Naked Economics (30 page)

Banks hold bonds for the same reason individual investors do; bonds are a safe place to park funds that aren’t needed for something else. Specifically, banks buy bonds with depositors’ funds that are not being loaned out. To the economy, the fact that Citibank has swapped bonds for cash makes all the difference. When a bank has $100 million of deposits parked in bonds, those funds are not being loaned out. They are not financing houses, or businesses, or new plants. But after Ben Bernanke’s metaphorical armored truck pulls away, Citibank is left holding funds that can be loaned out. That means new loans for all the kinds of things that generate economic activity. Indeed, money injected into the banking system has a cascading effect. A bank that swaps bonds for money from the Fed keeps some fraction of the funds in reserves, as required by law, and then loans out the rest. Whoever receives those loans will spend them somewhere, perhaps at a car dealership or a department store. That money eventually ends up in other banks, which will keep some funds in reserve and then make loans of their own. A move by the Fed to inject $100 million of new funds into the banking system may ultimately increase the money supply by 10 times as much.

Of course, the Fed chairman does not actually drive a truck to a Citibank branch to swap cash for bonds. The FOMC can accomplish the same thing using the bond market (which works just like the stock market, except that bonds are bought and sold). Bond traders working on behalf of the Fed buy bonds from commercial banks and pay for them with newly created money—funds that simply did not exist twenty minutes earlier. (Presumably the banks selling their bonds will be those with the most opportunities to make new loans.) The Fed will continue to buy bonds with new money, a process called open market operations, until the target federal funds rate has been reached.

Obviously what the Fed giveth, the Fed can take away. The Federal Reserve can raise interest rates by doing the opposite of everything we’ve just discussed. The FOMC would vote to raise the discount rate and/or the target fed funds rate and issue an order to sell bonds from its portfolio to commercial banks. As banks give up lendable funds in exchange for bonds, the money supply shrinks. Money that might have been loaned out to consumers and businesses is parked in bonds instead. Interest rates go up, and anything purchased with borrowed capital becomes more expensive. The cumulative effect is slower economic growth.

The mechanics of the Fed’s handiwork should not obscure the big picture. The Federal Reserve’s mandate is to facilitate a sustainable pace of economic growth. But let’s clarify how difficult that job really is. First, we are only guessing at the rate at which the economy can expand without igniting inflation. One debate among economists is over whether or not computers and other kinds of information technology have made Americans significantly more productive. If so, as Mr. Greenspan suggested during his tenure, then the economy’s potential growth rate may have gone up. If not, as other economists have argued convincingly, then the old speed limit still applies. Obviously it is hard to abide by a speed limit that is not clearly posted.

But that is only the first challenge. The Fed must also reckon what kind of impact a change in interest rates will have and how long it will take. Will a quarter-point rate cut cause twelve people to buy new PT Cruisers in Des Moines or 421? When? Next week or six months from now? Meanwhile, the Fed has the most control over short-term interest rates, which may or may not move in the same direction as long-term rates. Why can’t Ben Bernanke work his magic on long-term rates, too? Because long-term rates do not depend on the money supply today; they depend on what the markets predict money supply (relative to demand) will be ten, twenty, or even thirty years from now. Ben Bernanke has no control over the money supply in 2015. Also remember that while the Fed is trying to use monetary policy to hit a particular economic target, Congress may be doing things with fiscal policy—government decisions on taxes and spending—that have a different effect entirely (or have the same effect, causing Fed policy to overshoot).

So let’s stick with our speed limit analogy and recap what exactly the Fed is charged with doing. The Fed must facilitate a rate of economic growth that is neither too fast nor too slow. Bear in mind: (1) We do not know the economy’s exact speed limit. (2) Both the accelerator and the brake operate with a lag, meaning that neither works immediately when we press on it. Instead, we have to wait a while for a response—anywhere from a few weeks to a few years, but not with any predictable pattern. An inexperienced driver might press progressively harder on the gas, wondering why nothing is happening (and enduring all kinds of public assaults on his pathetically slow driving), only to find the car screaming out of control nine months later. (3) Monetary and fiscal policy affect the economy independently, so while the Fed is gently applying the brake, Congress and the president may be jumping up and down on the accelerator. Or the Fed may tap on the accelerator ever so slightly only to have Congress weigh it down with a brick. (4) Last, there is the obstacle course of world events—a financial collapse here, a spike in the price of oil there. Think of the Fed as always driving in unfamiliar terrain with a map that’s at least ten years out of date.

Bob Woodward’s biography of Alan Greenspan was titled
Maestro.
In the 1990s, as the American economy roared through its longest expansion in economic history, Mr. Greenspan was given credit for his “Goldilocks” approach to monetary policy—doing everything just right. That reputation has since come partially unraveled. Mr. Greenspan is now criticized for abetting the housing and stock market bubbles by keeping interest rates too low for too long. “Cheap money” didn’t cause inflation by sending everyone to buy PT Cruisers and Caribbean cruises. Instead we bought stocks and real estate, and those rising asset prices didn’t show up in the consumer price index. Add one new challenge to monetary policy: We were speeding even though the gauges we’re used to looking at said we weren’t.

It’s a hard job. Still, that conclusion is a long way from Nobel laureate Robert Mundell’s dire claim that bad monetary policy laid the groundwork for World War II. To understand why irresponsible monetary policy can have cataclysmic effects, we must first make a short digression on the nature of money. To economists, money is quite distinct from wealth. Wealth consists of all things that have value—houses, cars, commodities, human capital. Money, a tiny subset of that wealth, is merely a medium of exchange, something that facilitates trade and commerce. In theory, money is not even necessary. A simple economy could get along through barter alone. In a basic agricultural society, it’s easy enough to swap five chickens for a new dress or to pay a schoolteacher with a goat and three sacks of rice. Barter works less well in a more advanced economy. The logistical challenges of using chickens to buy books at Amazon would be formidable.

In nearly every society, some kind of money has evolved to make trade easier. (The word “salary” comes from the wages paid to Roman soldiers, who were paid in sacks of
sal
—salt.) Any medium of exchange—whether it is a gold coin, a whale tooth, or an American dollar—serves the same basic purposes. First, it serves as a means of exchange, so that I might enjoy pork chops for dinner tonight even though the butcher has no interest in buying this book. Second, it serves as a unit of account, so that the cost of all kinds of goods and services can be measured and compared using one scale. (Imagine life without a unit of account: The Gap is selling jeans for three chickens a pair while Tommy Hilfiger has similar pants on sale for eleven beaver pelts. Which pants cost more?) Third, money must be portable and durable. Neither bowling balls nor rose petals would serve the purpose. Last, money must be relatively scarce so that it can serve as a store of value.

Clever people will always find a medium of exchange that works. Cigarettes long served as the medium of exchange in prisons, where cash is banned. (It doesn’t matter whether you smoke; cigarettes have value as long as enough other inmates smoke.) So what happened when smoking was banned in U.S. federal prisons? Inmates turned to another portable, durable store of value: cans of mackerel. According to the
Wall Street Journal,
a single can of mackerel, or “the mack” is the standard unit of currency behind bars. (Some prisons have moved from cans to plastic pouches, because the cans can be fashioned into weapons.) In a can or pouch, mackerel doesn’t spoil, it can be bought on account in the commissary, and it costs about a dollar, making the accounting easy. A haircut costs two macks in the Lompoc Federal Correctional Complex.
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For much of American history, commerce was conducted with paper currency backed by precious metals. Prior to the twentieth century, private banks issued their own money. In 1913, the U.S. government banned private money and became the sole provider of currency. The basic idea did not change. Whether money was public or private, paper currency derived its value from the fact that it could be redeemed for a set quantity of gold or silver, either from a bank or from the government. Then something strange happened. In 1971, the United States permanently went off the gold standard. At that point, every paper dollar became redeemable for…nothing.

Examine that wad of $100 bills in your wallet. (If necessary, $1 bills can be substituted instead.) Those bills are just paper. You can’t eat them, you can’t drink them, you can’t smoke them, and, most important, you can’t take them to the government and demand anything in return. They have no intrinsic value. And that is true of nearly all the world’s currencies. Left alone on a deserted island with $100 million, you would quickly perish. On the other hand, life would be good if you were rescued and could take the cash with you. Therein lies the value of modern currency: It has purchasing power. Dollars have value because people peddling real things—food, books, pedicures—will accept them. And people peddling real things will accept dollars because they are confident that other people peddling other real things will accept them, too. A dollar is a piece of paper whose value derives solely from our confidence that we will be able to use it to buy something we need in the future.

To give you some sense of how modern money is a confidence game, consider a bizarre phenomenon in India. Most Indians involved in commerce—shopkeepers, taxi drivers, etc.—will not accept a torn, crumpled, or overly soiled rupee note. Since other Indians know that many of their countrymen will not accept torn notes, they will not accept them either. Finally, when tourists arrive in the country, they quickly learn to accept only intact bills, lest they be stuck with the torn ones. The whole process is utterly irrational, since the Indian Central Bank considers any note with a serial number—torn, dirty, crumpled, or otherwise—to be legal tender. Any bank will exchange torn rupees for crisp new ones. That doesn’t matter; rational people refuse legal tender because they believe that it might not be accepted by someone else. The whole bizarre phenomenon underscores the fact that our faith in paper currency is predicated on the faith that others place in the same paper.

Since paper currency has no inherent worth, its value depends on its purchasing power—something that can change gradually over time, or even stunningly fast. In the summer of 1997, I spent a few days driving across Iowa “taking the pulse of the American farmer” for
The Economist.
Somewhere outside of Des Moines, I began chatting with a corn, soybean, and cattle farmer. As he gave me a tour of his farm, he pointed to an old tractor parked outside the barn. “That tractor cost $7,500 new in 1970,” he said. “Now look at this,” he said angrily, pointing to a shiny new tractor right next to the old one. “Cost me $40,000. Can you explain that?”
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I could explain that, though that’s not what I told the farmer, who was already suspicious of the fact that I was young, from the city, wearing a tie, and driving a Honda Civic. (The following year, when I was asked to write a similar story on Kentucky tobacco farmers, I had the good sense to rent a pickup truck.) My answer would have been one word: inflation. The new tractor probably wasn’t any more expensive than the old tractor in real terms, meaning that he had to do the same amount of work, or less, in order to buy it. The sticker price on his tractor had gone up, but so had the prices at which he could sell his crops and cattle.

Inflation means, quite simply, that average prices are rising. The inflation rate, or the change in the consumer price index, is the government’s attempt to reflect changing prices with a single number, say 4.2 percent. The method of determining this figure is surprisingly low-tech; government officials periodically check the prices of thousands and thousands of goods—clothes, food, fuel, entertainment, housing—and then compile them into a number that reflects how the prices of a basket of goods purchased by the average consumer has changed.

The most instructive way to think about inflation is not that prices are going up, but rather that the purchasing power of the dollar is going down.
A dollar buys less than it used to. Therein lies the link between the Federal Reserve, or any central bank, and economic devastation. A paper currency has value only because it is scarce. The central bank controls that scarcity. Therefore a corrupt or incompetent central bank can erode, or even completely destroy, the value of our money. Suppose prison officials, in a fit of goodwill, decided to give every inmate 500 cans of mackerel. What would happen to the price of a prison haircut in “macks”? And mackerel is better than paper, in that it at least has some intrinsic value.

In 1921, a German newspaper cost roughly a third of a mark; two years later, a newspaper cost 70 million marks. It was not the newspaper that changed during that spell; it was the German mark, which was rendered useless as the government printed new ones with reckless abandon. Indeed, the mark lost so much value that it became cheaper for households to burn them than to use them to buy firewood. Inflation was so bad in Latin America in the 1980s that there were countries whose largest import became paper currency.
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In the late 1990s, the Belarussian ruble was known as the “bunny,” not only for the hare engraved on the note but also for the currency’s remarkable ability to propagate. In August 1998, the Belarussian ruble lost 10 percent of its purchasing power in one week.