.
MONEY
WHAT IT IS
HOW IT WORKS
Credit is the
lifeblood of the
economy. The amount and quality of credit market debt is a
measure of the
size and vitality of a nation's economy. All such debt rests like
an
inverted pyramid on a small foundation of money known as the monetary
base. The implicit assumption is that credit market debt
is convertible at maturity into base
money.
The monetary
base is the definitive money of a nation,
meaning the State has no obligation to convert it on demand into some
other
form of money. The State defines the unit of account in base money, makes it legal tender for all debts, public
and
private, and requires that payments to the State be in base
money. In the following, we deal mainly with base money of the A Brief
History During the era of gold
as money, gold coins
comprised the monetary base. The production of money was
basically in the
hands of the private sector. The State minted it or printed the
certificates used in trade to represent it, while private enterprise
mined the
ore and reaped the benefits of doing so. The total amount
produced was
not under State control, but the relative scarcity of gold acted to
maintain
its exchange value at an acceptable level most of the time. The State had to acquire a share of the base
money by levying taxes and fees on the public. Today the monetary
base is created in the
form of inconvertible notes issued by the Federal Reserve, and bank
credits at
the Fed which can be exchanged for notes on demand. When the A private enterprise
with sufficient
financial capital may obtain a charter that permits it to accept
deposits of
base money from the public, and to issue loans in the form of credit
convertible to base money on demand. These depositories, commonly
known
as banks,
must hold sufficient base money, called reserves, for that
purpose. When one deposits a
check or cash in his
account at a bank, he receives credit in exchange which we will refer
to as bank money.
We expect banks to redeem
those credits for cash on demand. Most of the money in
use today exists as
credits issued by private banks. However when one pays by drawing
on his
bank account, if the check is deposited in another bank, the payer's
bank must
transfer an equal amount of reserves to the payee's bank. Thus base money is
the foundation of the bank money system. Base Money as
Credit In reality, base money
itself is a form of
credit. In the same way a contract
can be viewed as a document
or the agreement
it represents, money
can be viewed as a token
or the credit
it represents. And since credit for the holder is debt for the
issuer, money
can also be viewed as a token representing third party debt. In the case
of base
money, the third party is the Fed. All base money
originates with the
Fed. For the most part, it is issued in exchange for securities
the
public bought from the Treasury with base money previously acquired
from the
Fed. This circular system of credit is difficult for some to
understand,
especially for those who think of money only in terms of the token
itself
rather than the credit represented by the token. If base money is
simply a form of credit
backed by Treasury securities, which are another form of credit, then
what
assures its viability as money, and what is the real basis of its
value? The Viability of
Base
Money A token qualifies as
money when it is widely
accepted as a medium of exchange. To be accepted in that way, it
must be
seen as a store
of value, even though its value may decrease before its
planned
re-use. Notes and coins are convenient tokens because they are
easy to
use and reasonably durable. Bank deposits, which are claims on
base
money, can easily be transferred by wire to or from any bank. It
remains
to explain then why those tokens have value. Their status as
legal tender
in the discharge of debts is not sufficient because it says nothing
about their
value in ordinary use. The viability of base
money ultimately
depends on the government enforcing tax collection, and acting to
maintain a
modest rate of price inflation. Base money acquires value because
that is
what the private sector must deliver in paying Federal taxes.
Those who
have no tax liabilities readily accept payment in base money because it
is
needed by so many others. In essence, base money is a tax credit.
The Fed's base money
liabilities are closely
matched by its assets in the form of Treasury securities that it
previously
bought from the public. But what prevents the real value of those
Treasury securities from being diluted by continued deficit
spending? As
will be explained, the purchasing power of base money has very little
to do
with the amount of deficit spending. However it does depend in
the long
run on the cost to banks of acquiring base money, which the Fed itself
controls. Fed
Operations Since base money is a
monopoly of the State,
the Fed must issue enough to avoid a shortage of what the public must
use to
pay its taxes. In practical terms, that means it must provide
whatever
reserves the banking system needs to ensure the liquidity of the
payment
system. When the Fed needs to
increase aggregate
reserves, it buys Treasury securities from the public and credits the
sellers'
banks with additional deposits at the Fed. Conversely the Fed
sells
Treasury securities to the public from its own portfolio when it needs
to
decrease aggregate bank reserves. Bank reserves are only a small
part of
the monetary base, but they play a key role because they are the grease
that
enables the bank credit system to function. These transactions by
the Fed are designed
to balance supply and demand for bank reserves at the Fed's target
interest
rate on overnight loans between banks, otherwise known as the Fed funds
rate. The Fed funds rate is the benchmark for all
short-term interest rates. It has a significant influence on the
amount
of bank money issued, and thus the liquidity of the private
sector. In
controlling the Fed funds rate, the Fed necessarily relinquishes
control of the
amount of base money it issues. The private sector itself
determines the
net amount issued. Treasury
Operations The Treasury spends
out of its account at
the Fed. It continuously replenishes
that account with transfers from its accounts in commercial banks where
it
deposits its receipts from taxes and the sale of bonds. These
so-called Treasury Tax
and Loan accounts in commercial banks are backed by deposits
at
the Fed, which are reserves of the banking system. Treasury operations
simply recycle base
money previously issued by the Fed. It approximately balances its
receipts from taxes and the sale of bonds against its spending in order
to
avoid large variations in the demand deposits of the private sector
which could
significantly affect liquidity. It targets a fixed balance in its
account
at the Fed in order to minimize variations in the aggregate reserves of
the
banking system. The Fed compensates for the variations by adding
or
draining reserves on a short-term basis through its open market operations.
If the private sector
as a whole holds more base money
than it needs, it will normally use the excess to purchase
interest-earning
Treasury securities, since base money earns no interest. Thus the
Treasury will always be able to recapture its deficit spending through
the sale
of securities, since it can pay whatever interest the market
demands. Managing
Inflationary
Expectations The interest rate the
Treasury must pay to
borrow is a market rate which is influenced by Fed policy. The
short-term
rate closely tracks the Fed funds rate due to arbitrage. Longer-term
rates include a premium over the
Fed funds rate which varies with inflationary expectations.
Although many
diverse factors affect those expectations, the Fed itself has
considerable
influence through its monetary policy decisions. It is therefore up to
the Fed to keep
inflationary expectations within acceptable limits. By doing that
well,
it protects the purchasing power of base money, and ensures that
interest rates
on long term borrowing will not become so burdensome as to prevent
economic
growth. Contrary to
conventional wisdom, the
historical record shows no significant correlation between the amount
of
deficit spending and the inflation rate or interest rates. Most
central
banks now target a small positive inflation rate to provide a margin
against a deflation
trap. Deflation hurts
aggregate demand by creating a money-hoarding psychology which is
difficult to
overcome, and may result in a prolonged recession. Under the
gold-based
system, the State's ability to counter inflationary and deflationary
pressures
was very limited. In Summary Base money is simply
another form of
credit. The Fed issues base money in exchange for credits issued
by the
Treasury which the public previously bought with base money. This
circular system of credit works as long as the State broadly enforces
tax
collection. Price inflation varies in the short run for a number
of
reasons not directly under the control of the State. In the long
run, Fed
policy in setting the cost to banks of acquiring base money is the key
to
controlling the average inflation rate. |
