What money is
We use money to transact and the money we use is fiat money, money backed only by government decree. In economic terms, money is a transaction good and all that fiat money is, is a transaction good; the only point in holding such money is to be able to engage in transactions—its expected swap value(s) in exchange is its only value.
The use of money as a transaction good is driven by expectations. People take your money because they expect to use it in future transactions. You offer money in transactions because of that expectation. (Since there is no information from the future, we can only ever act on the basis of expectations; expectations that are derived from existing information.)
Anything that is used in a transaction for its swap value is being used as a medium of exchange. That does not, however, make it money. It is only money if it is also embodies the unit of account. Something that is used as a medium of exchange and embodies the unit of account is a medium of account and so money; something used to both quantify and pay exchange obligations.
(Money is also a store of value, but that is the least distinctive thing about it; many things are stores of value. Money’s role as a store of value comes from its swap value, which takes us back to it being a medium of account. Yes, we use it because of expectations about its future ability to operate as a medium of account, but that is what is distinctive about it, not being a store of value.)
In modern economies, the central bank—the Reserve Bank of Australia (RBA); the Bank of England (BoE); the US Federal Reserve (the Fed); in the Eurozone, the European Central Bank (ECB); the Bank of Japan (BoJ)—is the monopoly provider of local money, the money issued and used in your country. (Or, in the case of the Fed, the monopoly provider of the global reserve money which is also US local money.) The RBA, like the Fed, has a “dual mandate” of keeping inflation down and employment up. Such a mandate is, in effect, a legal obligation imposed on the central bank to neither flood the economy with excess money (causing inflation) nor to starve it of money (causing a fall in transactions from people maintaining their preferred level of money holdings by cutting back on spending and thus transacting). Since—for a given level of prices—the level of transactions determines the level of spending, and thus income (everyone’s money income is someone else’s spending), the latter matters; serious transaction “crashes” are known as recessions and depressions.
The ECB has price stability as its primary objective, with other objectives being subordinated to it. The BoE has a growth and employment objective, but it is subordinate to price stability. The BoJ just has a price stability objective. The problem with such inflation targeting by the central bank is that the central bank then explicitly promises (or is strongly expected) not to provide excess money but has no such explicit or implicit commitment to provide sufficient money to keep the level of transactions up. The central bank then acquires unbalanced credibility—people believe that their money will retain value but have much less basis for confidence in the future direction of income; unlike expectations about future prices (and so the future value of money), the future direction of income lacks any policy anchor. So, if people increase their holdings of money, and the central bank fails to adjust for this, people then cut back on spending, transactions fall so income falls, so people cut back on spending to maintain their preferred holdings of money, and the downward spiral is on. People (quite rationally) have lowered expectations of income and so engage in less spending, which confirms (and magnifies) the lowered expectations of income.
The level of money provision (and associated expectations) being required to stop actual deflation (which the central bank is expected to do to maintain an inflation target) being less than the level of money provision (and associated expectations) required to have transactions recover (which the inflation targeting central bank is not expected to do), an economy can remain “stuck” in output being well below capacity—the most obvious manifestation of which is unemployment, where labour use is well below labour supply—for a considerable period. (Or, in a milder version, stuck with much lower levels of capacity increase than would have been otherwise possible—Japan has been a manifestation of this as the Bank of Japan has regularly clamped down to maintain its, very low, inflation target; thereby offsetting any stimulatory effect from the amazing run of government budget deficits that have driven Japan’s public debt to the highest in the developed world.)
If an economy has high debt levels, then the level of economic stress from any significant fall in transactions (and so income) is even higher, as people struggle to pay back debts with lowered income. (For an example, see the Eurozone.) If the stress is sufficiently great, the potential for debt defaults—and so significant destruction of financial assets (one agent’s debt being another’s asset)—and consequent threat of major damage to, or even the collapse of, the financial system then further encourages a flight to “safe assets” and away from spending. (Again, see the Eurozone.)
In such a situation, the central bank (as the monopoly provider of local money and so dominant generator of expectations about same) is doing what monopoly providers normally do—it is under-providing its product (in this case, expectations coverage rather than actual currency) to maximise return (in this case, its credibility as an inflation targetter). Once an economy is in this situation, it can be hard for the central bank to change course, because that would have serious reputational effects on the officials running the bank, as it would be an implicit (or explicit) admission that their failure had caused the transaction crash and consequent economic misery in the first place. (For an example, see the Fed.)
As Danske Bank economist Lars Christensen has pointed out in his excellent Market Monetarist blog, failure by the Fed and the ECB to respond to increased demand for dollars and euros in the second half of 2008 is what caused the Great Recession to be The Great Recession—the largest peacetime crash in US money income (i.e. transactions) since 1938 and the largest crash in overall OECD money income since the organisation was founded.
Both the Fed and the ECB have since behaved as monopoly providers, under-providing (expectations about) money to maximise their credibility as inflation targeters and, in refusing to shift policy, minimising reputation damage from their failure to react to changes in demand for money. The failure of the bulk of the economics profession to call them on it (a constant frustration for Scott Sumner) means that the reputation effect continues to militate against policy change.
Most commentators being unaware of (or simply flatly wrong about) the role of monetary policy in the ongoing economic crisis has greatly helped the Fed and ECB avoid accountability. The obvious political and economic dysfunctions of Greece, in particular, has been a great distractor from the failures of the ECB. Yes, of course the “weakest link” in the Euro chain has had the greatest crisis, but the problems in the Eurozone go way beyond Greece’s dysfunctions. And if it “falls off the edge” of the Eurozone, the next weakest link will simply take its place; a position made all the more precarious from the preceding example of the Greek exit/collapse. There is nothing like an income crash to make debt problems (private or public) much worse.
Yes, the Fed has massively increased the US monetary base (coins, currency and bank reserves at the Fed), but the Fed has not generated any confidence that it has any commitment to having transactions recover to their pre-Great Recession path. So the increase in monetary base has not had the necessary effect on expectations about future income to generate the necessary increased willingness to spend required to have transactions recover to their pre-Great Recession path. So the US remains stuck with stubbornly high unemployment and it—and, even more, the Eurozone—hovers on the brink of a further downturn, a new crash in transactions.
Money is not just some unified quantity; it can be held, spent or leave the country.* Because of the hold/spend/flight options with money, expectations are crucial and quantities do not speak for themselves.
Monetary flight, manifesting in depleting bank deposits and the money multiplier effect thereof (money deposited in a bank being lent out again), can also result in falling transactions and so falling income. With a floating exchange rate, the result is a falling exchange rate (a fall in the price of that money compared to others due a fall in demand for that money and an increase in demand for other moneys) and increased ability to sell exports. In a fixed exchange rate (or if the exchange rate is otherwise unable to fall sufficiently to compensate), the result is a fall in the money supply and so transactions unless the central bank increases the money supply to compensate. (The history of fixed exchange rates has not been a notably happy one.) All members of the Eurozone have a fixed exchange rate relative to each other and are stuck with a common exchange rate for other moneys, while the ECB has not generated compensating increases in money supply for money flight from the distressed Eurozone economies. On the contrary, it has generated expectations that it will not maintain transaction levels in those economies.
Australia stands out in this. [How much so is expressed in a striking series of graphs assembled by economist Tom Conley.] Yes, our public debt levels were much lower than the US’s, or the Eurozone, when the crisis hit but our combined levels of public and private debt were (as a percentage of GDP) at very similar levels. (Japan’s was much higher and the UK’s has since climbed to similar stratospheric levels.) But we sailed through the Global Financial Crisis and the Great Recession without any significant economic downturn. This despite a severe (if temporary) crash in commodity prices which meant our drop in exports (as % of GDP) was worse than the US’s.
It is true that we did not having a housing price crash and Chinese demand for our commodities has been a boon to mining export States, though the resulting high $A exchange rate has been less happy for manufacturing and services exporting States. But it is also true we have not had a recession (defined as two successive quarters of fall in GDP, i.e. output) since 1991 even while our terms of trade (the ratio of prices of what we export to what we buy) continued in what had been their long-term decline (since dramatically reversed).
The reason is very simple; our central bank, the Reserve Bank of Australia (RBA), does not have such unbalanced credibility. On the contrary, it has solid credibility for both keeping inflation down and transaction levels (and thus spending, so income) up. It does have an explicit target (something the Fed lacks)—which is very beneficial for anchoring expectations, as the RBA’s commitment to its target has been highly credible—but it is not a strict inflation target. In the words of the RBA’s website:
The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3 per cent, on average, over the cycle. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.
So the RBA has no temptation to have money supply follow any fall in output down, so as to keep changes in the price level constantly on target. In particular, it does not have to obsess over single quarter results. It is, instead, committed to only maintaining an average level of inflation over the business cycle.
The result is that, if output surges, the RBA tends to tighten monetary policy to minimise inflationary pressures and, if output falls, the RBA tends to loosen monetary policy to minimise effects on income (i.e. any fall in transactions is compensated for by an increase in prices, so keeping money incomes up). People have anchors for their expectations about both the future value of their money and their future income, so we in Australia have not had any of those transaction crashes we call “recessions”.
In particular, major increases in the (domestic) demand for money unmatched by changes in money supply have not occurred so as to lead to crashes in transactions. Having a central bank responsive to both inflationary pressures and shifts in output has successfully anchored expectations, as the RBA has balanced credibility. Since the RBA is accountable for both the value of money and the level of transactions, we have also had beneficial reputation effects operating on our central bank officials. (Which shows up in its statements and actions.)
I used to be a fan of inflation targeting, due to my scepticism about having one instrument—monetary policy—targeting two variables—inflation and unemployment—and concern that the RBA could evade responsibility by pointing to whichever variable was performing better. But the RBA’s actual target is effectively a promise to maintain steady growth in prices and output, which is money income—(in the language of national accounts, nominal GDP; i.e. GDP in money terms not adjusted for inflation; what in macroeconomics is also known as aggregate demand)—making my scepticism ill-founded. (The combination of the ongoing economic crisis and the growth in economic blogging has been a powerful educator in monetary economics.)
So, not only does money supply and demand matter, so do expectations about money. To see how powerful expectations are, consider the ratio of monetary base to GDP in Japan, the US, and Australia over 2011:
Australia: 4.0 %
In Australia, people have anchored money income expectations, so have much lower demand for money. In the US and Japan (and the Eurozone), people have strongly anchored inflation expectations but no such anchor for money income expectations, so the demand for money is high and willingness to spend is low. These expectations are entirely rational and have major economic consequences, as we can see on the figures for nominal GDP (i.e. aggregate money income) growth over the past five years:
Australia: 41.3 %
Of course, the Fed and the Bank of Japan (and the ECB) could change these expectations with a press release, which would be a lot cheaper (and far less wasteful) than surges in public debt from fiscal stimulus. Especially as the effect of any fiscal stimulus is entirely dependant on the central bank accommodating it, otherwise any flow-on increase in transactions is simply neutered by monetary tightening. Just as the central bank can counteract any restrictive effect from falling government deficits, or even government surpluses, by engaging in monetary easing—the austerity that is devastating the Eurozone is not fiscal austerity (the level of which, at least in terms of spending reductions, is generally much exaggerated) but monetary austerity generated by the ECB.
To see how much Germany and other parts of the Eurozone are in different economic worlds, consider the two graphs of NGDP in Germany and the rest of the Eurozone in this post. While the US and UK are in similar places of demand shortfall misery. And lack of demand is lack of spending is lack of income is lack of jobs. We can even see where the Fed “lost the plot” in its NGDP forecasts. The same place where poor sales surged ahead of taxes, regulation and labour quality as the prime concern of small business in the US.
(As an aside, her opposition to the euro triggered the end of Margaret Thatcher’s Premiership; yet her analysis of the fundamental problem of the proposed euro has proved to be correct. I wonder if any of those Great and Good who publicly sneered at her opposition to the next great project of European Union have had the grace to apologise?)
Too much talk about interest rates
Notice that I have discussed monetary policy without mentioning interest rates once. First, as the above indicates, it is perfectly possible to usefully discuss monetary policy without mentioning interest rates. Second, the role of interest rates in monetary policy is primarily as a signalling device. Lowering the base rate lowers the price of credit (so is usually stimulatory for activity) and indicates the central bank sees inflationary pressures as weakening; raising the base rates raises the price of credit (so is usually restrictive of activity) and indicates the central bank sees inflationary pressures as strengthening. But that signalling role is itself embedded in a framework of expectations about central bank policy (or its reaction function, if its policy target is inferred, as in the case of the Fed, rather than explicit, as in the case of the ECB and the RBA). If the bank has unbalanced credibility, the signal will “work” for inflation expectations but not for income (transaction levels) expectations. If, as in the case of the RBA, it has balanced credibility, it will work for both.
A recent, dramatic, example of the power of credible central bank action was the Swiss central bank acting to stop the appreciation of the Swiss franc by announcing it would defend an exchange rate of 1.2 to 1 on the euro; since the Swiss central bank can print any number of Swiss francs it can obviously swamp any speculative pressure, so its decision was highly credible and the surging appreciation of the Swiss franc simply stopped. Without endorsing the rest of the monetary policy of the Swiss central bank (such as why the Swiss franc was appreciating so strongly in the first place), it was an excellent example of the power of expectations, as all the Swiss central bank actually did was issue a press release. But it was a highly credible press release. (Which, one might note, had nothing to do with jiggling interest rates.) An example of the Chuck Norris effect. Or central banking as Jedi mind trick.
One of the problems which has helped central banks evade accountability is obsessive focus on interest rates. Particularly the delusions that (1) low interest rates indicate that money is loose and (2) that a liquidity trap, or Zero Bound, renders monetary policy impotent. Think about money and monetary policy in supply, demand and expectations terms, and the so-called “zero bound” looks like nothing more than a policy phantasm from over-relying on a specific signalling device.
Especially as central banks just announce the base rate, they don’t actually do anything to underpin it, as (provided it is within whatever other constraints are operative) markets are not so silly as to bet against someone who always has more (local) money than you because they make the stuff and can produce any amount of it (the cost of production of paper or plastic notes and electronic data entries is, well, not a constraint).
As for the first delusion, interest rates are the price, not of money, but of credit (of renting money; so interest rates are no more the price of money than rents are the price of houses). As Milton Friedman pointed out, low interest rates are generally an indicator that money is tight (for use in transactions), not loose. Again, we can see this from looking at the 5 year Government bond yield over the last five years:
Australia: 3.69 %
In Japan and the US, there is lots of money available for safe assets, so of course their rental rate [
price] is low (remembering that bonds are a form of credit). It is money for transactions that Japan and the US (and the Eurozone) are starved of. Milton Friedman’s words have a certain haunting quality now:
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. … After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
Sadly, apparently they do not. That a central bank lowering interest rates is taken as monetary easing, raising it as monetary tightening, probably helps keep the fallacy alive. But the price of credit is not the price of money and is certainly not a positive indicator of the availability of money for transactions. Monetary easing, after all, is about making more money available for transactions and monetary tightening is about making less money available for transactions.
To put it another way; lowering the cost of credit encourages spending while raising the cost of credit discourages spending. But that is always a “from where we are now” move, it is not an absolute indicator. High interest rates suggest high money risk (i.e. money is expected to lose value at a significant rate) which suggests high levels of spending compared to actual output (i.e. that money is loose). Low interest rates suggest low money risk (i.e. money is not expected to lose value at a significant rate) which suggests low levels of spending compared to output (i.e. that money is tight).
About capital, assets and money
Since capital is the produced means of production, it represents resources withheld from present consumption for future (productive) use or which cannot be used for consumption. The cost of deferring resource use or acquiring resources purely for productive use incorporates the risk of failure (such as misallocation or accident), the risk of adverse shifts in the value of the resources used and the base risk in not having immediate access to the resources. Which replicates the elements in interest rates (asset risk, money risk, base cost). Capital is often bought via credit, but opportunity cost is enough to make interest rates the cost of capital, given these are all alternate uses of money not used for consumption. Asset prices are inter-connected, because the same deferral considerations operate across all of them, creating a continuum of opportunity costs according to level of expected risk. (Their prices will also take into account expected income and strength as a store of value.)
This again points to the limitations of interest rates as the central transmission mechanism in monetary policy. If there was no credit, there would still be money and questions for monetary policy. Even with the existence of credit, interest rates are not somehow quarantined from other asset prices.
Assets range from gold—a pure store of value that provides no income—to bonds—whose role as a store of value is entirely determined by their value (including attendant risks) as sources of income. Betwixt and between these poles, there are assets who provide income (either explicitly by being rented out or implicitly by being used by the owner) but can also be priced as stores of value beyond their current expected value as an income source. Housing land during housing booms is notoriously an example of this (houses are large decaying physical objects, it is the land the houses are on that jumps around in price).
Asset prices are fundamentally based on assessments of risk. The easiest way for asset prices to go on a trajectory that proves unsustainable is through distorted or unsustained assessments of risk. (Hence arguments about the contemporary destruction of prudence.) Obviously, shifts in income expectations matter too, but they tend to flow from current income, so have a more specific grounding in information.
Economists draw a distinction between risk (which can be calculated) and uncertainty (which can not). What Keynes called “animal spirits” is how people are currently framing uncertainty. Since uncertainty represents a lack of sufficient information to infer calculation of risk, any framing of uncertainty is unstable—easily shifted (or even reversed) by new information. There is a large area of uncertainty from new technology, which can create asset price instability. Strong expectations about income will tend to encourage positive framings of uncertainty; poor expectations about income will tend to encourage negative framings of uncertainty.
Monetary policy can affect asset prices through its effects on income and price expectations. The former through effect on expected income from assets, the latter through the level of money risk (expectations about money as a store of value). The mere availability of money is not sufficient to drive asset prices (otherwise US and Japanese asset prices would be rather higher than they currently are); it is (interrelated) assessments of risk, expected income and reliability as a store of value that drive asset prices. Public policy is far more likely to affect prices of assets through its effect on levels of risk or by distorting risk assessment (including through constraining supply) than the mere availability of money. For money is not just some unified quantity; it can be held, spent on consumption or assets or leave the country.* Because of the hold/spend on assets or consumption/flight options with money, expectations are crucial and quantities do not speak for themselves.
Reputations protected over the misery of millions
Meanwhile, Japan, the UK, the US and the Eurozone remain starved of money for transactions, utterly unnecessarily; as is the unemployment and economic stress that flows from that. The story of the central bank failures of our time is the story of unbalanced central bank credibility resulting in massively mismanaged expectations all flowing from a dramatic lack of accountability. Officials valuing their reputations as much more important than any amount of utterly unnecessary economic misery and not being effectively called on it.
Monetary policy matters; it really matters. And people need to understand how and why it matters if the institutions and officials that run it are to be held to account.
* If a currency only has purchasing power within a single country, this will require “swapping out” to a different currency. Either way, what is known as “capital flight” generally has negative impacts on the level of transactions.
[UPDATE: In the light of some of the discussion below.
Note for non-economist readers:
NGDP = aggregate demand = Price level (P) times output (y) = Py.]
Yichuan Wang has a great pithy post on NGDP targeting and credibility.