if I had
the money back in a safe. The money’s not here. It’s in Joe’s house . . . right
next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a
hundred others. Why, you’re lending them the money to build, and then, they’re
going to pay it back to you as best they can. Now what are you going to do?
Foreclose on them?” 7
The inspiring speech is not enough to placate the panicked crowd. In the end,
George Bailey quells the incipient bank run with his own money, parceling out
cash to any depositor who demands it. Of course, the psychology of a bank run
works in reverse, too. Once borrowers are assured they will be paid, they are less
prone to demand payment. In the lingo of finance, George Bailey used his
honeymoon savings to serve as the “lender of last resort.” The emergency capital
ends up saving an institution that might otherwise have collapsed and dragged
other businesses with it. This, too, is a singular feature of financial institutions.
They do not fail quietly alone. Each is like a mountain climber tethered to many
others—when one slips, many can fall.
In fact, It’s a Wonderful Life shows us what would have happened if the
Building & Loan had collapsed—the counterfactual, as social scientists call it.
The conceit of the film is that an angel allows George Bailey to see what the
world would have been like if he had never lived (and therefore had not bailed
out the Building & Loan). In that scenario, Bedford Falls is transformed into a
den of desperate people, sleazy businesses, and general economic distress, as the
script describes:
The character of the place has completely changed. Where before it was a quiet, orderly small
town, it has now become in nature like a frontier village. We see a SERIES OF SHOTS of night
clubs, cafes, bars, liquor stores, pool halls and the like, with blaring jazz MUSIC issuing from the
majority of them. The motion picture theatre has become a burlesque house. Gower’s drugstore is
now a pawnbroker’s establishment, and so on.
Okay, to get the main point here one does not have to believe in angels, or
that one bank failure would destroy Bedford Falls, or even that pawn shops,
liquor stores, and pool halls are inherently bad. The important idea is simpler
and indisputable: financial panics happen, and when they do, the damage spreads
beyond the affected parties. Think of 2008—one did not have to be involved in
the housing bubble in any way to feel the impact of its collapse. When things go
bad, the rest of us end up with pawnshops and pool halls, figuratively speaking,
and government is often called on to clean up the wreckage. As the Economist
has noted, “The old saw about bankers—that they believe in capitalism when it
comes to pocketing the profits and socialism when it comes to paying for the
losses—is too true for comfort.” 8 The relevant policy question is if and how the
government ought to intervene to reduce the likelihood of financial crises and to
lessen the damage of those that do happen. Always has been, always will be.
The next chapter will explore the role of central banks (such as the Federal
Reserve in the United States), which serve a crucial function at the intersection
of government and finance. Before we get there, however, let’s first examine the
awesome power of credit, the financial equivalent of TNT. The dynamite
metaphor is not as random as it might appear. A fractional banking system—
where banks make money by lending out funds that belong to someone else—
can help us build great things, or it can cause financial panics that harm
borrowers, lenders, and lots of innocent parties. To understand the unique
promise and pitfalls of credit, let’s leave the fictional world of Bedford Falls and
enter a place even less tethered to reality: a hypothetical rural society sustained
primarily by rice farming. This is a simple, happy place with no shady subprime
mortgage brokers or evil investment bankers. No one has ever heard of a credit
default swap. There is no central bank and no fiat currency. It’s all about the
rice. If Frank Capra, writer and director of It’s a Wonderful Life, were to make a
film about an idyllic farming hamlet, this is the kind of place he would portray.
Yet this society is every bit as prone to a financial boom and bust as the United
States was in 2008, perhaps more so.
Let’s start with that rice, which is a very good commodity to serve as money
—durable, scarce, and easy to measure and divide. But not perfect. Carrying
around bags of rice is a pain, literally and figuratively. For that reason,
responsible individuals might seize upon a logical business opportunity: rice
storehouses. The proprietor of the rice storehouses would issue receipts for any
rice you deposit. These receipts would likely substitute for the rice itself in
everyday transactions. Voilà, we have a commodity-based paper currency, or
perhaps even several currencies, depending on the number of rice storehouses.
The credibility of such a currency would depend on the credibility of the rice
storehouse issuing the receipt. As long as people believe a certificate will be
redeemed at face value, they will accept it as payment and use it as such. Other
than those folks who actually need rice—to eat or to plant—most of the residents
in the hamlet would rather have certificates than fifty-kilo bags of rice. The
storehouse can anticipate a small and relatively predictable number of
redemptions (e.g., more at planting time or during the wedding season).
The “money supply” in this area is a function of the quantity of rice on
deposit, as that is what determines the number of rice certificates in circulation.
This money supply will naturally ebb and flow. When the harvest is particularly
good, the deposits on account will rise. After a bad harvest, the quantity of rice
on deposit will fall. These fluctuations are likely to be quite large; when the rice
haul is good, it is likely to be good for everyone, and vice versa. This leads us to
the first interesting insight from our hypothetical hamlet: there will be large
swings in the money supply, and therefore in prices, even with a commodity-
based currency. (This is similar to the price swings caused by the discoveries of
gold and silver in the New World that were described in chapter 2.) When rice is
abundant, so are rice certificates. If the quantity of other goods that people want
(liquor, furniture, firewood) is unchanged, their price as measured in rice will
rise. This is just basic supply and demand. When everyone has lots of rice, there
will be more of it chasing other goods. This is the basic relationship between the
money supply and prices, whether we are talking about gold, paper dollars, or
rice certificates.
Meanwhile, even without government or a central bank, the rice storehouse
can facilitate checking accounts, or something akin to them. If you have rice on
account at the storehouse, and I have rice on account at the storehouse, we do
not need to swap rice certificates to conduct commerce. When I buy a case of
rice wine from you (our hamlet needs to have some fun), I can simply write a
note to the storehouse owner telling him to transfer some of the rice in my
account to your account. Now we have checking accounts (typically called
“demand deposits” in the finance literature), even without giving our hamlet
electricity or running water. The proprietor of the storehouse would debit my
account seven bags of rice and credit your account the same.
If you have an account at a different rice depository, my rice “check” can
still work in the same way. It is likely that other villagers are also writing
checks, some of which are directing rice to be sent from your storehouse to
mine. The owners of the rice storehouses need not haul bags of rice back and
forth every time one of these requests is made. They can keep a running tally and
settle up at the end of the day, or the end of the week. Checks and other
electronic transactions are handled this way in a modern financial system. One
important if unglamorous role of the Federal Reserve is to facilitate the
“plumbing” of the financial system by serving as a clearinghouse for member
banks, all of which are required to keep reserves on account with the Federal
Reserve. In advanced economies, funds held in checking accounts (demand
deposits) are treated as part of the money supply just like currency—as they
should be since the funds in your checking account can be used for transactions
almost as easily as the cash in your wallet.
So far, so good. Our idyllic hamlet seems well served by a basic rice banking
system. How do we end up with pool halls and pawnshops? Let’s move on to the
element of rice banking that will eventually cause riots in the dusty streets, or at
least a lot more consumption of rice wine. The proprietors of the rice storehouses
will undoubtedly observe over time that most people with accounts do not show
up to demand their rice. Instead, the deposits and withdrawals ebb and flow in a
predictable pattern. What a waste! All this potentially productive rice locked
away, just attracting rats. So let’s introduce an enterprising storehouse owner
who realizes that he can make a profit by loaning out bags of rice from the vault
while they are sitting there idle.
Yes, our rice loaning entrepreneur is technically loaning out something that
does not belong to him, but why not? That’s what Jimmy Stewart was doing in
It’s a Wonderful Life, and everybody likes him, particularly during the holidays.
After all, these loans have the potential to make all parties better off. New
farmers can get started by borrowing rice to plant, which they will repay with
interest after the harvest. The borrowers offer collateral, such as the title to their
land, so the storehouses will be compensated in the event of default. Meanwhile,
families with surplus rice can earn a small sum for keeping their rice in the vault,
whereas previously they had to pay a storage fee. The rice banker makes a profit
by acting as the intermediary between rice lenders and rice borrowers. Banking
really does make our Norman Rockwell–inspired hamlet better off—just as it
has everywhere else, for all of history. As the Economist has noted, “The rise of
banking has often been accompanied by a flowering of civilization.” 9
This is why we love bankers—until we want to kill them with pitchforks.
When we last left our bucolic rice-based economy, storehouse owners had
reckoned that they could safely loan out some of the rice sitting in their vaults.
Assume that the typical storehouse proprietor feels comfortable keeping half the
rice in the vault and loaning out the other half (a reserve ratio of 0.5, if one is
going to be technical about it). Something really wacky happens when rice
bankers start loaning out other people’s capital: money is created. Some very,
very simple math can make a very, very powerful point. Suppose there are ten
thousand bags of rice on deposit in various storehouses, each with one paper rice
certificate issued against it. The money supply in the hamlet is ten thousand bags
of rice. When the storehouse proprietors decide to loan out five thousand bags of
rice (half of what is on account), the money supply grows to fifteen thousand
bags of rice. This is not magic; it is fractional banking, or at least a simple
version of it.
Everyone with rice at a storehouse has a certificate for that deposit; those
certificates are circulating for commerce (or checks can be drawn on the
deposits). When the bank (storehouse) makes loans, another five thousand bags
of rice (or certificates) enter circulation. We are double counting, but that is
exactly the point. The money I deposit in the bank counts as my money, and
when it gets loaned out, it counts as someone else’s money, too.†
Banks generate credit, and credit is new money. Even with a gold standard.
Or rice.
For this reason, the banking system plays a crucial role as a link between the
Federal Reserve and the money supply, which will be explored in the next
chapter. As an aside, any other institution that generates credit can create money,
too. In 2009, when California did not have enough cash on hand to pay its bills,
the state issued IOUs and used them to pay creditors, including taxpayers who
were owed refunds. The IOUs were redeemable for dollars roughly three months
after they were issued (or before then, if the state fixed its budget problems) and
paid 3.75 percent interest.10 The same thing happened during the Great
Depression, particularly when local banks had failed or were forced to close by
the government. Institutions with enough credibility that others would accept
their homemade IOUs issued an estimated $1 billion in scrip. These money
substitutes were printed on metal, leather, paper, fish skin, and even old tires.11
An IOU is a loan (from the party getting the IOU to the party writing it). Any
loan is an expansion of credit, and any expansion of credit expands the money
supply. As Charles Kindleberger has noted, there are essentially an infinite
number of ways in which credit can be expanded on a fixed money base.12
For now, we are slowly working our way toward riots and mayhem in our
bucolic hamlet. (The use of the phrase “double counting” foreshadows how this
might end badly.) The financial system amplifies booms and busts, primarily
because of the “procyclical” nature of credit. Banks lend most aggressively when
times are good and most cautiously when times are bad—which makes the good
times better and the bad times worse. When a party gets going, credit has the
effect of turning up the music and adding grain alcohol to the punch. When that
party starts to falter—for any reason, real or imagined—credit becomes scarcer,
which is like dumping out the punch and turning on the lights. Again, the
metaphor is not chosen at random. The quote that best encapsulates the boom
leading up to the 2008 financial crisis was from Citigroup CEO Chuck Prince,
who told the Financial Times in the summer of 2007, “As long as the music is
playing, you’ve got to get up and dance. We’re still dancing.” 13 It is not
coincidence that former Fed vice chair Alan Blinder titled his book on the
subsequent crisis After the Music Stopped. Suffice it to say, Citigroup stopped
dancing, Citi shareholders lost a staggering amount of money, and Chuck Prince
stepped down as CEO.
For now, we are still dancing in our hamlet. Let’s envision a boom: The
harvest is good. Families are awash with rice. Deposits at the rice storehouses
climb, enabling more loans. Land values are rising, both because credit is more
readily available and because villagers believe future harvests will continue to be
bountiful. One feature of booms is a heightened optimism, sometimes bordering
on delusion. Sir Isaac Newton, the famous scientist who also happened to have
lost a great deal of money in a speculative real estate bubble, concluded, “I can
calculate the motions of the heavenly bodies, but not the madness of people.” 14
Some prominent economists would dissent here—there is a small cadre in the
profession who cling to the belief that there is no such thing as a “bubble” or a
“mania.” In their highly ideological view of the world, there is always a rational
explanation for large swings in asset prices, not just mass hysteria. My sense is
that these folks need to read more history, spend more time outdoors, or both.‡ I
would like to live in the world they describe, where humans are always and
everywhere rational, I just don’t believe we do.
In any event, the interaction between a booming economy and aggressive
credit markets can promote reckless behavior that ends in crisis. To recap: The
money supply has gone up because of the big harvest. It has gone up even
further because banks are lending more aggressively. Land values are rising,
both because of higher expectations about future crops and because it has
become easier to buy land on credit. (Rising land values facilitate borrowing,
and vice versa.) A bank might also lower the proportion of rice deposits held in
the vault, say from 0.5 to 0.25, freeing up even more rice to be loaned out. This
is not entirely irrational, as farmers are sitting on bountiful harvests and
expecting good crops in the future; few will be rushing to the bank to demand
their deposits. Robert Solow has written, “Large quantities of liquid capital
sloshing around the world should raise the possibility that they will overflow the
container.” 15 Yes, that is more foreshadowing. If this were a film, we might
begin to hear the first strains of ominous music, barely audible.
Some investors, who have little or no interest in growing rice, begin to buy
land (using credit) with the expectation of selling later when prices have gone up
even further. (If we were to be unkind, we might call these investors
“speculators.”) On the outskirts of the hamlet, land previously thought to have
little productive use has become more valuable. (Hereafter we will refer to this
as subprime land.) Meanwhile, political leaders in the village are united in their
belief that poor citizens should have greater access to credit to buy subprime
land. Conservative rice farmers, who live in the “red” part of the hamlet,
consider this to be an important part of their vision for an “ownership society.”
Over in the “blue” part of the hamlet, rice farmers also believe that poor
villagers should be able to buy land. For too long, greedy bankers have shut the
door to opportunity on these marginalized citizens! These red and blue
politicians may not agree on whether gay rice farmers should be allowed to
marry one another, but they are united in the belief that more lending to low-
income people—so they can finally afford a paddy of their own—is a good
thing.
Asset prices (and debt) are rising. Farmers are feeling richer. Prosperity
percolates through the hamlet, contributing to growth in businesses that have
nothing to do with rice farming. Everyone is dancing—not the waltz, the
jitterbug. As Kindleberger wrote in his book Manias, Panics, and Crashes,
“During the mania the increases in the prices of real estate or stocks or in one or
several commodities contribute to increases in consumption and investment
spending that in turn lead to accelerations in the rates of economic growth.” 16
Yes, this is how the United States felt in 2005. And East Asia in the early 1990s.
And Japan in the 1980s. And the United States in the Roaring Twenties (when
there literally was a dance craze, the Charleston). Because this is the way it
always looks before a crash.
Now is the time to cue the scary music, the kind that makes people want to
stop dancing and run to the bank to get their money. Everything I have just
described begins to run in reverse. Maybe the dancing stops because there is a
bad harvest, or a bad weather forecast, or even a rumor of a bad weather
forecast. In any event, the dancing tends to stop abruptly. Something spooks the
farmers and the bankers. Greed turns to fear; recklessness becomes paranoia.
Land values begin to fall, particularly for subprime land. The banks curtail
credit, which further hurts land prices. Some farmers cannot repay their loans,
either because the harvest has fallen short of expectations or because they were
counting on rising land values to repay their debt. Bad loans create trouble for
the rice banks, which prompts villagers to rush to get back whatever rice they
can. At this point, a winsome storehouse owner implores depositors not to
withdraw all of their rice at once: “You’re thinking of this place all wrong. As if
I had the rice back in a safe. The rice is not here. It’s in Joe’s paddy . . . right
next to yours. And in the Kennedy paddy, and Mrs. Macklin’s paddy, and a
hundred others. Why, you’re lending them the rice to plant, and then, they’re
going to pay it back to you as best they can after the harvest. Now what are you
going to do? Foreclose on them?”
The rice banks do foreclose, selling off land that was put up as collateral,
which drives prices down further. Banks with too many bad loans go bust. Even
some healthy banks can be dragged into insolvency when anxious depositors
rush to get their rice back. Farmers who wisely realize that this would be a great
time to buy land are handicapped by the fact that paranoid bankers have turned
off the credit taps. Every bad thing makes more bad things happen.
As Kindleberger wrote, “The decline in the prices of some assets leads to the
concern that asset prices will decline further and that the financial system will
experience ‘distress.’ The rush to sell these assets before prices decline further
becomes self-fulfilling and so precipitous that it becomes a panic. The prices of
commodities—houses, buildings, land, stocks, bonds—crash to levels that are 30
to 40 percent of their prices at the peak. Bankruptcies surge, economic activity
slows, and unemployment increases.” 17 This sounds just like 2008—except that
Kindleberger died in 2003. In fact, he was describing America’s panics in 1816,
1826, 1837, 1847, 1857, 1866, 1873, 1907, 1921, and 1929. This is not just bad
luck. As Yale economist Gary Gorton told the Financial Crisis Inquiry
Commission, “There is a fundamental, structural, feature of banking, which if
not guarded against leads to such crises.”
We now rejoin our farming hamlet, where the village council has appointed a
Rice Panic Inquest Commission, Elizabeth Warren is running for chief elder, and
angry farmers with pitchforks have surrounded the rice storehouses.¶ We now
introduce one more character, Ram, who sold rice cakes in our hamlet before the
crash. Ram is young, attractive, and hard-working. During the boom, Ram was
smart enough not to speculate in land or to take on excessive debt. But after the
crash, his business was devastated, both because the demand for his products
collapsed and because he cannot get even a basic, well-collateralized loan to
keep his business running. Ram is wiped out; his family is growing hungry and
desperate.
Here is why Ram matters: he is the innocent victim. No one likes the bankers
or the speculators. Farmers who borrowed too much have themselves to blame.
But Ram, well, he’s collateral damage. So what to do about Ram? That is the
question at the heart of any financial system, simple or complex. There is a
compelling case, both economically and morally, that government should let a
crisis run its course: a lot of stupid people who did a lot of stupid things will pay
an appropriate price for their actions—and perhaps do fewer stupid things in the
future. As Treasury Secretary Andrew Mellon supposedly advised President
Herbert Hoover during the depths of the Great Depression, “Liquidate labor,
liquidate stocks, liquidate the farmers, liquidate real estate. . . . It will purge the
rottenness out of the system. . . . Values will be adjusted, and enterprising people
will pick up the wrecks from less competent people.” 20 In other words, wipe out
anyone and anything foolish enough to get swept up in the crisis and start over
with what is left.
There is some dispute about what Mellon actually said, since President
Herbert Hoover related the comments and we have no video. However, you can
watch the YouTube clip of CNBC reporter Rick Santelli’s famous 2009 diatribe
on the floor of the Chicago Board of Trade in which he rails against bailing out
overly indebted U.S. homeowners. He turns to the traders crowding around him
and yells, “How many of you people want to pay for your neighbor’s mortgage
that has an extra bathroom and can’t pay their bills?” Someone yells back, “How
about we all stop paying our mortgage!” 21 Santelli says he is going to hold a tea
party in Chicago on Lake Michigan—the moment that is credited with launching
the Tea Party.
Bad grammar aside, Santelli and his supporters have a point. Why should we
spend a lot of our time and money fighting a house fire caused by a guy smoking
in bed? That’s where Ram complicates things. Think of him as the next-door
neighbor whose house may also be consumed in the blaze. In fact, as 2008
reminds us, this can be a pretty densely populated neighborhood. Therein lies the
dilemma: To protect the neighborhood, we may have to invest public resources
in saving the house of the guy who was smoking in bed—who may or may not
learn his lesson. Or we may have to impose regulations on homeowners before
there is a fire (e.g., sprinklers and smoke detectors) to protect the neighborhood.
Both are unpopular. No one likes regulations before a crisis, when they seem
intrusive and expensive. And no one likes bailing out bad actors once a crisis
unfolds.
It is ironic that Chicago, the place where Rick Santelli launched the Tea
Party, was once completely wiped out by fire. A fire that began in a single barn
destroyed the modern equivalent of $4 billion in property and left 100,000
people homeless.22 Even as we lament regulation and government bailouts, we
expect government to stop those kinds of conflagrations. The argument in favor
of regulating the financial industry (and intervening to dampen a crisis, if
necessary) typically comes down to three points:
Bankers have done something unique: they have unified the world’s major
religions against them. Jesus expelled the moneychangers from the temple.
Muhammad banned usury. The Torah directs that all debts be discharged every
seven years. The unifying belief is that moneylending is somehow unjust and
unproductive. Economists see it entirely differently. Moneylending is the good
part of banking. The whole point is to put idle capital into the hands of those
who can make productive use of it; anyone who facilitates such a deal is
performing a valuable service and should be paid as such. The problem is when
moneylending goes wrong—namely when depositors rush the temple and the
moneylenders don’t have the money. If Jesus were a central banker, that would
be his concern.
________
* Technically the Building & Loan was not a bank or the Federal Deposit Insurance Corporation would
have insured the accounts. FDIC insurance was created in 1933 to prevent the kind of bank run portrayed in
the film. It’s a Wonderful Life was released in theaters in 1946 (to initially disappointing results).
† This process can continue. Suppose the farmer taking out the loan is not ready to use the borrowed rice (or
rice certificates) and deposits them for the time being in her own bank. Half of these funds can be loaned
out, too (assuming a reserve ratio of 0.5). Now we are triple counting. Half of my rice can be loaned to
someone, so that each bag of my rice on deposit creates a half bag of new money when loaned out. And
each of those half bags, when deposited in a bank and partially loaned out, can generate another quarter bag
of new money. As you might surmise, this process can continue until there is no more incremental rice to
loan out. In a fractional banking system, the formula for the expansion of the money supply from new
deposits, the money multiplier (m), is the following: m = 1/reserve ratio. If the reserve ratio is 0.5, as in our
example, every new bag of rice deposited adds two bags of rice to the money supply. The lower the reserve
ratio, the more dramatic the expansion of the money supply. With a reserve ratio of 0.1, every bag of rice
(or dollar) on deposit increases the money supply tenfold. You should also appreciate that the money
multiplier works in reverse. When banks slow down their lending, or hold more reserves, the money supply
will contract sharply.
‡ If I sound mildly bitter on this point, it’s because I am. In graduate school I had a disagreement with my
macroeconomics professor—one of the most influential finance experts in the world, who now teaches at
one of the most influential universities in the world—over the role that psychology plays in markets. He
insisted that psychology does not determine market outcomes, only economic fundamentals. I disagreed, as
it seemed asinine to me to overlook human nature, which is prone to euphoria and panic. Time has been
kinder to my view of markets than his. (The 2002 Nobel Prize in Economics recognized important work at
the intersection of psychology and economics; the subfield of behavioral economics now explores this
important area.) Okay, yes, I’m still annoyed that I got a B-in that class, and that is small of me. But when I
take a bigger view, I get even angrier. With very few exceptions, the macroeconomic community did not
anticipate the collapse of the real estate bubble nor its dire effects on the broader financial system. In fact,
the crisis was almost certainly made worse by many precise but inaccurate macroeconomic models that
downplayed the global risks and gave false comfort to reckless financiers. Seldom in academe has the ratio
of arrogance to excellence been so out of whack in a way that imposed such large human cost.
§ During the 2008 financial crisis, global investors were so eager to park their money in U.S. Treasury
securities that yields briefly turned negative. As opposed to earning interest, panicked investors were
willing to pay a small premium to park their capital in highly liquid securities with a very low risk of
default.
¶ After America’s first bank panic in 1792, angry investors surrounded the New York jail holding one of the
culpable speculators and pelted it with stones.
“The Slumps that Shaped Modern Finance,” Economist, April 12, 2014.
# Technically, a bank has borrowed funds from its depositors.
** The investment bank Lehman Brothers was a global financial services firm that declared bankruptcy on
September 15, 2008, setting in motion a cascade of adverse events that spread and deepened the global
financial crisis.
CHAPTER 5
Central Banking
Our economic system will work best when producers and consumers, employers and employees, can
proceed with full confidence that the average level of prices will behave in a known way in the
future—preferably that it will be highly stable.
—Milton Friedman1
Getting prices right is hard. The financial system is inherently prone to panics.
Those financial panics can derail the broader economy. Who are the adults in
charge of all this?
We just heard from one, Ben Bernanke, who was chair of the Federal
Reserve, America’s central bank, during the financial crisis. A central bank,
whether it is the U.S. Federal Reserve or the Bank of Canada or the European
Central Bank, is the institution with primary responsibility for managing the
money supply and protecting the stability of the financial system. In the United
States, Congress has also charged the Federal Reserve with using monetary
policy to promote full employment.
Central banks have evolved in different countries in different ways. (The
European Central Bank, for example, was created to manage monetary policy in
all the countries that share the euro.) Central banks are government entities,
albeit more like the Supreme Court than Congress. They are created and
empowered by national governments. Congress created the Federal Reserve and
could, in theory, eliminate it. Yet top central bank officials are typically shielded
from direct democratic control (like Supreme Court justices). The senior Federal
Reserve Board members, including the chair, are appointed by the president and
confirmed by the Senate. Once in office, however, they cannot be removed by
the president or Congress for any policy-related decisions.
Why does that matter? Because doing what is best with regard to monetary
policy is not always about doing what’s popular. In fact, if economics nerds—of
which there are many—had a central banking superhero, it might be Inflation
Fighter Man. This superhero would have a single power, raising and lowering
interest rates, and with that power he could whip rising prices into submission.
Inflation Fighter Man would be balding and tall, almost six foot seven, with a
slight stoop, a gravelly voice, and a penchant for cheap cigars. With his power
over interest rates, Inflation Fighter Man would send a powerful signal
throughout the economy that rising prices could not stand.
Unions demanding higher wages? Boom! Inflation Fighter Man raises
interest rates until the economy slows to the point that workers fear for their
jobs. Forget the double-digit raise! Once Inflation Fighter Man tightens the
screws on monetary policy, workers are happy just to be employed at whatever
wage they made last year. Companies looking to raise prices? Pow! Inflation
Fighter Man makes it so expensive for consumers to borrow that homebuilders
and auto manufacturers and other businesses dependent on consumer credit must
hold prices down to stay in business. Doesn’t sound like a hero? That’s the point.
Read on!
Inflation Fighter Man is so feared and respected that when he says he will
break the back of inflation, people everywhere know he is willing to do whatever
it takes. This credibility becomes a self-fulfilling prophecy. When Inflation
Fighter Man makes an utterance about his intentions—usually while enveloped
in a haze of smoke from those cheap cigars—markets around the world react.
Wham! Prices and interest rates change immediately because he says they will
change. Yes, Inflation Fighter Man controls interest rates, but his reputation is
also a hidden power.
Like any good superhero, Inflation Fighter Man has a dark side. Fighting
inflation inflicts pain. Raising interest rates deliberately slows the economy:
consumers purchase less, asset prices fall, firms find it more expensive to borrow
and invest. Entire industries, such as real estate, fall into distress. This special
power—manipulating interest rates—can impose real costs on real lives. Those
who suffer blame Inflation Fighter Man; they send him angry letters (or worse)
and plead with Congress for relief. But Inflation Fighter Man keeps his eye on
the prize. He knows that price stability is what maximizes prosperity in the long
run. Inflation Fighter Man is not cowed by personal attacks and emotional
stories of economic distress. He knows that society will be better off when the
system is rid of inflation—and the expectation of inflation—once and for all.
Then households will no longer see the value of their savings eroded by
inflation; businesses can make plans knowing what prices will be five, ten, or
even thirty years in the future. Sure enough, when the world emerges from an
inflationary period, people everywhere say, “Thank you, Inflation Fighter Man.”
There is a reason that Inflation Fighter Man is tall, stooped, bald, and keen
on cheap cigars. His character is based on the most heroic inflation fighter of all
time, Paul Volcker, who was chair of the Federal Reserve, America’s central
bank, from 1979 to 1987. In 1980, inflation in the United States was running at
14 percent.2 The economy was also weak, defying expectations that inflation
should be good for growth and employment. Inflationary expectations were
baked into the cake. Everyone expected price increases, which brought about
price increases, which planted inflationary expectations ever more deeply.
Something would have to change to break the back of inflation. Not only would
that require a drastic dose of higher interest rates, but the public would have to
believe that the Fed would tolerate the economic pain associated with a sustained
period of high interest rates. Paul Volcker was just the guy. As William Poole,
former president of the Federal Reserve Bank of St. Louis, has explained, “The
days of ‘easy credit’ turned into the days of ‘very expensive credit.’ The prime
lending rate exceeded 21 percent. Unemployment reached double digits in some
months. . . . Volcker’s tough medicine led to not one, but two, recessions before
prices finally stabilized.” 3 The result of this bitter medicine was three decades of
modest inflation and economic stability that came to be known as the Great
Moderation.
When Inflation Fighter Man is turned into a blockbuster film, there will be
changes to update him from the 1970s. First, the cigar must go. The Federal
Reserve is now a smoke-free workplace. Also, Inflation Fighter Man will be a
woman. Janet Yellen took over as chair of the Federal Reserve in 2014, the first
woman to hold that post. Yellen is neither tall nor balding. Meanwhile, the world
has emerged from the financial crisis of 2008 facing a different threat than it did
in the 1970s: falling prices. In the United States, Europe, and Japan, monetary
policy officials are working hard to ward off deflation. Governments are
consistently missing their inflation targets—on the low side. In early 2015, a full
seven years after the onset of the financial crisis, the Economist declared, “The
world is grievously underestimating the danger of deflation.” 4
So, in an acknowledgment of changing times, the blockbuster film will be
called Deflation Fighting Woman. Nonetheless, feminists will rightfully point
out that Angelina Jolie, in the lead role, bears no resemblance to Janet Yellen.
And why does the Fed chair need a tight-fitting body suit? Did Alan Greenspan
wear curve-hugging spandex? Ben Bernanke? No and no. Still, the diehards will
camp out for tickets. Why? Because Deflation Fighting Woman (or Inflation
Fighter Man) is the most powerful unelected official in the world. He or she can
affect the economic fate of billions of people around the planet. Raising and
lowering interest rates in the United States really is a superpower. Like any
superpower, it can be used for ill or for good, which makes for an exciting film.
In real life, central banks have become some of the world’s most important
economic institutions. With currencies backed only by the paper on which they
are printed, a responsible central bank is all that stands between stable prices and
Zimbabwe-like hyperinflation. (Yes, Zimbabwe had a central bank—just not a
good one.) The people who lead central banks have striking amounts of
unchecked powers by democratic standards. Ben Bernanke steered the global
economy through the financial crisis, drawing on his experience as a scholar of
the Great Depression so as not to repeat the monetary mistakes made then.
(Chapter 9 will discuss the degree to which he succeeded.) Janet Yellen has had
to deal with slowly reversing the extraordinary measures taken post-2008 and
the specter of deflation (without a body-hugging spandex suit or X-ray vision).
In Europe, Mario Draghi, president of the European Central Bank, is trying to
hold the euro together, as countries like Spain, Portugal, Italy, and Greece
struggle with the burdens imposed by a single supranational currency. (That’s
chapter 11.) The degree to which these central bankers succeed or fail affects the
fate of the global economy—employment, bankruptcies, wealth, even war and
peace. Global monetary policy after World War I spawned the Great Depression
and gave rise to many of the economic tensions that helped bring the Nazi Party
to power.
Meanwhile, all kinds of people lambaste central bankers for all kinds of
reasons (often conflicting). While there is broad consensus in the economics
profession on the basic things that any central bank should seek to do (promote
stable prices and steady economic growth), there is less agreement on how those
goals are best accomplished. John Taylor, one of the most prominent voices in
the field of monetary policy and a noted conservative, has accused the Federal
Reserve (and the U.S. government) of doing just about everything wrong in the
2000s. The subtitle of his 2009 book is How Government Actions and
Interventions Caused, Prolonged, and Worsened the Financial Crisis. In
general, critics from the political right have criticized the Fed’s response to the
financial crisis as reckless and inflationary. As an extreme example, Texas
governor Rick Perry declared while running for president in 2012 that Ben
Bernanke’s aggressive actions as Fed chair were “almost treasonous.”
On the other political flank, progressives like Paul Krugman, a Nobel Prize
winner and no monetary policy slouch, believe that the Fed should have been far
more aggressive in lowering interest rates in the aftermath of the financial crisis
(and that the Europeans are still being too timid in that regard). Meanwhile,
libertarians like Ron Paul would like to eliminate the Fed altogether and return
to the gold standard. (Hence his book End the Fed.) Conspiracy theorists on both
the left and the right see the Federal Reserve at the heart of myriad nefarious
global plots. One of the first Fed-related conspiracy theories was that the
wealthy banker J. P. Morgan (mentioned earlier for putting together the
consortium to stop the Panic of 1907) plotted the construction and sinking of the
Titanic (1912) to kill off critics of the creation of the Federal Reserve System
(1913).* A 1989 book, Crossfire, blamed John F. Kennedy’s assassination on
forces loyal to the Federal Reserve. (Kennedy issued Executive Order 11110,
which was supposedly the beginning of an effort to rein in the unchecked power
of the Fed; he had to be stopped.) Modern conspiracy theories focus on the Fed
as part of a cabal of global bankers intent on enriching themselves at the expense
of the rest of us, a view clearly sharpened by the bank bailouts during the
financial crisis. If you have an Internet connection and a free afternoon, you can
read a lot of wacky theories. Research Magazine ran an article in 2010 on the
Fed and its enemies, documenting many “baseless, even bizarre beliefs.” Some
are funny; some are scary; all are creative. But as the author of the piece aptly
notes, “That such ideas are outlandish does not make them inconsequential.” 5
The reading material in Osama bin Laden’s compound included Secrets of the
Federal Reserve, a book written by a Holocaust denier alleging that the Federal
Reserve is a criminal syndicate controlled by elite financiers for their own
interests.6
The Federal Reserve is an opaque institution, poorly understood. The Fed
has compounded that image problem at times by deliberately obscuring its
activities. Alan Greenspan’s language was so impenetrable during his tenure as
chair that the Motley Fool radio program created a game show called “What Did
the Fed Chief Say?” The hosts would play audiotape of Greenspan’s testimony
before Congress and invite listeners to call in to the program and summarize
what the Fed Chief was trying to say. I was the judge; anyone who could
accurately summarize excerpts from Greenspan’s remarks in plain English
would win a free hat. We gave away surprisingly few hats.
Part of the motivation for this book is to clear away the mysteries
surrounding the Federal Reserve, and central banks in general. The role of a
central bank is typically threefold: to manage the money supply; to act as a
lender of last resort; and to regulate the financial industry. (The regulatory
responsibility is often shared with other arms of government.) In the United
States, the Federal Reserve has the added mission of using monetary policy to
promote full employment. Every developed nation has an institution similar to
the Fed: the Bank of England, the Reserve Bank of India, the European Central
Bank (which oversees the entire eurozone), the Bank of Japan, and so on. The
responsibilities of these institutions stem directly from phenomena covered in
previous chapters. A central bank can prevent panics, smooth economic
fluctuations, and protect the value of a fiat currency. Of course, central banks
can also commit monetary malpractice. Zimbabwe’s central bank wrecked the
economy with too much money; in the United States during the 1930s, the
relatively young Federal Reserve allowed the money supply to shrink
precipitously, turning what might have been a routine economic downturn into
the Great Depression. Yes, a doctor can cure cancer; he can also amputate the
wrong limb. So it is with central bankers.
Like so many things American, the Federal Reserve System is a quirky
combination of centralized and decentralized powers. The Federal Reserve
comprises twelve regional Reserve Banks serving districts across the country. A
seven-person board of governors oversees the system; each governor is
appointed by the president for a single fourteen-year term, subject to
confirmation by the Senate. The president also appoints the chair and vice chair
(currently Janet Yellen and Stanley Fischer, respectively). As noted earlier, none
of the board members can be fired for their policy-related decisions or behavior;
like Supreme Court justices, they are appointed by the political process but
subsequently insulated from that process. The twelve regional Reserve Banks are
quasi-public institutions designed to serve both the public and the member banks
in the district. All federally chartered banks are required to be a member of their
regional Reserve Bank—and therefore hold stock in that institution. State-
chartered banks can opt to be shareholders. The member banks choose the board
of directors for each Reserve Bank; the board in turn chooses a president.
This arcane structure, particularly the fact that the regional banks are
“owned” on paper by America’s private banks, contributes to the myriad
conspiracy theories swirling about the Fed. In practice, government officials in
Washington make monetary policy with meaningful input from the presidents of
the regional Reserve Banks. The Federal Open Market Committee (FOMC) is
the entity that raises or lowers interest rates and sets other key policies. The
FOMC consists of the seven members of the board of governors, the president of
the Federal Reserve Bank of New York, and four other presidents of the regional
banks on a rotating basis. (Everybody gets a turn!) So yes, it is true that
Deflation Fighting Woman is really just one member of an important committee
with just one vote. (The film title Woman Who Sits on a Powerful Committee
tested badly with focus groups, even with Angelina Jolie in the title role.) The
reality is that the Fed chair holds disproportionate sway over monetary decisions.
In recent decades, the FOMC has tended to operate by consensus, with the chair
responsible for building that consensus. Members do on occasion dissent from
committee votes, but those dissenting votes are newsworthy (unlike the Supreme
Court, where it is the unanimous decisions that are unusual).
The tools of a central bank follow logically from our discussion of banking
in the last chapter. First, the central bank sets the reserve requirement, the
quantity of funds that a commercial bank must hold in the vault or on deposit at
the Fed in the event that depositors come asking for their money. A reserve
requirement of 50 percent means that banks are allowed to loan out half of their
funds on deposit; a reserve requirement of 10 percent allows banks to loan
significantly more—$9 for every $10 on deposit. The latter expands credit more
aggressively but also leaves the system more vulnerable to shocks. As was
discussed in the last chapter, a fractional banking system creates new money. If
the reserve requirement is 50 percent, every new dollar injected into the banking
system expands the money supply by $2, whereas if the reserve requirement is
10 percent, every new dollar in the banking system has the potential to expand
the money supply by $10.† All else being equal, lowering the reserve
requirement expands the money supply; raising it does the opposite. As noted
earlier, banks can hold these reserves on deposit at the Fed as opposed to
keeping huge quantities of cash in the vault. A central bank can pay interest on
reserves held there, and even interest on reserves held above the legal reserve
requirement (excess reserves). Manipulating this interest rate—essentially the
rate that banks get for keeping their funds on deposit at the Fed rather than
loaning them out—is one more tool the central bank can use to encourage or
discourage lending by its member banks.
A central bank can also loan funds directly to the banking system through a
mechanism called the “discount window.” The Fed is the lender of last resort; as
the name would suggest, banks are encouraged to go elsewhere first. The interest
rate at which the Fed will loan funds directly to banks, the discount rate, is
typically set slightly above the market rate at which banks borrow from one
another.‡ Historically there has been not only a small pecuniary penalty for
borrowing from the central bank but also a stigma. Borrowing from the Fed is
like borrowing money from your parents once you are over thirty. You can do it,
but everyone involved would prefer that you found the funds somewhere else.
The Fed’s discount lending adheres to Walter Bagehot’s admonition that a
lender of last resort ought to lend freely at a punitive rate. At the height of the
financial crisis, both Morgan Stanley and Goldman Sachs, two of America’s
preeminent investment banks, legally converted themselves into traditional bank
holding companies in part so that they would have access to emergency lending
from the Fed.7
A central bank typically has a legal monopoly over the power to create new
money, albeit electronically rather than by printing currency. This power gives
an institution like the Fed the unique power to feed money into the economy or
to withdraw it, thereby manipulating the “price” of money (interest rates). The
authority to create new money also provides unlimited liquidity. A good lender
of last resort has deep pockets, thereby convincing the financial markets that
there is no need to panic. (George Bailey’s honeymoon fund was big enough to
persuade depositors that they would get their money back—which curtailed the
demand to get their money back.) A central bank has bottomless pockets. There
is no theoretical limit to the quantity of money a central bank can create to deal
with economic distress. In response to the financial crisis, the Fed pumped over
$4 trillion into the global economy. Who needs a spandex suit when you can do
that?
And finally, a central bank can raise or lower short-term interest rates
throughout the economy. Obviously Janet Yellen does not have the authority to
tell Citibank what rate you ought to pay on your boat loan—but she can achieve
the same thing indirectly. Central banks around the world manipulate interest
rates in their respective countries by increasing or decreasing the supply of funds
available to be loaned out. (How they manage to do this will be discussed in a
moment.) For now, keep in mind that the interest rate is just the “price” of
borrowed funds. Raising the supply of loanable funds in the economy relative to
demand lowers the market interest rates. (There are more loanable funds out
there, so it becomes cheaper to borrow them.) Reducing the supply of loanable
funds does the opposite.
In the United States, the benchmark measure of short-term interest rates is
the federal funds rate, which is the rate at which private banks loan funds to one
another overnight. As noted above, the Federal Reserve cannot directly affect the
interest rate at which one private bank loans money overnight to another.
Instead, when the Fed decides to cut interest rates by a quarter percent, that
typically means the Fed’s decision makers have cut the target federal funds rate
by a quarter percent. The Fed will do what it takes to induce private banks to
lend more cheaply to one another—a quarter point more cheaply, on average.
What does it take? More money in the banking system, so that the supply of
loanable funds goes up and the price at which those funds are loaned out goes
down. The Fed changes the supply of money in order to raise or lower the price
of credit, which is a more intuitive way of describing the interest rate.
How does the Fed affect the money supply? This can be accomplished in any
number of ways. Janet Yellen could put on her tight-fitting body suit and drive
around the country in an armored truck passing out new money to banks. Or the
folks with the fancy computers at the Fed could send new money to lucky
depositors in randomly selected banks—monetary policy meets the lottery. (How
much fun would that be!) As always, there is the option of dropping cash from
helicopters (much of which would get deposited in banks). While each of these
approaches for manipulating the money supply would be fun and exciting, they
have two crucial flaws. First, the Federal Reserve would be randomly affecting
the wealth of Americans, which is far beyond its mission. Second, even if
Americans might tolerate random deposits when the money supply was
expanding, they would be significantly less tolerant when the Fed was shrinking
the money supply—Janet Yellen driving around in an armored truck randomly
taking cash away from people. (Much less fun.)
Instead, central banks are much cleverer than all that. In the United States,
the Fed buys and sells Treasury bonds from banks in a process called open
market operations.§ Banks hold bonds for the same reason individual investors
do: bonds are a safe place to park funds that are not needed for anything else.
Specifically, banks buy bonds with depositors’ funds that are not being loaned
out. When the Fed wants to expand the money supply, the traders at the Federal
Reserve Bank of New York buy government bonds from banks eager to sell
them. The key is that banks are giving up government bonds, which cannot be
turned into loans, for money that can. When Citibank sells $100 million in bonds
for $100 million in new money, those funds can now be loaned out. (The banks
with the greatest opportunities to make new loans are the most likely to sell
bonds to the Fed in exchange for new money, which is another attractive feature
of the process.) For reasons discussed earlier, these new funds have a cascading
effect. Every new dollar the Fed injects into the banking system can support
eight or nine dollars in new loans.
To shrink the money supply, the Fed sells bonds to banks, taking loanable
funds out of the system. Citibank buys $100 million in bonds from the Fed and
gives up $100 million that would otherwise have been loaned out. No need for
Janet Yellen to ride around in an armored truck trying to take money away from
banks.
The federal funds rate is the thermostat for the credit market. The FOMC sets
the thermostat and then conducts open market operations until the target interest
rate is achieved. You should recognize that the Fed is not creating new wealth,
only new money. Unlike dropping money from helicopters or randomly
depositing new money at banks, no one is getting richer when the Fed injects
new money into the system (or poorer when the funds are withdrawn). This is all
about liquidity. The Fed is exchanging money for an equivalent amount of
bonds, and vice versa. As noted earlier, the Fed injected some $4 trillion in new
money, or liquidity, into the economy to battle the Great Recession; over that
period, the Federal Reserve System acquired $4 trillion in bonds and other assets
in exchange. The financial crisis prompted the Fed to take unusual measures,
which will be explained and analyzed in chapter 9. For all the fanfare and vitriol,
however, these were really just new variations on the same basic plays.
At some point, presumably when the economy nears full strength, the Fed
will begin to unwind this process, selling bonds into the banking system to
withdraw liquidity and curtail the money supply. For years after the financial
crisis, interest rates remained extremely low by historical standards and the
financial news was constantly abuzz with stories about when the Fed would
begin tightening the credit markets (raising interest rates).
A central bank changes the price of money. With one decision, our real-life,
unembellished superhero—Woman Who Sits on a Powerful Committee—can
change the price of credit and therefore the behavior of consumers and investors
around the world.
What to do with this awesome power?
Manage Prices
The supply of fiat currency is essentially infinite; someone has to mind the store.
A primary goal of a central bank is to maintain the value of the currency. For
reasons explained in chapter 3, most central banks do not aim for zero inflation.
Instead, they advertise an inflation target, or an inflation range. The U.S. Federal
Reserve has a stated inflation target of 2 percent. The European Central Bank
has a target of “below, but close to 2 percent.” 8 New Zealand has a target range
of 1 to 3 percent.9 And so on. From there, it becomes like a carnival game: raise
or lower interest rates to keep inflation near the target or in the range. (As noted
above, raising interest rates is typically referred to as tightening monetary policy
and lowering rates as loosening it.) Here is how it generally works.
1. Any economy has a “speed limit” in the short run—a relatively fixed
capacity to produce goods and services. In the short run, we have a finite
supply of the things the economy needs as it expands: land, workers, steel,
yoga instructors, and so on. If the demand for goods and services exceeds
our capacity to produce them, prices will rise. That is how businesses ration
scarce products. A shortage of steel leads to higher steel prices. A shortage
of workers leads to higher wages (which sounds like a great thing, except
that the higher wages are consumed by higher prices on everything the
workers want to buy). And so on.
Conversely, when there is slack in the economy, prices tend to fall
(subject to the caveats discussed in chapter 3). If an auto dealer has inventory
that is not moving, he marks down prices. If apartments are sitting empty,
rents tend to fall.
2. The price of credit affects the demand for goods and services. You are more
likely to buy a new Mercedes if you can finance it for 2 percent instead of 5
percent. The same is true for buying homes, washing machines, or anything
that is typically financed. On the business side, firms find it cheaper (and
therefore more profitable) to expand when interest rates fall (other things
being equal). Obviously the whole process works in reverse when interest
rates go up: everything that involves borrowed money becomes more
expensive.¶
3. Central banks manage the price of credit (interest rates) to keep an economy
running as close to its speed limit as possible. If an economy “overheats”—
meaning that demand exceeds what can be produced—prices across the
economy will go up: inflation. On the other hand, if an economy grows more
slowly than its potential, resources will sit idle. Factories close; workers are
unemployed. The excess capacity causes prices to fall: deflation. There will
also be significant human hardship, a point that will come up repeatedly in
the second half of the book.
It is worth noting that if prices rise steadily for long enough, the process
takes on a life of its own as consumers and businesses begin to anticipate
inflation, so-called inflationary expectations. Workers automatically ask for
higher wages to account for the inflation they expect in the future;
companies build regular price increases into their plans (in part because
workers keep asking for more money). Once inflationary (or deflationary)
expectations become anchored in the economy, it becomes very hard to
reverse the trend. Prices go up or down for the same reason my mother
serves oyster dressing at Thanksgiving: because that’s what we did last
year.#
Like most carnival games, hitting an inflation target is harder than it may first
appear. Let’s start with the most basic challenge when it comes to maintaining
stable prices: Which prices? For all the reasons discussed in chapter 3, there is
no right measure of inflation or deflation. In the United States, the Fed typically
focuses on underlying inflation, which excludes food and energy prices. In
contrast, “headline inflation” includes the full basket of goods in the CPI. The
logic behind this decision is that food and energy prices tend to be volatile. A
rapid increase in food and energy prices might reflect political tension in
Venezuela or a bad harvest in Iowa more than underlying inflationary pressures
across the economy. Current critics of the Fed maintain that inflation is higher
than it appears because the Fed is literally looking in the wrong places. Before
we can agree what time to meet, we have to synchronize our watches.
Oh, but it’s much harder than that. A central bank has to fight rising or
falling prices before prices begin to rise or fall. Wayne Gretzky, the greatest
hockey player of all time, once described his seemingly unique talent: “I skate to
where the puck is going to be, not where it has been.” The same may be said for
central banking. The Fed does not respond to where prices are; they respond to
where they think prices are going. Just about everything related to monetary
policy happens with a lag, meaning that some time elapses between cause and
effect. If the corn crop is lousy in the Midwest this summer, food prices might be
higher this fall, or next year, or some combination of both. An extraordinary
amount of research and analysis at the Fed goes into figuring out where the puck
is going. Before each FOMC meeting, Fed officials prepare a report called
“Current Economic and Financial Conditions,” or the “Greenbook” because of
its green cover. (These people have a lot of work to do, leaving very little time
for creativity.) The goal is to summarize the domestic and international
economic forces relevant to Fed policy. This analysis is used to create a report
called “Monetary Policy Alternatives,” or the “Bluebook,” which lays out the
monetary policy alternatives that the FOMC could consider at the upcoming
meeting.10 (Bonus question: Why is it called the Bluebook?**)
Former Fed chairman William McChesney Martin once described the job of
the Federal Reserve as taking away the punch bowl just as the party gets going.
From an inflation-fighting standpoint, once people start dancing on the tables, it
is too late. Although deflation has been less of a problem since the Fed was
created, the metaphor still works: it’s too late to spike the punch if the band has
packed up and the cool people have left. In either event, the point is that when a
central bank raises or lowers interest rates, the impact on the economy—and
eventually on prices—also happens with a lag, particularly if inflationary or
deflationary expectations have taken hold. If companies have become
accustomed to raising prices 10 percent a year, and workers expect salaries to
rise at that rate (or have bargained for cost-of-living adjustments that
automatically raise wages to account for inflation), it is going to be hard to
change those patterns. Paul Volcker recalls a labor leader telling him six months
after the battle on inflation had been launched, “Well, that’s all very interesting,
but I’ll tell you how I feel about it. I just negotiated a wage increase of 13
percent a year for the next three years for my employees, and I’m very happy
about it.” 11
Higher interest rates will eventually slow the economy. But it could take
months for everyone to get that memo from the Fed. How long is the lag? Well,
that depends on all kinds of unique circumstances. The effect is like driving a car
with a gas pedal and a brake that function with a long and unpredictable delay.
Just as you push the pedal farther to the floor, the car responds to the burst of gas
five minutes ago, and suddenly it’s careening out of control. When you hit the
brake, sometimes it works quickly, and sometimes it takes several miles.
Did I mention that Congress is also hitting the gas and the brake, often in
ways that are not coordinated with the Fed’s objectives? Fiscal policy—taxing
and spending by the government—can also speed up or slow down the economy.
Lower interest rates can promote faster growth; but so can a dollop of
government spending or tax cuts under certain conditions. (Cutting government
spending or raising taxes has the potential to do the opposite.) I’m sure there is a
planet somewhere in the universe where Congress thoughtfully designs fiscal
policy in perfect harmony with what the Federal Reserve is trying to accomplish
—we just don’t happen to live on it. So to stick with our driving metaphor,
imagine the Federal Reserve in one of those driver’s education cars and
Congress and the president have their own set of pedals on the passenger side.
They may be pushing on the brake or the accelerator (or both at the same time,
as they have been known to do) in ways that are at odds with what the Fed is
trying to accomplish.
If you still think you could win a goldfish by hitting the inflation target,
we’re not done yet. I’ve referred periodically to the speed limit of an economy—
its capacity to produce goods and service without generating inflation. Here’s the
funny thing: we don’t really know that speed limit with any degree of certainty.
During the 1990s, Alan Greenspan and the Federal Reserve wrestled with the
degree to which the Internet and information technology had increased the
productivity of American workers. If workers equipped with PCs and the
Internet had become significantly more productive, the economy could grow
faster without inducing inflation—an increase in the speed limit. But
productivity is hard to measure in real time. Nobel laureate Robert Solow
famously observed in 1987, “You can see the computer age everywhere but in
the productivity statistics.” 12 The relationship between technology and
productivity was—and still is—a crucial variable for central bankers probing the
speed limit.
In the aftermath of the financial crisis, Ben Bernanke and Janet Yellen have
had to evaluate whether workers who left the labor force during the economic
downturn are likely to return. If so, there will be ample opportunity for the
economy to grow before falling unemployment generates inflationary pressures.
But if not—if the larger number of workers who stopped looking for work
during the Great Recession stay out of the workforce for good—the speed limit
for the American economy will be permanently lower.
Protect the rest of the system. (Darn, looks like the house is going to burn down,
but we can still save the neighborhood.) Some prospective reforms are focused
on letting institutions fail without disrupting the broader system. Dodd-Frank
requires institutions to create a “living will,” which is a hypothetical bankruptcy
plan showing that the institution can collapse without bringing down the rest of
the financial system.
Designate systemically important institutions. (If this skyscraper were to catch
on fire, it would be a disaster for the whole city—so let’s pay special attention to
this skyscraper.) This is the “too big to fail” problem. Some institutions are so
large and have such deep and complex interconnections with the rest of the
financial system that the global implications would be dire if they were to fail, or
suffer serious distress. The Dodd-Frank reforms created a fifteen-member
Financial Stability Oversight Council (FSOC) with responsibility for
“identifying risks and responding to threats to financial stability.” 18 The chair of
the Fed is automatically one of the ten voting members of the council. FSOC has
the authority to deem a financial institution as “systemically important.” Those
institutions designated as such are subject to regulatory supervision by the Fed
and other “enhanced prudential standards.” For 2014, that list contains some
household names—JP Morgan Chase, Goldman Sachs, Citigroup—but also
some less familiar global players, such as the Agricultural Bank of China.19
I will leave it to another author to determine which regulations actually have
their intended effect. History suggests that changing reckless behavior is much
harder than trying to change reckless behavior.
Nothing in this chapter should suggest that the Fed, or any other central bank, is
without flaws. Chapter 9 will examine the Fed’s response to the 2008 financial
crisis; chapter 14 is all about doing central banking better. (That’s why the
chapter is called “Doing Central Banking Better.”) In fact, we know an economy
can function without a central bank at all. Industrious people throughout history
have found ways to engage in commerce with whatever money facilitates
transactions, from bags of salt to bitcoin. The United States did not have a
central bank until the Federal Reserve System was created in 1913. Two earlier
central banks, the First and Second Banks of the United States, lapsed after their
charters were not renewed by Congress.
Yet a properly functioning central bank makes a modern economy function
more smoothly. The Economist wrote in 2011, when the worst of the financial
crisis had passed, “Central bankers have become the most powerful and daring
players in the global economy. By providing massive liquidity to the financial
system, they saved the world from economic collapse in 2008. They have
propped up the recovery since, not least by buying boatloads of government
bonds; and they have rewritten the rules of global banking. All this has brought
rock-star status.” 24
Okay, so maybe they’re not superheroes. But rock star is pretty good, too.
________
* J. P. Morgan, a proponent of the Federal Reserve System, helped to create and finance the holding
company that owned the White Star Line, the shipping company that built the Titanic. He booked passage
on the maiden voyage but canceled at the last minute. John Jacob Astor IV, the richest man in the world at
the time and a critic of the idea of creating an American central bank, went down with the ship. Morgan’s
devious plan was supposedly inspired by an 1898 novel, Wreck of the Titan, in which an “invincible” ship
sinks in the North Atlantic because it is traveling too fast and hits an iceberg. In the book, most of the
passengers die for lack of lifeboats.
See
http://www.reddit.com/r/conspiracy/comments/1xni4f/did_jp_morgan_build_the_titanic_to_kill_off_the/.
† This relationship is formally known as the money multiplier, which connects the quantity of deposits to
the broader money supply. The money multiplier = 1/reserve ratio. For large commercial banks in the
United States, the required reserve ratio is 10 percent. Thus, every new dollar of deposits has the potential
to expand the money supply by $1/.1, or $10, if banks loan out all available funds. Of course, the opposite is
true, too. When deposits flee the system, such as when panicked depositors prefer to keep cash under the
mattress, the money supply can shrink sharply. This was one of the factors that contributed to the length and
severity of the Great Depression.
‡ The term “discount rate” originates from the era when banks used to extend credit by buying invoices
from merchants at a discount. If someone owes me $100 a month from now and the bank buys that debt
obligation for $98 today, it has effectively charged me 2 percent for a one-month loan.
§ In lay terms, a bond is any debt instrument with which one party loans money to another for a determined
period of time at some agreed-upon rate of interest (fixed or variable). When it comes to the U.S. Treasury,
the nomenclature gets more complex. Technically, a Treasury bond has a maturity of ten to thirty years. A
Treasury note has a maturity of one to ten years. A Treasury bill has a maturity of less than a year. To avoid
getting bogged down in jargon, I will (somewhat lazily) use the term “bond” to include all of these
securities. Similarly, the term “Treasury securities” includes bills, notes, and bonds.
¶ Interest rates also affect the economy through two less obvious channels. First, when a central bank cuts
interest rates, it tends to weaken the currency, which boosts exports, as will be explained in the next
chapter. Second, an interest rate cut causes asset prices to rise, particularly housing (because low interest
rates make mortgages more affordable) and stocks (because lower interest rates on bonds make stocks
relatively more attractive). Rising asset prices make many households richer and therefore more inclined to
spend. The key idea is that lower interest rates speed up the economy, other things held equal, and higher
rates slow it down.
# When my wife and I inherited Thanksgiving dinner about a decade ago, we successfully killed off the
oyster dressing, making us the Paul Volcker of Thanksgiving dinner.
** The Bluebook is named to honor founding Fed chairman Harry Bluebook. No, I’m just messing with
you. It has a blue cover.
†† The Federal Reserve Reform Act of 1977 established the current objectives. This act says the Fed is to
“promote effectively the goals of maximum employment, stable prices, and moderate long-term interest
rates.” The last injunction is typically ignored as redundant, since the best way to ensure moderate long-
term nominal interest rates is via stable prices.
CHAPTER 6
Devaluing a currency is like peeing in bed. It feels good at first, but pretty soon it becomes a real
mess.
—Anonymous Federal Reserve official1
In 2013, fear swept through Iran’s Manoucheri Square. Business was slowing
appreciably for vendors in the square, unlike the old days when business was so
good that money was literally stacked in piles all around. What had gone wrong?
What had brought business to a near halt?
Peace and prosperity. Or at least the threat of it.
Manoucheri Square in Tehran is the gathering place for Iran’s illegal (but
generally tolerated) moneychangers. The currency bazaar evolved to trade—
literally—on the fears of ordinary Iranians eager to dump Iranian currency, the
rial, in exchange for dollars. The more desperate the situation for the Iranian
economy and the rial, the better the business for the moneychangers. As 2013
drew to a close, the prospects for a nuclear deal with the United States were
improving, which might lead to the loosening of sanctions and a jolt of energy
for the sickly Iranian economy. The New York Times reported at the time, “The
fortunes of the long-suffering Iranian currency are looking up.” 2 That meant
smaller profits and slower days for moneychangers whose businesses thrive on
wild swings in the value of the local currency.
Nothing had been as good for business as Mahmoud Ahmadinejad, the
Iranian president from 2005 to 2013 whose combative international positions
and questionable domestic policies isolated the nation and sent the economy into
a tailspin. “Those were fantastic days,” one trader recalled for the Times.
Ahmadinejad was denying the Holocaust, threatening to wipe out Israel, and
building a nuclear program that led to steadily tightening international sanctions.
As bad news bred economic decline, worried middle-class Iranians dumped rials
for dollars to protect their savings. During one week in 2012, the Iranian rial fell
by 40 percent against the dollar.3
The situation in Manoucheri Square can tell you most of what you need to
know about exchange rates. The rest is detail—albeit crucially important,
conflict-inducing, economically essential detail. Different countries have
different currencies, each of which can be exchanged for goods and services
wherever the currency typically circulates. A $10 bill will get you a taxi ride in
Manhattan; a Tokyo taxi driver will not accept American currency. Conversely,
a thousand yen will get you a comparable taxi ride in Tokyo while getting you
nothing but scorn and contempt from a New York taxi driver.
Pieces of paper that have enormous value in one place have no immediate
use somewhere else. I experienced this firsthand while staying at a cheap hostel
in Australia in the late 1980s. When my traveling companion and I were out of
the room, a thief or thieves broke in and stole money that was locked in our
packs. The criminals took all the Australian dollars but left our American
currency behind. What kind of criminal doesn’t take American dollars? A lazy
criminal. Because one currency can always be swapped for another, legally in
most places and illegally everywhere else (even North Korea). But why and
how? That is the point of this chapter. Given that no modern currency has any
intrinsic value, how can we calculate at what rate one piece of paper (or bytes in
an electronic ledger) should be exchanged for a different piece of paper (or
different bytes)?
At the most basic level, the answer can be told with the simple example of
the Iranian currency traders. One currency can be swapped for another at
whatever rate two parties are willing to make a voluntary trade. How much is my
2001 Volvo worth? Whatever someone is willing to pay for it. Currencies are no
different, paper or not. The traders in Manoucheri Square are just middlemen,
like banks and currency exchanges. They sell dollars for rials to middle-class
Iranian citizens who are worried their savings will get eroded by inflation. They
then sell the rials to government officials or companies that have earned dollars
abroad and would like to convert them to Iranian currency for local purchases.
The currency traders are just market makers, finding the price at which the
market for rials and dollars will clear—meaning that the number of buyers and
sellers for each currency is roughly the same (while taking a healthy commission
for doing so). We can add layers of complexity to this process, but the most
important insight is that currency transactions are voluntary trades. The
exchange rate between two currencies will reflect the price at which reasonable
people find it advantageous to swap one currency for the other.
Governments get in the way of those transactions all the time. (The Iranian
currency stalls are technically illegal, though enforcement is episodic.)
Governments can also make it more or less attractive to hold a particular
currency. Mahmoud Ahmadinejad did it by accident; economic distress caused
Iranians to dump currency out of fear for the future. Central banks are typically
more deliberate. Raising interest rates (other things being equal) attracts capital
from the rest of the world, as investors seek the highest possible return. This
inflow of new capital causes the currency to appreciate (e.g., foreigners have to
buy dollars in order to take advantage of higher interest rates in the United
States). Lowering rates has the opposite effect, causing a currency to depreciate.
Either way, our understanding of exchange rates has to begin with the simple
fact that most currency transactions are trades, and all trades—from kids trading
snacks in a school lunchroom to hedge fund managers buying real estate in the
Hamptons—are rooted in the fact that both parties feel they will benefit from the
transaction.
In the aggregate, the exchange rate between two currencies—the price at
which one currency can be exchanged for another—will reflect supply and
demand. If a huge number of Americans (holding dollars) suddenly want more
Mexican pesos, the demand for pesos relative to dollars will go up, meaning that
the “price” of pesos in dollars will climb. An economist would say that the peso
has appreciated relative to the dollar, but really the price of that currency has
gone up for the same reason roses are more expensive on Valentine’s Day:
people are willing to give up more dollars to get them. If you want to sound
fancy about it, you can say roses have appreciated relative to dollars.
That brings us back to the New York and Tokyo taxi drivers. The second
core principle related to exchange rates is that swapping one currency for
another ought to enable you to buy more or less the same stuff, albeit in a
different country. If $10 will get you a short taxi ride in New York, it’s likely
that converting $10 into yen at the market rate will get you roughly enough yen
—somewhere in the ballpark—to take a short taxi ride in Tokyo. This is by no
means a precise relationship for reasons that will be discussed for the balance of
the chapter. But it is extremely unlikely that you could take $10 to the currency
exchange at the Tokyo airport and get enough yen to buy a big screen television
or a Honda Civic. To understand why that cannot happen, let’s instead imagine
that it can. In that case, you might have a conversation with your roommate that
goes something like this:
This chapter began with a quotation about peeing in bed. So far, we have not
broached anything nearly that exciting. We have established that currencies have
some logical anchor to one another based on purchasing power parity, though
market exchange rates may deviate from that for assorted reasons. Anyone who
plans to travel the world eating Big Macs will care deeply about all this. The rest
of us might find it kind of a snooze. In fact, exchange rates have profound
economic and political consequences. Governments and central banks have the
capacity to manipulate their exchange rates, which in turn creates economic
winners and losers—both within countries and across the global economy. One
of the most significant ongoing disputes between the United States and China
concerns the exchange rate between the U.S. dollar and the Chinese yuan.‡ East
Asian countries are as likely to engage in bitter disputes over currency values as
they are about islands in the South China Sea. In the aftermath of the 2008
financial crisis, commentators warned ominously of a “currency war.” 5
Nobody has peed in bed yet, but we’re getting there. The political tension
related to currency values stems from a single economic truism: all other things
being equal, a weak currency is good for exports and bad for imports. A strong
currency does the opposite: exports become more expensive and imports
cheaper. This concept is so crucial to international economics, and therefore to
global politics, that it deserves a simple numerical example. Consider a company
like Ford that builds cars in the United States for export to Canada. For the
purposes of simplicity, we’ll assume that Ford’s key inputs—labor and parts—
are priced in American dollars; the cars and trucks are sold in Canada for
Canadian dollars. Suppose the exchange rate between the Canadian dollar
(called the loonie for the loon on the back of the dollar coins) and the U.S. dollar
is parity: one Canadian dollar can be exchanged on currency markets for one
U.S. dollar. Further suppose that Ford can manufacture a car for $18,000 (in
U.S. dollars) and sell it in Canada for $20,000 (Canadian dollars). That’s a
comfortable $2,000 profit margin after the loonies are converted back into U.S.
dollars.
But now suppose that for reasons that have nothing to do with automobiles,
the U.S. dollar appreciates by 15 percent relative to the Canadian dollar. Every
U.S. dollar now buys $1.15 Canadian; conversely, each loonie buys only $.87
U.S. Two quick notes: First, there is nothing crazy about this kind of swing in
the exchange rate. As I sit here working in the spring of 2015, the Canadian
dollar has depreciated roughly 17 percent relative to the U.S. dollar over the past
year. Second, firms with an exclusively domestic focus do not care about any of
this. A Canadian delicatessen that pays workers and suppliers in Canadian
dollars and sells sandwiches exclusively in Canada does not give a hill of beans
about the exchange rate with the U.S. dollar. (A “hill of beans” is a technical
term used by some currency experts to gauge the level of interest in exchange
rate movements.)
Back in Michigan, Ford cares a lot. The cost of making cars in America has
not changed—same parts, same union agreements, same number of U.S. dollars
on all the contracts. Nor has the price at which Ford can sell cars in Canada. The
typical Canadian car buyer thinks about prices in terms of loonies—because they
are paid in loonies and they buy their goods in loonies. (When you walk into an
appliance store, do you evaluate how much you are willing to pay for a TV
based on the dollar-yen exchange rate?) If the competitive price for an entry-
level Ford pickup was $20,000 Canadian before the loonie began losing value,
the competitive price for the same truck after the currency loses value will be
unchanged. In fact, nothing changes about selling American cars and trucks in
Canada—until Ford converts that revenue back into U.S. dollars. Now $20,000
Canadian is worth only $17,400 U.S., which is less than the cost of producing
that truck in America.
This is why exchange rates have such a profound effect on international
firms. Nothing has changed about how Ford makes or sells cars—not the
production costs, the sale price, or the relative attractiveness of Ford’s vehicles.
Yet Ford has gone from making money on each sale to losing money—all
because of a swing in the currency market. This admittedly oversimplified
example would leave executives with a dilemma: They could raise prices in the
Canadian market to make up for the unfavorable exchange rate and risk losing
sales. Or they could hold Canadian prices firm and accept short-term losses in
the hope that the exchange rate drift will reverse itself. Or some combination of
the two. Overall, it’s not a great set of choices, and none of it has anything to do
with building better cars and trucks.§
As a point of comparison, let’s suppose Honda Motors operates a plant in
Toronto, where it builds cars and trucks for the Canadian market using
exclusively Canadian inputs. Neither Honda’s production costs nor its sale price
are affected by the change in the exchange rate with the United States. In the
Canadian market, Honda is no different from the aforementioned delicatessen; it
is entirely insulated from swings in the exchange rate (which is one reason firms
like Honda have built plants in America and in other countries with large
markets). If Honda exports cars to the United States from its Toronto factory,
things get even better. Assume that prior to the Canadian currency depreciation
Honda could build pickups in Canada for $18,000 Canadian and sell them south
of the border for $20,000 U.S. When the two currencies were at parity, this was
a nice $2,000 profit per vehicle. After the Canadian dollar depreciates, those
exports get sweeter still. The cost structure in Canada is unchanged—each car
still costs $18,000 Canadian to produce. But now the $20,000 earned from every
U.S. sale is worth 15 percent more when repatriated into Canadian dollars—
$23,000, to be exact. That gives Honda executives an attractive set of choices:
keep prices the same and earn a higher profit, or cut prices in the U.S. market
and gain market share from its American competitors. Honda could sell its cars
as cheaply as $17,500 in the United States and still make $20,125 when the
revenues are converted into Canadian dollars. Honda could conceivably steal
business away from its American competitors, earn a slightly higher profit per
vehicle, and still give consumers a better deal than before the currency
depreciation.
The example above is hypothetical; the situation is not. After the 2008
financial crisis, the Japanese yen became a refuge currency as panicked investors
looked for safe harbor. By 2010, the yen hit a fifteen-year high against the dollar
and a similar peak against the euro. Toyota, which produces a high proportion of
its cars in Japan and depends heavily on Japanese suppliers, was being buffeted
by the strong yen. Other Japanese automakers, such as Nissan and Honda, have
been more aggressive in moving production elsewhere in the world, leaving
them less vulnerable to a rising yen. The New York Times ran a headline in 2010,
“Japan Counted on a Cheap Yen. Oops.” The story went on to explain how
expensive that “oops” had become: “For every yen to the dollar that the Japanese
currency gains beyond the value that Toyota assumes in its planning—90 yen to
the dollar—the company says it loses 30 billion yen ($355 million) in operating
profit.” In contrast, Nissan was losing only half as much per yen of appreciation
against the dollar because of the company’s overseas production.6
Let us not forget that while exporters are struggling from a stronger
currency, importers are giving out cake and balloons in the corporate cafeteria.
Starbucks buys coffee beans from around the world. When the dollar appreciates
20 percent, all of those coffee beans become 20 percent cheaper. Maybe that
means cheaper lattes for all of us or just higher profits for shareholders. Either
way, it’s good. Many companies are both exporters and importers, meaning that
a change in the exchange rate cuts both ways. Boeing assembles 787s in Seattle
for export around the globe using parts imported from Japan, Canada, Italy,
France, Sweden, and other nations.7 A weaker dollar boosts profits from jets sold
abroad, but it also raises the cost of imported components. Even at Starbucks, the
cafeteria party would be dampened by the fact that sales from overseas stores
would be worth less in U.S. dollars.
So which is better: a strong currency or a weak one? Any currency that is
wildly out of sync with PPP will unfairly reward one group of citizens at the
expense of another. I cavalierly declared that the Canadian delicatessen did not
give a hill of beans about the exchange rate with the dollar, as all of its sales and
production costs are denominated in loonies. That’s true. But the delicatessen
employees likely buy some imported American goods. If the Canadian currency
becomes artificially weak, imported goods become more expensive. Yes,
Canadian exporters are enjoying a global advantage—but at the expense of
consumers who buy imported goods. A government that deliberately keeps its
exchange rate undervalued is essentially taxing consumers of imports and
subsidizing producers of exports. Would you support a tax on every imported
good you bought so that the government could mail checks to firms producing
exports?
Obviously if we knew with exactitude what the right exchange rate for two
countries ought to be, we could just make that the target. Unfortunately we do
not. Purchasing power parity is a rough long-run approximation; exchange rates
often deviate widely and for long periods from what PPP would predict.
Alternatively, economists sometimes describe an “equilibrium exchange rate,” a
rate at which the economy is at full employment, inflation is low, and the flow of
trade and capital in and out of the country is sustainable. This makes sense,
except that we do not have a complete grasp of what is sustainable (e.g., what
about America’s huge and growing debt to the rest of the world?). A more
practical approach is to analyze the factors that have determined exchange rates
in the past and use those factors to predict what exchange rates should be now.
That works great—unless the present is appreciably different from the past. The
investment bank Morgan Stanley has at least thirteen different models for
determining the underlying value of currencies.8 A 2007 paper from the Office
of International Affairs at the Treasury Department confirmed what you have
probably been thinking: there is a lot of groping in the dark going on here. The
authors write, “There is no ‘fail-safe’ method in estimating the proper value of
an economy’s foreign exchange rate or in establishing a precise measure of over-
or undervaluation.” 9
As with other policies related to money, the right exchange rate is therefore
as much about politics as it is about economics. Where you stand on the strength
of the currency depends on where you sit. Are you selling American cars in
Europe? Or importing wine from France? Within countries, different parties
often advocate for a cheaper or dearer currency. What’s best for the country
overall? Bob McTeer, former president of the Federal Reserve Bank of Dallas,
has written, “A strong dollar usually serves us well, but occasionally and
temporarily, a weaker dollar serves us better.” In other words, that depends, too.
A strong currency does not necessarily reflect a strong economy. The dollar
was strong in the 1990s when the economy was robust and capital from around
the world was rushing to Silicon Valley. The dollar was also strong in the 1980s
when capital was flowing to the United States because high government deficits
forced us to borrow from the rest of the world. Christina Romer, a former chair
of the Council of Economic Advisers, explains, “Both developments—brilliant
American innovation and troublesome American budget deficits—caused the
dollar to strengthen. Yet one is clearly positive for the American economy, the
other a negative. The point is that there is no universal good or bad direction for
the dollar to move. The desirability of any shift in the exchange rate depends on
why the dollar is moving.” 10
When the economy is running at capacity—full employment and so on—a
strong dollar is a nice thing. Prosperous Americans can buy goods cheaply from
the rest of the world. I remember a professor once making a statement that is
obvious only after the fact: exports are the price we pay for imports. All else
being equal, we would like to give up less to get more. When factories are
running at capacity and everyone has a good job, what’s not to like about
cheaper French wine and Japanese cars? A strong dollar is like getting a discount
coupon for the rest of the world’s goods while selling your own stuff at full
price.
When an economy is weak, however, things get more complicated. This is
when countries start peeing in bed, figuratively speaking. A cheaper currency
stimulates exports, and exports put people back to work. In 2010, when the U.S.
economy was still staggering back from the financial crisis, a New York Times
business article offered a tantalizing economic magic wand: “Say there was a
way to create a half million American jobs over the next two years without
adding a dime to the debt or deficit. And say it would also revive moribund Rust
Belt factories, reduce the country’s gaping trade deficit and help stabilize the
international economic system.” What was this job-creating elixir? A cheaper
dollar relative to the Chinese yuan.
Like most elixirs, this one was probably oversold. Still, the basic idea holds:
exports are good for a struggling economy; a weak currency promotes exports.
Of course, there is no free lunch. A weak currency means that a nation gets less
in return for what it produces. Suppose an American autoworker can use four
hours’ worth of earnings to buy a television set made in China. If the dollar
depreciates relative to the yuan, it may take five hours of wages to buy the same
television. This is effectively a wage cut—a fact that will loom large in our
discussion of the eurozone in chapter 11. The situation resembles a struggling
department store: yes, it would be wonderful to sell everything at full price, but
if there is a lot of unsold merchandise hanging on the racks, the next best option
is to hold a sale. A cheaper currency is like putting your whole country on sale
for the rest of the world. As the Economist observed, “Once upon a time, nations
took pride in their strong currencies, seeing them as symbols of economic and
political power. Nowadays it seems as if the foreign-exchange markets are home
to a bunch of Charles Atlas’s 97-pound weaklings, all of them eager to have
sand kicked in their faces.Ӧ11
In the years after 2008, just about every economy in the world had unsold
merchandise hanging on the racks. Central banks were lowering interest rates to
stimulate their domestic economies and depreciate their currencies. Other things
being equal, lower interest rates make a country a less attractive place to invest.
When investors sell the local currency to take advantage of more attractive
investments elsewhere in the world, the exchange rate weakens. Which brings us
to 2010, when the Wall Street Journal reported, “At least half a dozen countries
are actively trying to push down the value of their currencies, the most high
profile of which is Japan, which is attempting to halt the rise of the yen after a 14
percent rise since May.” 12 (Yes, that was the rise in the yen that was killing
Toyota.) A weaker currency is a logical reaction to a global recession.
It feels good at first, but pretty soon it becomes a real mess. Yes, we have
finally reached that point. The strength of a currency is relative. If one currency
gets weaker, another currency has to get stronger. The head of the International
Monetary Fund warned at the time, “Today, there is a risk that the single chorus
that tamed the financial crisis will dissolve into a cacophony of discordant
voices, as countries increasingly go it alone. This will surely make everybody
worse off.” It’s mathematically impossible for all currencies to get weaker at the
same time. It’s like standing up at a football game to get a better view—a great
strategy until everyone else does same thing. As the Economist has described (in
the context of British football matches and currency depreciations), “No one’s
view has improved but everyone is a lot less comfortable.” 13
The irony of currency manipulation is that many nations looking exclusively
after their own interests can end up in a wet, cold bed. A currency war can lead
to higher inflation in the affected countries (as they all increase their money
supplies) without changing relative exchange rates; worst case, trade patterns are
disrupted in a way that does significant economic harm. The current situation
may not be as bad as all that. It’s true that from a trade standpoint, the affected
countries are all standing up at the same time; no one is getting a better view.
However, monetary experts like University of California–Berkeley economist
Barry Eichengreen, who has also studied the competitive devaluations of the
1930s, argue that the looser monetary policy (lower interest rates) associated
with weaker currencies is an important antidote for global recovery, particularly
with deflation looming as a more serious problem than inflation.
Eichengreen writes about the Great Depression, “No country succeeded in
exporting its way out of the depression, since there was no one to sell additional
exports to. But this was not what mattered. What mattered was that one country
after another moved to loosen monetary policy because it no longer had to worry
about the exchange rate. And this monetary stimulus, felt worldwide, was
probably the single most important factor initiating and sustaining economic
recovery.” 14 Eichengreen is essentially describing a situation in which a group
of department stores all throw a massive sale. None succeeds in stealing
customers from its competitors, since they are all offering the same basic
discounts. But the lower prices are an important stimulus to get people shopping
again, which is good for the stores overall.
Eichengreen’s argument has two important implicit footnotes. First,
competitive devaluations during the Great Depression were a way for countries
to slip out of the economic handcuffs imposed by the gold standard. The next
chapter will argue that gold does not glitter as a monetary instrument and that
policymakers did extraordinary economic damage as they clung tightly to gold
during the 1930s. Second, even if the post-2008 devaluations do not leave all
parties wet and cold, the current process is uncoordinated and disruptive.
Eichengreen writes, “Better, of course, would be for the major countries to agree
to coordinate their monetary policy actions. Then exchange rates will not move
by large amounts in one direction today and the opposite direction tomorrow.
There will not be further disruptions to the global trading system. There will not
be international recriminations over beggar-thy-neighbor policy.”
This question—how the world’s major economies coordinate their exchange
rate policies—will come up in greater detail in the second half of the book. For
now, it raises a more basic question: What is the mechanism used to value one
currency against another? The answer is that different countries have different
exchange rate regimes, ranging from the United States (let the market decide) to
China (let’s manipulate the market) to North Korea (the exchange rate is what
the Great Leader says it is). More formally, the world has an array of
mechanisms that can be used to value currencies relative to one another.
Floating Exchange Rates
Most of the world’s largest economies have exchange rates that are determined
like everything else in a market economy: by supply and demand. (China is a
major exception that will get a chapter of its own.) Different currencies are
traded for one another on foreign exchange markets around the world. Hence,
the exchange rates are said to “float” as market conditions change, like a raft that
rises and falls with the tides. This morning one Canadian dollar buys .91
American dollars; by lunch it will be slightly different. The foreign exchange
market is just a bigger version of Iran’s Manoucheri Square. There are
individuals, firms, and governments looking to swap Canadian dollars for
American dollars, and there are individuals, firms, and governments looking to
sell American dollars and acquire Canadian dollars. The exchange rate at any
given moment is just the price at which those two groups are willing to make a
voluntary exchange.
In the long run, we would expect the exchange rate to move toward what
purchasing power parity predicts, especially between rich countries where there
is no appreciable difference in the cost of nontradables. In the short run, assorted
global forces affect the relative demand for currencies. As noted earlier, higher
interest rates make a currency more attractive (other things being equal). If the
real return on government bonds is 3 percent in Canada and 3.5 percent in the
United States, Canadian investors will seek the higher return in the United
States. To do so, they will sell loonies and buy U.S. dollars, causing the
American dollar to appreciate relative to the Canadian dollar. Strong growth
opportunities will also attract global capital and strengthen the currency (e.g.,
Silicon Valley in the 1990s); a flagging economy or political instability will do
the opposite (e.g., Iran in the Ahmadinejad era).
Fear and panic are powerful motivators when it comes to international
capital flows. The Swiss franc appreciated 3 percent relative to the U.S. dollar in
the first three hours after the first plane hit the World Trade Center on September
11, 2001. A decade later, investors fearing economic disruption in the eurozone
fled to the relative stability of Switzerland. In just eighteen months—between
the beginning of 2010 and August 2011—the Swiss franc appreciated 43 percent
relative to the euro. (This helps to explain why the Swiss franc was so
overvalued according to the Big Mac Index.) Investors weren’t moving capital to
Zurich to buy watches and chocolate; they were avoiding the consequences of a
euro meltdown that might have been precipitated by a Greek debt crisis.
Governments and central banks can always buy and sell their own
currencies, affecting supply and demand directly. However, the foreign
exchange market is so huge—trillions of dollars changing hands daily—that
most countries do not have deep enough pockets to move the market
significantly. A currency intervention is often like trying to warm a cold bathtub
with spoonfuls of hot water—especially while other market participants are
dumping in buckets of cold water at the same time.
The primary benefit of a floating exchange rate is that currencies can
fluctuate as economic conditions dictate. The government is not responsible for
conducting economic policy to maintain a particular exchange rate, leaving it
free to manage interest rates and other policy tools in a way that best suits the
domestic economy. As we will see shortly, any system that fixes currencies
against one another, such as the gold standard, limits a government’s options in
this regard.
The drawback of floating exchange rates is, well, they float. More to the
point, they can float a lot, often in unpredictable ways. Australia is a good
example of how swings in the exchange rate can disrupt the economy. Beginning
around 2009, the Australian dollar soared as China bought up its natural
resources—iron, coal, and other commodities. By 2013, the Australian dollar hit
its highest level in twenty-eight years, as measured against a basket of currencies
weighted by their share of Australia’s trade, or “trade-weighted.”# Other
exporters have found it difficult to stay globally competitive with such a dear
Australian dollar. Mitsubishi closed a plant; other car companies laid off
workers. Wine exports fell.15 This phenomenon, when natural resource exports
cause the exchange rate to appreciate to the point that it chokes the
competitiveness of manufactured goods, is known as “Dutch disease.” Dutch gas
exports in the 1970s had such an effect, as have oil exports in many countries
ever since.16
The Gold Standard
One way to avoid the vagaries associated with floating exchange rates is to fix
the rate at which currencies can be exchanged against one another. No major
economy uses a gold standard anymore, but it remains an important and intuitive
example of how the world’s currencies can be fixed against one another. Prior to
World War I, the world’s major trading nations fixed their currencies relative to
gold. Of course, with the world’s currencies linked to gold, they were also
explicitly linked to one another. If $35 can be exchanged in the United States for
an ounce of gold, and 350 francs can be exchanged in France for an ounce of
gold, then the exchange rate has to be $35 for 350 francs. The era prior to World
War I was hailed for its internationalism, in part because of the global stability
facilitated by the gold standard.
The gold standard also has an elegant mechanism for sorting out trade
imbalances. Suppose one country begins to suffer a major trade deficit, meaning
that it is buying more from the rest of the world than the world is buying in
return. For the sake of simplicity, we can do the analysis with just two countries,
France and the United States, back in the day when France still had the franc and
both countries were on the gold standard. Assume that France begins running a
trade surplus with the United States (which means the United States must be
running a trade deficit with France). French exporters are accumulating dollars,
which can be redeemed for gold in the United States and repatriated to France.
Gold will flow out of the United States and into France.
The flow of gold from the United States to France will affect monetary
policy in both countries. With the supply of gold shrinking in the United States,
the money supply will shrink, since under a gold standard all currency must be
backed by gold reserves. Conversely, the money supply will expand in France
(just as it did when gold and silver were discovered in the New World). The
result will be twofold: First, prices will rise in France and fall in the United
States. Remember, more money chasing the same quantity of goods (France)
causes prices to rise; a shrinking money supply does the opposite (the United
States). These changing prices make American goods relatively more attractive,
helping to reverse the trade deficit and stop the flow of gold out of the United
States.
At the same time, interest rates will rise in the United States relative to
France for a related reason. As the shrinking money supply in the United States
makes capital scarcer, the cost of renting it rises. (The opposite happens in
France as the money supply expands.) International investors, scouring the globe
for the best return on investment as always, withdraw their capital (gold) from
France and send it to the United States to take advantage of higher interest rates.
The key point is that the gold standard has a mechanism by which global
imbalances fix themselves—as one country accumulates gold, it naturally sets in
motion responses (rising prices and falling interest rates) that cause the
imbalance to reverse itself.**
In fact, the gold standard is awesome—until it wrecks the global economy
and imperils humanity. The major drawback of the gold standard follows
naturally from the simple analysis in the last paragraph: gold flows around the
globe in response to economic circumstances. What can be so bad about that? A
gold standard can turn a recession into a depression, as it arguably did in the
1930s. When an economy is weak (as in the United States in 1929), the best
policy response is to lower interest rates to stimulate demand. But lower interest
rates will cause foreigners to demand gold for their dollars so they can invest
elsewhere in the world; gold will flow out of the country. The result is a
dilemma: to defend the nation’s gold reserves, a central bank must raise interest
rates—even though a weak economy needs the opposite. Economist Paul
Krugman, who won the Nobel Prize in 2008 for his work on international trade,
has explained how “the sacred importance of maintaining the gold value of one’s
currency” exacerbated the economic carnage of the Great Depression. He writes,
“In the early 1930s this mentality led governments to raise interest rates and
slash spending, despite mass unemployment, in an attempt to defend their gold
reserves.” 17 The gold standard, or any regime of rigidly fixed exchange rates,
forces a nation to subvert its domestic economic interests to maintain the
exchange rate.
Pegs and Bands
Nations can also fix their exchange rates against one another without gold to
back up the deal. Countries can pledge to “peg” their exchange rates at some rate
with another country, or a group of countries. Since 1983, the Hong Kong dollar
has been pegged to the U.S. dollar at a rate of 7.8 to 1. In this system, the dollar
plays the same role as gold; the Hong Kong government has pledged to take all
steps necessary to maintain that exchange rate, regardless of the implications for
the domestic economy. Argentina tried a similar plan in 1991; every Argentine
peso was fully convertible to American dollars at a fixed rate, as with a gold
standard. (Like most things related to Argentine monetary policy, this did not
end well.) Prior to the adoption of the euro, many European countries were
members of the European Exchange Rate Mechanism (ERM), which sought to
keep the participating European currencies trading within defined “bands”
relative to one another. For example, the British government pegged the pound
to 2.95 German marks, with an allowable trading range of 6 percent in either
direction.
The primary problem with pegs and bands is that governments must defend
them, even when it means doing nasty things to the domestic economy. Global
investors recognize that politicians don’t always have the resolve to do that.
When a currency begins to look weak, as the British pound did in 1992,
speculators pounce, hoping to make huge sums when the government gives up
on the peg and currency is devalued. Of course, as speculators begin
aggressively selling the currency, devaluation becomes all the more likely. This
is why financier George Soros is so much richer than you are. In 1992, Soros
made nearly $1 billion in a single day by betting that the British government
would not maintain its commitment to the European Exchange Rate Mechanism.
As part of the ERM, the British government pledged not to let the pound fall
below a floor of 2.778 marks. At the time, Britain was in the midst of a
recession; the weak economy was one reason global investors were taking their
money out of the UK
Despite this downward pressure, the government of Prime Minister John
Major vowed to defend the pound. As noted throughout the chapter, the Bank of
England had two tools for doing that: intervening directly in currency markets to
buy the pound and prop up its value, and raising interest rates to draw capital
back into the country. Neither option was attractive. The Bank of England had a
finite amount of foreign currency with which to buy pounds; earlier efforts had
been ineffectual as private investors fled pounds. Meanwhile, raising interest
rates in the midst of a recession would have caused further economic damage,
which is not something any elected politician is keen to do. (Norman Tebbit,
who had been a cabinet minister in Margaret Thatcher’s government, had taken
to calling the ERM the “eternal recession mechanism.”)18 Still, Major reiterated
his commitment to keeping Britain in the ERM.
George Soros called the government’s bluff. In September 1992, Soros
borrowed a huge quantity of British pounds and immediately sold them for other
European currencies, such as the German mark (thereby further contributing to
downward market pressure on the pound). John Major’s government did not
have what it took to maintain the pound’s peg in the ERM. On September 16,
Britain withdrew from the ERM and allowed the pound to depreciate against the
major European currencies by roughly 10 percent. Therefore, when Soros
swapped his European currencies back into pounds at the new exchange rate, he
got roughly 10 percent more than he had borrowed, enabling him to pay off his
loans (and interest) and keep the rest—roughly $1 billion. Not bad for a day’s
work. The bigger point is that fixed exchange rates are only as credible as the
governments defending them. Even a hint of weakness in government resolve
can bring things crashing down.
Dollarization
How much local currency can you get for $100 when you land at the airport in
Quito, Ecuador? Hah, it’s a trick question! No need to exchange anything. The
official currency of Ecuador is the U.S. dollar. In 2000, Ecuador went through a
process of “dollarization” in which the local currency, the sucre, was replaced by
the American dollar. Serious inflation and a banking crisis had caused a loss of
confidence in the local currency. “The decision to dollarize was taken in
desperation,” said Stanley Fischer, a senior official at the International Monetary
Fund at the time who is now vice chair of the Federal Reserve.19
El Salvador dollarized in 2001, albeit for different reasons. The economy
was stable; adopting the dollar was a strategy for harmonizing El Salvador’s
economy with the United States’. At the time, two thirds of Salvadoran exports
were going to the United States, and $2 billion in remittances from Salvadoran
workers in the United States were flowing the other direction (an amount
equivalent to roughly 15 percent of GDP).20 Panama adopted the dollar as its
official currency at independence, way back in 1904.
So why doesn’t everybody adopt the dollar? The primary drawback is that
these countries lose their ability to conduct independent monetary policy.
Monetary policy in El Salvador is determined by the U.S. Federal Reserve. With
all due respect, the Fed does not care much about economic conditions in El
Salvador (or Ecuador or Panama) when making interest rate decisions.
Currency Union
An alternative to fixed exchange rates is for a group of countries to share the
same currency. The obvious example is the euro, which is now the official
currency for nineteen countries in the European Union and seven countries that
are not part of the EU.21 (Other countries and territories peg their currencies to
the euro.) Unlike El Salvador, the eurozone countries have their own central
bank (the European Central Bank) whose mission is to oversee monetary policy
for the member nations. The euro might reasonably be described as the ultimate
fixed exchange rate. The member states’ currencies do not fluctuate against one
another—because they are the same currency. Currency unions offer the
stability and predictability of fixed exchange rates, making it easier to conduct
trade across international boundaries. One might say that the fifty American
states have a currency union: they all share the dollar, with the Fed looking after
the whole lot of them.
The big drawback to a currency union is that the participating countries lose
the capacity to set their own monetary policy. As Harvard economist Gregory
Mankiw explains, “The European Central Bank sets interest rates for Europe as a
whole. But if the situation in one country—Greece, for example—differs from
that in the rest of Europe, that country no longer has its own monetary policy to
address national problems.” 22 Chapter 11 delves into the euro, and this challenge
in particular. (For now, let’s just say that the Greeks and the Germans are having
some issues.)
Just Make Up a Number
What’s the official exchange rate between the North Korean won and the U.S.
dollar? Whatever North Korean dictator Kim Jong-un says it is. Governments
often create an official exchange rate that is completely untethered from
economic reality (or in some cases partially untethered). The government can
require companies and individuals moving money in and out of the country to
exchange currency at the official rate. In 2013, when eccentric former Chicago
Bulls star Dennis Rodman made a trip to North Korea to meet with the Great
Leader (a big fan of the NBA, apparently), Reuters pointed out that a Chinese-
made basketball selling in a Pyongyang toyshop cost $500 at the official
exchange rate. Needless to say, few North Koreans were spending their entire
annual salary to buy a basketball because it doesn’t really cost $500. At the
black market rate—the rate at which sane people will voluntarily trade won for
dollars—the basketball cost a little less than $6.23
Like many things North Korean, this is kind of funny until one recognizes
the human consequences. A ridiculously overvalued exchange rate is yet one
more way a rotten government can enrich itself at the expense of its people. If a
hypothetical North Korean firm earned $500 by selling swanky designer clothes
in New York, the Pyongyang government could force the company to exchange
that $500 for just enough won to buy a cheap basketball—because that is the
official exchange rate. Here’s the trick: Government officials can then use the
expropriated foreign currency to load up on extravagant imports. Meanwhile, the
overvalued currency makes it difficult for exporters to compete in international
markets. (If North Korea were trying to export basketballs to the United States,
they would sell for $500 at the official exchange rate.) North Korea is probably a
bad example because its insular economy has so few export industries. Still,
history is replete with official exchange rates that deviate significantly from
what supply and demand would dictate. These countries invariably have black
markets where the currency trades at a rate that more closely approximates
purchasing power parity (e.g., the North Korean basketball should cost $6, not
$500).
All of this raises two fundamental policy questions: What is the best exchange
rate regime for an individual country? And how can currency values around the
world be coordinated in a way that best promotes global stability and economic
success?
Not easy questions, but let’s start with the first. As you have probably
inferred, there is no perfect exchange rate regime (though we can safely say that
having Kim Jong-un arbitrarily set an exchange rate is not ideal). There are
tradeoffs associated with all of the systems described above. More specifically,
economists have identified what is known as the “trilemma” of international
finance: no country can simultaneously allow free flow of international capital
flow; use monetary policy to serve domestic economic needs; and maintain a
fixed exchange rate. The term “trilemma” is a clever play on the policy dilemma
here—policymakers can control any two of these two policy levers, but that
requires letting go of the third.
Greg Mankiw, who is a former chair of the Council of Economic Advisers,
has described each of these logical policy goals:
Those sound like really great things to do! Alas, as Mankiw explains,
“Here’s the rub: You can’t get all three. If you pick two of these goals, the
inexorable logic of economics forces you to forgo the third.” The best way to
illustrate the trilemma is to point out the choices different countries have made—
and the inevitable tradeoffs.
The United States uses monetary policy to achieve domestic policy
objectives. The goal of the Federal Reserve is to maintain price stability and full
employment. We also have free flow of capital in and out of the country. And
our exchange rate? To quote my teenage daughter, “It is what it is.”
China has chosen to manage the money supply and the exchange rate. The
government uses monetary policy to promote domestic economic goals while
managing the exchange rate to promote export-oriented industries. To do so, the
government controls the flow of capital in and out of the country—both how
much money Chinese citizens can take out of the country and how much foreign
firms can invest in China.
Much of Europe is different still. The nations bound together by one
currency, the euro, have controlled the exchange rate. (French companies doing
business in Germany face no exchange rate risk.) There is free flow of capital
throughout the eurozone. But the participating nations have given up the ability
to conduct their own independent monetary policy. The fact that countries like
Italy, Spain, and Greece have different economic needs than Germany is one of
the stress points of the single currency.24
Countries, like teenagers, choose what works best for them. How is that working
out for the rest of us? There are two global concerns related to exchange rates.
The first is that international capital flows can sometimes turn into what looks a
lot like a bank run. Capital finds its way to whatever corner of the globe
promises attractive returns. But when investors run for the exits, they ditch the
local currency, exacerbating the crisis and prompting more investors to get out
before the currency falls further. (This is exactly why the Iranian currency
traders liked the bad old days of Ahmadinejad.) The local central bank is stuck
with a dilemma: raise interest rates to stop currency hemorrhaging from the
country (and make the economy worse), or lower interest rates to ameliorate
whatever economic problem caused the crisis in the first place (and make the
currency plunge worse). Numerous countries have been through this drill just in
recent decades: Mexico, Argentina, Turkey, Russia, Iceland, South Korea,
Thailand. The International Monetary Fund acts as the lender of last resort for
countries, just as the Fed does for U.S. banks. (Yes, this creates the same basic
moral hazard problem that was broached in the last chapter.)
Such crises are destabilizing for the global financial system; obviously it
would be better to prevent them in the first place. There is a consensus that
floating rates are less prone to crisis, as they provide a buffer for economic
shocks and do not invite attack by speculators trying to anticipate the collapse of
a peg (as George Soros did). The IMF has also broached the topic of capital
controls—placing limits on how quickly investors can move capital in or out of a
country, or taxing such flows. This concept was previously anathema to
economists, as the whole point of markets is to allow capital to flow freely to
wherever it is valued most. However, the destabilizing effects of “hot money”
may outweigh the benefits.
The second concern relates to whether exchange rates and capital flows are
coordinated in a way that maximizes global efficiency. In 2014, Raghuram
Rajan, head of India’s central bank and the former chief economist at the
International Monetary Fund, lamented, “International monetary cooperation has
broken down.” Unanticipated and uncoordinated monetary policies cause all
kinds of global economic complications. By 2014, a strengthening U.S. dollar
was threatening foreign firms that had borrowed heavily in dollars during the
stretch of low U.S. interest rates. (These firms had to make debt repayments in
dollars that were getting steadily more expensive relative to their local
currencies.) The preceding years had caused a different problem: low interest
rates and slow growth in the developed world sent money flooding into the
developing world in search of higher yields, a phenomenon one IMF official
described as an “international monetary tsunami.” The result was often asset
bubbles and overvalued exchange rates.25 Raghuram Rajan told a group of
schoolchildren in Mumbai (knowing full well that lots of other people were
listening, including the world’s central banks), “We would like to live in a world
where countries take into account the effect of their policies on other countries
and do what is right, broadly, rather than what is just right given the
circumstances of that country.” 26
Oh, Raghu (he was a colleague at the University of Chicago, so I can call
him that), we have not lived in that world for a long time. We did manage to
create a system of coordinated exchange rates for a few decades in the twentieth
century. Near the end of World War II, the Allies gathered in Bretton Woods,
New Hampshire, to plan a global monetary system to replace the gold standard
for the postwar period. This was the last successful effort to coordinate the
world’s major currencies. Bretton Woods produced a quasi–gold standard with
the U.S. dollar pegged to gold and the other participating currencies pegged to
the dollar.†† (The Bretton Woods Conference also produced both the World
Bank and the International Monetary Fund.) Thus, gold was the anchor of the
postwar international financial system. Even then, other countries, particularly
France, were upset by the dollar’s outsized role in the Bretton Woods system.
The system eventually broke down in 1971, when America’s fiscal imbalances
made it increasingly hard for the United States to redeem dollars presented by
foreign nations in exchange for gold.
On August 15, 1971, after huddling with his advisers for the weekend at
Camp David, Richard Nixon terminated the right of foreign governments to
exchange dollars for gold, closing what had become known as the “gold
window.” The Bretton Woods Agreement was terminated, severing any
remaining tie between the dollar and gold. From that point on, a nation holding a
surplus of U.S. dollars was just holding lots of dollars. As the Economist noted
on the fortieth anniversary of that fateful weekend, “The era of paper money and
floating exchange rates had arrived.” 27
There have been bursts of global currency teamwork since. In 1985,
representatives of France, West Germany, the United States, the UK, and Japan
met in New York to discuss global imbalances caused by an overly strong dollar.
Per the Plaza Accord, named for the hotel where it was negotiated, the
participants agreed to act together to depreciate the dollar. Over the next two
years, the dollar fell by 50 percent against both the yen and the German mark.
The Plaza Accord has been hailed as “a high-water mark of international
cooperation.” 28 But here’s the thing: When the world’s major economies hit that
high-water mark there was still an East and West Germany. Barack Obama
hadn’t started law school. Chapter 14 will ask if it might be time for Bretton
Woods II. Is there some way to harness the flexibility of floating exchange rates
without the destabilizing volatility?
The traders in Iran’s Manoucheri Square hope not. Volatility is what makes
for good business—even as the opposite is true for most firms doing business
across international boundaries. There is something inherently strange about
paper currencies. However, once one accepts that money is merely a claim on
things of value, paper currency makes sense. Swapping one kind of paper for
another begins to make sense, too. The irony is that mainstream economists are
now unanimous in the belief that gold no longer has a place in international
finance. As the next chapter will argue, all that is gold does not glitter.
________
* As with interest rates, economists make a distinction between the nominal exchange rate, the rate at which
one currency can be exchanged for another (the numbers posted at the airport currency exchange) and the
real exchange rate, which takes changing prices into account in both countries (inflation or deflation) and is
therefore a better indicator of changes in the purchasing power of one currency relative to another. For
example, assume that the U.S. dollar can be exchanged for 10 Argentine pesos, and that prices are stable in
the United States but rising by 10 percent a year in Argentina. A year later, the currency exchange will swap
$1 for 11 Argentine pesos. The dollar has appreciated by 10 percent relative to the Argentine peso (each
dollar now buys 10 percent more pesos) but each peso buys 10 percent fewer goods in Argentina. The
nominal exchange rate has changed (the numbers on the currency exchange window) but because of
inflation in Argentina over the course of the year, the real exchange rate (what you can buy when you swap
one currency for another) has not changed at all. Any reference to exchange rates in the balance of the
chapter refers to real exchange rates.
† Except India, where the Maharaja Mac is made from chicken.
‡ China’s official currency is the renminbi, often abbreviated RMB. The basic unit of that currency is the
yuan. For that reason, you will see Chinese money referred to as renminbi or yuan.
§ International corporations subject to this kind of exchange risk will often use financial tools, such as the
futures market, to protect against currency losses. This does not obviate the basic point here, which is that
fluctuating currency values have a significant impact on importers and exporters. The cost of hedging
against that risk becomes an additional cost of doing international business; the bigger the expected swings
in exchange rates, the higher the cost of protecting against such swings.
¶ Charles Atlas developed and marketed a special bodybuilding regimen in the early twentieth century that
promised to turn “97-pound weaklings” into muscular tough guys. Atlas said he was inspired to develop his
special program by a bully who kicked sand in his face when he was young.
# For example, if two thirds of U.S. trade were with Canada and one third with China, a trade-weighted
measure of the dollar’s value would weight exchange rate changes with Canada twice as heavily as changes
relative to the Chinese yuan.
** In the run-up to the Great Depression, France (and to a lesser extent the United States) took policy
measures to prevent its growing gold hoard from setting in motion the usual adjustments. My Dartmouth
colleague Doug Irwin has written an intriguing article titled “Did France Cause the Great Depression?” that
will be discussed in the next chapter.
http://www.nber.org/papers/w16350.
†† Individuals were not able to present dollars for gold. Franklin Roosevelt severed the dollar’s connection
with gold in 1933. However, until 1971, foreign governments had the right to exchange dollars for gold.
CHAPTER 7
Gold
Had the price of gold been raised in the late 1920s, or, alternatively, had the major central banks
pursued policies of price stability instead of adhering to the gold standard, there would have been
no Great Depression, no Nazi revolution, and no World War II.
Robert Mundell, Nobel Prize lecture, 19991
Let’s stipulate that Winston Churchill was one of history’s bravest, most
forward-looking leaders. His unique fortitude as prime minister inspired Britain
during the depths of World War II; his strategic mind was essential to winning
the war. But even Churchill made some monumental mistakes. As First Lord of
the Admiralty during World War I, Churchill was the chief advocate for the
disastrous British attack on the Gallipoli Peninsula (in modern-day Turkey),
where some 46,000 Allied troops were killed before the campaign was aborted.2
As Chancellor of the Exchequer between the wars, Churchill was responsible for
what might be described as his economic Gallipoli. Britain suspended gold
convertibility during World War I (as it had during previous wars), meaning that
the pound was no longer convertible to gold. With the pound untethered from
gold during and after the war, prices rose steadily. By one reckoning, the British
price level in 1925 was twice what it had been in 1914.3 With the legislation
suspending gold convertibility set to expire in 1925, Churchill made the decision
that Britain should return to the gold standard with the pound pegged at its
prewar price relative to gold (and the U.S. dollar).
Churchill’s view, shared by nearly all economic experts at the time, was that
a pound sterling backed by gold was an essential feature of the British Empire.
The pound had been fixed to a specific quantity of gold for two hundred years, a
source of both pride and monetary stability. During the European wars of the
nineteenth century, gold convertibility was temporarily suspended, but it had
always been restored at the prewar exchange rate, as Churchill was attempting to
do in the twentieth century. A strong pound, like the queen, was an essential
feature of the British Empire. As one observer noted, “From the end of the
seventeenth century to the beginning of the twentieth, the British defended the
gold standard with an almost religious zeal.” 4 (Note: the phrase “religious zeal”
will come up again in this chapter.)
Due to British wartime inflation, postwar pounds bought fewer goods in
1925 than they had in 1914. As a result, the pound had weakened significantly
relative to both gold and the U.S. dollar. (Anyone swapping gold or dollars for
pounds after the war demanded extra pounds to compensate for the fact that each
pound bought less than it used to.) If Britain were going to return to the gold
standard at its prewar level, the pound would have to regain its lost value. The
only way that could happen was if British prices fell significantly. (Lower prices
in Britain would strengthen the pound by inducing those trading gold and dollars
to accept fewer pounds in return, as each pound would have more purchasing
power.) In other words, Churchill would have to engineer a deflation. As I’ve
noted in earlier chapters, prices and wages do not go down without a fight. The
eminent British economist John Maynard Keynes recognized this at the time. In
a series of articles and essays, Keynes argued that strengthening the pound to its
prewar value “would be far more difficult and painful than the Treasury
supposed.” Foreshadowing: he was right. If this were an economic horror movie,
we would cue the scary music.
Keynes urged British policymakers to make stable domestic prices a priority
rather than a fixed exchange rate with gold and the dollar. In the lingo of the last
chapter, Keynes was advocating floating exchange rates so that the Treasury
could focus on the domestic economy. Gold enters the economy at a rate
independent of the supply of goods and services, meaning that prices will
inevitably fluctuate based on gold’s relative scarcity. Keynes, a fierce critic of
the gold standard in general, eloquently stated the logical result: “Gold is liable
to be either too dear or too cheap. In either case, it is too much to expect that a
succession of accidents will keep the metal steady.” 5 With regard to Churchill’s
plan to restore the pound to gold at its prewar value, Keynes observed—again
correctly—that prices and wages are “sticky.” Exporters, in particular, would
need lower costs in order to stay competitive with American firms once the
pound appreciated relative to the dollar. (As discussed in the previous chapter,
once the pound appreciated, each dollar in export revenue would generate fewer
pounds when repatriated back to the UK; that lost revenue would have to be
made up somehow.) Keynes predicted that unions would fight wage cuts; the
result would be higher unemployment. Churchill would be intentionally
throttling the economy, just as Paul Volcker did in the United States in the early
1980s. The difference is that Volcker was trying to stabilize prices while
Churchill was forcing them to fall. In Keynes’s view, the economic damage was
unnecessary. He famously lambasted the gold standard as a “barbarous relic”—
but if Britain must return to gold, then it ought to be at a level consistent with
postwar prices rather than forcing deflation.
Churchill went ahead with his plan, Keynes’s objections notwithstanding.
The result was significant economic disruption. With a stronger pound, export
industries struggled. British coal mines were losing a million pounds a month;
they responded by asking miners to take a pay cut. As Keynes had predicted, the
unions balked, leading to a lockout and eventually a general strike as other
unions walked off the job in sympathy with the miners. In 1925, Keynes
published “The Economic Consequences of Mr. Churchill,” a critical essay
riffing on his earlier prescient criticism of the Versailles Treaty ending World
War I (“The Economic Consequences of the Peace”). British economic problems
merged with the global disruption caused by the nascent Depression. By 1931,
the situation in the UK and elsewhere was eerily similar to the bust in our
hypothetical rice farming village: “Bank lending had been clamped shut, forcing
commodity prices to collapse, which led in turn to bankruptcies and bank
failures.” And so on and so forth. In the fall of that year, Britain left the gold
standard, a mere six years after restoring convertibility. Churchill would describe
this chapter as perhaps the worst blunder of his career. That’s saying a lot, given
that nearly fifty thousand British soldiers died at Gallipoli.
Gold is an element that has captivated humans across cultures since the dawn of
civilization. Gold is lustrous, dense, nonreactive, noncorrosive, and uniquely
malleable, so that it can be fashioned into jewelry with relative ease. Less
obvious, gold is imperishable. As Peter Bernstein describes in his book The
Power of Gold, “You can do anything you want with it and to it, but you cannot
make it disappear. Iron ore, cow’s milk, sand, and even computer blips are all
convertible into something so different from their original state as to be
unrecognizable. This is not the case with gold.” 6 Most important for the balance
of this chapter, gold is scarce. All the gold ever produced would fit in a single
supertanker.7 As money evolved over the ages, gold coins were a logical
development. The shiny stuff was prized across different societies, so it was
suitable for trade. The density and scarcity made it possible to pack a large
amount of value in a small coin or bar. The malleability made minting coins
possible; the indestructibility meant they lasted, or could be melted down and
made into new coins or jewelry.
Having said all that, what makes for good jewelry, or for effective money in
sixteenth-century Europe, does not make for good money in a twenty-first-
century global economy. Churchill’s experience—and Keynes’s prescient
objections—encapsulate the appeal and the drawbacks of a system in which
money is defined as a fixed quantity of gold (or any other precious metal). No
modern nation fixes its currency against gold. Paul Volcker (a man who is
keenly aware of the inflation risk associated with fiat currencies), has written,
“Yes, gold will be with us, valued not only for its intrinsic qualities but as a last
refuge and store of value in turbulent times. Yet its days as money, as a means of
payment and a fixed unit of account, are over.” 8
Still, the fascination remains, including calls in some political quarters for a
return to the gold standard (among the so-called gold bugs). To economists, this
is the equivalent of calling for a commission to study whether the world is flat.
True, a gold standard has two important strengths:
Alas, the disadvantages of a gold standard follow directly from those same
properties. The supply of gold is not meaningfully related to the growth rate of
our global economy, as Keynes pointed out, meaning that prices will rise in
periods of rapid gold production and fall when the supply of gold lags behind
growth in the rest of the economy. The latter, as Churchill learned, can be
especially pernicious. The rigidity of fixed exchange rates has a downside, too,
as the last chapter discussed. When nations are tethered to one another via a gold
standard, they must subvert their domestic economic interests to defending the
exchange rate. This was Britain’s undoing between the wars; it would soon
become a global problem as other nations made similar mistakes, broadening
and deepening the Great Depression. Hence the breathtaking assertion by Nobel
Prize winner Robert Mundell that a bungled international monetary system
“brought on Hitler, the Great Depression, and World War II.” 9
Mundell is not some kook. Milton Friedman also has written extensively on
how a severe contraction in the supply of money turned the stock market crash
of 1929—a relatively “minor” economic disruption, in his view—into the
economic catastrophe that it became.10 (Friedman argues that the Federal
Reserve could have pursued more expansionary money policy while still
maintaining the gold standard, a distinction that will be explored in chapter 9.)
For now, I won’t pull my punches: money backed by gold makes no sense
whatsoever in a modern economy. At best, gold is a siren call, a simple fix for a
complex challenge. (As such, it conforms neatly to my favorite public policy
aphorism: Every public policy problem has a simple solution—and it’s usually
wrong.) At worst, policymakers cling tenaciously to gold like some kind of
religious text; as with other kinds of fundamentalism, supporters cling most
tightly during times of confusion and rapid change—exactly when new thinking
is essential.
As noted earlier, the Initiative on Global Markets at the University of
Chicago’s Booth School of Business periodically polls an ideologically diverse
group of highly respected economists on issues of the day. In 2012, Booth’s
IGM panel was asked to agree or disagree with the following statement: “If the
U.S. replaced its discretionary monetary policy regime with a gold standard,
defining a ‘dollar’ as a specific number of ounces of gold, the price-stability and
employment outcomes would be better for the average American.” Every single
respondent answered “disagree” or “strongly disagree.” There was not even a
single “uncertain.” 11
To mainstream economists, returning the United States to the gold standard
is the economic equivalent of restoring control of America to the British
monarchy—such a wacky idea that it barely merits discussion. During the
Reagan administration, after a decade in which the United States had been
buffeted by historically high inflation, Congress did create a sixteen-person
commission to examine the role of gold in domestic and international monetary
affairs. In 1982, the commission concluded, “Under present circumstances,
restoring a gold standard does not appear to be a fruitful method for dealing with
the continuing problem of inflation.” 12
The gold standard is an idea whose time has gone. Why? Because a
competent central bank managing a fiat currency has all the advantages of a gold
standard without the drawbacks. The belief that the world would be better with a
“hard currency” neglects a core understanding of money, banking, and central
banking.
And yet . . .
There are still those who believe with great fervor that a return to gold would
be economically beneficial—that gold would liberate the money supply from the
hands of bureaucrats and facilitate healthier and more stable economies. Former
congressman and presidential candidate Ron Paul has attracted significant
support for his call to bring back gold.† He recounts a speech he gave at the
University of Michigan that helped to inspire his most recent book on the
subject, End the Fed: “When I mentioned monetary policy, the kids started
cheering. Then a small group chanted, ‘End the Fed! End the Fed!’ The whole
crowd took up the call. Many held up burning dollar bills, as if to say to the
central bank, you have done enough damage to the American people, our future,
and to the world: your time is up.” 13 The 2012 Republican platform included a
proposal for a reprise of the 1980 Gold Commission “to investigate possible
ways to set a fixed value for the dollar.” 14 Across the Atlantic in 2014, Swiss
activists gathered the 100,000 signatures necessary to put a referendum onto the
national ballot that would have forced the Swiss National Bank to hold 20
percent of its reserves in gold. The Economist reported at the time, “Bigger
reserves, activists argue, will make the Swiss economy more stable and
prosperous. In fact the opposite is true.” 15 The referendum failed, though more
than 20 percent voted yes.
Money backed by gold has intuitive appeal. In times of economic distress,
why not return to something as “good as gold”? Isn’t money with some intrinsic
value better than money with none? And isn’t the system more stable if money is
fixed in supply rather than limitless? No, no, no. Gold is utterly impractical for a
twenty-first century economy. We are better served by a more flexible, if less
beautiful, form of money. Let us count the reasons.
Gold is not immune from inflation. Prices under a gold standard rise and fall
with the supply of gold, as they do with the supply of any other kind of money.
Remember those discoveries of gold and silver in the New World? European
prices went up. The same thing happened in the nineteenth and early twentieth
centuries after major gold discoveries in California, Australia, and South Africa.
We should not confuse two important concepts. Yes, gold exists in finite supply,
but that in no way guarantees stable prices. If the quantity of gold coming out of
the ground grows faster than the rest of the economy, prices (in gold) will
typically rise. If growth in the supply of gold lags behind the rest of the
economy, gold will become relatively more valuable and prices will fall. This
was Keynes’s critique—though really it is just basic supply and demand.
China, Russia, and South Africa should not be in charge of U.S. monetary
policy. The money supply under a gold standard is a function of gold production.
As the South Africa example above illustrates, higher gold production (other
things being equal) will lead to higher prices; lower gold production has the
opposite effect. Right now the world’s largest gold producer is . . . China. The
fourth largest producer is Russia, a real stalwart ally; South Africa is sixth. The
United States is home to less than 6 percent of the world’s known gold reserves.
(Russia and South Africa have over 20 percent between them.)17
Why would any nation cede control of its money supply to foreign powers?
Anything that interrupted the pace of gold mining—deliberate or otherwise—
could have a serious adverse economic impact. As the United States learned
during the Arab oil embargos of the 1970s, other countries can and will
strategically manipulate the supply of commodities in ways that are harmful to
the U.S. economy. Conversely, a major gold discovery (under the melting
Arctic?) could be inflationary. In any event, the price level is determined by the
amount of gold taken out of the ground rather than by policy of the government
or central bank.
But wait a minute: Isn’t that exactly the point? Obviously the people of
Zimbabwe would have been better off if their money supply had been
determined by global gold production rather than by the whims of an autocratic
government with a special talent for printing money. Prices under a gold
standard may fluctuate arbitrarily, but at least there are constraints on the degree
to which money can be devalued. True enough. But let me ask this question:
Was Zimbabwe a successful, thriving nation except for its monetary system? Of
course not. Robert Mugabe, Zimbabwe’s only leader since its independence in
1980, has a poor human rights record. He has stolen at least one election. One of
his major economic policies was a land reform program that confiscated farms
from white farmers. And so on and so forth. The place was an economic disaster,
one symptom of which was the government printing money with reckless
abandon. Which brings us to the next point.
Bad governments cause bad money, not the other way around. In End the Fed,
Ron Paul writes, “Tyranny always goes hand in hand with government’s
wrecking of the money system.” 18 I will concede that despoiling the currency is
an important tool for any really lousy government—but there is a causality
problem here.‡ Bad governments cause worthless money, not the other way
around. Having a fiat currency is not going to turn the United States into
Zimbabwe. In fact, bad governments throughout history have proved perfectly
capable of stealing from their subjects by manipulating money, whether it was
with the printing press or by debasing gold and silver coins. It’s always for the
same basic reason: they’ve run out of other options for paying the bills.
If the king cannot pay his obligations in gold coins, and no one is willing to
loan him more, the cleverest thing to do is make the existing gold go farther.
Yes, every soldier will get fifty-seven gold coins for fighting the Huns, as
promised—but each coin will have less gold than it used to. This is really just an
ancient version of turning on the printing presses.
Peter Bernstein tells the impressive story of Dionysius of Syracuse (430–367
BC) who was heavily indebted to his citizens and had insufficient income to pay
them back. “[Dionysius] ordered all coins in the city brought to him, under
penalty of death. He restamped the coins so that each drachma coin now read
two drachmas. After that, paying off his debts was easy.” You won’t read that in
any public finance textbook.
The Romans were impressive debasers. Silver coins had 60 percent less
silver in AD 260 than they did when Augustus became emperor in 27 BC. King
Jean II of France, known as Jean le Bon, financed his taste for luxury (and wars
with the English) by altering the currency eighteen times in the first year of his
reign, with seventy more debasements over the next decade. Across the Channel,
England’s Henry VIII may be most famous for beheading his wives and feuding
with the pope, yet he still found time to aggressively substitute copper for silver
in the coinage. His efforts in this regard (and those of his successor Edward VI)
are officially recognized in British history as the Great Debasement. The point is
that paper currency does not cause bad monetary policy, nor does gold (or silver)
protect against it.
For that matter, governments on the gold standard can always just go off, or
change the price of gold. The United States has done both. Shortly after Franklin
Roosevelt took office in 1933, Congress granted him the power to change the
gold content of the dollar. One day every dollar was fixed to a specific amount
of gold; the next day it was fixed to slightly less gold. (The director of the
budget at the time predicted, “This is the end of Western civilization.”) Secretary
of the Treasury Henry Morgenthau described in his diary how he would meet
with FDR every morning in the president’s bedroom to discuss economic policy,
part of which was setting the price of gold for the day. (The higher the price of
gold, the less each dollar would be worth.) On one morning, Roosevelt chose 21
cents for a particular quantity of gold because it was a lucky number.
In 1934, the price of gold was fixed at $35 an ounce, up from its legal price
of $20.67 in 1900. In other words, the gold value of each dollar had been
reduced roughly 40 percent.19 Of course, private citizens could no longer redeem
dollars for gold anyway; Congress had ended the convertibility of dollars into
gold by U.S. citizens in 1933. Only foreign governments could present dollars
for payment in gold after that. In 1971, Richard Nixon abruptly ended that
practice, too.20 Key lesson: a currency is as good as gold—until the government
says it is not.
To be fair, some advocates of gold, including Ron Paul, would remove the
government altogether. Let the market dictate what individuals and firms choose
as a medium of exchange. Perhaps that will be bitcoin someday. (Ironically,
bitcoin has even less intrinsic value than U.S. dollars—there is not even any
paper!) Money has operated without government involvement throughout
history, such as macks in federal prisons. The U.S. government currently forbids
any competing legal tender other than the dollar, which seems a curious and
unnecessary regulation. (If a bunch of nutjobs want to pay each other in gold,
why not let them?) The prohibition has become a cause célèbre for gold bugs,
who argue that if gold were given a fair chance, it would prove to be a superior
currency to fiat money like the dollar, the yen, and the euro. In a Wall Street
Journal op-ed that embodies this view, Peter Schiff, president of Euro Pacific
Capital, wrote, “Gold is money because people make it money. Paper money is
money because governments make it money.” 21 Gold is the libertarian people
power!
The reality is that no sane person would write a long-term contract
denominated in gold. The purchasing power of gold is far more volatile than any
currency under the control of a reasonably competent central bank.
The CPI measures the purchasing power of the dollar over time. The price of
gold measures the purchasing power of gold. Remember, the purpose of money
is to facilitate transactions. Which of those two forms of money—gold or the
dollar—seems like a more predictable unit of exchange? For all the criticism of
the Federal Reserve’s actions after 2008 (particularly from the gold bugs), the
purchasing power of the currency has remained strikingly stable. As The Atlantic
magazine pointed out in 2012, “There’s been 23 times less variance in prices
since the Fed started quantitative easing than there was under the gold standard.”
22
For all that, there is no reason to be hypothetical on this point. There are
groups that can choose whatever money they like, regardless of the law: drug
dealers and arms merchants and the like. These people are not constrained by
silly laws forbidding gold as legal tender; their businesses are predicated on
ignoring laws in general (or else they wouldn’t be dealing weapons and drugs).
What is the currency of choice for arms merchants, drug dealers, dictators, and
other thugs who have little interest in what the government has to say? The
dollar.§ When was the last time you turned on the television news and a major
drug bust had confiscated two kilos of gold? The dollar circulates broadly
outside of the United States on a purely voluntary basis. Presumably drug
dealers and arms merchants choose the dollar for the same reason as everyone
else: relative to the other options, it has strikingly consistent purchasing power
over time.
Given all the grief the Fed has taken in recent years, perhaps there is even
room for some kind of promotional campaign, like those American Express
commercials. “Hi, people call me El Jefe. I can’t give you my real name,
because I lead one of Mexico’s major drug cartels and I’m wanted on both sides
of the border. I kill people, I take bribes, and I distribute drugs around the world.
When I get paid, I like the American dollar. It’s easy, dependable, and accepted
everywhere.” Then there would be a voiceover with the tag line: “The American
$100 dollar bill: Don’t leave home without a suitcase full of them.”
I suspect the unimaginative folks at the Fed will reject this public relations
campaign. Still, the data support my point. According to the Federal Reserve,
there are twenty-three $100 bills in circulation for every American.23 I currently
have two of them, which my mother-in-law sent me for my birthday. I usually
have none. Most people I know aren’t carrying a wad of $100s. Where are all
these big bills? According to Edgar Feige, a University of Wisconsin economist
who researches this kind of thing, no one is quite sure, in part because many of
them are likely being used for illicit purposes or in the underground economy.
Feige explained in an e-mail, “All we know is that some fraction of U.S. cash
supply is held abroad and that per capita domestic holdings far exceed the
amounts of cash that U.S. firms and households admit to holding.” 24
Does gold really have intrinsic value? This is a trickier question than one might
think. I’ve stipulated that gold has universal appeal for jewelry and
ornamentation. That’s not likely to change. However, people around the world
also acquire gold to hoard—as a store of value that can be sold to other people
who like gold if necessary. However, the price at which that gold can be sold is
hard to determine. Gold has very limited industrial uses (in large part because it
is scarce and expensive). Thus, the value of gold at any given time—compared
to, say, wheat or snow tires—is largely driven by human emotion. There is an
irony here: gold is valuable in part because other people believe gold is valuable,
which is not entirely different from the reason that a $100 bill is valuable. As
Peter Bernstein points out, “Gold would never have attained its position as
supreme monarch of monetary systems without its unique physical attributes, yet
the demand for gold became so insatiable over time because it was used as
money.”
Unlike the purchasing power of a $100 bill, which the Federal Reserve
works hard to manage, the value of gold in terms of other goods bounces all over
the place. There is no empirical way of determining how valuable gold ought to
be relative to bread, milk, real estate, or other goods. As Wall Street Journal
personal finance writer Jason Zweig points out, “With no measures like
price/earnings ratios or bond yields as benchmarks of value, figuring out whether
the precious metal is cheap or dear is like trying to solve a Rubik’s cube while
blindfolded.” 25
For personal investors, this brings up an important point: gold is a dead asset,
meaning that unlike bonds or real estate or certificates of deposit, gold does not
earn a return. Burying gold in the basement makes sense if you fear extreme
inflation, or that society will come unraveled. (Though it seems like goats and
shotguns would be a better hedge against the latter; do we really think that
people would be wearing lots of jewelry in a postapocalyptic world?) Acquiring
gold is a logical way to save in nations with underdeveloped banking systems,
such as India, where a family’s wealth may be held in the form of jewelry and
bangles. Such wealth is prone to theft or loss; perhaps more important, it cannot
be rented out for productive purposes. As Bernstein writes, “Hoarding is similar
to buying an insurance policy. Like an insurance policy, hoarding gold has a
cost, for the idle metal earns nothing.” There are other ways to hedge against
inflation that still earn a return on capital. Land appreciates with inflation; it can
also be cultivated, generating regular income. Apartments rise in value when
other prices are going up; they provide rental income at the same time. The U.S.
Treasury’s Inflation-Protected Securities (TIPS) pay a fixed yield plus an
additional amount to compensate for inflation over the relevant period.
Hoarding a dead asset has a cost for society, too. Whatever wealth is buried
in the basement or dangling from a bride’s wrist is capital that cannot be loaned
to an entrepreneur starting a business, or to a student attending medical school.
The whole point of a financial system is to match savers and borrowers, making
both parties better off in the process. Gold does not work that way. India
considers this a serious enough problem that the government has floated a policy
that would create gold banks that would allow Indians to deposit gold in
exchange for certificates; the long-run goal is to loan out the gold on deposit in
some manner.
Much of the world’s gold lies in vaults deep beneath the Federal Reserve of
New York. Warren Buffett, one of the most successful investors of all time, has
pointed out how curious it is that something ostensibly so valuable lies idly in a
vault: “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt
it down, dig another hole, bury it again and pay people to stand around guarding
it. It has no utility. Anyone watching from Mars would be scratching their head.”
26
For all that, the most compelling argument against the gold standard may be the
most prosaic. It’s the one that could have made this chapter only a paragraph
long. The one that made me feel chagrined when Paul Volcker pointed it out to
me in his office several years ago . . .
There is not enough gold. As Volcker pointed out, “The volume of gold in the
world is way, way short of all the international currencies that are around.”
Remember, all the gold that has ever been produced would fit on a single
supertanker. It’s like we started a regular poker game many years ago with five
players and fifty chips. Now we have hundreds of tables playing poker—but still
only fifty chips. It can’t work. Or, more accurately, it cannot work in any
practical way. Yes, we could set the price of gold so high that it could
technically support all the currencies in circulation—say every ounce of gold
was worth $10,000. But that defeats the purpose of having a gold standard. No
sane person would give up $10,000 in current purchasing power for an ounce of
gold. We don’t like jewelry that much. The dollar would still effectively be
backed by nothing.
The proponents of gold typically offer a litany of complaints about our current
monetary system. Most of these points are entirely valid. Fiat currency can be
abused in ways that lead to inflation. The Fed should be more transparent. A
central bank that acts as a lender of last resort does create moral hazard. The
international monetary system needs more predictability and stability. The
fallacy is that gold is an effective remedy for any of these challenges. The
remedy is better central banking.
For a modern economy, gold fails all three of the basic tests for effective
money:
And yet in many ways, gold is a far more intuitive form of money than
paper. Reverting to gold during a time of economic distress feels like the right
thing to do—then again, so did burning witches after a bad harvest. Centuries of
evidence suggest that neither is likely to fix the underlying problem. So let’s
finish where we began, with the enormous human cost of clinging to a system
that does not make economic sense, however intuitive it may feel.
Economist Barry Eichengreen has written an entire book making the case
that the gold standard is the “key to understanding the Great Depression.” This
idea will be explored in greater depth in chapter 9. For now, it is important to
recognize just how dangerous the false allure of gold can be, especially in times
of economic disruption. Eichengreen writes:
The gold standard of the 1920s set the stage for the Depression of the 1930s by heightening the
fragility of the international financial system. The gold standard was the mechanism transmitting
the destabilizing impulse from the United States to the rest of the world. The gold standard
magnified that initial destabilizing shock. It was the principal obstacle to offsetting action. It was
the binding constraint preventing policymakers from averting the failure of banks and containing
the spread of financial panic. For all these reasons, the international gold standard was a central
factor in the worldwide Depression. Recovery proved possible, for these same reasons, only after
abandoning the gold standard.27
Bad ideas have consequences, then and now. There is no serious risk that the
United States will return to a gold standard. Still, the same misperceptions that
make gold attractive tend to complicate current monetary policy. Financial
Times columnist Martin Wolf has described serving on a panel with a U.S.
politician who asserted that the Federal Reserve’s response to the 2008 financial
crisis would lead to hyperinflation. Wolf writes, “Like many others, he failed to
understand how the monetary system works. Unfortunately ignorance is not
bliss. It has made it more difficult for central banks to act effectively.” 28
This stuff matters. Monetary policy may seem esoteric. Then again, so did
some of those weird derivatives Wall Street was peddling in the early 2000s.
How did that work out? When monetary policy works well, we barely notice.
We go about our daily lives using money that we take for granted, making use of
a financial system that is not imploding, casting aspersions on regulators who
seem to make everything more complicated.
But it does not always work that smoothly. As the second half of the book
will elucidate, getting money wrong can wreck economies and ruin lives.
________
* Even the benefits of a gold standard may be overblown. The period prior to World War I under the gold
standard was a time of unique economic stability and global integration. British Prime Minister Benjamin
Disraeli and others have argued that this period of economic calm caused the gold standard, rather than the
other way around. Long before the gold standard collapsed, Disraeli told a group of Glasgow merchants,
“Our gold standard is not the cause, but the consequence of our commercial prosperity.”
Peter L. Bernstein, The Power of Gold: History of an Obsession (Hoboken, NJ: John Wiley & Sons, 2012),
258.
† Congressman Paul was a member of the Gold Commission. He and fellow commission member Lewis
Lehrman coauthored a dissenting report: “The Case for Gold: A Minority Report of the U.S. Gold
Commission.”
‡ For a more comprehensive discussion of the difference between correlation and causation, please read my
earlier book Naked Statistics (Norton, 2013).
§ Though as chapter 13 will point out, bitcoin is making inroads on this front.
PART II
why it matters
CHAPTER 8
You come to us and tell us that the great cities are in favor of the gold standard. I tell you that the
great cities rest upon these broad and fertile prairies. Burn down your cities and leave our farms,
and your cities will spring up again as if by magic. But destroy our farms and the grass will grow in
the streets of every city in the country . . .
If they dare to come out in the open field and defend the gold standard as a good thing, we shall
fight them to the uttermost, having behind us the producing masses of the nation and the world.
Having behind us the commercial interests and the laboring interests and all the toiling masses, we
shall answer their demands for a gold standard by saying to them, you shall not press down upon
the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.
—William Jennings Bryan, “Cross of Gold” speech, Democratic National Convention, 18961
Did the Dutch really buy Manhattan from the Indians for $24 worth of beads,
as we were all taught in elementary school? And if so, was it really such a crazy
bad deal for the local Lenape Indians? To begin with, Manhattan was just a
relatively uninhabited patch of land. It’s not like the Dutch got Fifth Avenue,
Central Park, or anything with Donald Trump’s name on it. There was a lot of
open land back in those days. The bead story may be apocryphal anyway. A
letter from a liaison for the Dutch East India Company to the Dutch government
makes reference to purchasing “the Island Manhattes from the savages for the
value of 60 guilders.” 2 This sum was later reckoned to be worth about $24 using
a nineteenth-century exchange rate; historians point out that it’s difficult to know
the real value of guilders at the time for either the Dutch settlers or the Indians.
Presumably guilders were only valuable to the Indians for other trades with the
Dutch.
Meanwhile, it’s not clear that the Indians even owned the island, let alone
used it. One strand of thinking points out that “ownership” of land and water
were alien concepts in Native American culture, so the sum could be interpreted
as more of a fee for sharing.3 One law professor has described the transaction as
“not relinquishing the island, but simply welcoming the Dutch as additional
occupants.” A more insidious (and amusing) theory is that the Indians selling the
land were just a band passing through from Long Island; they sold the Dutch an
island they never had claim to and went home with whatever they could extract
from the naïve buyers. We can debate about whether you are a fool to sell a used
Mercedes for $5,000. But if you manage to sell a used Mercedes that is not
yours for $5,000, that makes you a commercial genius.4 It would be a wonderful
irony if the real naïfs in the transaction were the Dutch. But suppose there were
beads involved, rather than Dutch guilders. Who says those beads were such a
bad trade? Was it silly to give up an island for a handful of shiny objects? Just
about anyone reading this book would gladly part with their home, car, and other
valuables in exchange for a bag of diamonds or a suitcase of gold bars—
different shiny objects with little practical value.
In any event, the Manhattan story overlooks some of the more interesting
things that we do know about the role money played when European settlers
encountered Native Americans. The Dutch were perplexed by the value that the
Native Americans assigned to wampum, the decorative beads made from
clamshells and string that functioned as money. In 1650, Dominie Johannes
Megapolensis, pastor of the Church of New Amsterdam, wrote, “The Indians
value these little bones so highly as many Christians do gold, silver and pearls,
but they do not like our money.” 5 The Dutch adapted, just as American tourists
do when they show up in Paris or Hong Kong. Wampum became a widespread
medium of exchange among the settlers throughout the Northeast. This
precipitated a challenge with commodity money that I’ve glossed over to this
point. In theory, the benefit of a commodity-based currency is that it has a
standard and widely appreciated value: tobacco is tobacco; cows are cows. In
fact, some tobacco is better quality than other; some cows are fat and healthy
while others are thin and sick. Wampum seemed more stable—it was always
strung and the typical denomination was the length of a man’s arm. Yet the
Dutch observed an interesting trend: when the Indians came to receive a quantity
of wampum, they would bring a towering man; when it came time for them to
pay, it seemed the Indians would always bring a dwarf.6
In addition to smallpox and liquor, the European settlers introduced another
scourge: wampum inflation. The Narragansett Indians traditionally held a near
monopoly on wampum production. Supply was relatively low and steady due to
the laborious production process: gather the shells, break into the hard, thick
center, grind each shell to a uniform size, cut a hole through the middle, and
string the shells. The Dutch brought steel tools to the process, which was the
equivalent of giving more printing presses to the Zimbabwean government. The
colonists generated a hundredfold increase in the supply of wampum, causing an
inevitable inflation.7 As Milton Friedman observed, “Wampum inflation is
everywhere and always a monetary phenomenon.” Okay, he never really said
that, but he might have if he had spent more time studying Dutch colonists.
Ironically (though not surprisingly) the machine-made wampum eventually
rendered it obsolete as a medium of exchange.
Money has played a crucial role at every juncture in American history. And by
money, I do not mean wealth (chickens, factories, and apartments)—I mean the
stuff we have used as a medium of exchange to buy chickens, factories, and
apartments: wampum, Spanish doubloons, continentals, gold, paper, computer
bytes. American history is also the history of money. We’ve used commodities
and gold and paper. We’ve had inflation. We’ve had deflation. We’ve even had
stagflation. Some of the most pitched political battles in America have revolved
around the nation’s money, whether it was Alexander Hamilton arguing for a
national bank or Andrew Jackson trying to kill that bank. William Jennings
Bryan was looking after the interests of western farmers when he campaigned to
expand the money supply with silver coinage; New York bankers were
protecting their interests by creating the Federal Reserve to mitigate the banking
panics that had characterized the nineteenth and early twentieth centuries. As the
last chapter argued, America’s attachment to the gold standard deepened and
prolonged the Great Depression. To the extent that the Depression (which was
most severe in the United States and Germany) brought about World War II, this
may be the worst public policy disaster in history.
Every chapter of American history that we’re familiar with—colonial times,
the Revolution, the Civil War, the settling of the West, the Depression, and so on
—has a corresponding monetary tale. Sometimes these tales are amusing side
notes. In other cases, they have changed the nation’s trajectory. Jimmy Carter
lost the presidency in part because of the stagflation of the 1970s. Ronald
Reagan won reelection in 1984 using the theme “It’s morning in America” in
part because Paul Volcker had beaten inflation. As I write, some critics are
lambasting the Fed for its overly aggressive response to the 2008 financial crisis;
others argue that America’s central bank has not done enough to lower
unemployment. Time will shed more light on this debate.
Economic historians have written volumes on each of these subjects. I have
already made liberal use of Barry Eichengreen’s work on the Great Depression.
One of Milton Friedman’s towering achievements, written with coauthor Anna
Schwartz, was the tome A Monetary History of the United States, 1867–1960.
My purpose is simpler (in large part because I know so much less about this
topic than the people just referenced). The point of this chapter is to reinforce the
idea that money and its related institutions matter. Money, banking, and central
banking have affected the course of American history. They will continue to do
so. Here is a tour of familiar chapters in American history with the less familiar
monetary details attached to them—a sampling, if you will.
The Civil War (Read This Section, Even If You Already Know
Who Wins)
We know who started it: the South. By “it,” I mean the inevitable printing of
money and inflation. The Confederacy had the weaker economy and resorted
almost immediately to printing money to pay war expenses. The price level in
the South increased nearly thirtyfold between 1861 and 1865.45 The Union was
able to keep the printing presses idle for a while by raising taxes and borrowing,
but eventually that would not be enough. In 1862, Treasury Secretary Salmon P.
Chase proposed issuing Treasury notes that would be declared legal tender but
were not redeemable for gold or silver. Massachusetts senator Charles Sumner
summarized the skepticism of the Congress toward such a scheme: “Surely we
must all be against paper money.” But even Sumner bowed to the exigencies of
the situation, telling the Senate, “Your soldiers in the field must be paid and fed.
. . . Reluctantly, painfully, I consent.” 46
The Union began printing “greenbacks”—a double entendre inspired by the
green ink on one side of the currency and the fact that the notes were not backed
by gold or silver—only by the green ink. Compared to the massive inflation in
the South, the new currency fared reasonably well and helped the North solidify
its economic advantage. As historian H. W. Brands argues, “The greenback
underwrote the Union victory in the Civil War and accelerated America’s
industrial revolution.” 47 In the midst of the Civil War, the North had created
America’s first successful fiat currency—money with no value other than the
fact that the government declared it had value.
As the end of the Civil War approached, the nation’s currency stock was a
hodgepodge of greenbacks and notes issued by different state-chartered banks.
Before accepting any bank note as payment, one would have to verify that the
bank actually existed; that the note was not a counterfeit; and that the bank was
financially healthy and could be trusted to redeem the note for gold or silver. All
of this became more difficult as the geographic distances involved in commerce
increased.48 When a New York merchant traveled to New Hampshire with $5
bills from his local bank, he may have found someone to accept them, but
typically at a price discounted from the $5 face value. Ironically, some
counterfeits of notes issued by large, reputable banks were more highly valued
than legitimate notes issued by lesser-known banks.
Stagflation: The Food Here Is Terrible and the Portions Are Too
Small
The 1970s brought a handful of historical anomalies: disco, leisure suits, bad
hair, and stagflation. Although I feel strongly about the first three (especially
having been sent to middle school dance classes where I was forced to do line
dances to the soundtrack from Saturday Night Fever), I shall be addressing only
stagflation, the curious combination of high inflation and high unemployment.
As the book to this point has sought to explain, high inflation and high
unemployment should not coexist under normal circumstances. Inflation is
typically what happens when an economy bumps up against its speed limit:
Companies raise prices when demand for their goods exceeds supply, which
usually happens when most everyone has a paycheck. Similarly, wages start to
shoot up when the economy is near full employment; firms have to pay more to
attract new workers.
When unemployment is high—lots of people without paychecks—prices and
wages usually fall, or at least stop rising. (A department store with racks of
unsold merchandise does not usually raise prices.) To paraphrase Woody Allen,
unemployment and inflation are like small portions and bad food: usually only
one of them is a problem. Except in the 1970s.
Economists are still sorting through what went wrong. As with leisure suits
and disco, we may never know exactly who to blame. Still, there is a strong
argument to be made that the Federal Reserve mismanaged the money supply,
holding interest rates too low for too long. Allan Meltzer, a Carnegie Mellon
economist and author of a comprehensive history of the Federal Reserve,
criticized the Fed during the 1970s as having only two speeds: too fast and too
slow.89 One problem lay in a theory embraced by many macroeconomists at the
time that higher inflation would bring lower long-term unemployment, the so-
called Phillips curve (named for the New Zealand–born economist William
Phillips who first posited this relationship). By this way of thinking, higher
inflation was necessary to bring unemployment down. This view of the economy
has since been discarded. (Milton Friedman presciently argued against it in the
1960s.90) Most mainstream economists still believe that the Phillips curve can
hold true in the short run, if the inflation is unexpected. Consumers are fooled
into believing they are getting richer, so they spend more. Firms respond to
higher spending by expanding production. (Remember Bert’s Big Beef in
chapter 2?) Eventually this effect wears off, as consumers and firms realize that
everyone has more money but prices are higher by roughly the same amount. As
Ben Bernanke has explained, “The analogy might be to a candy bar: if you eat a
candy bar, in the short run it gives you a burst of energy, but after a while, it just
makes you fat.” 91
Monetary policy was also complicated by an OPEC (Organization of
Petroleum Exporting States) oil embargo against the United States in 1973 to
protest American policies in the Middle East. Oil prices quadrupled, creating
what economists refer to as a “supply shock,” a disruption that causes both a rise
in the price level and a reduction in economic output. During the 1970s,
economist Arthur Okun created an indicator called the “misery index,” which is
the inflation rate added to the unemployment rate. During Jimmy Carter’s
presidency, the misery index averaged over 16 percent, the highest for any
president in the postwar period. (At the end of Carter’s term in 1980, it was
nearly 20 percent—helping to explain why there was no second term.)92
Economists Alex Nikolsko-Rzhevskyy and David Papell have revisited data
from the period, including reasonable assumptions about the full employment
speed limit of the economy. They conclude that the federal funds rate (the short-
term interest rate targeted by the Fed) was consistently too low if the Fed was
aiming for 2 percent inflation.93 Meanwhile, the public had come to accept rising
prices as a fact of life, whether the economy was strong or weak. This, of course,
helped to ensure rising prices whether the economy was strong or weak and
complicated the Fed’s inflation-fighting task. Allan Meltzer has argued that the
Fed simply lost its nerve in battling inflation. He writes, “When their anti-
inflationary moves caused the unemployment rate to rise to 6.5 percent or 7
percent, they forgot their promises and again began expanding the money supply
and reducing interest rates.” 94 The more firmly embedded inflationary
expectations became in the public mind, the more painful the process would be
to halt. As Ben Bernanke has pointed out, loose monetary policy was
compounded by other policy mistakes. The government was running deficits to
pay for the Vietnam War (“guns”) and other social expenditures (“butter”),
which further stoked demand. Remember that model of the economy as a
driver’s education car with two sets of pedals—monetary policy and fiscal
policy? By the early 1970s, both the Fed and Congress were pushing the pedal to
the floor. Then, with the economy running over the speed limit, the Nixon
administration tried to fight inflation by imposing government wage and price
controls, a policy that Milton Friedman compared to trying to fix an overheating
furnace by breaking the thermostat. Prices were artificially suppressed for a
while, until the policy collapsed and “prices surged, like a spring that was
released,” as Bernanke has described. Combined with the badly timed OPEC oil
embargo, this mélange of bad policies created a seemingly unsolvable economic
problem.95
Stagflation may in fact have been unsolvable if someone other than Paul
Volcker had been appointed chairman of the Federal Reserve in August 1979.
Volcker (aka Inflation Fighter Man) took the job with a determination to end
inflation. The courage of this battle was described in chapter 5. Three months
into Volcker’s term, the Federal Open Market Committee (over which he
presided) raised interest rates sharply. Volcker knew that a sustained tightening
of the money supply was necessary to rid the country of inflationary
expectations, despite the inevitable short-term economic costs. The Fed chair
faced immense criticism from the public and from politicians over rising
unemployment, which peaked at over 10 percent. Volcker’s steadfastness paid
off: inflation fell from twelve percent in 1980 to 3 percent by the middle of
1983.96 In 1987, Volcker retired and was succeeded by Alan Greenspan, who
would lead the Fed until 2006.
Harry Reid came into the room, and I believe Mitch was with him. He said,
“In about 10 minutes Chairman Bernanke is going to be here, along with
Treasury Secretary Paulson. I want you to listen to them. It’s very important
what they have to say.” And then they left.
So about 4 or 5 minutes later Chairman Bernanke came in with Secretary
Paulson and a couple of staff, not many. They sat down, and without any sort of
opening remarks, Chairman Bernanke simply said, “If Secretary Paulson doesn’t
get what he’s asking for, and he doesn’t get it within seventy-two hours, the
entire banking system of the United States will fail, and it will bring the world
banking system down with it.” 98
________
* This gives me an inspired idea for fighting the periodic deflation threats in the eurozone: the European
Central Bank should give unlimited free euros to anyone (me) willing to spend them on a European
vacation (provided we pay for the paper on which the euros are printed).
† Any bimetallic regime is prone to instability, as the two metals (e.g., gold and silver) are likely to
fluctuate in supply independent of each other. For example, a large new discovery of silver will diminish
the scarcity of silver relative to gold—even though the law fixes their relative values. Any citizen can take
gold or silver to the mint to get dollars. When silver becomes more plentiful (and therefore less valuable in
the market), citizens will increasingly choose to turn silver into dollars while holding on to gold, or to trade
gold for silver at the market rate and then use that silver to get more dollars than if the gold had been taken
directly to the mint. An example with different commodities will help make the point. Suppose Congress
fixed the value of the dollar in 1990 at either one mountain bike or one DVD player. At that time, the two
items had roughly similar values. By 2015, a mountain bike is much more valuable than a DVD player,
even if Congress says they should have the same value in terms of dollars. Anyone seeking new money will
bring a DVD player to the mint, not a mountain bike. In fact, a clever person could trade a mountain bike
for multiple DVD players and take those DVD players to the mint to get more dollars than if he had just
“minted” the mountain bike. For this reason, most bimetal standards eventually evolved into a single metal
currency, either implicitly or by law.
‡ The First and Second Banks of the United States also practiced a rudimentary form of monetary policy.
By acquiring state bank notes, the bank provided additional reserves that state banks could use to make
loans, thereby expanding the money supply. Conversely, the bank could redeem state notes for gold or
silver, thereby shrinking state bank reserves against which they could lend and lowering the money supply.
§ Naked Statistics: Stripping the Dread from the Data, which the New York Times described as “sparkling
and intensely readable,” in case you were wondering.
¶ There was an ancillary benefit of this arrangement for the Union in the final stages of the Civil War. The
requirement that national banks buy Treasury bonds and deposit them with the comptroller of the currency
created a bigger market for these government bonds, and therefore made it easier and cheaper for the North
to raise war funds.
# Bryan recorded the speech later in Gennett Studios on July 3, 1923. You can listen to it through the
Authentic History Center at http://www.authentichistory.com/1865-1897/4-
1896election/19230703_Cross_of_Gold_Speech_Recording-WBJ.html.
** The Fed was only granted the power to set interest rates independent of the Treasury in 1951. Congress
amended the Federal Reserve Act in 1977 to give the Fed explicit goals: “maximum employment, stable
prices, and moderate long-term interest rates.” That would become known as the dual mandate despite the
fact that three goals were explicitly identified.
https://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/background/; and
Ferguson, “The Evolution of Central Banking in the United States.”
†† Probably not, but it’s worth asking.
CHAPTER 9
It will become apparent that the economic policymakers of the 1920s and early 1930s were like the
eighteenth-century doctors who treated Mozart with mercury. Not only were they singularly
ineffective in curing the economic disease, they also killed the patient.
—MIT economic historian Peter Temin1
A small compensation for the enormous tragedy of the Great Depression is that we learned some
valuable lessons about central banking. It would be a shame if those lessons were to be forgotten.
—Ben Bernanke, six years before the onset of the 2008 financial crisis2
In the summer of 2007, two hedge funds at Bear Stearns declared bankruptcy.
Both were highly leveraged and had significant real estate exposure. Real estate
prices had started to cool, so it was no great surprise that some hedge funds
holding the most exotic mortgage-backed securities* had begun to stumble. The
Bear Stearns hedge fund news was quickly lost in the cacophony of other stories.
In hindsight, of course, it was the beginning of the end for Bear Stearns and one
of the first indications of how much damage falling real estate prices could do to
the broader financial system.
Roughly nine months later, on Sunday, March 16, I vividly recall working at
my desk when shocking news hit the Internet: JPMorgan Chase was offering to
buy Bear Stearns for $2 a share. Less than a year earlier, Bear Stearns shares had
traded as high as $169. Two dollars was an unimaginably low price for one of
Wall Street’s venerable firms. My father had retired from Bear Stearns several
years earlier, having spent the last half of his career there. I used to visit him on
the frenetic trading floor, where everyone referred to him as “Wheels.” He still
owned a big chunk of Bear Stearns stock in his retirement portfolio.
When I saw the Bear Stearns news (which was really a collapse of the firm),
I called my parents in Florida. I can’t remember who answered. I vaguely recall
that my wife and kids had already flown down to visit for spring break. At any
rate, I said, “Tell Dad that JPMorgan is buying Bear Stearns for $2 a share.” The
price was so low that my parents thought I was joking. I had a habit of calling
and saying implausible things (“I got on the wrong flight and I’m now in
Albania”). Remarkably, they often believed me, at least for a while. On this
Sunday evening, they figured a takeover at $2 a share was another practical joke.
It was not. JPMorgan Chase ultimately raised the price of the deal to $10 a share,
but that was small consolation. One of Wall Street’s preeminent firms had been
essentially wiped out by large bets using arcane real estate–related financial
products.3
The Bear Stearns collapse was perceived for a while as an isolated event. In
fact, it was the first major ripple of what would become the 2008 financial
crisis.† Lehman Brothers would fail six months later, on September 15, 2008. By
then, the ripple had become a tidal wave. The ensuing crisis would destroy jobs,
toss Americans out of their homes, and spread similar misery around the world.
Unemployment as a result of the financial crisis peaked at 10 percent. Nearly
twelve million properties went into foreclosure between 2008 and 2012. The
economy shrank over 4 percent in real terms before hitting bottom. And yet, as
the vignette at the end of the last chapter suggests, it could have been worse—
much worse. We were careening toward financial disaster, yet we managed to
steer the economy away from total implosion. By comparison, the
unemployment rate climbed to over 25 percent during the Great Depression; the
economy shrank by about the same.
This chapter will argue that the Great Depression and the financial crisis
were strikingly similar in many respects. Both had their roots in the popping of a
bubble—stocks in 1929 and real estate in 2008. Both were exacerbated by the
inherent vulnerabilities of the financial system, particularly bank runs (broadly
construed) during a panic. Both crises fed on themselves, as people who lost
savings, homes, and businesses cut back on spending (causing others to lose
savings, homes, and businesses). But there is one crucial difference. During the
Great Depression, the Federal Reserve—the institution created explicitly to
prevent crises and smooth economic fluctuations—failed in its mission. As MIT
economic historian Peter Temin asserted, the doctors killed the patient.
Policymakers responded to events in 1929 and the early 1930s in ways that, with
the benefit of hindsight, were wholly counterproductive.
In 2008, we saved the patient. We did so primarily because of lessons
learned from the 1930s. Yes, there was still pain. Human folly and greed were
on display from beginning to end. Policymakers made mistakes, some of which
will become apparent only as more time passes. The regulatory changes made in
response to the financial crisis may or may not avert the next major crisis. None
of this should obscure the fundamental point: we were not doomed to repeat
history, in large part because we learned from it.
In a fortuitous coincidence, Ben Bernanke, who served as chairman of the
Federal Reserve from 2006 to 2014, is a scholar of the Great Depression. He
wrote in 2000, when he was still an economics professor at Princeton, “I guess I
am a Great Depression buff, the way some people are Civil War buffs.” 4 That is
not why he was appointed by President George W. Bush to be chair of the
Council of Economic Advisers, and later to succeed Alan Greenspan as Fed
chair, but it would turn out to be highly relevant. Bernanke gave a prescient
speech in 2002 in Chicago at a conference to honor Milton Friedman on his
ninetieth birthday. Friedman (as you will read shortly) spent much of his career
expounding on the Fed’s calamitous incompetence during the 1930s. Bernanke
spoke that evening about the seminal work done by Friedman and his frequent
coauthor Anna Jacobson Schwartz on the role of monetary policy and the Great
Depression. He finished the birthday tribute with a remarkable statement, given
what would happen to Bernanke, the Federal Reserve, and the United States over
the ensuing decade: “Let me end my talk by abusing slightly my status as an
official representative of the Federal Reserve. I would like to say to Milton and
Anna: Regarding the Great Depression. You’re right, we did it. We’re very
sorry. But thanks to you, we won’t do it again.” 5
The Fed did not do it again. The policy responses in 2008, both in Congress
and at the Federal Reserve, were improvised, unpopular, and often poorly
explained. The long-term ramifications of those policies are still not fully
known. The crisis is over, but as I write, we are not back to normal. Short-term
interest rates are still near zero. The Fed is holding $4.5 trillion in assets on its
books—roughly five times what it had in 2007.‡6 Bernanke’s legacy will depend
on the long-term implications of the Fed’s extraordinary actions during the
crisis. Paul Volcker’s stature has grown over time because of the durability of
his victory over inflation; Alan Greenspan’s has been diminished because of
regulatory lapses on his watch that set the stage for the mortgage debacle. For
now, there is a compelling case that the Bernanke Fed did not repeat the
mistakes of the 1930s. Milton Friedman died in 2006. As best I can tell, Ben
Bernanke honored his promise to him.
The Great Depression
The stock market crash of 1929 was part of a series of events that would become
the Great Depression. The market crash did not cause the Great Depression—
this is a key point. As Ben Bernanke has written, “The crash of 1929 was only
the first step in what was a much more serious decline.” 7 The plunge in share
prices was almost certainly exacerbated by inept policy at the Federal Reserve
and elsewhere in the government. This kind of history is admittedly tricky, as we
can never know for certain what would have happened if policymakers had
responded differently—the so-called counterfactual. As a point of comparison,
we do know that on October 19, 1987, the stock market fell 22.6 percent in one
day—a percentage drop not wildly different from Black Monday and Black
Tuesday in 1929 (24.5 percent).8 Yet the broader economic effects of the 1987
stock market crash were relatively benign. So how did the 1929 crash turn into
the Great Depression—especially since the vast majority of Americans at that
time, some 90 percent, did not own any stocks?9
The precipitous fall in share prices spread to Main Street via two accelerants
discussed at length earlier in the book: leverage and the inherent frailties of the
banking system. As stocks climbed vertiginously in the 1920s, investors and
speculators could purchase shares on margin, meaning that buyers could pay as
little as 25 percent of the purchase price and borrow the rest. (Yes, this section
should remind you of real estate in the 2000s.) When prices are going up,
leverage amplifies the gains. If an investor pays cash for a $100 stock and the
share price doubles to $200, it is a 100 percent gain. Pretty darn good. But it can
be so much better with borrowed money. By buying on margin (putting only 25
percent down), the purchaser can use the same $100 to buy $400 worth of shares
(borrowing $300 to pay for the rest). When the shares double in price to $800,
the purchaser pays back the $300 loan (plus interest paid on the borrowed funds)
and pockets nearly $400—a 400 percent gain on the initial $100 in capital.
As with any bubble, public perception was that stock prices could go only
one direction: up. Irving Fisher made what may be the worst economic
prediction of all time when he pronounced on October 17, 1929, just days before
the crash, “Stock prices have reached what looks like a permanently high
plateau.” 10 Banks and brokerage houses eagerly made margin loans, often at
very profitable rates. Unfortunately, when the music stops, leverage tends to
blow things up. Let’s revisit the same example that made us so much money in
the previous paragraph, only now let’s assume the market falls by just 25
percent. If you paid cash for a $100 stock, it’s now worth $75. That’s not a good
day, but it doesn’t destroy you. You’ve still got 75 percent of what you started
with.
But the same 25 percent drop will wipe out a highly leveraged investor. The
$400 worth of shares drop in value to $300, which is how much the purchaser
borrowed to buy the shares. The investor’s original $100 in capital is entirely
gone. Leverage has turned a 25 percent market drop into a 100 percent loss. Debt
is an equal opportunity amplifier: bigger gains and bigger losses. (This theme,
too, will return during the 2000s.) When investors get wiped out, rather than
merely losing money, it’s not long before their Wall Street bankruptcies cause
pain on Main Street, even when most folks on Main Street don’t own stocks.
In 1929, the music stopped with the October market crash (though the Fed
had taken the punch bowl away earlier in the year by raising interest rates
sharply in an effort to curb speculation). While the Fed was raising rates to rein
in Wall Street, the economy was already in recession (beginning in August
1929), as Milton Friedman and Anna Jacobson Schwartz have pointed out. The
Fed’s first policy mistake may well have been raising interest rates when the
broader economy needed more alcohol in the punch, not less. (The topic of using
monetary policy to curb speculative bubbles will be discussed more generally in
chapter 14.) At any rate, plummeting share prices caused more economic
damage, particularly to the banking system. Shareholders and brokerage firms
defaulted on their margin loans, leaving some banks insolvent. As always, the
whiff of insolvency prompted bank runs. Depositors with no exposure to the
market crash rushed to withdraw their savings, prompting more bank failures
(and more panicked depositors). In November 1930, 256 banks failed; another
352 failed the next month.
Several mechanisms spread the crisis across the Atlantic, beginning with
higher U.S. interest rates in 1928. One feature of the gold standard was that other
nations were forced to match tight U.S. monetary policy (high interest rates) or
risk the flight of gold to America. As noted earlier, if other countries did not
respond to tight monetary policy in the United States, higher American interest
rates would attract global capital, causing gold to flow to America. Countries
that lost significant quantities of gold would no longer have sufficient reserves to
exchange their currencies for gold at the promised rate, thereby forcing them off
the gold standard. Peter Temin (quoted at the beginning of the chapter) has
written, “It was the attempt to preserve the gold standard that produced the Great
Depression. These attempts imposed deflationary forces on the world economy
that were unprecedented in their strength and worldwide consistency.”
France played a curious role in gold hoarding. Dartmouth economist Doug
Irwin has written a provocative paper pointing out this unique role that France
played in the monetary contraction of the 1930s. (His not-so-subtle title: “Did
France Cause the Great Depression?”) French economic policies placed a
priority on the accumulation of gold beginning in the 1920s. As Irwin has
documented, France increased its share of global gold reserves from 7 percent in
1927 to 27 percent in 1932 while short-circuiting the economic processes that
would normally have rectified this imbalance.§ The whole point of a gold
standard is that gold exists in fixed quantity. If France has more, everyone else
must have less—and therefore less money supported by gold. As Irwin explains,
“This ‘gold hoarding’ created an artificial shortage of reserves and put other
countries under enormous deflationary pressure.” 11 (There is a bizarre historical
postscript here: Osama bin Laden had a copy of Irwin’s seemingly esoteric paper
in his compound when it was raided by U.S. Navy SEALs.)12
In 1931, Kreditanstalt, Austria’s largest bank, failed for reasons only
tenuously related to the problems brewing in the United States. Several large
German banks failed the following month. At that point, the banking systems on
both sides of the Atlantic were under stress. As Milton Friedman noted,
“Financial panic is no respecter of international boundaries.” 13 The economic
damage fed on itself. Businesses and consumers reacted to lower incomes and
punishingly high real interest rates by buying and investing less (thereby
lowering other people’s income). America’s Smoot-Hawley Tariff, passed in
1930, imposed punitive tariffs on imported goods; other nations responded in
kind, leading to a trade war that left all exporters worse off.
In the six months from August 1931 through January 1932, another 1,860
banks suspended operations. According to Friedman and Schwartz, the total
money stock was falling during this stretch at an annual rate of 31 percent—the
largest rate of decline in the fifty-three years they studied.14 Bank failures curtail
the money supply in three ways. Obviously there are fewer banks making loans.
At the same time, fearful consumers decide to keep more of their wealth in
currency; cash stashed under the mattress is money that cannot be loaned out via
the banking system. Finally, the banks that remain solvent tend to hold higher
reserves and lend more cautiously. All of these mechanisms starve the economy
of credit and do damage to businesses and households that might otherwise be
healthy.
Given falling prices and failing banks, Americans were keen to hold cash—
but often there just wasn’t enough of it. One feature of the Great Depression was
a chronic shortage of currency. The cash shortage was made worse when
Roosevelt declared a bank holiday on March 6, 1933, only thirty-six hours after
taking office.15 All banks were ordered closed for four days, which would later
be extended to a week.16 In the absence of currency, governments, companies,
and wealthy individuals issued an estimated $1 billion of scrip, which were just
fancy IOUs: on paper, leather, metal, wood, and even old tires. When the New
York Daily News sponsored a boxing match at Madison Square Garden in 1933,
the cash crunch was bad enough that promoters offered tickets in exchange for
anything worth roughly 50 cents, including spark plugs, nightgowns,
frankfurters, Bibles, jigsaw puzzles, and “golf knickers.” 17
By any metric, the Great Depression was bad. There is probably a more
descriptive adjective, but let’s let the numbers speak. Prices fell nearly 10
percent in both 1931 and 1932 and another 5 percent in 1933. Deflation was
crippling for those Americans, such as farmers, who were trying to pay fixed
debts by selling a product plummeting in price. The economy shrunk by roughly
a quarter between 1929 and 1933 (and 15 percent globally). Unemployment
reached 25 percent in the United States. Roughly 9,000 American banks failed
during the 1930s—some 4,000 in 1933 alone.18
Simply put, the Fed botched the job.¶ Just as runaway inflation must be
blamed on an irresponsible central bank, the same is true for deflation.19 One of
the major contributions by Milton Friedman and Anna Jacobson Schwartz was to
demonstrate compellingly that a shrinking money supply caused the massive
economic disruption of the early 1930s, not the other way around. (Friedman
deliberately referred to the period as the Great Contraction, not the Great
Depression.) Anna Jacobson Schwartz summarized their findings: “The Federal
Reserve System, by failing to act as a lender of last resort during a series of
banking panics, permitted a massive contraction of the money supply that was
responsible for the compression of aggregate demand, national income, and
employment.” 20
The United States rebounded only when the Roosevelt administration ended
the deflation by taking the country off the gold standard (depreciating the dollar
significantly) and introducing deposit insurance to stop the bank panics. As Ben
Bernanke has pointed out, “The two most successful things that Roosevelt did
were essentially offsetting the problems that the Fed created or at least
exacerbated by not fulfilling its responsibilities.” 21 But why the ineptitude?
What caused the Fed to kill the patient? Crop failures and drought caused some
economic damage in the 1930s, but for the most part the crisis was man-made—
a complete policy debacle.
Some historians blame poor leadership at the Federal Reserve. The system
was young and highly decentralized. American economist John Kenneth
Galbraith has described America’s central bank at the time as “a body of
startling incompetence.” 22 Because the Federal Reserve System was made up of
twelve regional banks, the Fed’s actual tools for implementing monetary policy
were decentralized as well. This structure caused confusion, inaction, and
frequent power struggles. The Roosevelt administration eventually restructured
the Federal Reserve, giving complete authority over monetary policy to the
Fed’s Open Market Committee in Washington, DC.#
The bigger problem, however, was ideological. Prominent leaders, inside the
Fed and out, were wedded to ideas that compounded the economic problems of
the Depression rather than ameliorating them. (Hence Peter Temin’s comparison
to treating Mozart with mercury.) Many influential thinkers at the time
subscribed to a “liquidationist theory” of the economy. They argued that the
economy had grown too fast in the 1920s and that a period of deflation was
necessary to restore balance. As imprudent families, farms, and firms were
wiped out by bankruptcy—with any remaining assets liquidated to pay off debts
—it would purge the rottenness and excesses from the system and create an
opportunity for a fresh start. As Ben Bernanke has explained, “This theory held
that the Depression was unfortunate but necessary.” 23
But the mother of all problems was the Fed’s strict adherence to the gold
standard, which limited its ability to save the banks and counteract falling prices.
The Fed could not create new money to act as the lender of last resort for failing
banks, as new money had to be backed by gold. The Fed could not lower interest
rates dramatically to counteract the shrinking economy, as that would have
caused outflows of gold. Other struggling nations faced the same constraint. In
the United States and around the world, policymakers protected their gold
supplies by keeping interest rates high—the opposite of what was necessary to
promote recovery. As Peter Temin concludes in his book Lessons from the Great
Depression, “Holding the industrial economies to the gold standard was about
the worst thing that could have been done.” 24
The countries that did not adhere to the gold standard managed to avoid the
Depression almost entirely (China, for instance). The countries that were first to
leave the gold standard (such as Britain) were the first to recover. The countries
that stayed on gold longest had the deepest and longest depressions (the United
States and Germany). In fact, as Temin has pointed out, not a single country was
able to sustain a meaningful recovery while still on the gold standard.
I suppose one could argue that clinging to a faulty cure is really just a
different form of incompetence. Semantics aside, we can agree that the Fed
failed in its core mission: delivering macroeconomic stability by keeping the
value of the currency consistent and protecting against financial panics. As Ben
Bernanke has written in his assessment of the Great Depression, “[The Fed] did
not use monetary policy aggressively to prevent deflation and the collapse in the
economy, so it failed in its economic stability function. And it did not adequately
perform its function as lender of last resort, allowing many bank failures and a
resulting contraction in credit and also in the money supply. So the Fed did not
fulfill its mission in that respect. These are key lessons, and we want to keep
these in mind as we consider how the Fed responded to the 2008–2009 financial
crisis.”
The point is not to heap scorn on dead policymakers. The point is to avoid
making the same mistakes. With that in mind, let’s take a look at the financial
crisis. In particular, what did Ben Bernanke—one of the world’s preeminent
scholars of the Great Depression—do differently?
By the time 2007 rolled around, investors around the world had borrowed
heavily to load up on extremely complex mortgage-backed securities in the
belief that they were safe investments. As with overvalued stocks in the 1920s,
the bursting of the real estate bubble was just the beginning of the problem. As
Ben Bernanke has pointed out,
If you put together all the subprime mortgages in the United States and assumed they were all
worthless, the total losses to the financial system would be about equivalent to one bad day in the
stock market: they were not very big. The problem was that they were distributed throughout
different securities and different places and nobody really knew where they were and who was
going to bear the losses.32
Now that real estate prices were collapsing, who owed what to whom? What
exactly was embedded in those complex securities that financial firms had been
selling for the past five years (and holding on their balance sheets)?
Sophisticated investors were staring at a pile of shredded newspaper, suddenly
interested in reading the stories.
That brings us to the short answer for what happened during the crisis: the
popping of the housing bubble created a modern-day bank run. This was not
customers standing outside the Bailey Building and Loan trying to get their
deposits back; FDIC insurance protected regular depositors. Instead, the leverage
and lack of transparency embedded in the complex mortgage-related securities
coursing through the financial system created a different kind of panic. In the
decades after the Great Depression, a shadow banking system evolved to provide
different ways for corporations to store cash or to borrow. One of these
innovations was the creation of sale and repurchase agreements, or “repos.”
These were very short loans, often overnight, made to creditworthy firms that
typically posted securities as collateral.
For all intents and purposes, the repo market functioned as a bank for large
firms. Remember, FDIC deposit insurance typically only insures an account up
to $250,000. As Gary Gorton has pointed out, “There is no checking account
insured by the FDIC if you want to deposit $100 million.” 33 Instead, firms need
a relatively safe, liquid place to park large amounts of cash while earning a
reasonable return. The repo market was just that.
For example, a mutual fund company like Vanguard, which buys stocks and
bonds on behalf of its account holders, might have several hundred million
dollars in cash on hand that it is preparing to invest in the stock or bond markets.
Rather than leaving this money in a file cabinet, or depositing it in a
conventional bank, Vanguard can loan the excess funds overnight for a small fee
to a firm that needs short-term capital. Many companies, particularly Wall Street
firms, use the repo market to finance their activities, rolling over the short-term
loans as needed. If you need to borrow $100 million, you can borrow that sum
for ten years, or you can borrow it over and over every day for ten years. The
latter is more flexible (though potentially more cumbersome), but during normal
times, there is not much difference.‡‡ Firms borrowing in the repo market
posted collateral for the full amount of the loan; asset-backed securities, such as
the mortgage-related bonds we have been discussing, were a typical form of
collateral.
Maybe you can now see where this is going. As I’ve noted earlier, if it lends
like a bank, and it borrows like a bank, it’s a bank. It just might not be insured
like a bank. By the 2000s, the whole shadow banking system had the
fundamental vulnerabilities of any banking system without the protections put in
place after the Great Depression. In fact, many of these institutions had been
designed explicitly to avoid those protections and their associated costs. (For
example, banks pay a fee on their deposits to be eligible for FDIC insurance.)
The repo market was essentially a bank. Firms lending into the repo market
are like depositors. They can get their money whenever they want it. But rather
than rushing to the bank to make a withdrawal, they just stop renewing the
overnight loans (or they demand much more collateral). This is when borrowing
$100 million for ten years starts to feel very different than borrowing $100
million every day over and over again. Firms like Bear Stearns and Lehman
Brothers were borrowing short-term in the repo market to finance long-term
operations. It would be like paying off your house by refinancing the mortgage
every evening; if the value of the property drops, that refinancing gets a lot
harder.
When lenders became skittish about the value of the mortgage-related
securities being posted as collateral, bad things began to happen. Some lenders
refused to renew repo loans. Others demanded more collateral (e.g., posting
$120 million in securities for a $100 million loan). Bear Stearns and others
began to find themselves short of capital. To raise funds, they were forced to sell
assets (such as mortgage-backed securities), driving down the price of those
assets and causing more financial distress throughout the system. It was
impossible to gauge the exposure of different firms to this financial distress
because of the way mortgage debt, particularly subprime debt, had been
packaged, sliced, and diced. Gary Gorton compares the role that bad mortgage
debt played in the crisis to the discovery of ground beef contaminated by E. coli.
He explained in his testimony before the Financial Crisis Inquiry Commission,
“Millions of pounds of ground beef might be recalled because the location of a
small amount of E. coli is not known for sure. If the government did not know
which ground beef possibly contained the E. coli, there would be a panic: people
would stop eating ground beef. If we all stopped eating hamburgers for a month,
or a year, it would be a big problem for McDonald’s, Burger King, Wendy’s,
and so on. They would go bankrupt. That’s what happened.” 34
Nobody wanted to be holding the contaminated ground beef, or lending to
anyone holding contaminated ground beef, or entering into trades with firms that
might have exposure to contaminated ground beef. Former Fed governor Kevin
Warsh has said that the “Panic of 2008” is the most apt description of what
happened. Yes, a real estate bubble set it in motion. Yes, irresponsible lending
and the securitization of bad loans amplified and spread the problem. But at the
end of the day, this was an old-fashioned financial panic. Customers were not
lined up outside of banks; instead firms and institutional investors were
demanding their cash back from financial firms like Bear Stearns, Lehman
Brothers, Citibank, and the other names you’ve seen in the news. As one witness
told the Financial Crisis Inquiry Commission, “The repo market, I mean it
functioned fine up until one day it just didn’t function.” 35
The Financial Crisis Inquiry Commission spread the blame widely: shoddy
mortgage lending; too many fancy derivatives; irresponsible ratings agencies;
massive failures in corporate governance and risk management; a breakdown of
ethics; widespread regulatory failures; and a toxic combination of “excessive
borrowing and risky investments.”
But the most powerful statement in the whole report is the commission’s first
finding: “We conclude this financial crisis was avoidable.”§§36
As with the Great Depression, adverse feedback loops exacerbated the
economic damage. Troubled banks made fewer loans, which starved the private
sector of credit. Struggling firms laid off workers and postponed capital
investments. Unemployed workers had trouble paying their mortgages,
compounding the damage being done by mortgage-related securities. Banks sold
homes in foreclosure, driving real estate prices down further and making it
harder for other households to refinance or sell their homes with some equity
intact. Even healthy households and firms hoarded cash and postponed
purchases, dragging down industries like autos and hospitality. More workers
were laid off. And so on and so forth. You remember all this, right?
Prevent the crisis of 2023. In a lecture after the financial crisis to students at
George Washington University, Ben Bernanke noted, “The Fed made mistakes
in supervision and regulation.” This is certainly a nominee for understatement of
the decade. The Financial Crisis Inquiry Report was more expansive in its
criticism, pointing out that the Fed was the only government entity empowered
to set prudent mortgage lending standards before the crisis, which it failed to
do.43 The Fed was not alone in dereliction of duty, of course. The Financial
Crisis Inquiry Commission concluded that “widespread failures in financial
regulation and supervision proved devastating to the stability of the nation’s
financial markets.” 44 Ouch.
Ever since, politicians have been falling all over themselves to nail the barn
door shut. I’ve already read the 500-page Financial Crisis Inquiry Report. I
don’t have the energy to read the 2,300-page Dodd-Frank Act, which was
Washington’s response to the crisis. To be fair, financial panics erupt with
striking frequency, so nailing the barn door shut is not a bad place to start. Dodd-
Frank contains provisions to protect against many of the things that went wrong
in 2008: a consumer protection bureau to protect against predatory financial
products; higher capital requirements to strengthen financial institutions; more
transparency around financial derivatives to make it easier to gauge their risk;
and so on. Perhaps most important, Dodd-Frank created the Financial Stability
Oversight Council, composed of the heads of the major federal financial
regulatory agencies, to look across the financial system and identify threats to its
stability. The Federal Deposit Insurance Corporation (FDIC), the independent
government agency that insures and monitors banks, was granted “orderly
liquidation authority” for large financial institutions. This gives the FDIC the
power to take over and liquidate large financial firms—including those
previously thought too big to fail—in an orderly and efficient way, just as it has
historically done with insolvent banks.
Broadly speaking, Dodd-Frank is a logical response to what went wrong in
2008. That said, regulation is notorious for producing unintended consequences;
financial firms are clever at finding ways to avoid doing what they have been
told. Whether Congress has prevented the next crisis—or perhaps even made it
more likely—is an open question.
The Critics
On May 4, 2009, the New York Times published two opinion pieces by
prominent economists: one by columnist and Princeton professor Paul Krugman
and one by Carnegie Mellon economist Allan Meltzer. These are both very smart
guys with a deep understanding of monetary policy. And yet their prescriptions
were diametrically opposed. Krugman warned that falling wages could worsen
household debt, dampen the recovery, and lead to deflation and economic
stagnation. He called for more economic stimulus. The piece concluded
ominously, “The risk that America will turn into Japan—that we’ll face years of
deflation and stagnation—seems, if anything, to be rising.” 45 Anyone reading
that piece would be inclined to call Ben Bernanke’s personal line at the Fed and
demand some Super Quantitative Easing (SQE).
But on the very same op-ed page, Meltzer had a different take on the
situation. He accused the Fed of going far beyond its mandate in ways that were
bound to lead to inflation. He wrote, “Independent central banks don’t do what
this Fed has done.” In fact, he argued that inflation, if measured correctly, was
already under way. The piece concluded ominously, “For the next few years,
[the Federal Reserve] cannot neglect rising inflation.” 46 At that point, you would
call back on Bernanke’s private line: “Uh, yeah, I just left a message calling for
some Super Quantitative Easing. Is it too late to cancel that order?”
A 2012 piece on Ben Bernanke in The Atlantic noted, “The left hates him.
The right hates him even more.” 47 Why the rancor? It all boils down to a simple
question, with profound consequences: too much, too little, or just right? The
Fed gets generally high marks for its immediate response to the crisis,
particularly on the liquidity front. But as time has gone on—up to the current
tenure of Janet Yellen—the question on the monetary policy front has become
“How much monetary stimulus is too much?”
Critics from the political left have tended to be most vociferous in calling for
more aggressive monetary easing to put Americans back to work, though they
are not alone. The Economist (typically right-leaning on economic issues)
warned in late 2014 that “ending quantitative easing may be penny-wise, pound
foolish.” This camp has argued steadily that the global recovery is still weak and
precarious. Unemployment is higher than it need be and wages are more or less
stagnant. The Fed and other central banks around the world need to keep
stepping on the gas until the recovery is stronger. Adam Posen, American
member of the Monetary Policy Committee for the Bank of England, wrote in
2011, long after the worst of the crisis was over, “Throughout modern economic
history, whether in Western Europe in the 1920s, in the United States in the
1930s, or in Japan in the 1990s, every major financial crisis has been followed
by premature abandonment—if not reversal—of the stimulus policies that are
necessary for sustained recovery. Sadly, the world appears to be repeating this
mistake.” 48
On the other hand, a number of conservative economists and investors wrote
an open letter to Ben Bernanke in 2010 with the following admonition: “We
believe the Federal Reserve’s large-scale asset purchase plan (so-called
“quantitative easing”) should be reconsidered and discontinued. We do not
believe such a plan is necessary or advisable under current circumstances. The
planned asset purchases risk currency debasement and inflation, and we do not
think they will achieve the Fed’s objective of promoting employment.” 49
And Now?
So far, the inflation fears have been unfounded. Still, it’s too early to declare
victory. The outcome will all hinge on one thing: reserves. American banks are
sitting on a staggering $2.7 trillion in reserves kept on account at the Fed.50 In
other words, a large portion of the money the Fed has been pumping into the
economy is sitting idle in the equivalent of bank vaults. Critics of quantitative
easing, particularly the later rounds, fear that if banks begin suddenly loaning out
these reserves, the money supply will explode and prices will shoot up. Fed
officials insist that there are many tools for managing the reserves and
“unwinding” the Fed balance sheet (selling off all the securities the Fed
accumulated during the crisis). Time will tell whether in fighting this crisis the
Fed has laid the groundwork for another. For now, one can say unequivocally
that Ben Bernanke did not make the mistakes of the Great Depression.
Will an excessively slow recovery turn America into Japan, as Paul Krugman
has warned? I don’t know. But that does raise a great question: What the heck
has been happening in Japan for the last two decades?
________
* Mortgage-backed securities are an asset backed by a bundle of mortgages. For example, an investment
bank can buy a bundle of one thousand mortgages (from the banks that made the loans), package them into
a single security, and then sell that security to an investor (earning a fee in the process). The investor who
owns the mortgage-backed security receives the payments from the underlying mortgages as they are paid;
of course the investor also inherits the risk of missed payments or default. As more households have trouble
paying their mortgages, the value of mortgage-backed securities can drop precipitously. Asset-backed
securities can also be created using bundles of car loans, credit card debt, or other forms of debt that
produce a steady stream of future payments.
† The economy went into recession at the end of 2007, but the events that we now associate with the
beginning of the financial crisis did not start until 2008.
‡ These are the assets that the Fed accumulated during the crisis as it injected new money into the financial
system in exchange for government bonds and other securities.
§ France was “sterilizing” its growing gold reserves, meaning that the rising stock of gold was not used to
support a concomitant rise in the stock of money, as is the usual process. Normally this process is self-
correcting. Rising prices in France would have made imports cheaper and exports more expensive, which
would have affected France’s trade balance in a way that caused gold to start flowing out of the country
again. Instead, the French government would take measures such as selling government bonds to “sop up”
the extra money that would have been created by the large gold inflows.
¶ Doug Irwin offers a reasonable defense of the Fed, which is that it had no congressional mandate at the
time. There was no clearly articulated description of what the Fed was supposed to be doing or how its
performance should be measured. If the goal was to stay on the gold standard, the Fed achieved that until
Roosevelt and Congress changed the policy.
# As was described in chapter 5, the Federal Open Market Committee (FOMC) comprises the seven
presidentially appointed governors of the Federal Reserve Board, the president of the Federal Reserve Bank
of New York, and four of the other eleven Reserve Bank presidents on a rotating basis.
** Their full names are Federal National Mortgage Association (Fannie Mae) and Federal Home Loan
Mortgage Corporation (Freddie Mac).
†† The capital was an $85 billion loan from the Federal Reserve. As part of the deal, the federal government
took a 79.9 percent ownership stake in AIG.
‡‡ In theory, the interest rate on a ten-year loan should be the same as the expected average rate on a series
of ten consecutive one-year loans. Each one-year loan is the expected average rate on 365 overnight loans.
§§ The FCIC concluded that Fannie Mae and Freddy Mac contributed to the crisis but were not a primary
cause. Also, the commission concluded that the Community Reinvestment Act, a 1977 law designed to
promote bank lending in low-income neighborhoods, was “not a significant factor in subprime lending or
the crisis.” I point this out because one convenient if wholly inaccurate version of the financial crisis is that
bad government policy caused the private sector to go off the rails. The government certainly fell down on
the regulatory front, but it is a wholly inaccurate interpretation to suggest that the financial crisis was the
result of excessive government intervention or affordable housing goals gone awry. As this chapter should
amply demonstrate, the private sector messed up over and over again.
¶¶ As an aside, let me say that whoever named the various Fed interventions—TALF and QE (and TARP
over at Treasury)—should be imprisoned with the gold in the vaults beneath the Federal Reserve Bank of
New York. The good news is that one could actually live down there. The vaults are locked every night, but
one quaint tradition is that sandwiches are placed inside the vault at closing time in case anyone is
inadvertently locked inside overnight.
CHAPTER 10
Japan
Yes, nobody wants to be Japan, the fallen angel that went from one of the fastest growing economies
in the world for more than three decades to one that has slowed to a crawl for the past 18 years. No
one wants to live with the trauma of the deflation (falling prices) that Japan has repeatedly
experienced.
—Kenneth Rogoff, Harvard economist and former chief economist for the International Monetary Fund,
20101
Japan in the 1990s wrote the book on how policy stumbles can tip a modern economy into deflation.
Now it is adding a chapter on how to pull out.
—Jacob Schlesinger, Wall Street Journal, 20142
Suppose you run into a friend who has just returned from the doctor’s office.
Your friend reports that the doctor has told him repeatedly to gain more weight,
yet he keeps failing. Each appointment they set a target together—another five
pounds. And each appointment he disappoints, often losing a pound or two. He
just can’t seem to pull off the weight gain that the doctor recommends. At times,
your friend questions whether it is even possible, as he has developed all kinds
of habits that seem to preclude weight gain (running uncomfortably long
distances, eating nasty bran muffins, wearing spandex). You explain that gaining
weight is remarkably easy—and fun, too. In fact, you have excelled at it for most
of your adult life. Pizza helps. Ice cream is really good. And popcorn—don’t
skimp on the butter. Never drink light beer. Fry things. Always have a snack
before bed. In general, if it tastes good, eat it.
Your friend commits to gaining weight and then misses the goal once again.
Finally, in exasperation (having recently gained twelve pounds yourself), you
exclaim, “It’s not hard to gain weight! Look around, most of the country has the
opposite problem. Every diet book that’s ever been written is about losing
weight. Every food that tastes good has lots of calories. This should not be a
problem!” Your belly jiggles slightly as you yell this last bit. The stress of the
situation makes you crave a chocolate donut.
Ben Bernanke gave this speech in 2002. Okay, not exactly this speech. But if
one recognizes that losing weight is a metaphor for deflation, he gave this
speech. In the history of fiat currencies—the era in which governments could
make more money at will—the scourge has always been inflation. Irresponsible
governments can pay their bills by creating more money. The resulting inflation
devalues the existing government debt. In the process, of course, the rising
prices make the citizens using the currency worse off. The ability to print extra
money is the sundae bar of monetary policy—hard to resist.
If Zimbabwe is the poster child for this irresponsible temptation—heaping
caramel on top of hot fudge—Japan is the curious exception. For over two
decades, Japan has struggled with deflation and its attendant economic costs.
When prices are falling, real interest rates can be relatively high, even when
nominal rates look cheap. Consumers postpone purchases to wait for lower
prices (which forces retailers to cut prices). Debts grow in real value. Assets like
real estate fall in price, making households less wealthy and harming banks
holding those assets as collateral. An International Monetary Fund report
concluded in 2003, “Japan’s ongoing experience is a warning to policymakers
elsewhere about the costs of even mild deflation and the need to prevent it from
manifesting rather than face the challenge of curing it. For Japan, the lesson is
clear: deflation, however mild, continues to impose significant costs on the
economy. Policies to revive inflation expectations are therefore critically
needed.” 3
For years, economists have admonished Japan to induce inflation, or at least
stop prices from falling. Like gaining weight, it should be really, really easy. Just
do the things that would be irresponsible under other circumstances. Print more
money and find a way to put it in the hands of consumers. This is the monetary
policy equivalent of making a third trip to the buffet. As you push an old lady
out of the way to take the last eggs Benedict, you can say apologetically, “Sorry,
my doctor says I need the hollandaise sauce.”
When Ben Bernanke addressed the National Economists Club (yes, such a
group really exists) in 2002, his major theme was why Japanese-type deflation
could never afflict the United States. He spoke like a central banker: “Under a
fiat (that is, paper) money system, a government (in practice, the central bank in
cooperation with other agencies) should always be able to generate increased
nominal spending and inflation, even when the short-term interest rate is at
zero.” Stilted language notwithstanding, Bernanke’s speech may be one of the
most consequential talks ever delivered by a Federal Reserve official. He pointed
out that the Fed can always combat falling prices by increasing the supply of
dollars (or threatening to do so). For example, the government could cut taxes,
with the Fed buying up the equivalent amount of government debt, thereby
financing the tax cut with “new money.” Bernanke told his audience, “A money-
financed tax cut is essentially equivalent to Milton Friedman’s famous
‘helicopter drop’ of money.” 4 It was at that moment that Bernanke earned the
nickname Helicopter Ben.
Bernanke went on to explain that a central bank would not “run out of
ammunition” even when short-term interest rates hit zero—the zero bound that
has been mentioned previously. He described a series of nontraditional tools for
stimulating the economy: buying longer-term government bonds; committing to
hold short-term rates low for a specified amount of time; lending to banks
against a wide range of private assets deemed eligible as collateral, including
mortgages; and so on. He asserted, “A principal message of my talk today is that
a central bank whose accustomed policy rate has been forced down to zero has
most definitely not run out of ammunition.” The tools he described were the
playbook the Fed used to combat the financial crisis several years later. It’s all in
that speech.
Bernanke left one crucial question unanswered: What was happening in
Japan? This has become one of the great macroeconomic puzzles of our time.
Japan’s economic stagnation, beginning with the popping of a massive real
estate and stock bubble in 1989, has dragged on for more than two decades.
(What was originally described as the “lost decade” has now become the lost
decades.) In 2011, the Wall Street Journal commented, “Japan has been a puzzle
to economists for years, like a patient with a low-grade fever that doesn’t get
worse, doesn’t get better and won’t go away.” 5
The causes of the economic malaise are complex, and Japan is still one of the
world’s richest countries, but nearly any analysis of Japan’s travails has
concluded that deflation has compounded the economic malaise. Rising prices
might not cure all that ails the Japanese economy, but ending the deflation would
help, perhaps significantly so. If creating inflation is so easy in an era of fiat
money, why can’t (or won’t) the Japanese central bank engineer higher prices?
Just order a milkshake with that piece of pie.
Then again, perhaps conventional economics has it wrong. The former head
of the Bank of Japan (the central bank) insisted that trying to create inflation
given Japan’s unique demographics was like “punching air.” 6 (His critics
countered that expectations matter; if the central bank chief does not believe that
prices will rise, no one else will either.) Japan is a rich country with a shrinking
and aging population, a high level of public debt, and organized political groups
whose interests do not necessarily align with the health of the overall economy.
(Deflation tends to be good for savers and old people on fixed incomes.) Given
that much of the developed world will eventually resemble Japan (slow growth,
lots of old people), we ought to look carefully at the lost decades and the role
that monetary policy and the banking system have played in losing them.
Yet now we get to the point where Japan’s economic travails become unique.
Policymakers most certainly did not deal with it. Instead, the “zombie firms”
were born.
So far, Prime Minister Abe’s arrows seem to be wobbly but generally heading
for their targets. Japan expert Adam Posen wrote at the end of 2014, “In essence,
the Japanese recovery is going right even if it is not going well.” 35 There have
been glimmers of inflation. Japan’s consumer price index, excluding fresh food
and the impact of a new, higher consumption tax, rose about 1.5 percent by the
middle of 2014.36 Inflation slipped back to zero in early 2015, in part due to
falling global oil prices.37
The Council on Foreign Relations offered its assessment in a 2015 briefing:
“So far, the success of these ‘three arrows’ is unclear. Despite massive
government stimulus, Japan fell back into recession in the second quarter of
2014. Inflation initially inched upwards but is now falling on the back of
plunging global oil prices, and the country may again face deflation in 2015.
Concerns over ballooning debt remain, and many doubt that Abe can muster the
political will for difficult structural reforms—some of which remain deeply
unpopular among certain industries—even after his coalition’s strong showing in
early elections called in December 2014.” 38
Financial crises are bad. As Paul Volcker pointed out to me (while chuckling, if
I recall correctly), “The first lesson is don’t permit two huge bubbles to be
created in the first place.” 41 The real estate and stock market crashes created an
economic mess that was going to be hard to clean up no matter how
policymakers responded. Better to prevent those booms and busts in the first
place. Ben Bernanke made the same basic point when he explained in 2002 why
and how the United States could resist a Japanese-style crisis: “The Fed should
and does use its regulatory and supervisory powers to ensure that the financial
system will remain resilient if financial conditions change rapidly.” 42 But wait a
minute: while Bernanke was giving that speech, the real estate bubble in the
United States was just gaining steam. The interesting question—based on both
the Japanese and the U.S. experiences—is whether a central bank can recognize
a bubble, and if so, what ought to be done about it. This is one of the major
challenges in central banking and will come up again in chapter 14. In any event,
if a bubble does burst, clean up the mess, particularly the banks and related
institutions. As one Japan expert points out, “There is nothing worse than having
a crippled financial sector hanging over your head.” 43 This is a message that
American policymakers took to heart during the 2008 financial crisis.
Deflation is bad enough that central banks ought to err on the side of
inflation. The problem with perfect price stability—zero inflation—is twofold.
First, even a tiny bump can turn it into deflation, setting in motion a cascade of
other problems. Second, it gives the central bank less room to maneuver real
interest rates. If inflation is 2 percent and the nominal interest rate is 1 percent,
the real interest rate is negative 1 percent—providing a robust monetary
stimulus. The central bank cannot generate negative real interest rates when
inflation is zero or negative. For these reasons, the Fed and other central banks
now typically keep a buffer zone, a target inflation rate of 1 to 3 percent, rather
than aiming for zero.
________
* That said, there was an increase in the sale of safes, so savers could stash cash at home. With prices
falling, there is no penalty for hoarding currency. Money stuffed in a safe gains value over time, rather than
losing purchasing power as it would when prices are rising.
“To Lose One Decade May Be Misfortune . . .” Economist, December 30, 2009.
† From a practical standpoint, this would be accomplished by “monetizing” government debt. The
government would issue bonds to pay for new spending. Rather than selling the bonds to the public, where
they would add to government debt, the bonds would instead be sold to the Bank of Japan in exchange for
new money. In essence, the government would be using new money to pay its bills. Normally that is a
wildly irresponsible practice; in Japan, economists argued, a little more irresponsibility would be a good
thing.
CHAPTER 11
The Euro
We argue that the gold standard and the euro share the attributes of the young lady described by
Henry Wadsworth Longfellow:
“There was a little girl, who had a little curl
Right in the middle of her forehead,
And when she was good, she was very, very good.
But when she was bad she was horrid.”
—Barry Eichengreen, University of California–Berkeley, and Peter Temin, MIT1
What is the appropriate domain of a currency area? It might seem at first that the question is purely
academic since it hardly appears within the realm of political feasibility that national currencies
would ever be abandoned in favor of any other arrangement.
—Robert Mundell, 1961—thirty years before the creation of the euro2
On January 1, 2002, the French franc went out of existence. And the German
deutsche mark. And the Italian lira. At the stroke of midnight, twelve of the
countries in the European Union (EU) adopted a common currency, the euro.
(The official launch was three years earlier; bank deposits and electronic
transfers were denominated in euros beginning in 1999.) The ATM machines
dispensed crisp new euro notes. Prices across the eurozone were posted in the
new transnational currency. A new European Central Bank, the ECB, was
created to conduct monetary policy for all of the participating nations with a
strict mandate to maintain price stability (defined as an inflation rate “below, but
close to, 2% over the medium term”).3 The national central banks, such as the
German Bundesbank, continued to operate in their regulatory capacity and as a
source of support for the ECB. The launch of the euro was unprecedented in its
scale and ambition. The euro replaced local currencies for more than 300 million
people.4 One news account compared the launch of the euro to the Wright
Brothers, who proved that something heavier than air could fly, because the euro
proved monetary union was possible without political union.5 By 2015, nineteen
countries in the European Union were members of the so-called eurozone.
Several small countries outside of the EU have also adopted the euro; many
other nations have pegged their currencies to it.
A Happy Beginning
The launch of a common currency for much of Europe was heralded with all the
excitement of a marriage. After all, these were not just any countries. One could
say, literally and figuratively, that the twentieth century had been a bloody
disaster for many of them: Germany, France, Italy, Belgium. (Nor were many of
the previous centuries marked by peace and cooperation.) The nations that had
faced one another from the trenches of World War I, and then again as Hitler
terrorized the world, were now linked in a bold economic endeavor. This
marriage was an act of reconciliation designed to move Europe aggressively
toward the vision of Jean Monnet, the French diplomat who envisioned a unified
Europe in the years after the calamity of World War II.
The euro was a significant step in an ongoing journey of European
integration. Less than a decade after the end of World War II, a handful of
European states, including France and West Germany, created the European
Coal and Steel Community to share natural resources among participating
nations. One explicit goal was minimizing future armed conflict. Other
supranational organizations would follow, each expanding economic and
political cooperation across the continent. The European Economic Community
(1958) established a free trade zone among the member nations and imposed a
common tariff for goods imported to the zone. The European Rate Mechanism
(1979) created a set of pegged exchange rates with narrow bands to minimize
exchange rate volatility among member nations. In 1992, the Maastricht Treaty
created the European Union (EU), an organization of twenty-eight states that
share a set of common laws (regarding labor, food safety, and so on); free
movement of people, goods, services, and capital throughout the member states;
and assorted supranational political institutions, such as the European
Parliament.
In other words, these countries had been dating for a long time. A common
currency would consummate the relationship. As Paul Krugman has written,
“The creation of the euro was proclaimed the logical next step in this process.
Once again, economic growth would be fostered with actions that also reinforced
European unity.” 6 A single currency would facilitate European trade and
promote transparency in pricing. (It’s much easier to spot price differences
across international boundaries when comparable goods are priced in the same
currency.) In the eyes of some participants, the euro would lead naturally to even
closer political cooperation. In particular, it would anchor a bigger
(postreunification), powerful Germany firmly within a strong Europe. For their
part, the Germans were assured that the new European Central Bank would have
the same passion for fighting inflation—even the barest hint of it—that had
characterized Germany’s central bank, the Bundesbank.
As with any marriage, especially when the families have a history of bad
blood, there were some misgivings. Milton Friedman argued that the creation of
the euro would cause political tensions, rather than ameliorate them. To
Friedman, the nations proposing union did not have enough in common to share
the euro. He wrote two years before the euro’s launch, “As of today, a subgroup
of the European Union—perhaps Germany, the Benelux countries, and Austria
—come closer to satisfying the conditions favorable to a common currency than
does the EU as a whole.” A single currency would “exacerbate political tensions
by converting divergent shocks that could have been readily accommodated by
exchange rate changes into divisive political issues.” 7
That’s pretty much what happened. For some time now, Greece and
Germany have been hurling insults at each other. The group of southern
European nations struggling under the constraints of the euro—Portugal, Italy,
Greece, and Spain—has been branded the PIGS, which is never a good sign.*
(This is an insulting play on investor shorthand for Brazil, Russia, India, China,
and South Africa: the BRICS.) There is risk that the euro will collapse, perhaps
at great cost to the global economy. Whatever the outcome, the honeymoon is
clearly over. Long over. Greece and Germany have grown so rancorous that
Greek politicians have demanded reparations for the Nazi occupation of Greece
during World War II.8 The possibility of Greece exiting the euro has even
acquired its own name: “Grexit.” As when any relationship goes sour, people are
now wondering, “Why didn’t we listen?”
But I am getting ahead of myself. The launch of the euro was a time of
excitement and economic promise. There was no prenuptial agreement. None of
the treaties creating the European Union and the euro made any contingency for
dissolving the common currency. This was a deliberate act. Money and finance
are built on confidence. Negotiating the dissolution of the euro at the beginning
of the endeavor would have suggested a lack of commitment to its success
(which is the same reason some people do not like prenuptial agreements). Sure
enough, in the early years, it was a happy union. The family grew as additional
countries joined: Greece, Cyprus, Estonia, Latvia, Slovenia, and others. The euro
fell in value initially but then climbed steadily, making it a candidate to replace,
or at least supplement, the dollar as the world’s reserve currency.
Paul Krugman accurately summarizes the two tragedies of how things have
turned out. First, the euro has, so far, been a case of good intentions gone bad.
And second, many of the signs of trouble—basic economics, really—were there
at the beginning. He writes, “The tragedy of the Euromess is that the creation of
the euro was supposed to be the finest moment in a grand and noble undertaking:
the generations-long effort to bring peace, democracy and shared prosperity to a
once and frequently war-torn continent. But the architects of the euro, caught up
in their project’s sweep and romance, chose to ignore the mundane difficulties a
shared currency would predictably encounter—to ignore warnings, which were
issued right from the beginning, that Europe lacked the institutions needed to
make a common currency workable.” 36
Yes, time will tell whether the euro is a bold step forward in monetary policy
or a failed experiment. So far, it has been both. Sharing a currency is a hard
thing to do. But here is the weird thing: not sharing a currency is hard, too. That
is one of the major sources of friction between the United States and China at the
moment.
________
* Ireland, another country on the periphery of Europe that eventually needed a bailout, is sometimes
included, making it PIIGS.
† They were definitely dating at one point and went to a dance together. But then they supposedly broke up,
though they still go hiking together and he parks at our house before school almost every day. I really have
no idea what is going on. In any event, he is a very nice and intelligent guy who asks good questions about
monetary policy.
‡ Obviously, there is a range of options in between.
§ Note to anyone with a filthy mind: fracking is a process of horizontal drilling used to release natural gas.
¶ In 2011, the European Banking Authority was established with the authority to overrule national
regulators if necessary to protect the broader EU banking system.
# For example, if inflation were 4 percent across the eurozone, and Greek firms held nominal wages
constant, that would amount to a 4 percent real pay cut—which would help firms stay competitive. Inflation
also lessens the real value of outstanding government debt by allowing countries to pay back their debts
with money that is worth less—the equivalent of reducing the outstanding balance in real terms.
** The annual difference between what the government was spending and what it was collecting in
revenues.
CHAPTER 12
The Chinese are subsidizing the American way of life. Are we playing them for suckers—or are they
playing us?
—James Fallows, The Atlantic, 2008
The U.S. and Chinese economies—the world’s largest and the fastest-growing major economy,
respectively—have become inextricably intertwined, locked in a kind of codependency that neither
side thinks is particularly healthy, but which for the moment neither will move to break.”
—Washington Post, on the eve of President Obama’s first official visit to China, 20091
In November 2009, President Obama made his first visit to China. In the
months prior to that meeting, the New York Times reported that Chinese officials
were asking their American counterparts extensive and detailed questions about
the health care legislation that would eventually become the Affordable Care
Act, or “Obamacare.” Obviously Obamacare does not affect health care delivery
in China, so why were Chinese bureaucrats so interested in the arcane details of
the legislation making its way through Congress? There are numerous potential
explanations.
One explanation is that the Chinese officials were studying health care
reform in order to better make small talk with President Obama when he arrived
in Beijing. Any good host finds out what his guest’s interests are and then steers
the conversation in that direction. During a lull in the conversation at the
diplomatic banquet, for example, a Chinese official might say something like, “I
was impressed with the incentives for community health organizations to
economize on their use of mammography machines, as was described in the
footnote on page 731 of your health care legislation.” How could the president
not be impressed and engaged by such attention to his legislative priorities? So
that is one possibility.
Another explanation is that the Chinese officials had a deep intellectual
interest in health care. How would a private, insurance-based system with a
personal mandate compare in terms of access and cost to a single-payer system
like Canada and Britain? These are the kinds of things that my economics
colleagues discuss (voluntarily and with enthusiasm) over lunch. Health care is a
remarkably difficult public policy challenge, in the United States and around the
world. The legislation that would become the Affordable Care Act was complex,
unique, and transformative. How could any policy wonk not be interested in the
details? So maybe the Chinese were fascinated by the policy nuances of health
care, like my work colleagues.
No. It turns out neither of these explanations is anywhere near correct.
Chinese officials were interested in American health care reform for the same
reason that the bank holding the mortgages on your home, vacation home, and
two cars would be interested in the new forty-seven-foot boat you plan to buy. It
has nothing to do with boating or fishing or the cool captain’s hat you bought to
wear when taking the helm. The bank wants to know whether you can pay back
your loans, especially now that you are laying out more cash on a very
expensive boat. The New York Times article describing the health care briefing in
Beijing went on to explain, “Chinese officials expect that they will help finance
whatever Congress and the White House settle on, mostly through buying
Treasury debt, and like any banker, they wanted evidence that the United States
had a plan to pay them back.” 2
At that time, China owned roughly $800 billion in U.S. Treasury debt. Now
it is closer to $1.3 trillion. China is the American government’s largest foreign
creditor.3 There are drawbacks to being dependent on a large lender. (Ask the
Greek government about this.) Someone who regularly lends you funds can use
that financing as a source of leverage. Might American dependence on Chinese
lending be used as a diplomatic weapon in areas of disagreement, such as human
rights or Taiwan or control of the South China Sea? On the other hand, as John
Maynard Keynes once pointed out, “If you owe your bank manager a thousand
pounds, you are at his mercy. If you owe him a million pounds, he is at your
mercy.” And if you owe him $1.3 trillion, he is practically a prisoner, as some
Chinese officials have asserted.4 America may be dependent on China for new
lending, but China is dependent on America to pay back more than a trillion
dollars.* In 2013, when Congress reached a budget impasse and the Republicans
were threatening not to raise the debt ceiling—which technically could have led
to a default on some U.S. government debt—the response by the Chinese
government was shrill. The official Xinhua news agency issued a statement that
read like it had been drafted by a hysterical teenager. It called for a replacement
of the dollar as the world’s reserve currency (not necessarily by the yuan—but
by something!) and a “de-Americanized world.” A New York Times headline
captured the bigger picture: “Seeing Its Own Money at Risk, China Rails at
U.S.” 5
The two nations are locked in a curious embrace, the unhealthy
codependency described in the quote at the outset of the chapter. China has been
running vast trade surpluses—selling more to the rest of the world than it buys.
The United States is China’s largest market for those exports, causing Chinese
firms to accumulate huge stocks of American dollars.6 If those dollars were
routinely spent on American goods and services, the rest of this chapter would
be unnecessary. In that case, Chinese exports to the United States would be
broadly equivalent to U.S. exports to China. That’s generally how trade works:
you swap things of roughly equivalent value. Both sides are left better off
because they prefer what they are getting to what they are giving up. Just watch
little kids in a school lunchroom—potato chips for a chocolate chip cookie, and
everyone leaves smiling.†
The U.S.–China trade relationship is more imbalanced; Chinese exports to
America are not offset by exports crossing the Pacific in the other direction. In
fact, the usual mechanism for ameliorating trade imbalances has been short-
circuited. What would normally happen is that Chinese firms that have
accumulated surplus dollars would convert those dollars into yuan to spend at
home. If China is running a chronic trade surplus—selling more stuff to America
than America sells to China—there will be more firms looking to sell dollars for
yuan on the foreign exchange market than the other way around. What happens
when the butcher has more pork chops than customers want to buy? He lowers
the price until consumers are induced to buy all the chops in the cooler. In the
U.S.–China case, the surplus dollars are the product that needs to be moved; the
firms selling dollars for yuan lower their price until they can move all the
merchandise. Of course, the price is the exchange rate with the yuan. That is the
self-correcting mechanism. As the dollar depreciates relative to the yuan,
American exports to China get cheaper; Chinese exports to the United States
become more expensive; and the changing relative prices work to fix the original
trade imbalance. Floating exchange rates have the potential to naturally
ameliorate trade imbalances.
Alas, the last paragraph used phrases like “under normal circumstances” and
“floating exchange rates.” The U.S.–China relationship is not normal; the
Chinese yuan does not float. Over the last several decades, China has
consistently run large current account surpluses with the United States. (The
current account consists of the trade balance plus some other flows of funds
between the countries, such as remittances and income from foreign
investments.) Despite the perennially lopsided trade relationship, the yuan has
not appreciated relative to the dollar as sharply as some observers feel it ought
to. (I’ll come back to those observers—including some very angry members of
Congress—in a moment.) Instead, the policy of the Chinese government for the
past twenty years has been to “recycle” the accumulated dollars back to the
United States by buying Treasury securities—in effect, loaning the dollars back
to America. One explicit purpose of this policy is to prevent the yuan from
appreciating as quickly as it otherwise would—because the dollars earned in
America are not converted back into yuan. U.S. Treasury bonds are also a
relatively safe place to park huge quantities of accumulated capital. (The
Chinese government may rail at U.S. policymakers for their profligacy, but if
you’ve read the last two chapters, you will recognize that neither the yen nor the
euro is a great substitute.)
There is a lot to like about this arrangement for both countries—in the short
run. For China, the cheap yuan has helped facilitate a robust export-led growth
strategy. For a relatively poor country like China, one proven method of
becoming less poor is to take advantage of cheap labor by producing things for
export to richer countries around the globe. This is the path that Japan pursued
after World War II. It also explains the economic success of the “Asian tigers”:
Singapore, South Korea, Taiwan, and Hong Kong. One way to bulk up the
export sector is to keep the currency undervalued (or at least keep it from
appreciating significantly). Remember, a cheap currency is like a discount
coupon for the rest of the world looking to buy your stuff. The cheaper the
currency, the bigger the discount.
Meanwhile, American consumers are getting that discount. If it says “Made
in China” and you bought it with dollars, the weak yuan (and relatively strong
dollar) has made your paycheck go farther. But that’s not all! China’s huge
purchases of U.S. Treasury debt has pushed down interest rates in the United
States. Like everything else in life, bonds respond to the law of supply and
demand. When there is great demand—e.g., China purchasing billions of dollars
of them every month—the Treasury can offer a lower rate of interest. So the
U.S. government can borrow more cheaply and consumers get lower interest
rates, too. Nothing says “America!” better than cheap goods and easy credit for
buying them.
What’s the problem? The relationship is not sustainable over the long run.
China is supporting its export market by loaning huge quantities of funds to its
customers. Not only does that lead to the steadily mounting American debt that
Chinese officials are now monitoring anxiously, but the artificially cheap yuan
creates distortions within the Chinese economy. The dollars that are recycled to
the United States might be better invested at home—in infrastructure, schools,
and public health. An economy built on export-led growth must eventually
transition to producing goods for the domestic market, a process discouraged by
the implicit subsidy that an undervalued currency provides to exporters.
Policymakers around the world often exhort China to pursue “more balanced
growth.”
For its part, the United States has literally been living beyond its means—
buying more from the rest of the world than we sell in return and paying for the
difference with borrowed funds. That’s not a sustainable situation; at some point
the lenders stop lending if they begin to fear they won’t get paid back. As many
commentators have noted, China is living less well than it could, and America is
living better than it should. Nicholas Lardy, a China expert at the Peterson
Institute for International Economics, compares it to the relationship between an
addict and a drug dealer: “Americans became hooked on cheap goods and cheap
money, and China came to depend on the income from selling those goods.” 7
So here we are: America’s and China’s imbalances come together in one
glorious dysfunctional relationship, symbiotic in the short run and unsustainable
in the long run, thereby inviting economist Herbert Stein’s famous observation,
“If something cannot go on forever, it will stop.” James Fallows, a
correspondent for The Atlantic and longtime China observer, channels Herb
Stein in his assessment: “Like so many imbalances in economics, this one can’t
go on indefinitely, and therefore won’t. But the way it ends—suddenly versus
gradually, for predictable reasons versus during a panic—will make an
enormous difference to the U.S. and Chinese economies over the next few years,
to say nothing of bystanders in Europe and elsewhere.” 8
This Is So Weird
Let’s step back for a moment to examine in greater depth just how curious the
U.S.–China economic relationship has become. To begin with, poor, fast-
growing countries do not typically loan huge sums to rich, mature countries. As
economist and former Harvard president Larry Summers has pointed out, “From
a distance, this, to say the least, is strange.” 9 Both theory and history suggest the
capital should flow the other direction—accumulated in rich countries and
loaned to developing countries, where the marginal return on investment is likely
to be higher. Building a new road or port or factory should have more impact—
and therefore produce higher potential profits—in places with relatively few
roads, ports, and factories than it would in a developed nation like the United
States. This is why capital flowed from the rest of the world to the United States
in the nineteenth century. But from China to the United States in the twenty-first
century? Fallows points out that for all the ink devoted to glittering Chinese
investments, there are plenty of places, particularly outside of the cities, where
improvements in basic infrastructure could have a significant impact on the
quality of life and future productivity of citizens. He writes, “Better schools,
more abundant parks, better health care, better sewers in the cities—you name it,
and if it isn’t in some way connected to the factory-export economy, China
hasn’t got it, or not enough.” 10
In a similar vein, China has a bizarrely high national savings rate—on the
order of 50 percent. The act of saving implies that a dollar spent in the future
(including the interest earned) will produce more value (or satisfaction or
happiness) than a dollar spent today. That’s a curious determination to make
when so many households are still relatively poor. Yes, China has been growing
rapidly, but from a very low base. GDP per capita (measured using an exchange
rate based on purchasing power parity) is still only around $13,000. And that’s
just an average, meaning that hundreds of millions of people are much poorer. In
the absence of a well-developed social safety net (no Social Security or
Medicare, for example), it makes sense for poor households to tuck away
significant sums for a rainy day (that washes away the house). Still, saving 50
cents for every dollar earned is a significant act of self-denial in a country where
many basic needs are not being met.
Just as curiously, the savings rate in the United States is bizarrely low,
necessitating large net borrowing from abroad. Personal saving fell from an
average of 7 percent of GDP in the 1960s, 1970s, and 1980s to 4.5 percent in the
1990s to 1.1 percent in the 2000s. Government saving has been negative in the
2000s (due to chronic deficits).11 America, a country with a GDP per capita of
$55,000,12 does not have the cash on hand to finance all of its consumption and
investment.‡ Thus, it’s not a complete caricature to say that China (a poor
country) is denying itself some basic needs so that America (a very rich country)
can buy a handbag that it cannot afford but must have today (figuratively
speaking).
Now, I have not meant to imply that individual Chinese firms and
households are responsible for this saving decision. One defining feature of
China’s nondemocratic, managed economy is that the government maintains a
heavy hand in allocating capital. Specifically, firms that accumulate dollar
earnings from export sales must ultimately surrender those earnings to the
central bank, the People’s Bank of China, at a rate stipulated by the government.
Unlike in the United States or other open economies, firms do not have the
option of spending or investing the dollars; they go to the People’s Bank. The
process is more circuitous than I’ve described, but the operative point is that
Chinese export earnings are “recycled” into dollar-denominated Treasury
securities via explicit government policy, not because many economic actors
independently decide to invest surplus dollars in America. As one commentator
has noted, “At no point did an ordinary Chinese person decide to send so much
money to America.” 13
To be fair, Chinese government policy has built an export juggernaut that has
lifted an unprecedented number of people out of poverty in the span of a single
generation. Chinese policymakers maintain that Japan was bullied into allowing
the yen to appreciate sharply as a result of the Plaza Accord in 1985, thereby
contributing to the subsequent bubble and economic stagnation.14 (The IMF has
gone to great lengths to rebut this argument, to no apparent avail.15) The 2008
financial crisis only deepened Chinese skepticism that free-flowing capital and
floating exchange rates work swimmingly in a modern economy. In 2010, then
Chinese premier Wen Jiabao defended his country’s exchange rate policy: “If
the yuan is not stable, it will bring disaster to China and the world. If we increase
the yuan by 20 percent or 40 percent, as some people are calling for, many of our
factories will shut down and society will be in turmoil.” 16 Okay, that would be
bad.
Nobody Likes a Manipulator
The Chinese yuan does not float. When the Chinese government buys huge
quantities of U.S. Treasury securities, one explicit purpose of accumulating a
stockpile of dollar assets is to manage the exchange rate of the yuan vis-à-vis the
dollar, so that the yuan neither appreciates nor depreciates significantly against
the dollar. This rough peg to the dollar is essential for a robust export sector,
which in turn is the key to rising prosperity. As Arthur Kroeber, a China expert
at the Brookings Institute, explains, “Chinese leaders observe that all countries
that have raised themselves from poverty to wealth in the industrial era, without
exception, have done so through export-led growth. Thus, they manage the
exchange rate to broadly favor exports, just as they manage other markets and
prices in the domestic economy in order to meet development objectives such as
the creation of basic industries and infrastructure.” 17 So far, the strategy is
working—just as it did for Britain in the nineteenth century and the United
States in the twentieth, two countries, as Kroeber points out, that became
advocates for free trade after “their firms were secure in global technological
leadership and the need for protection waned.” The exchange rate is one tool in a
broader development strategy.18 Wild swings in the exchange rate would
endanger this development strategy, which in turn could easily cause political
instability. Remember, there are not a lot of real elections going on. The
legitimacy of the Chinese government depends on delivering steady growth and
a rising standard of living.
Meanwhile, across the Pacific (where there are real elections), American
politicians have been railing against China’s “unfair” trade practices. Senator
Debbie Stabenow, a Michigan Democrat, said on the Senate floor, “The No. 1
trade barrier used by Asian countries is currency manipulation.” In 2015, she and
Senator Rob Portman, an Ohio Republican, cosponsored an amendment to
legislation associated with the Trans-Pacific Partnership (a twelve-nation trade
pact§) that would have pressured trade negotiators to include rules against
currency manipulation in such agreements. The amendment failed in a close vote
(48–51). The Obama White House opposed the amendment, as did Republican
Majority Leader Mitch McConnell, on the grounds that the currency
manipulation rules would make it harder to negotiate successful trade
agreements. Still, forty-eight votes in the Senate is tough talk on currency
manipulation. The cheap yuan (or any other undervalued currency) is the
equivalent of a subsidy paid to exporters, as if a foreign government is picking
up part of the tab for every toaster oven an American buys at Wal-Mart. This is
perceived as stealing profits from American firms, taking jobs from American
workers, and contributing to America’s chronic current account deficit. It’s no
coincidence that Senators Stabenow and Portman hail from Michigan and Ohio,
two states where manufacturing has been under siege from Asian competition.19
Free trade, in the eyes of China’s critics, depends on fair trade, and fair trade
means a currency that is not artificially suppressed below its true value. China’s
trade partners are not the only ones taking issue with the undervalued yuan. The
International Monetary Fund has expressed concern about the “imbalances”
generated by the U.S.–China relationship as a potential source of instability for
the global financial system. The IMF Articles of Agreement forbid currency
manipulation to gain “unfair competitive advantage,” though the IMF has never
ruled a member nation guilty of such misdeeds and has no meaningful
enforcement power even if it did. Rules aside, the whole point of prices in a
market economy is to convey information; when prices are “wrong,” they send
bad signals and distort decisions, both within China and globally.
Of course, it’s one thing to say a currency is undervalued and another to
declare China a currency manipulator. Yes, for the bulk of the past two decades,
the circumstantial case has been strong. China’s monetary policy has been the
equivalent of a guy standing near a crime scene holding a stolen purse. It doesn’t
look good: constant intervention in foreign exchange markets; a steady
accumulation of dollars; a currency that looks cheap based on benchmarks like
purchasing power parity. In 2010, the Economist proclaimed as part of its annual
Big Mac Index that an undervalued currency is no free lunch, but in China “it
can provide a cheap one.” Based on the dollar-yuan exchange rate at the time, a
Big Mac cost the equivalent of $2.18 in Beijing, compared to an average of
$3.71 in the U.S.20
However, as you will remember from chapter 6, there is no precisely correct
exchange rate from an economic perspective. In 2005, IMF economists sampled
a broad range of studies in the hope of establishing if China’s trade prowess
could be attributed to an artificially cheap yuan. They were not able to answer
that basic question. Different studies at different times with different
methodologies have arrived at different assessments of the degree to which the
yuan was undervalued, ranging from zero to 50 percent.21 That’s not good
enough to convict.
During his confirmation hearing as Treasury secretary, Tim Geithner
submitted written answers to questions posed by senators. An answer to a
question from New York senator Charles Schumer, a strenuous critic of China’s
currency policy, used the m-word: “President Obama—backed by the
conclusions of a broad range of economists—believes that China is manipulating
its currency.” But the administration quickly walked the statement back,
declaring that the testimony had been written by a mid-level staffer and did not
reflect the opinions of Mr. Geithner.22
More recently, the Initiative on Global Markets Forum at the Booth School
of Business asked an ideologically diverse panel of prominent economists to
evaluate the following statement: “Economic analysis can identify whether
countries are using their exchange rates to benefit their own people at the
expense of their trading partners’ welfare.” The most common answer was
“uncertain” (37 percent), with the balance of the experts almost evenly divided
between “agree” (30 percent) and “disagree” (34 percent). Not a single expert
answered “strongly agree” or “strongly disagree.” 23 The IGM panel was asked a
follow-up question that may be more important from a policy standpoint: Are
Americans really made worse off by foreign currency shenanigans? Specifically,
the experts were asked to agree or disagree with the statement “Bank of Japan
monetary policies that result in a weaker yen make Americans generally worse
off.” Yes, it’s the yen, not the yuan, but the basic idea is the same. Most experts
disagreed with the assertion that the weaker yen harms Americans (54 percent);
another 36 percent were uncertain. Only 9 percent agreed that a cheaper yen
comes at the expense of Americans (overall).24
When asked in 2012 if trade with China “makes most Americans better
off”—the cheap yuan presumably implicit in the question—100 percent of the
economists answered “agree” or “strongly agree.” 25 Sure, Ford may lose some
customers to Toyota . . . but then again, every American walking into a Toyota
dealership is going to get a better deal.
Both governments have work to do. But amid all the debate over governments
and currencies, something curious has been happening: entrepreneurs have
created new kinds of money that cut governments out of the loop entirely. Is that
the answer to all this conflict?
Is bitcoin the future?
________
* Technically speaking, this debt may not have to be paid back. There are many reasons the Chinese
government may choose to hold large quantities of interest-bearing U.S. securities, which can be paid off at
maturity by issuing new securities. The larger point still holds: the Chinese government does not want the
value of its U.S. bonds significantly devalued by default, threat of default, or inflation.
† Yes, I realize that the child with a serious nut allergy may not end up smiling, but rather in anaphylactic
shock from the nut residue in the chocolate chip cookie. Still, as an example, let’s just go with it.
‡ National saving consists of saving (or dissaving) by the government, households, and businesses. Net
national saving takes that figure and subtracts depreciation of the existing capital stock (e.g., buildings and
computers that are less valuable this year than last).
§ China is not included in the Trans-Pacific Partnership trade agreement.
CHAPTER 13
Who knows what will be the future incarnations of money? Computer bytes?
—Milton Friedman, 19941
There are lots of ways to make money: You can earn it, find it, counterfeit it, steal it. Or, if you’re
Satoshi Nakamoto, a preternaturally talented computer coder, you can invent it. That’s what he did
on January 3, 2009, when he pressed a button on his keyboard and created a new currency called
bitcoin. It was all bit and no coin. There was no paper, copper, or silver—just thirty-one thousand
lines of code and an announcement on the Internet.
—Joshua Davis, The New Yorker, 20112
Is bitcoin money?
To answer that future-oriented question, ironically, we need to begin by
looking back in time. In the nineteenth century, the Pacific island of Yap gained
notoriety when European explorers discovered its giant stone money. There was
nothing unique about the inhabitants of Yap developing their own medium of
exchange; that is the basic story of all civilizations. One would expect a
relatively isolated society to find money that works for it, just like mackerel in
prison or wampum in colonial America. But Yap’s money is, well, really big.
Specifically, the islanders use large discs of limestone with holes carved in the
middle known as rai to conduct important transactions. The largest and most
valuable circular stones can reach more than ten feet in diameter and weigh
thousands of pounds. These giant rai are moved, if necessary, by groups of men
who carry the stone on a pole slid through the hole in the center.*
The stone used to make rai is not indigenous to Yap. Rather, the limestone
was mined on the islands of Palau—some 250 miles away—and carried back to
the island by canoe or raft (and later ships). The costs of producing the stones—
mining, carving, and transporting—helped to create the scarcity essential for any
commodity that serves as money. We have heard variations on this story over
and over again. To express amazement that people on a Pacific island use large
round stones as currency, when we eagerly acquire pieces of paper with Ben
Franklin’s likeness on them, would be culturally arrogant, to say the least. (True,
it doesn’t take six people and a pole to carry a $100 bill; on the other hand, the
rai are harder to counterfeit.) For all that, one curious incident involving a single
rai offers striking insights into the future of money.
More than one hundred years ago, a boat carrying a large rai back to Yap
sailed into a storm. In the turbulent seas, the valuable stone was lost to the
depths of the ocean. Yet that particular rai continued to function on Yap as
money. At first, this seems crazy. If your wallet falls into a sewer grate, you
can’t walk into Starbucks and buy coffee with the dollars lost in the bowels of
the water treatment system, no matter how persuasive you might be. But the
more one thinks about how rai function to facilitate commerce, the more sense it
makes that a stone on the bottom of the ocean can work just fine. In fact, it
makes perfect sense—though it takes a short intellectual journey to get to that
understanding.
Let’s begin our intellectual journey with the fact that rai were used primarily
for large transactions and as a store of value—more like jewelry than a $100 bill.
Because the rai were different sizes, and therefore had different values, they did
not function well as a unit of account. Prices were typically quoted in baskets of
common food crops, such as taro. (There is some disagreement among scholars
about whether rai were really money in the technical sense of the term.) For
now, imagine keeping a giant rai on your front lawn until one of the kids goes to
college, at which point you would give your rai to the University of Yap. (I don’t
know if there is a University of Yap, but it would make a great sweatshirt for
monetary policy geeks.) At any rate, the university takes possession of the rai,
and when the U of Yap (just known as the U on the island) hires a superstar
monetary policy expert, he or she might get the rai. Here is the curious part: the
rai would still be in your front yard. When ownership of rai changed, the stones
did not typically move, which makes sense when you have a currency that can
weigh up to ten thousand pounds. “Those involved in the exchange need only
communicate that purchasing power has been transferred,” explains Michael
Bryan, an economist at the Federal Reserve who has studied the island
currency.3 The process is like transferring the title to a car. The ownership
change is clear, regardless of where the car happens to be parked.
Yap and its stone currency are typically introduced as some wondrous
curiosity. In fact, everything I have just described makes perfect sense if one
takes a broader view of the role of money. Some cultures like big, round stones;
others like gold and silver. Each of these minerals is scarce and serves well as a
store of value. The fact that rai change ownership without being physically
moved should not be puzzling; this turns out to be a feature of any modern
banking system. As Bryan points out, “Most dollar transactions in the course of
an ordinary business day occur without the transfer of anything physical.
Electronic payments, which represent the overwhelming share of the value of all
dollar transactions, require only balance sheet adjustments between banks.”
Under the gold standard, people were not hauling around bars of gold. The
precious metal sat in a bank vault, with paper certificates circulating to keep
track of who had the right to come claim it (even if they never did). At the
international level, countries settled debts by transferring gold to one another.
Even then, a high proportion of the world’s gold was stored in a giant vault deep
beneath the Federal Reserve Bank of New York. (To this day, the vault still
holds gold on behalf of many other countries. The exact number of countries
storing gold at the Fed is secret, and despite my best efforts, the New York Fed
would not even give me a hint.) When countries settled up, gold was wheeled
from one room in the Fed’s vault to another. The gold really served as an
accounting tool—no more or less practical than a large, round stone in your front
yard.
You may recall the comment from chapter 7 commonly attributed to Warren
Buffett, “[Gold] gets dug out of the ground in Africa, or someplace. Then we
melt it down, dig another hole, bury it again and pay people to stand around
guarding it. It has no utility. Anyone watching from Mars would be scratching
their head.” 4 Buffett’s insight brings us to the end of our short intellectual
journey, with a question: If the gold never comes out of the Fed vault but still
serves to facilitate commerce via transfers of ownership, how is it different than
a rai sitting at the bottom of the ocean?
It’s not.
When the rai was lost to the depths, there was agreement on its size, value,
and ownership. When that is known, and all parties agree, what difference does
it make whether the rai is in your front yard or on the bottom of the Pacific, or in
a vault beneath the New York Fed? The whole purpose of the stone is just to sit
someplace—anyplace—and keep track of the credits and debits as people on
Yap exchange things of value, like a bank ledger or chips in a casino. The
information is what matters, not the stone or the ledger or the chips. As Michael
Bryan explains, “Yap stones serve as a memory of one’s contributions on the
island.” If we focus too narrowly on the curious commodities used as money, we
can miss the larger purpose, which is to keep track of who has provided a good
or service to someone else.
Imagine some kind of commune in which the basic tasks are shared: raking
leaves, babysitting kids, making bootleg liquor. If an hour of labor has consistent
value—babysitting for an hour is just as valuable as making moonshine for an
hour—then money is not theoretically necessary. The hours worked could be
tracked on a giant Excel spreadsheet; the laggards could be reminded
periodically that they owe some work to the group. However, the spreadsheet
would become a real mess when the community grows larger or when different
tasks are accorded different values. (I raked your lawn for an hour. You spent
thirty minutes doing couples counseling with Fred and Angela, but couples
counseling is 1.75 times more valuable than leaf raking—and so on and so
forth.) Money enables us to decentralize this accounting process. Rather than
trying to reconcile what we all owe each other in a giant spreadsheet, we pass
tokens among ourselves as the transactions take place. As an added bonus, we no
longer need to remind the laggards that they are getting more from the group
than they are giving; they just run out of tokens at some point. The movement of
money through the community is an implicit record of the transfer of value—a
more convenient version of changing names on the stone rai or updating the
ledger. Bryan writes, “Some have argued, at least as far back as the seventeenth-
century philosopher John Locke, that money is merely a communication device
that serves as a societal memory of someone’s production and consumption.”
Money is memory.
As cool as that phrase sounds, I didn’t come up with it. In 1996, Narayana
Kocherlakota wrote a staff report for the Federal Reserve Bank of Minneapolis
with the title “Money Is Memory.” Kocherlakota made the case that anything
that can be accomplished with money, in terms of efficient economic
transactions, could in theory be accomplished with memory—or to be less poetic
about it, with really good record keeping. Kocherlakota wrote his thought piece
long before the creation of bitcoin, but he anticipated its essence. Kocherlakota
pointed out that credit card use was rising at the time—not because of changes in
the laws or practices around short-term debt, but because the costs of storing and
accessing information were plunging. He explained, “Like money itself, credit
cards are primarily mnemonic devices.” 5 Of course, so is the rai at the bottom of
the ocean. Kocherlakota offers his own version of Milton Friedman’s famous
dictum: “Money is always and everywhere a mnemonic phenomenon.” 6
This is the point where the past converges with the future. If money is
accounting, or “memory,” then bitcoin, an electronic currency generated by
computer code, is not appreciably different than the stone rai. Each is a record-
keeping device. (It is an ironic coincidence that both rai and bitcoins are
“mined,” one in stone quarries and the other using complex computer
algorithms.) There is a reason that an economist at the Federal Reserve was
writing about stone money on Yap. Way back in 2004 (still several years before
the advent of bitcoin), Michael Bryan connected the dots between commodity
money, fiat money (issued by governments and having no intrinsic value), and
future money. He reasoned, “Fiat money can keep track of transactions as
effectively as a commodity, while saving on production and storage costs. In
fact, from this perspective, we might foresee a future in which all transactions
are costlessly and instantaneously recorded for all to see, making the idea of
money, at least as a physical construct, obsolete.”
That future has arrived. Narayana Kocherlakota wrote in his money-is-
memory thought piece, “If the function performed by money can be superseded
by a perfect historical record of transactions, then money’s only technological
role must be to provide that record.” Bitcoin does that. It is a decentralized
ledger that allows participants to transfer bitcoins electronically anywhere in the
world—like Western Union, only faster, cheaper, anonymously, and using a new
unit of account, bitcoins, rather than dollars. It is a historical record of
transactions made possible by the Internet, clever programming, powerful
cryptography, and the willingness of entrepreneurs, speculators, libertarians, and
others to trade money that has the legal backing of a government for electronic
currency that does not.
But wait—why would anyone want bitcoins? Or any of the knockoffs, including
alphacoin, fastcoin, peercoin, namecoin, worldcoin, flycoin, zeuscoin, and even
bbqcoin.12 I can create Charlie Coins that I give out to people who run laps
around my house. That doesn’t mean anyone will want to accumulate them, let
alone accept them for goods that have real value, like a pizza or a car. Bitcoins
are just strings of numbers earned by solving relatively pointless math problems.
At least with paper currency, you can burn it or use it as toilet paper if it loses all
other value.
The short answer is that bitcoins have acquired value because bitcoins have
acquired value. Early entrepreneurs, such as Netscape cofounder Marc
Andreessen and Cameron and Tyler Winklevoss,‡ made investments—both in
the technology and in bitcoins themselves—that persuaded others that bitcoin
might become a viable electronic currency, or at least gain value over some
period of time. Every time the value of bitcoins rose, others were persuaded that
there might be some gain in owning bitcoins, which drove up the value. One of
the most notorious bitcoin transactions took place in 2010, when a pioneering
bitcoin enthusiast, Laszlo Hanyecz, made a post on a bitcoin message board
offering 10,000 bitcoins to anyone who delivered him two pizzas. Another
bitcoin nerd accepted the deal and had two Papa John’s pizzas delivered to
Hanyecz. By 2015, those 10,000 bitcoins were worth $2.3 million.
Cryptocurrency enthusiasts now celebrate the anniversary of that seminal
transaction, May 22, as Bitcoin Pizza Day.13
Along the way, some mainstream merchants, such as OkCupid (online
dating) and WordPress (blogging), have begun to accept bitcoins. The LA
Clippers basketball team accepts bitcoin for tickets.14 So far, this feels more like
a marketing gimmick than a mechanism for improving the ease of commerce.
Retailers typically convert their bitcoin revenues into dollars immediately via
third-party payment firms.15 In 2014, the Wall Street Journal reported that a
Lake Tahoe property was sold for 2,739 bitcoins.16 Again, this feels like the
exception that proves the skepticism. Is it news when a house is sold for dollars
or euros?
The fact that someone could end up paying the equivalent of $2.3 million for
a couple of pizzas is one of several things that make bitcoin lousy money,
despite the whiz-bang technology. An asset that is rising and falling
unpredictably in value makes for a miserable currency, electronic or otherwise.
Money works best when it maintains relatively constant purchasing power. As
Steve Forbes has lamented, “Money is most optimal when it is fixed in value just
as commerce is facilitated when we have fixed weights and measures. When you
buy a pound of hamburger you expect to get 16 ounces of meat. An hour has 60
minutes. A mile has 5,280 feet. These measurements don’t ‘float.’ ” 17 Forbes’s
column was aptly titled, “Bitcoin: Whatever It Is, It’s Not Money!” I’m going to
toss my lot with Steve Forbes on this one. To circle all the way back to chapter
1, money has three basic functions: as a unit of account, a store of value, and a
medium of exchange. Bitcoin fails two of these measures, and perhaps even the
third.
Bitcoin is not a meaningful unit of account. Let’s go back to that Lake Tahoe
property purchased for 2,739 bitcoins. Is that a big lot or a small lot? You have
no idea. But when I tell you that the property was worth $1.6 million at the time
of the transaction,18 you immediately know it is a very nice piece of property (or
perhaps a modest lot in a really swanky area). For most people on the planet,
$1.6 million means something and 2,739 bitcoins does not. (To my point, the
Wall Street Journal article trumpeting this groundbreaking real estate transaction
in bitcoin quoted the price in dollars in the first paragraph and the price in
bitcoins in the second.) Sure, people can figure out the value of a bitcoin at any
given point in time, just as they do when visiting a new country and learning to
think in the local currency. But bitcoin has been bouncing all over the place. The
value of a single bitcoin grew 5,000 percent between January 2013 and January
2014.19 The climb was not steady. Bitcoin began the year at $15, climbed to
$230 in April, fell to $70 in July, then climbed vertiginously above $1,000 in
November.20 (This is how someone ends up spending the equivalent of $2.3
million on pizza.) In August 2014, bitcoin fell 12 percent in a single day. The
owner of a bitcoin investment fund explained at the time, “This is just how
bitcoin trades, for better or worse.” 21 Let’s put that in perspective: if the
domestic purchasing power of the dollar fluctuates by more than 3 or 4 percent
in a year that is considered to be lousy work on the part of the Fed. Twelve
percent in a day?
Let’s go back to our old financial friends, euphoria and panic. For most
people, the most attractive thing about bitcoin has been its steadily rising value.
If you buy an asset primarily in the hope that it will rise in value, you are
speculating. And if you are speculating on an asset that has no underlying value
(profits or rents or some other stream of income), watch out for a bubble. The
greater fool theory—buying something today in the belief that someone else will
pay more for it tomorrow—has had a seat at the table for every bubble in the
history of human civilization. If people are induced to buy bitcoins by rising
values, there is no reason they won’t dump them when things look like they are
going in the other direction. Bitcoin, like the euro, dollar, and yen, has no
intrinsic value. The difference is that no government or central bank is
responsible for maintaining the value of bitcoin, nor does any government
stipulate that they must be accepted as legal tender. As the Economist noted,
“All currencies involve some measure of consensual hallucination, but bitcoin, a
virtual monetary system, involves more than most.” 22
Even if the bubble does not burst, the whole point of a unit of account is to
have predictable purchasing power, especially over the long run. The dollar is an
effective form of money not merely because you can buy coffee with it right
now but also because you can buy a house in dollars with a thirty-year mortgage.
Both you and the bank have a reasonable idea of what the dollar will be worth
over those decades. The future value of the dollar is not perfectly predictable,
but its purchasing power is a heck of a lot more stable than a bitcoin. Proponents
of bitcoin get excited when the e-currency’s value rises relative to the dollar (and
therefore relative to most goods and services). What’s not to like when the 30
bitcoins you bought from the hipster at the bike store buy seven times more
marijuana than they did last year? (This drug reference is not entirely gratuitous,
as I will illustrate in a moment.) But any currency with such wild swings in value
is miserable for longer-term transactions. Imagine the financial danger of taking
out a mortgage, or entering into any other contract, in which you commit to
making payments that could end up being ten or twenty or fifty times what you
expected in real terms. And obviously if bitcoins fall sharply in value, the party
on the receiving end of the payment stream suffers the loss instead.
Consider this: even the Bitcoin Foundation doesn’t really pay its people in
bitcoin. Instead, the organization quotes salaries in dollars and then makes
payments in bitcoin at whatever the exchange rate happens to be on payday.23
For similar reasons, bitcoin is not a good store of value, the second key
function of money. The quantity of bitcoins that will ever be mined is ostensibly
fixed, unlike fiat money, which can be produced at will by a central bank. No
meddling by bureaucrats with printing presses (or the electronic equivalent). Fair
enough. But given that we cannot identify who wrote the bitcoin program, one
might reasonably ask how we can be certain that the fixed quantity is credible.
(Electronic money is potentially even less scarce than paper.) If we are going to
put “no government oversight” in the bitcoin benefit column, we might want to
put it in the drawback column as well.
One of the most significant limitations of electronic money as a store of
value—bitcoin and its competitors—may be the most prosaic: it can easily be
lost or stolen. Each bitcoin has a personal key—a string of numbers—that can be
stored electronically in an electronic wallet. Or you can just write the numbers
down and stick them in a drawer with all your passwords. Neither is failsafe.
Two software security researchers discovered 120 different kinds of malware
designed to steal bitcoin wallet files from personal computers. Those experts
recommend “cold storage” offline, like storing “cash in a physical safe.” 24
Either way, if the personal key is lost, so are the bitcoins, forever. Have you ever
forgotten or lost a password? Now imagine looking for a yellow Post-it note
frantically, because if you don’t find it your retirement savings will be gone
forever. Or was it a blue Post-it?
This is a good place for an intriguing aside. One potential benefit of
electronic money of any kind is that it may have a salutary effect on crime.
Street crime is often predatory and opportunistic; fewer (real) wallets bulging
with cash means fewer opportunities. A group of researchers associated with the
National Bureau of Economic Research asked the question, “If cash motivates
crime, could the absence of cash reduce crime?” The answer appears to be yes,
based on a clever study in Missouri, where the state transferred its welfare and
food stamp benefits from checks (which are cashed) to an electronic system with
cards that can be swiped at retailers. The transition was phased, with different
counties going electronic at different times. Going digital led to a significant
decrease in crimes like burglary and assault (with no corresponding decrease,
unfortunately, in crimes like rape, prostitution, or drug offenses).25
But let’s not get too excited. Jesse James said he robbed banks because that’s
where the money was. Well, he would rob different places in the twenty-first
century. In an era when hackers can steal personnel info for eighteen million
federal employees, it is naïve to think digital currency is immune, particularly
with no institution responsible for its safekeeping. After all, the ultimate robbery
is one where you can steal a huge amount of money using a computer in your
living room while watching a football game. That’s already happened. In
February 2014, the largest bitcoin exchange, Mt. Gox in Tokyo, reported that
744,400 bitcoins were missing, presumably stolen by cyberthieves.§26 (By then,
that was more than enough to buy a pizza—on the order of half a billion dollars.)
About a week later, a Canadian “bitcoin bank” closed down when hackers stole
all the bitcoins in its “hot wallet” (online storage for bitcoins). And so on.27 The
cost of these cyber-robberies is more than just the money heisted electronically;
there is typically a fall in the value of bitcoin, which spreads losses to everyone
else holding the currency. That was never the case when Jesse James robbed
dollars from banks.
This brings us to the last core function of money, as a medium of exchange.
In this respect, bitcoin has enormous value—for some people. Bitcoin has the
potential to play an important role in countries like Argentina and Venezuela,
where there is a history of hyperinflation, the banks are a mess, and currency
controls have made it hard to move money in or out of the country. The New
York Times reported in 2015, “Argentina has been quietly gaining renown in
technology circles as the first, and almost only, place where bitcoins are being
regularly used by ordinary people for real commercial transactions.” 28
Throughout history, individuals have resorted to using gold and gems when the
traditional financial system has broken down. E-gold might serve the same
function.
Digital money combines many of the benefits of cash with the reach and
convenience of electronic payment systems. Anyone who wants to make an
international purchase with a credit card typically incurs a large fee and leaves a
trail of personal information. No one likes the fee. Bitcoin’s unique technology
has the potential to lower significantly the cost of moving money around the
globe, particularly for groups like foreign workers sending remittances back to
their home country. Other parties really don’t like the paper trail. Anyone
looking to buy weapons in Kazakhstan—without leaving lots of electronic
evidence for law enforcement authorities—has to find a way to get suitcases of
cash into the country. Cryptocurrencies combine the relative anonymity of cash
with the convenience of a wire transfer. Bitcoin makes it possible to ship
suitcases of cash around the world electronically—and is therefore particularly
attractive to people who like to do large anonymous deals.
Now, I’m sure there are a lot of honest, upstanding people who do not want
the Internal Revenue Service, the Drug Enforcement Agency, and the Federal
Bureau of Investigation all up in their business. I also know that there are a lot of
drug dealers, tax cheats, and arms merchants who would prefer not to share their
receipts with the IRS, DEA, or FBI. From inception, bitcoin has provided a very
attractive medium of exchange for some very unattractive characters. For
example, Silk Road was the first website where one could buy and sell illicit
goods, mostly drugs, with ease and impunity using bitcoin and another new
technology, Tor, that allows a party to host a website without revealing its
physical location.29 One news outlet described the site as “Amazon for illegal
drugs.” 30 The FBI closed Silk Road down in 2013, but not before the site had
facilitated more than 1.6 million bitcoin in sales. (To my earlier point, that
probably means nothing to you; it’s about $365 million at the current exchange
rate.)
More surprisingly, Charles Shrem, a Bitcoin Foundation board member and
CEO of a prominent website where bitcoins can be purchased using dollars, was
arrested in January 2014 for alleged involvement in Silk Road. There are layers
of irony in these bitcoin-related busts. Shrem was arrested at Kennedy Airport
on his way to speak at the North American Bitcoin Conference.31 The FBI shut
down Silk Road and seized 144,000 bitcoins from the company, making the U.S.
government the largest owner of bitcoins at the time.32 The bigger point is that
law enforcement and regulators are going to do whatever they can to keep up
with the technology. As Ben Bernanke observes, “It’s hard to become a globally
useful currency if regulators keep cracking down on it, which they will do if they
see it primarily as a vehicle for illicit activities.” 33 Meanwhile, one has to expect
that the luster will rub off digital currencies—even for libertarians—if some of
the major beneficiaries are drug lords and terrorists.
For most of us, however, the primary problem with new forms of electronic
money is that they are not very good at what they purport to do—act as money.
As a professor (and not a particularly hard grader), here is my assessment:
Cryptocurrencies as unit of account: F.
Cryptocurrencies as a store of value: D.
Cryptocurrencies as a medium of exchange: C for most people; B+ if you are
in a country where the government is falling apart; A+ if you are a terrorist,
weapons merchant, drug dealer, or kidnapper.
But let’s not throw out the awesome technology with the cryptocurrencies.
Bitcoin and related technologies have the potential to transform how we pay for
things and move money around, even if it is in dollars rather than bitcoins.
Traditionally we have had two basic options for any transaction that moves a
token of value from one party to another. The most straightforward process is
using physical currency. The elegance of cash is that when I give you a dollar,
you have it and I don’t. It’s hard to have much confusion or dispute around that.
All other payment mechanisms have traditionally relied on an intermediary to
verify a transaction. If I write a check or use a debit card, my bank verifies that I
have funds in the account and then transfers those funds to someone else’s
account. Visa, MasterCard, Western Union, and PayPal are all doing variations
on the same basic thing. They verify that recipients are getting money from me
that really exists and that I’m not simultaneously spending it in six other places.
(In the case of credit cards, they may also loan me the money that I’m spending.)
These parties take a significant fee for playing intermediary, which is not
unreasonable given the importance of electronic payments in a modern
economy.
Historically, any electronic form of payment without an intermediary has
been doomed by the very nature of digital information: it can be copied over and
over again. Suppose I have a digital file of some sort that represents $50 of
value. It’s the opposite of cash. After I e-mail it to you, I still have it. In fact, I
can e-mail it to the rest of my contact list, too. Now we all have a file worth $50.
That cannot work as a payment system. The genius of bitcoin is that the
decentralized peer-to-peer network verifies the transaction, not an intermediary
like Visa. As the Chicago Fed’s François Velde explains, “The bitcoin protocol
provides an elegant solution to the problem of creating a digital currency—i.e.,
how to regulate its issue, defeat counterfeiting and double-spending, and ensure
that it can be conveyed safely—without relying on a single authority.” 34 That
innovation has the capacity to transform commerce and capital flows—making
them faster, easier, and cheaper. Which is what money is supposed to do. Even
the Economist (whose editorial views on cryptocurrencies tend to include terms
like “bitconned”) draws a parallel to Napster, the peer-to-peer file music sharing
service that was shut down for copyright infringement but still managed to
transform the music industry.35
This is a good place to make explicit one theme of the whole chapter. There
is a fundamental difference between electronic payment systems—mechanisms
for making electronic transactions using traditional currencies—and a whole
new form of digital money. For all the reasons I’ve explained, the latter faces
huge barriers. But the former—cheaper and easier ways of doing commerce
electronically—will inevitably march forward. For example, M-Pesa is a popular
mobile payment system in Kenya that allows users to transfer money using
mobile phones. Users can buy goods using their phones, or even withdraw cash
at stores and stands. M-Pesa lessens the need to keep cash around, which
minimizes theft. As the Wall Street Journal describes, “[Transactions] come
from cow herders in the country’s dusty Rift Valley villages, pedicab drivers in
the bustling port of Mombasa and technology entrepreneurs in traffic-clogged
Nairobi.” 36 According to one study released by the Kenya Bankers Association,
some 60 percent of Kenyans use their phones to carry out financial transactions,
while only 30 percent go to the bank and 8 percent use ATMs.37 But do not lose
sight of a crucial detail: all those transactions are in Kenyan shillings.
People may reasonably assert that cash will die out; at a minimum, paper
money will become less common as we increasingly swipe cards, wave phones,
tap wallets, and use any other technology that makes it faster and easier to buy a
bagel. We have already seen airlines and other institutions transition to accepting
only electronic forms of payment. I suspect there will always be some demand
for cash, because of its anonymity and ease of use for small transactions—time
will tell. (It boggles the mind that we still have pennies, but that’s for another
book.) This is a good time to step back and remind ourselves that the purpose of
money is to make the rest of the economy work better, whether we are using
paper dollars, bitcoins, stone rai, or pouches of mackerel. In that respect, we can
make some powerful predictions.
We will always need a stable unit of account, even if we are buying coffee at
Starbucks via mental telepathy. Government-backed currencies in nations with
a responsible central bank, particularly the U.S. dollar, have had remarkably
consistent and predictable purchasing power over the past three decades. At the
risk of replacing Irving Fisher, I’m going to say that government-backed
currencies will not be supplanted anytime soon. The nature of money and
transactions will change—but not the fundamental need to maintain a unit of
account.
There will always be borrowers and lenders. The nature of that borrowing and
lending will evolve. Traditional banking has been partially supplanted by
shadow banking. Futurists have declared that the Internet will give rise to peer-
to-peer lending, in which borrowers and lenders find each other online and cut
out the middleman. Maybe. Yet hopefully history has taught us that any system
of lending is prone to panics. Perhaps someday borrowers and lenders will
rendezvous in space to consummate their deals, having arrived on cheap
commercial spacecraft. Whatever. Unless human nature changes, there will be
circumstances in which lenders want their money back immediately and
borrowers will not have it. Space travel will not help, unless it gets Jimmy
Stewart to the scene and he starts passing out his honeymoon cash to calm the
panic. The situation requires a lender of last resort.
________
* The U.S. dollar is now legal tender on Yap and other island states in Micronesia, but the rai are still used
for some purposes.
Michael F. Bryan, “Island Money,” Federal Reserve Bank of Cleveland Commentary, February 1, 2004.
† I can neither confirm nor deny that I am Satoshi Nakamoto.
‡ The twins famous for their early involvement in Facebook, and then even more famous for their amusing
portrayal in the film The Social Network.
§ Okay, since the thieves were never caught, we don’t know if they pulled the heist from a living room
while watching football. But we do know that they didn’t have to storm into a bank wearing masks.
CHAPTER 14
By the mid-2000s, it was indeed not unreasonable to think that better macroeconomic policy could
deliver, and had indeed delivered, higher economic stability. Then the crisis came.
—Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro, IMF report, 20101
I think no one can claim that every year in every circumstance in every crisis the Fed got its policies
exactly right. But what is beyond debate is that this institution has served the country well.
—Paul Volcker, ceremony commemorating the centennial of the Federal Reserve Act2
The Fed celebrated its 100th birthday in December 2013. The centennial
celebration was subdued by American celebratory standards—nothing like the
American bicentennial that I remember vividly from elementary school. No
fireworks, no documentaries on television, no parades. Although the worst of the
financial crisis had passed by 2013, the Fed was still under siege politically from
both the left and right. Conservatives were warning of rampant inflation as the
result of the Fed’s aggressive intervention in the bond markets. Progressives
pilloried the Fed for the opposite, for doing too little to put more Americans
back to work more quickly. Fed chair Ben Bernanke must have been one of the
few people ever to face the wrath of both Elizabeth Warren and Rick Perry.
Meanwhile, Ron Paul continued to make it his mission to end the Fed and paper
money. There was no cake at the Fed to celebrate the 100th birthday.*
That’s too bad, because by any reasonably objective standard, the centennial
should have had caviar, ice sculptures, and one of those large dance bands. For
all the economic trauma of the past decade, the Fed as an institution has much to
celebrate, as do other central banks around the world. Shrill criticism
notwithstanding, the Federal Reserve steered the United States and the world
through a crisis that might have been more catastrophic than the Great
Depression had there not been an aggressive intervention. Longer term, the Fed
and other responsible central banks around the world have demonstrated that it is
possible to maintain low inflation with a fiat currency, thereby harnessing all the
benefits of commodity money without the drawbacks. True, the Fed failed its
first big test, the Great Depression. The 2008 financial crisis was a chance for a
redo. This time the Fed did a heroic job. People actually use that word: heroic.
Alan Blinder, the Princeton economist and former Fed vice chair who hails from
the political left, gives Bernanke an A- (with points off for letting Lehman
Brothers fail). Hank Paulson, the Treasury secretary appointed by George W.
Bush, has described Bernanke not merely as courageous but “one of the greatest
Fed chairmen of all times.” 3 So let’s call that an A.
The numbers support those grades. Unemployment peaked around 25 percent
during the Great Depression, compared to 10 percent during the financial crisis.4
The Great Depression stretched on, with some temporary reversals, for the better
part of a decade. The financial crisis caused a recession that lasted only three
years in the United States (albeit with slow growth after that). So why were there
no ice sculptures at the centennial celebration? Part of the reason is that those
grades for Bernanke and the Fed are provisional. The worst of the financial crisis
may be over, but the final chapters are not written. The Fed’s balance sheet is
still huge by historical standards; America’s central bank acquired an
unprecedented quantity of Treasury securities and other assets as it fed liquidity
to the economy. The Fed will have to manage those assets, gradually selling
them off or letting them mature. Meanwhile, banks are holding unprecedented
quantities of reserves (that they acquired from the Fed). The Fed’s critics in
Congress have proposed a bill that would require audits of the Fed, which is
really an attempt by lawmakers to involve themselves more directly in monetary
policy decisions. On Main Street, many Americans are still angry about the
bailouts.
I had occasion to interview Ben Bernanke during the summer of 2015. He
did not have the bearing of a guy who was running around high-fiving people to
celebrate the Fed’s impressive performance over the past seven years, or the
ninety-three before that. He looked more like a general who had been through
years of combat, victorious but exhausted. The 2008 financial crisis was the
central banking equivalent of a war—a huge, unexpected shock to the financial
system. The Fed response employed lessons from past conflicts—the Great
Depression, the United States in the 1970s, Japan in the 1990s—while also
improvising as circumstances required. Central banking, like medicine or
manufacturing, is a process that should get steadily better as past experiences are
incorporated into present practices. As the United States emerges from the
financial crisis and the Fed begins its second century as an institution, now is a
good time to look back, look around, and look forward. What did we learn about
central banking during the crisis, and more important, how can we use those
lessons to prepare for the next crisis or panic—because there will be one. How
can we do central banking better?
We Were Right
Many of the basic principles that undergird central banking—the stuff I was
taught in grad school—were reinforced during the financial crisis. As with
combat, some of the basic lessons are timeless (e.g., hold the high ground). Here
are some of the classic lessons of central banking, tested once again, that future
policymakers ignore at their peril.
We need a lender of last resort. A bank run is a bank run, whether it is Bailey
Building and Loan or the repo market. The financial crisis, at bottom, was a
financial panic. Ben Bernanke often refers to it as the Panic of 2008. He told the
American Economic Association in 2014, “The crisis bore a strong family
resemblance to a classic financial panic, except that it took place in the complex
environment of the twenty-first-century global financial system.” When panic
spreads, sick institutions infect healthy ones. Individuals and firms and
governments all scramble for liquidity, making the underlying crisis worse. Over
time, historians and economists will critique the specifics of the Fed’s
performance, as they should. However, as the visceral fear associated with the
crisis recedes, we should not forget how bad things might have become. As
humans, we are really bad at envisioning the counterfactual—what might have
happened if different choices had been made. We cannot forget how close we
came to a complete financial meltdown but for the intervention of the world’s
major central banks.
In October 2008, the Royal Bank of Scotland, one of the biggest banks in the
world, came to the brink of default before turning to the British government for
assistance. Alistair Darling, British chancellor of the Exchequer at the time, has
said, “I think we came within hours of a collapse of the banking system.” 5
How bad might it have been? David “Danny” Blanchflower, a member of the
Bank of England rate setting committee during the crisis, recalls a conversation
in which Alistair Darling described those crucial hours: “He’s told me that he
asked the staff, ‘What happens if I don’t rescue them?’ And they said,
‘Chancellor, we don’t exactly know, but we think there is a significant
probability that every credit card in the world and every cash machine will stop
working tomorrow.’ And he said, ‘Not much of a choice you’ve given me then,
have you?’ And they said, ‘No.’ ” 6
A central bank with the power to loan unlimited sums to solvent but illiquid
institutions is uniquely positioned to stop a financial panic. Until either human
nature or the world of finance changes fundamentally, there will be panics. And
as long as there are panics, we need central banks to lend when they strike.
A modest inflation target is better than zero. Prior to the financial crisis, a
consensus had emerged among central bankers that the ideal inflation target was
not zero, but rather something in the 1 to 3 percent range. The Fed has since
adopted an official target of 2 percent. This is not to say that inflation is a good
thing; there is nothing particularly attractive about a currency that is steadily
losing value. But a low, predictable rate of inflation gives the central bank more
room to cut real interest rates during a downturn before hitting the zero bound.
We’ve done the math before. If inflation is zero and the Fed lowers the nominal
interest rate to zero, the real interest rate—the true cost of borrowing—is also
zero. That can provide some important stimulus to the economy. But if inflation
is 2 percent and the Fed lowers the nominal rate to zero, the real interest rate is
negative 2 percent. When changing prices are taken into account, borrowers can
pay back less (in terms of purchasing power) than they borrowed. That’s even
more stimulus.
The other benefit of a modest inflation target is that it keeps the economy
further away from deflation and all its attendant problems. If you are worried
about falling over a cliff, don’t walk right on the edge. Similarly, if you are
worried about deflation, don’t aim for zero inflation, where even a small misstep
can lead to falling prices. Better to aim for 2 percent inflation, and then if the
economy is weaker than expected, the result is 1 percent inflation, not 1 percent
deflation.
The central bank should regulate the institutions for which it is the lender of
last resort. If I serve in the volunteer fire department that has agreed to drop
everything and rush to your house if there is a fire, it is not crazy for me to ask
you to move the oily rags out of your furnace room. The need for a lender of last
resort is well established; so is the risk of moral hazard. The only way to
reconcile these two forces—the fact that individuals or institutions that are
protected from some harm are therefore more inclined to act recklessly—is to
put some limits on potentially reckless behavior. In some countries, including
the United States, the regulatory role is shared between the central bank and
other government entities. There is a larger and more complicated discussion to
be had around how firms ought to be regulated most effectively—but the
operative word is how not if. Any institution that performs rescues when times
are bad ought to be conducting inspections when times are good. That is the
price firms pay for having ready access to liquidity during a panic.
We need to pay more attention to systemic risk. Before the crisis, we had a
decent grasp of the risks that might swamp an individual institution. To go back
to the fire analogy, we knew the most common dangers: smoking in bed; faulty
electrical outlets; oily rags stored near the furnace; and so on. Unfortunately we
had no idea how quickly a blaze, once started, might spread. Many experts
believed that the housing market was overheating in the early 2000s. Others
warned about shoddy mortgage underwriting and the curious derivatives being
engineered from sliced and diced bundles of mortgages. Yet virtually no one
anticipated how a drop in housing prices would set in motion a cascade of events
that would bring the global economy to the brink of collapse.
The new buzz phrases are “systemic risk” and “macroprudential regulation,”
both of which reflect the idea that discrete events can add up to something much
worse than the sum of the parts. Sure, your oily rags may be stored outside your
garage, far from the furnace. And I don’t smoke in bed; I smoke outside when I
go for a walk. Prior to 2008, we believed we had those risks under control. What
we learned in the financial crisis is that if I toss my smoldering cigarette butts
near your driveway as I walk by, and your oily rags are piled outside your
garage, we may have a systemic problem. Small disturbances can interact,
spread, and grow in ways that policymakers had not previously anticipated.
Can the Federal Reserve unwind its balance sheet in a way that does not cause
the next crisis? As we know, the Fed responded aggressively to the financial
crisis by buying bonds and other securities. The purpose was to inject liquidity
into the economy and lower interest rates. So far, so good. Here’s the thing:
when the Fed buys assets with new money, those assets have to go somewhere—
in a really big safety deposit box, in the corner of the Fed chair’s office—just
somewhere. It turns out that where they go from an accounting standpoint is on
the Fed’s balance sheet. That’s the way monetary policy always works. When
the Fed lowers interest rates, it buys Treasury securities in exchange for new
money, putting those securities on the balance sheet as assets while entering the
new money as a liability. That’s just double-entry bookkeeping applied to
monetary policy. To raise rates, the Fed does the opposite, selling assets from the
balance sheet in exchange for bank reserves (thereby eliminating both the assets
and the liabilities).
If you like the accounting stuff, great; if not, the important point is that the
Fed now owns an unprecedented quantity of securities. The accounting geeks
will appreciate that the asset side of the balance sheet swelled from roughly $800
million in 2005 to over $4 trillion in 2015.15 The rest of you can imagine boxes
and boxes of bonds piled in the Fed chair’s office and spilling out into the
corridors. Remember, the Fed bought these securities from banks, so there is a
parallel development: the banking system is sitting on nearly $3 trillion of
reserves—electronic money held on account at the Fed that could in theory be
loaned out at any time. How does this unprecedented situation resolve itself?
The sanguine view is that as the economy recovers, the Fed can begin
tightening by selling assets and drawing down bank reserves. That would be
lovely. A less optimistic scenario is that banks, feeling a burst of confidence as
the economy recovers, will begin loaning out these reserves, sending new money
coursing through the banking system and causing the inflation that critics have
been warning about for years. A related concern is that as interest rates begin to
rise, the Fed will lose money on the securities in its portfolio. (Bond prices move
inversely to interest rates, so as interest rates rise, the value of the Fed’s huge
bond portfolio will fall.) The Fed is not overly worried about either of these
prospects, in large part because there are tools to manage the rate at which banks
begin loaning out their reserves, such as raising the interest rate the Fed pays on
excess reserves held at the Fed. (Remember, the Fed is the banker for banks; it
can raise or lower the rate it pays on deposits held there by commercial banks
just like those banks do for their customers.) If the Fed raises the rate it pays on
excess reserves, the banks holding those reserves will be less inclined to use
them to make new loans. Meanwhile, the Fed is not like a sandwich shop or an
insurance company. The fact that the Fed is “losing money” because of the
change in value of assets on its balance sheet is largely a meaningless concept.
(When you can conjure money with taps on a keyboard, the normal rules of
finance don’t apply the same way.)
Still, we cannot declare the 2008 financial crisis over until it’s over. Allan
Meltzer, one of the monetary policy experts who anticipated significant inflation
after the Fed’s early interventions, still sees the huge quantity of bank reserves as
a threat. He wrote in late 2014, “I have admitted publicly that I made a mistake
by failing to anticipate that banks would decide to hold idle $2.5 trillion of the
new reserves that the Federal Reserve supplied. Nothing to that extent had ever
happened. The $2.5 trillion sits on the banks’ balance sheets. There is a slight
chance that the Federal Reserve will find a way to gradually remove the idle
reserves without causing inflation or a recession—or both. However, Federal
Reserve history does not give reason for confidence that it will succeed in this
task.” 16
Meltzer compares declaring the Fed’s actions a success at this point to
claiming victory in a sporting event at halftime. He has a point. We may be
nearly a decade past the onset of the financial crisis, but the fat lady is still in her
dressing room. This unusually long period of near-zero interest rates may have
planted the seeds that become the next crisis; at a minimum, there are likely to
be unintended consequences. We can see light at the end of the tunnel, but we
are still in the tunnel. Critics still see a train coming, as they have ever since
2008; we cannot yet prove them wrong.
What should the Federal Reserve be trying to do? This is not a trick question.
There is an ongoing argument over whether America’s central bank should focus
exclusively on price stability—promulgating its inflation target and then hitting
that target—or if the Fed should also commit to maintaining full employment, as
the law currently prescribes. The focus on price stability and maximum
employment is the so-called dual mandate created by the Federal Reserve Act of
1977.§ As with any life endeavor, providing two objectives muddies the task. If I
send my daughter off to college telling her, “Stay safe and have fun”—which
one is it? Sometimes staying safe isn’t so fun, and sometimes having fun isn’t so
safe. It’s not always a tradeoff, but sometimes it is, and managing a tradeoff is
inherently harder than focusing on a single indicator. Other central banks around
the world, such as the European Central Bank, are charged exclusively with
maintaining price stability.
To critics, the dual mandate is the central banking equivalent of attention
deficit disorder, causing the Fed to lose focus on its primary responsibility,
which should be fighting inflation. This group, which tends to hail from the
political right, considers the Fed’s focus on jobs to be ineffective and potentially
reckless. The massive bond purchases associated with quantitative easing
magnified this concern. CNN reported in 2010, “Some critics are sick and tired
of the Fed prioritizing job creation at the risk of rising prices. They say the
juggling act of promoting growth while staving off inflation has proven
ineffective, and has led to a policy of too much cheap money with dangerous
consequences for the economy.” 17 Around the same time, Mike Pence, a
Republican congressman from Indiana (and now governor), introduced
legislation that would have limited the Fed’s mission to maintaining price
stability.18 All the while, critics on the left were blasting the Fed for not acting
more aggressively on the jobs front, given the absence of inflation.
Paul Volcker claims the term “dual mandate” never passed his lips during his
tenure at the Fed, primarily because getting inflation under control was a
prerequisite for a healthier economy. He recalls, “The most important thing we
can do for a prosperous, stable growth is to maintain price stability. So we were
discharging the dual mandate.” 19 Yet the slow recovery after the financial crisis,
when conditions were totally different than in the 1970s, argues that the Fed has
an important role to play in boosting employment apart from its role as guardian
of prices. So far, unemployment has fallen steadily without any signs of inflation
(and faster than in other parts of the world where central banks acted less
aggressively). Ben Bernanke offers a nuanced defense of the dual mandate that
is at odds with Volcker’s singular focus on inflation. Bernanke explains, “In
practice, all central banks have dual mandates, at least to some extent. Lars
Svensson coined the term ‘flexible inflation targeting,’ which basically means
that you try to bring inflation to its target over a 2–3 year horizon, but in the
short term you have some scope to respond to economic conditions, including
developments in the labor market. If you looked at the actual behavior of the Fed
and the Bank of England, say, they wouldn’t look radically different, even
though the Bank of England is formally an inflation-targeter while the Fed has a
dual mandate. The flexible inflation-targeting approach gives that leeway; in the
case of the Fed, the mandate to pay attention to employment is just more
explicit.” 20
Does a central bank operate more effectively with explicit money policy rules
or with the discretion to act as necessary? In other words, did all that jazz
improvisation do more harm than good? Maybe the Fed should just read the
sheet music. There is broad agreement on the general parameters of how the Fed
ought to operate: lower interest rates when the economy is operating below
potential; raise them when things are at risk of overheating. The question is
whether concepts like “below potential” and “lower interest rates” can be more
rigidly codified to remove what Fed critics would describe as arbitrary meddling.
In other words, would the Fed function more effectively by following an explicit
monetary policy rule rather than adhering to the discretion of the Fed chair and
his or her fellow FOMC members? Milton Friedman proposed letting a
computer govern the money supply.21 But when it turned out that the relationship
between the money supply and the economy was much less stable than he
thought, he backed away from the idea. (The possibility that the relationship
between variables may change over time, or under different economic
circumstances, is an argument against strict policy rules.)
More recently, John Taylor, a Stanford economist who is a proponent of a
more rules-based approach, described his vision in an op-ed for the Wall Street
Journal: “A single goal of long-run price stability should be supplemented with
a requirement that the Fed establish and report its strategy for setting the interest
rate or the money supply to achieve that goal. If the Fed deviates from its
strategy, it should provide a written explanation and testify in Congress.” 22
Not coincidentally, the most common monetary policy rule is the Taylor rule
—yes, named for the aforementioned John Taylor. The Taylor rule suggests an
optimal federal funds rate based on a formula that reflects where the economy is
relative to its output potential and how prices are trending relative to the
inflation target.¶ The intuition is obvious and consistent with everything
discussed in the previous thirteen chapters. The appeal is in the simplicity and
the precision. One can plug in the numbers and get the “right” answer. By this
thinking, not only could my twelve-year-old son do monetary policy with the
Taylor rule, good data, and a calculator, but sticking to the formula would lead
to fewer mistakes than an overactive and arbitrary Fed. John Taylor has argued
that the Fed held rates too low before the real estate bust, then overshot in raising
them, and has now held them too low for too long. More important, he believes
that a rules-based approach would have avoided these mistakes.23
Not surprisingly, central bankers are loath to believe that they can be
replaced by a formula and a twelve-year-old with a calculator. Economists
uniformly embrace the Taylor rule as a handy back-of-the-envelope tool that
does a nice job of describing how monetary policy has operated over the past
several decades. The policy question is whether it has prescriptive value going
forward. That is a tougher case to make. Leave the twelve-year-old aside for the
moment and just think about the data. David “Danny” Blanchflower, the
Dartmouth economist who served on the rate-setting committee for the Bank of
England, points out that the rule suggests a false precision. He explains, “The
dispute, more than anything, about the Taylor rule is what you put in it. You
have to guess on the scale of the output gap [how far the economy is from its
natural speed limit]. In 2008, the biggest difference between me and the rest of
the committee was basically the size of the output gap and what was happening
to it.” 24
If there is disagreement over the economy’s speed limit, and even sometimes
over how fast we are currently traveling, no formula is going to tell us whether
we are going too fast or too slow. Moreover, the economy’s potential output is
going to change over time, as will some of the other relationships in the model.
As former Fed governor Kevin Warsh has said, “Economics, and the conduct of
monetary policy, after all, is not physics.” 25 And as Ben Bernanke points out,
it’s not like the Fed is pulling interest rates out of a hat. There are explicit goals
and rule-based processes—just none that ties the hands of the Fed as tightly as
critics would like.
Is a 2 percent inflation target high enough? Twenty years ago, no one could
have imagined this as a serious question. Too little inflation? Seriously? Yet one
lesson from the financial crisis is that a higher rate of inflation during normal
times provides a central bank with more room to cut rates when times turn bad,
as described earlier in the chapter. This is one of the ideas advanced in a report
entitled “Rethinking Macroeconomic Policy” prepared by economists at the IMF
in 2010. Olivier Blanchard, the Fund’s chief economist, and his colleagues
wrote, “Higher average inflation, and thus higher nominal interest rates to start
with, would have made it possible to cut interest rates more [during the financial
crisis], thereby probably reducing the drop in output and the deterioration of
fiscal positions.” 26 I made the case earlier for a modest inflation target, but if 2
percent is good, might 4 percent be better? We know the harms of inflation, but
they are minimized when the target is clear and the inflation is expected. A
world that has become used to 2 percent inflation could adapt to 4 percent in the
same way. Expectations would be reset and central banking would become
modestly easier.
Or would it? The battle against inflation was hard fought. If the public is
persuaded that the inflation target needs to double, what’s to stop it from
doubling again? Paul Volcker (aka Inflation Fighter Man) is a critic. Inflation
Fighter Man did not reset the world’s inflation expectations so that policymakers
could squander that accomplishment. In a New York Times op-ed, Volcker
warned of the siren song of higher inflation, which is both “alluring and
predictable.” Volcker was criticizing the idea of a temporary boost in inflation,
rather than a permanent change in the target, but his critique is generalizable.
“The instinct will be to do a little more—a seemingly temporary and
‘reasonable’ 4 percent becomes 5, and then 6 and so on.” Inflation Fighter Man
has no desire to come out of retirement to beat back rising inflation expectations
once again.27
There is another option that, in theory, could combine the benefits of
inflation targeting with more flexibility around the appropriate rate of inflation:
nominal GDP targeting. (Nominal GDP growth is real growth plus inflation—
the change in the production of goods and services plus the change in the price
of those goods and services.) Under this approach, the Fed would aim to hit a
consistent rate of nominal GDP growth, say 5 percent. The inflation rate would
then be allowed to fluctuate depending on how the economy is performing.
Suppose real growth is only 1 percent—below what most economists believe is
the economy’s natural long-run rate of growth (around 3 percent). Nominal GDP
targeting would prescribe an inflation rate of 4 percent—extra easy monetary
policy until growth returns to trend. Conversely, a booming economy, say 4.5
percent real growth, would prescribe much tighter monetary policy and a lower
inflation rate (just 0.5 percent). Targeting nominal growth rather than a specific
inflation target gives policymakers more flexibility in dealing with economic
fluctuations. As one economic blogger points out, “It is a surreptitious way of
temporarily raising the inflation target without the toxic politics of doing so
explicitly.” 28 (Others have made the same basic point, including New York
Times columnist Paul Krugman.) Thus, how you feel about nominal GDP
targeting probably depends on how you feel about the Fed moving its inflation
target around.
Ben Bernanke raises a more pragmatic concern: nominal GDP targeting
requires the public to have a sophisticated understanding of what the Fed is
trying to do, including the moving target for inflation. It is harder to anchor
expectations around a moving target than around a single number. If the public’s
inflation expectations do not track with what the Fed is trying to do, the policy
will not work.
The larger point here is that the Fed is always looking for better tools. When
Paul Volcker took the helm as Fed chair, the Fed was primarily concerned with
managing interest rates. Under Volcker’s direction, the Fed switched to a policy
that managed the money supply, which gave the Fed more power to fight
inflation. In the 1990s, the Greenspan Fed adopted inflation targeting, albeit
without a formal target. Ben Bernanke made the 2 percent inflation target
explicit. What might the next formal refinement be?
Should the central bank try to pop bubbles? Asset price bubbles—our old
friends euphoria and panic—are the bane of the financial system. Bubbles are to
finance what car accidents are to transportation: given the inevitable forces at
work, what is the best way to minimize the harm? To what extent, if at all,
should the central bank use monetary policy to prevent bubbles from getting out
of control, as opposed to cushioning the blow after the inevitable accidents
happen? One line of thinking among economists has been that central banks
should “lean against the wind” by raising interest rates when asset prices appear
frothy. Higher interest rates will dampen the euphoria and make the panic either
less likely or less damaging if it does happen. The Fed has been accused of
contributing to the housing bubble by holding rates too low for too long in the
2000s. (The Financial Crisis Inquiry Commission rejected this explanation for
the crisis, pointing out, for example, that there were housing bubbles in other
countries with much tighter monetary policy.)
The opposing view is that monetary policy is a lousy tool for dealing with
asset price bubbles and the Fed should instead stand ready to clean up any
postbubble mess by providing liquidity and low interest rates after the fact. This
approach is not as negligent as it sounds. It is hard to spot an asset bubble before
it bursts. In any event, higher interest rates might be a costly tool if the rest of
the economy is weak—the proverbial smashing of a gnat with a sledgehammer.
Of late, there has been some refined thinking in the “lean versus clean”
debate. Economist and former Fed governor Frederic Mishkin has drawn a
distinction between bubbles that seriously infect the credit markets and those
that do not. In a credit-driven bubble, excessive borrowing fuels irrational
exuberance, causing a credit-induced spiral and then a crash that does damage to
the broader financial system. We know the basic script: borrowing causes a rise
in asset values, which encourages further lending against such assets, which
drives up prices, and so on. In the euphoria of rising prices, financial institutions
become less concerned about lending standards because the rising value of the
collateral they are lending against will protect them against losses. Does any of
that sound familiar?
When the bubble bursts, it all goes in reverse: asset prices fall, loans go bad,
lenders cut back on credit, asset prices fall further. Financial institutions get in
trouble, further restricting credit in the broader economy. We’ve seen this film
before: Japan in 1989, the United States in 2008, our idyllic rice-growing village
in chapter 4. However, there is a less scary film—a second type of bubble in
which the irrational exuberance does not interact so deeply with the financial
system. For example, the Internet bubble in the late 1990s involved very little
lending against rising share prices. Yes, high-tech companies had ridiculous
valuations. Yes, firms that had never earned a dollar in profit were worth more
on paper than companies like IBM. Yes, seventeen-year-old hipster CEOs said
ridiculously stupid things. (“Technology will make government irrelevant.”#)
Yet for all the idiocy and craziness, the popping of the tech bubble had only a
modest impact on the broader economy because there was no significant
spillover to the financial system.
This suggests a third way in the “lean versus clean” debate. Regulators may
not be able to identify a bubble before it’s too late, but they can certainly spot
shoddy lending practices, regardless of whether assets turn out to be overpriced.
As noted earlier, my dog was offered a preapproved Visa card with a five-digit
credit limit sometime around 2005. (I subscribed to The New Yorker in his name,
W. Buster Wheelan, and some credit card issuer obviously bought the list.) This
would suggest that the credit markets were out of control. The subsequent real
estate bust would not have been nearly as catastrophic if financial institutions
had not been lending to dogs, literally and figuratively. Ben Bernanke told the
American Economics Association in 2010, “Stronger regulation and supervision
aimed at problems with underwriting practices and lenders’ risk management
would have been a more effective and surgical approach to constraining the
housing bubble than a general increase in interest rates.” 29
We have established an important point: dogs should not be getting credit
cards. Which raises the next question.
Have we got the regulation right? In 2005, the city of Boise, Idaho,
implemented a ban on full nudity in public, leaving an exception for “serious
artistic” expression. Shortly thereafter, the Erotic City Gentlemen’s Club in
Boise began holding “art nights,” during which patrons were given pencils and
sketch pads as they ogled fully naked women. The police cited the club for
breaking the law (because “officers concluded that patrons were not focused on
art”).30 Still, you have to admire the cleverness—and as a regulator, you need to
fear it. The nature of financial regulation is that it seeks to constrain certain
kinds of activities conducted by certain kinds of institutions, typically with
hundreds of pages of legislative language devoted to defining those activities
and institutions as specifically as possible (e.g., “bank” and “lending” and
“serious artistic expression”).
Regulating the financial system is like playing whack-a-mole. Financiers are
clever people. Like the rest of us, they don’t like the government telling them
what to do, or what not to do. When regulators try to fix one vulnerability in the
financial system, they often open the door for some other problem (for instance,
the rise of the shadow banking system). As Ben Bernanke explains, “One of the
inherent problems is that all regulations have a fence. Everybody inside this
category has to do ‘this’ and everybody outside is exempt. So naturally there are
always going to be attempts to get just outside the fence. That’s just the way
financial markets work, and the way human beings work.” 31 Congress devoted
some three thousand pages to try to change the behavior that contributed to the
financial crisis. Smart people will get paid a lot of money to find the loopholes.
(“Hey, this isn’t a strip club! It’s an art school.”) Then maybe we’ll need another
thousand pages.
Voters are prone to dislike regulators in any event. Just think about the
nature of what those regulators are trying to do. If regulation averts a crisis—the
real goal—the public never knows there would have been a crisis. We will just
resent whatever cost and inconvenience the regulations impose, totally unaware
that those precautions may have prevented a debt crisis or a real estate crash.
There are no heroes for stopping a problem before it happens. Of course, that is
the most successful kind of government intervention. And if something bad does
happen, regulators will be blamed for not having prevented it.
There is also a less benign view of why regulation is not as effective as it
might be: Wall Street firms have the clout to get what they want from Congress.
Simon Johnson, former chief economist at the International Monetary Fund and
author of 13 Bankers: The Wall Street Takeover and the Next Financial
Meltdown, points out that one of the many revolving doors in Washington is
between high-level regulatory positions in government and extremely lucrative
jobs in finance or in consulting to big financial firms. That relationship may be
too cozy, at great cost to taxpayers. Johnson says, “We often discuss central
banking in very dry, technocratic terms, and we forget about the power
structures behind them. When we look at other countries, we see the power
structures. We don’t like to look at it in the United States.” 32
It’s clear post-2008 that central banks must focus on financial stability. Many
of the regulations passed since then make perfect sense. For example, the
creation of “living wills” for systemically important financial institutions
theoretically protects the system from contagion without promoting moral
hazard. The living will is a plan for the orderly dissolution of a firm in the case
of insolvency to avoid spreading panic and instability to the rest of the system.
Will it work? Will financial institutions reinvent themselves and their products
in ways that leave them just outside the perimeter of the regulatory fence? I have
no idea, but I do know that the answers will determine whether the financial
crisis is a unique event in the twenty-first century or whether we will have to
start numbering them, like our world wars.
Is it time for Bretton Woods II? Everybody has a complaint about the post–
Bretton Woods era. The United States accuses China of manipulating the yuan.
China resents the dollar’s role as the world’s reserve currency. Small countries
with their own currencies are whipsawed by huge swings in exchange rates.
Small countries without their own currencies worry about becoming the next
Greece. The whole world is worried about imbalances—huge caches of
international reserves accumulated by countries like China and enormous
deficits run up by the United States. Capital flows across borders faster than
ever, exacerbating any inherent instabilities. What’s not to dislike?
The more constructive question is: What might be better? Answers do not
leap off the page. One lesson from the euro is that supranational monetary
arrangements do not work well without a corresponding governmental
apparatus; at present, there is no international institution with the authority and
enforcement power necessary to make a new international monetary system
work. And what might that look like anyway? The lesson from the last several
decades is that monetary policy has significant “cross-border spillovers,” as the
Brookings Institution’s Rethinking Central Banking committee described it.
When the United States engages in quantitative easing, countries from India to
Brazil must worry about an appreciating currency or sudden inflows of capital
seeking a higher return.33 It would be great if the system were more orderly and
predictable.
Like the gold standard? As a former senior Treasury official pointed out, the
more orderly and predictable the international monetary system, the more rigid it
is in a crisis. And the more rigid it is in a crisis, the more difficult the needed
adjustments. We want the impossibility set: the benefits of free-flowing capital
without the disruptions; the flexibility of floating exchange rates without the
unpredictability; and the ability to adapt monetary policy to domestic needs
without the headaches caused when other countries do the same. Simon Johnson
describes a grand global deal for some kind of Bretton Woods II arrangement as
“basically impossible.” 34
So we’re going to have to figure that one out.
None of this should detract from what the world’s central bankers, supported by
lots of important economic thinking, have accomplished. Sure, the financial
crisis is cause for humility. Then again, the outcomes were appreciably better
than they were during the Great Depression or the many panics before that. We
are getting steadily better at this.
There will always be unique challenges associated with managing a fiat
currency—the awesome power to create money where none existed. Or to take it
away. Just as neurosurgeons can manipulate a living brain—presumably for the
better, but always with the risk of making things worse—a central bank has a
similar awe-inspiring influence on the entire economy: our jobs, our savings, our
homes. People may not literally live or die based on Fed decisions, but they are
affected profoundly. At a minimum, I hope I have persuaded you that money
matters, not just because you’d rather have more of it than less, but because the
system that puts $20 in your pocket makes possible all the other economic
activities that we care about.
________
* I checked this. A Fed official sent me the following note: “There was no cake associated with the 100th
anniversary event in 2013.”
† Fed trivia: Paul Volcker wrote his college thesis on how the Fed ought to restore the independence that it
lost during World War II.
Transcript of the Ceremony Commemorating the Centennial of the Federal Reserve Act, Washington, DC,
December 16, 2013.
‡ Long-term interest rates can sometimes fall when the Fed raises short-term rates to fight inflation because
bond buyers no longer expect high inflation in the future and will therefore accept lower nominal rates.
§ As noted in chapter 5, the Federal Reserve Act of 1977 assigns the responsibility for three objectives:
price stability, full employment, and moderate long-term interest rates. Because low inflation leads
naturally to moderate long-term interest rates, these two objectives have become redundant and
policymakers now speak of the two remaining objectives as the dual mandate.
¶ i = r* + pi + 0.5 (pi-pi*) + 0.5 (y-y*)
Where:
i = nominal fed funds rater* = real federal funds rate (usually 2 percent)pi = rate of inflationpi* = target
inflation ratey = logarithm of real outputy* = logarithm of potential output
http://www.investopedia.com/articles/economics/10/taylor-rule.asp.
# Yes, I really heard someone say that.
Acknowledgments
This was a hard book to write. One does not just sit down at the computer and
begin typing interesting thoughts about monetary policy. The substance is hard.
So is the task of making it accessible and interesting. I had help at every stage,
beginning with the crucial task of background research. Jack Pinto was a terrific
research assistant, digging up many of the amusing anecdotes in the book. When
Jack graduated, Zachary Hardwick stepped into his huge shoes. Jeffrey Lang
was there at the end of the project, when I needed essential details, often on
ridiculously short notice.
My Dartmouth colleagues helped in big ways and small. Jim Feyrer was a
steady sounding board on all kinds of macroeconomic questions. Wandering into
his office to ask random questions is always enjoyable and usually helpful. I
admire his diverse intellectual interests.
David “Danny” Blanchflower was both a great resource for the book and a
fun golf companion—often at the same time. On several occasions I took a
digital recorder in the golf cart so I could record his stories. I am indebted to
Doug Irwin, both for his intriguing academic work on the gold standard and for
his helpful feedback on the manuscript.
Andrew Samwick has created a wonderful intellectual home for me at
Dartmouth’s Rockefeller Center. It is a privilege to work every day with such
talented, altruistic faculty, staff, and students. Most people don’t get up each
morning thinking about how they can make undergraduate education better, but
at “Rocky” they really do.
Two former Federal Reserve chairmen took time out of their busy lives to
speak to me about monetary policy: Paul Volcker and Ben Bernanke. I admire
both of their commitments to public service. Volcker—a.k.a. the superhero
“Inflation Fighter Man” in Chapter 5—had the temerity to face down the
inflation that plagued the U.S. throughout the 1970s. Bernanke steered the world
through the worst financial crisis since the Great Depression. Each of them took
a public political beating for their efforts.
The dynamic duo at W. W. Norton, Jeff Shreve and Drake McFeely, do a
remarkable job of applying all the tools necessary to turn good ideas into great
books. Tina Bennett helps to launch those projects in the first place. I appreciate
her longstanding and steadfast advocacy.
Last, but not least, Leah, Katrina, Sophia, and CJ provide just the right
balance of chaos, adventure, and support. Thank you for the joy that you bring to
our home. Katrina, ever skeptical of the life of a college professor, is fond of
asking, “What work do you really do?” At least now I can say, “I wrote this
book.”
Notes
Introduction
1. John Whitesides, “Senior U.S. Lawmakers Condemn ‘Provocative’ Currency Devaluation,” Reuters,
August 11, 2015.
Entries correspond to the print edition of this book. You can use your device's
search function to locate particular terms in the text.
haircuts, 109
Haiti, 13–14
Hamilton, Alexander, 158, 162–64
Hanyecz, Laszlo, 271
Harare, Zimbabwe, 20
Harvard Crimson, 32
Harvard University, 32, 70n
harvests, 65, 67, 69, 70–71, 94
Hawaii, 25
Hazard, Merle, 19
health care, 43, 47, 246–47
hedge funds, 77, 181–83
hedonics, 44–45, 48
Henry VIII, King of England, 144–45
“hill of beans,” 113, 116
Hitler, Adolf, 139, 228
Holocaust, 106
home equity loans, 27
Honda Motors, 114–15, 215
Honda Motors, 114–15, 215
Hong Kong, 250
Hoover, Herbert, 75
hotel rooms, 109–10
“hot wallets,” 275
House Banking Committee, 179–80
humanitarian aid, 13–14
hyperinflation, 12, 14, 15, 16, 20–21, 24, 27–28, 29, 30, 38–39, 55, 58, 83, 139,
151, 219, 276, 286
IBM, 301
Iceland, 243, 269
income:
levels of, 21, 33, 37–38
per capita, 111–12
rental, 148
surplus, 77–78
taxation of, 46–47, 48, 159–60, 220, 235
see also wages
India, 8–9, 10, 51, 86, 109, 111n, 132, 148–49, 230, 304
inflation:
anticipation of, 52n, 93–94, 102, 211
causes of, xv, xvii, 21, 22, 47, 96, 125, 220, 235, 241, 261, 289
currency issues and, 3–4, 116, 119–20, 124–25, 127
debt and, 34–35, 53–54, 55, 169–70
deflation compared with, xvii, 16, 21–28, 30, 32, 33–39, 52–54, 58–59, 83–
84, 87, 93–94, 95, 110n, 119–20, 136, 142, 158, 161n, 187–91, 201, 207,
210–26, 288
economic impact of, xv, xvii, 19–39, 45, 47, 96, 125, 220–22, 229, 235, 236,
241, 261, 289
Federal Reserve and management of, 24–29, 32–33, 81–84, 95, 98, 103, 116,
140, 151, 157–58, 177–78, 184–86, 207–9, 220–22, 228, 236–39, 282, 283,
286–88, 291–300
fixed vs. variable rates of, 90n, 98
government spending and, 47, 96, 125, 220, 235, 241, 261, 289
hyper-, 12, 14, 15, 16, 20–21, 24, 27–28, 29, 30, 38–39, 55, 58, 83, 139, 151,
219, 276, 286
interest rates and, 107, 188, 248n, 298–300
measurement of, 40–53, 94, 146
money supply and, 25–26, 55–56, 159–60, 222–24
nominal vs. real, 28–29, 32, 34–35, 52, 53–58, 110n panflation, 31
prices and, 21, 23, 24–39, 81–84, 93, 95, 169, 175, 176–77, 187n, 189, 208–9,
211–13, 216n, 220–26, 237, 243, 248–52
as stagflation, 158, 175–78
targets for, 92, 94, 96, 222–24, 288, 291–95, 296, 298–300
taxation and, 46–47, 48, 58
trends in, 51–52, 93–94, 102
unemployment and, 158, 175–78, 234–39, 242, 294–95
wartime, 136, 166–67
zero rate of, 225, 288
Inflation Fighter Man, 81–83, 102, 177–78, 221, 299
Initiative on Global Markets (IGM), 15, 140, 256–57
input costs, 31, 113–15
insurance policies, 148
interest:
annual rate of, 204–5
for banks, 5, 176–77, 202, 204–5, 208–9, 289–90, 293–94, 297
compound, 49, 216
currency exchange and, 122–27, 130, 131, 132, 258–59
economic impact of, 36–37, 101
on federal funds, 5, 89–90, 125–27, 176–77, 202, 204–5, 289–90, 297
inflation and, 107, 188, 248n, 298–300
on loans, 53, 68–69, 176–77, 181–82, 199, 203, 204–6
long-term, 204–5, 286, 289–90, 291n
low, xv, 5, 91–92, 119
low, xv, 5, 91–92, 119
negative, 35–36, 58
nominal vs. real, 35–36, 211, 218–19, 288, 291n as price of money, 89, 91,
280
rate of, 32, 35–36, 40–53, 61–62, 74, 93–94, 125–27, 176, 216, 217
on savings, 252–54
short-term, 89, 176–77, 184, 202, 204–5, 212, 286, 289–90, 291n, 297
zero rate on, 36, 118, 218, 289–90, 294
Internal Revenue Service (IRS), 47, 276
International Monetary Fund (IMF), xvi, 51, 79, 98, 119, 127, 131–32, 133, 211,
219, 241, 243–44, 254, 255–56, 260, 282, 298–99
Internet, xviii, 96, 182, 263, 268–72, 276–77, 278, 280, 291, 301
investment:
bitcoin, 271, 273–74
capital, xiv, 131–32, 217, 252–54
consortiums for, 79
foreign, 130
global, 78, 124, 125, 131–32, 237–38
return on, 51, 78, 121, 148, 199–200
risk in, 98
short-term, 198–99
speculation in, 69–71, 98, 99–100, 101, 125–27, 181–86, 273
in technology, 271
Iran, 105–7, 121, 131, 133–34
Ireland, 230, 234, 238, 239, 241
“irrational exuberance,” 301
Irwin, Doug, 110, 124n, 187–88, 189n Italy, xvi, 84, 116, 131, 227, 228, 230,
231, 237–38, 239, 241
It’s a Wonderful Life (film), 61–64, 65, 67, 74, 77
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