In praise of Bernanke, and a tutorial on money

From domestic critics to foreign governments, Ben Bernanke is taking heat for QE2. At the centre of domestic criticism is fear that the Federal Reserve’s endlessly growing balance sheet can only end in tears. Also unhappy are US trade partners and emerging markets whose domestic interest rates make their currencies irresistible to US and other rich-world investors.

To see why Bernanke is doing the right thing, and will need to do much, much more, we need to get to grips with ‘money’. Of the easily spendable money we use every day there are two kinds, though the public do not distinguish between them. The first is ‘central bank money’ (synonyms: high-powered money, base money, monetary base). The second is ‘bank money’. The easily spendable money perceived by the public consists partly of some central bank money (currency in circulation) and partly of bank money. This combination is ‘broad money’. (Be clear that broad money is not a type of money. It is an ‘aggregate’, a measure, a compilation of two types of highly liquid monies.)

Central bank money includes cash in circulation plus the deposits of the banking system at the central bank.

Bank money is money that is created by, well, banks. If someone wants a loan, and the bank sees fit to grant the loan, then it creates the funds to do so, of which it holds only a fraction in central bank money. Think of it this way: the bank does not hand over wadges of cash when you get a loan. But sure enough, you, the loan recipient, have new money. It just happens to be in the form of a bank account. You can easily spend it by debiting that account. (And you can even transform some of it into cash.) As you go along merrily debiting this account, paying for all the home-improvement projects you’re executing, you’re injecting this money into the economy. That plumber you paid should thank you for being so good as to ‘create’ money for the economy in the first place!

It should be clear to you now that when the banking system is writing lots of credit, the supply of money in the economy is growing. That’s pretty handy. Because if you like prosperity, then you like the idea of more people (both at home and around the world) going to work, more people enjoying better incomes, etc. All of which means rising output of goods and services. And if this is all to take place, then the money supply had better grow. Why must the money supply grow? Can’t we just make do with a constant amount of money? Think what that would require: it would require deflation. More stuff + same money = less money per stuff a.k.a. deflation. Think what this requires: that people are indifferent to falling wages. That your creditors are happy to renegotiate your loan. In short, it requires that money is ‘neutral’.

‘Monetary neutrality’ is an assumption of pure theory. It is what allows Austrian-school economists to be comfortable with deflation. It is what allowed many mainstream economists in days past to say that ‘money doesn’t matter’. It allowed serious analytical models to be built and heeded, describing an economy which lacks money entirely. The trouble is, monetary neutrality does not apply in the real world. Ben Bernanke knows this. Ben Bernanke is an expert on the non-neutrality of money. An important part of his research as an academic was devoted to understanding why money patently failed to be ‘neutral’ at a time when such neutrality was needed most: the Great Depression, and the (sinister) deflation that accompanied (/caused) it.

It is not complicated. If people have trouble accepting a decline in wages that matches the decline in prices generally, they price themselves out of the labour market. =unemployment. Remember that the employer’s income (i.e. sales) is falling right along with the price level. The employer needs to pay the workers an equally diminished salary, otherwise the workers become unaffordable. It turns out that money is especially non-neutral in respect of the ‘factors of production’. This includes labour and capital alike. Consider the bank loan. Does the bank send you a letter stating that you now owe less because your wage (along with the price of everything else in the economy) has fallen? Nah. And that means debtors are crushed by deflation. And capital seizes up, because, like labour, it is priced out of the market. (When prices are falling, the rate of interest you are anticipating to pay is not only the nominal rate quoted to you on the loan document, but also the rate of decline in consumer prices generally. This is the real interest rate and it rises during deflation, making capital too expensive.)

If you are really worried about Bernanke’s stewardship of the money supply, consider that he is operating in an environment where credit is contracting. The fear is that this eventually becomes a contraction in the money supply. This would be deflationary. That’s a problem, because of money’s non-neutrality; it cannot simply be wished away. It was a central feature of the Great Depression.

This also puts into context the grumbling of US trade partners. Yes, failure to embark on new QE would buoy up the dollar, because a smaller supply of it would be hitting the foreign exchange market. But does the United States need a buoyed-up dollar? Certainly not. On the contrary, it needs a much weaker dollar. It needs for the economy to start configuring itself around the traded sector. Come to think of it, why does the US administration robotically cling to the ‘strong dollar’ mantra? (Could it have to do with the political power of the financial services industry?) Anyway, the US economy was the buyer of last resort for the rest of the world for a very long time. It is now time for others to pick up that mantle. And what good would it do US trade partners anyway if the US were to tip into deflation and depression?

Emerging markets are in the unique position of having to cope with highly desirable currencies. This is because their economies offer interest rates unavailable in the rich world. The worry for them is that rising currencies price their traded sectors out of the market, killing off their very enviable growth dynamic. This is a genuine policy challenge. But it is manageable. Put crudely, it is a ‘high-class’ problem. These countries can try tightening the access of foreign investors to assets in their economy. They can institute disincentives to investment in short-term securities, and guide investment into long-term projects. They can discourage capital inflows altogether. They can do such things unilaterally, and already are. They can exercise their sovereignty. And that does not make this a beggar-thy-neighbour scenario. (Equally, if Brazil, for example, wants less appreciation in the currency, it needs to examine from where come the very high interest rates it offers. The answer has much to do with an out-sized government budget. But that is a lot more difficult than pointing the finger at another country.)

The truth is that QE2 is a  minimal step. The Fed will need to do much more. It will need to re-visit the funding of private-sector securities from the early days of the post-Lehman crisis. To see why, consider the mechanics. ‘Quantitative easing’ means what it says. With the policy short-term interest rate already set to zero, the balance sheet is used to operate on longer-term securities. The central bank’s money, already mentioned, is ‘base money’. It is contained on the liability side of the Fed’s balance sheet. (However, it is crucial to be clear that this money is nobody’s liability — not even the Fed’s. And that’s OK.) Base money — the liabilities on the Fed’s balance sheet — is backed by assets on the Fed’s balance sheet. In the Fed’s case, these assets are domestic securities. (For the moment, never mind what kind of securities.)

The Fed creates new central bank money by purchasing securities. When it does so, it is buying a security with a newly created quantum of central bank money. It buys securities from the banking system; it pays the bank from which it buys the security by crediting its account at the Fed. Banks keep money at the Fed and it is these holdings, in part, which determine how much ‘bank money’ banks can create. Banks cannot write bank money indefinitely; they can only write it up to a certain multiple of the bank’s holdings of central bank money. In this way is bank money tied to base money, and in this way is base money considered ‘high-powered’ money: it can be pyramided upon by the banking system.

It is this very potency of central bank money that has the critics worried. For every dollar the Fed credits to the banking system, a multiple lies in wait. But the key in this potency is the word ‘potential’. Critics see this as dangerous. In fact, it is at the root of the limited effectiveness of QE2. All the Fed is doing is pushing more money into the banking system. The banking system has little desire to spin this into new money for the economy, and the economy has little desire to be further ‘spun’. Banks are risk-averse and the public is credit-shy. This makes QE2’s usefulness mostly in the area of pushing down the government’s borrowing costs. But about half of the purchases under QE2 will be at less than five years’ maturity, where the borrowing cost is already very low. And even at the longer end of the yield curve the government can already borrow incredibly cheaply. The same goes for many corporations.

The Fed will need to liquefy the private sector and to do so it will need to purchase assets directly from it. If you were worried about QE and QE2 then you’ll be terrified by what’s in store. I personally will find it a great comfort. And I’ll be thanking my lucky stars that by some fluke Bush Jr chose an expert in the Great Depression to be the steward of the US money supply. Do keep in mind that when the Fed starts buying bonds directly from the private sector, it will merely be returning to standard operating procedure under the Fed’s original statutes. (The Fed when it was created could count only such securities as qualified domestic assets backing its liabilities.)