The future of money: inflation, deflation or disappearance into thin air

The future of money has been getting a little attention lately.  It could go one of three ways – inflation, deflation or part of it could disappear into thin air.  Concerns about money probably reflect concerns and uncertainty about where the economy is going.  Frequently behind these concerns lurk people who want a fixed money supply such as gold or bit coin.

This blogger figures money should be defined as a tool to facilitate the exchange of goods and services.  I do not like definitions that make it a store of wealth or a measure of value because these give money an intrinsic value which it does or should not have.  Money should only have value as a tool. 

One of the most important features of money should be the amount available  in the economy needs to be flexible.  It should be able go to up or down  with changes in the quantity of goods and services we want to exchange.  If the money supply is not flexible then as we change the quantity of goods and services then either prices must go up or down or the velocity, the rate at which money changes hands will change.  It is dangerous to assume there will be only growth.

Inflation happens when the money supply increases faster than the rate of economic growth and deflation happens when the money supply goes not keep up with the rate of growth.    Inflation is good for borrowers as the can repay their loans with money which has less real value.  This is one reason governments and their agents want to see mild inflation.  Deflation is good for lenders as they will be repaid with money which has more value.  The ideal should be price stability so nobody loses.

Our understanding of inflation and deflation has been distorted by the long period of economic growth we have just experienced. Most inflation has happened along with growth and most deflation has resulted from banking authorities trying to restrict the amount of money available.  This happened in the 1930s and todays central bankers have sworn to never again let that happen.

There is some evidence that our time of economic growth has terminated.  It is unclear how this will affect prices.  Quantitative easing which is an attempt to increase the money supply has not led to high inflation.  Past hyperinflations have occurred when governments have increased to money supply faster than the economy was capable of growing.  It appears the money created by quantitative easing has led to inflation in the financial markets rather than consumer markets.

Economists generally understand how fractional reserve banking works to increase the money supply but I am not aware of anyone who has thought out the opposite process.  Money that can be created out of thin air can just as easily disappear into thin air.

In fractional reserve banking banks are required to keep a portion of their deposits as reserves for protection against runs. The rest is loaned out and redeposited with the new deposits subject to the same fractional reserve.  The result is that a large proportion of our money supply is  somewhat precarious.  This blogger and many other people on the internet have explained the process.  Just search “fractional reserve banking.”

Central banks can add money to the system by purchasing financial instruments or by changing the reserve requirements.  The could also reduce the money supply by selling financial instruments or by changing the money supply although it is unlikely they will do either under current conditions.

Another way the money supply could be reduced is if the banks suffer large losses.  Any loans the banks have to write off will directly decrease their available reserves.  (The technical term is high powered money.)  This means they will have to decrease their outstanding loans with the same multiplier effect as the money supply was increased.  We will hear about it as a contraction of credit.

So if the banks experience unusually large losses there could be a drastic decrease in the money supply which could have dire consequences.  ( I have read that a number of Canadian and British banks are highly exposed to the energy industry with unsecured loans.)

If a large part of the money supply were to disappear into thin air in the short term a lot of economic activity would come to a screeching halt.  People have in the past used playing cards or candies as a substitute for money.  In the long term the level of activity would depend upon the physical resources available.

People who talk up monetary reform often want a return to a gold standard or facsimile (bit coin).  It is not clear that either of these would correct the problems inherent in the fractional reserve way of creating money.  Nor would they provide the flexibility that is needed in the total amount of money available.

We all think we know everything there is to know about money.  That is a part of what our parents teach us. However, it is a complex subject which few people understand and there are a lot of unknowns, especially if we have to deal with an extended period of low or negative growth.

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A grumpy old man in favour of a basic income scheme

The “free money” giveaway or basic income or universal income scheme being proposed by a few people is a great idea but one that is probably impossible to implement.  However it is nice to dream and fun to think out how to solve economic problems; so here goes.

The basic questions are where does the money come from and how to give the money to people?

The simple answer to the first question is that with a universal income scheme there will no longer be a need for subsidies to producers.  A more difficult answer is that the introduction of an income scheme would be the ideal time to reinvent money.

Generally subsidies (sometimes as tax exemptions)  are given to firms to encourage them to establish plants and provide employment or to save the business and save jobs.  This is great for those who get the jobs or whose employment is saved but it leaves a lot people with nothing.  Subsidies also distort prices so that when we make purchasing decisions based on price we are not necessarily getting the item that was cheapest or most efficient to produce.

Money is something most of us use daily and is probably the least well understood of all the things that are a part of our economy.  When central banks were doing quantitative easing there was some disbelief that they could create money out of nothing.  This is because we have for so long associated money with gold that we think of it as a commodity with value in itself.  It might be better to think of it as a tool with which to facilitate the exchange of goods and services.  It represents purchasing power.

Most of what we use as money is created by bankers making loans.  How this works is explained at numerous locations throughout the world-wide web.  My own version along with some of the problems with fractional reserve money is included in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.

One way to reinvent money and implement a universal income scheme would be to take the concept of “local exchange trading system”  and expand it to the national level.  A good part of the essay talks about how this could work and again  I refer you to the essay.  There are many details to be worked out and many problems to be overcome.  The mechanics of the money supply would be easy.  Getting people to accept new ways of thinking about money would be extremely difficult.   Getting people to accept that others should be allowed to do as they wish, whether that be creating art works or drinking beer, would also be difficult.  Getting people to change their vested interests would probably be impossible.

One of my concerns is that our economic order is going to return to something similar to what existed before the industrial revolution in which there was a small group living in relative luxury and the balance of the population lived at a subsistence level. (The ultimate inequality)  I am concerned because I think our economy is possibly going into an extended period of decline.  While there are lots of energy and mineral resources left on this planet the energy required to extract them is becoming more and more excessive to the point it will be less viable.  Without resources it will difficult to maintain everyone at what has been the North American standard of living.

An income scheme would make it a lot easier to cope with an economy on a downward slope.

More and more I am getting to be a grumpy old man.  My generation has been very lucky in the time and place we have lived out our lives.  More and more I am recognizing the next generations, including my grand children, are going to have to deal with a lot of economic pain.  I hope I am wrong and if not I hope I won’t have to see it.

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Why we can’t let banks fail

It appears investors are putting money into banks in the belief the banks are safe because governments can be relied upon to bail them out the next time they get into trouble.  These investors could be right.

It’s not so much that banks are too big to fail, it is more that they are too important to let fail.

Banks are essential in creating the money supply. When banks make a loan they create money and the total money supply is increased.. When the loan is repaid, the money supply decreases until the money is re-loaned and the supply goes back up.   Thus the money supply is constant – until a central bank purchases government bonds.  Because the central bank pays for these bonds by adding to the liabilities of its balance sheet, this is the creation of new money.   But because of fractional reserve requirements (banks are required to hold a percentage of deposits in reserve against withdrawals) money created by the central bank is called high powered money and the money supply goes up with a multiplier effect.

institution_iconAll this is explained in any textbook on the economics of money and banking. What I have never seen explained is the effect on the money supply when a bank writes off a loan. Probably it has the reverse effect of high powered money – a decreased money supply subject to the same multiplier. (Here is a link to the wikipedia article on money creation.)

In most cases the writing off of loans will have little effect on the money supply However, if the amounts to be written off are large as was the case with the American housing crisis or is likely to be the case with any sovereign debt write off, the impact on the money supply will be substantial and it we lead to an abrupt decline economic activity. People will invent alternatives to the lost money but the initial devastation will be  a problem.

 The Americans are considering cutting back on their food stamp program.  My prediction is that when the next financial crisis happens, keeping the banks going will come before feeding people.

One way to reduce the importance and power of the banks would be to find a new way of creating money.  One proposal for doing this is in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.

Let’s end this post with the following quote attributed to Henry Ford.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

(This is an update of a post originally published in June, 2011.)

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Mild inflation to help the economy?

Another suggestion to get the economy rolling again is for central banks to encourage a mild increase in inflation.   Here are one, two articles proposing this.

Let’s look at my favorite economic formula which happens to show the connection between the financial and real economies:.

MV=PQ

where M is the total money supply in the economy, V is the velocity or rate at which money is circulated,  P is the price and Q is the quantity of goods and services being exchanged.

Encouraging inflation would mean an increase in P.  This would lead to an increase in one or both of the variables on the other side – probably the M.  There have been reports lately that banks are not lending out money to the full extent of their balance sheets.  Therefore increasing P would probably help the banks to make more profits.

What’s not clear is how increasing P would lead to any increase in Q. The quantity of goods and services produced depends upon the resource base and the ease with which resources can be made available.

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