Lesson 15 Money and Monetary Policy

Janet Yellen is the head of the Fed. She and her colleagues at the Fed determine the nation’s money supply. Much has been said about her management of money and lately she is being labelled a lackey of the President and Mrs. Clinton. I doubt she is lackey but I would say that she is guilty of drinking the same Kool-Aid as her liberal progressive buddies in government.

We grew up with Kool-Aid and I don’t mean to disparage that lovely and colorful drink with enough sugar in it to start a diabetic colony.  What I mean is that Yellen, Obama, Clinton and many others share a similar philosophy in general and in particular with respect to the magical qualities of money.

And that’s what makes this post today so much fun. Money itself is about as exciting as your Uncle Ed who rocks himself to sleep at 1 pm in the living room while you watch his cigar ash fall on his partly open bathrobe. Money is paper. Or money is electronic entries that get transferred from one account to another. 

This is not exciting stuff. You buy something – whip out a bill or a debit card – and the deed is done. Nothing to write home about there. It’s like your best friend Peter. You wear plaids and so does he. You wear stripes and so does he.

Although money itself lacks any real excitement, governments can turn it into Charlie Sheen on crack. There was a day when the world did not have money. We called that barter. A farmer would trade three carriage loads of corn for two dresses. That worked okay but corn farmers could not always find dressmakers and so pretty soon money evolved. If everyone carried money it made transactions much simpler.

Money went through a number of stages. Money needed to be around. At first it was commodities – stuff that most people already had and knew the value of – like corn or wheat. Then they were replaced by commodities that seemed to be more durable and held value better – like silver and gold. Silver and gold are pretty but those commodities are heavy or bulky and not easy to safeguard or carry to Sam’s Club. The next stage created paper money  wherein the paper money had to be backed by gold. Paper was essentially valueless but it represented an amount of gold.

Are you history-lovers still awake? Finally came the stage where money could be pulled out of a hat. Not really a hat but essentially the same thing. Central banks create money at will. They need nothing but a magic wand and an Internet connection. Money is “backed” by faith that the central bank will always create the right amount. Not too much and not too little. Like Goldilocks, we like just the right amount of money. The Fed pretends to give us what we want.

And here is where ideology comes in. The conservative school of thought sees the world as being very complicated and uncertain. The right amount of money is no easy thing to attain. Jim suddenly needs money to fix his roof. Dan swears money off when he decides to live in the forest. Imagine figuring out the right amount of money for a whole country day by day. Humbly, conservatives prefer a passive approach. Transactions usually grow by about 5% per year. So let the money supply grow by 5%. End of story. Go fishing.

But liberals always think they know more and apparently they are nervous people who don’t like fishing. They erect giant data collecting machines and try to measure the demand for money on a minute by minute basis. They take great delight and credit by measuring and the ups and downs of money and then trying to match those demand changes with more or less money. Think Whac-a-Mole. Liberals admit that sometimes they get it wrong. They admit that sometimes they even cause recessions when they get it wrong. But alas they are progressives and they are pretty sure that sometime in the future their models will be more correct and the world will be saved. Think Don Quixote.

If the above is not enough to make you reach for the JD pitcher there is more. Even though the infamous JM Keynes said that controlling money was like pushing on a string other modern liberal economists decided to give monetary policy a bigger role in society. Matching money supplied to transactions needs was way too boring for these moderns. So they decided they would match money to employment, prices, exchange rates, and hooker sales. If employment was too low then pump a bunch of money. If prices are too high take it back out. If exchange rates rise then blame China. If hooker sales go up or down call Charlie Sheen.

Talk about a way to guarantee that your name will get into the Bloomington Herald Times on a regular basis. The Fed now has so many balls in the air that it would take a multi-headed hydra to try to catch them all. But undaunted they collect data every day and they have serious discussions and then they go home to their mansions and foreign sports cars.

Yellen and her buddies at the Fed and in the government are not necessarily colluding. They simply have this faith that they know how to manage a 21^st century global economy. That they have been doing it badly never concerns them. They never question this faith that more active policy is better. They are modern and smart. They will learn from their mistakes and finally get it right. They will save us.

Their disease is incurable because failure begets more activism and then more failure. Nowhere in their playbook is taking a deep breath. Nowhere in their training is the idea that too much variance and activism creates uncertainty. Nowhere in their discussions is that it takes time to disentangle short-term noise from long-term trends. Nowhere in their arsenal is the knowledge that some problems are non-monetary in nature and require non-monetary solutions. 

Lackey? I don't think so. Misguided and dangerous? I think so. 

Cash: It's Just as Good as Money by Guest Blogger Buck Klemkosky

What Yogi Berra said is only partially true. In fact cash and money are not the same thing. There is a lot more money in the world and the U.S. than cash. Currency is another name for cash and in the U.S. it includes coins minted by the U.S. Treasury and bank notes ($1 to $100 bills) printed by the Federal Reserve Bank. The U.S. has $47.6b of coins in people’s pockets or piggy banks and $1,369.2b of FRB notes floating around. Not all are circulating in the U.S. as the dollar can be used in almost any country in the world. No one knows exactly how many dollars are outside the U.S. but government estimates are up to one-half. They have been talking about a cashless society for years but the amount of U.S. coins and notes increases 5-6% annually.

Currency (coins plus FRB notes) in circulation in the U.S. is $1,416.8b. Money includes all that currency but in addition includes bank demand (checking) deposits, shares at credit unions and money market funds and outstanding traveler’s checks. That equation describes M1, a narrow version of the money supply which totals $3,050.2b today. M1 plus savings deposits and time deposits less than $100,000 equals M2, which totals $12,466.7b. M2 is a broader measure of the money supply which the Fed monitors closely in setting monetary policy. 

Currency in circulation is less than half of M1 and 11.4% of M2. So cash may be as good as money but it’s not the same as money which is more widely used and more important in economic transactions.

Cash may be just as good as money for small economic transactions but obviously very burdensome for large transactions. Analysis of the denominations of currency outstanding tells an interesting story. In the U.S., $100 notes outstanding total $1,080.b, 78% of all notes. In Europe, there are $322b of €500 notes ($550) outstanding, 30% of total euro notes; Switzerland has $39b of SF1000 ($990) notes, 92% of all Swiss notes and Japan has $67b of ¥10,000 ($88.50) notes, 92% of all yen notes outstanding. Luxembourg, a country notorious as a tax haven, has euro notes outstanding equal to 200% of its economic output.

The obvious question is why there are so many large denomination bills outstanding in these countries? Most Americans don’t carry a lot of $100 bills and many Europeans don’t know the 500-euro note exists; most are in Russia and other countries outside the Eurozone. Swiss retailers usually will not accept the SF1000 bill for payment. 

Subtracting the amount of U.S. currency abroad still leaves over $2000 for each of the 330 million U.S. citizens and over $5000 per household. The obvious answer is that many of the high-denomination notes play little role in the functioning of the legitimate economy. It is the currency of choice for illegal purposes such as drug trafficking, money laundering, fraud, tax evasion, corruption and terrorist activities. It has been estimated by the IRS that $350b-$400b annually is not reported as income because of cash transactions in the underground economy. A 2011 study found as much as 18% of all taxable income goes unreported costing the government nearly $500b in revenue. There are legitimate reasons for having cash transactions but the probability of abuse increases.

Many are in favor of abolishing all high-denomination bank notes to make it more difficult to carry on illicit activities. Canada scrapped a C$1000 note in 2000 and Singapore a S$10,000 note in 2015. In 1969, the Fed and U.S. Treasury stopped issuance of $500, $1000, $5000 and $10,000 bills although they remain legal tender. At the end of 2015, $300m of these bills are still outstanding, most as collector’s items. While the U.S. Treasury says they have no plans to change the denominations in use today, the European Central Bank will consider abolishing the €500 note later this year. Achieving international consensus to eliminate other high-denomination bank notes will not be easy but it will be on the G20 agenda later this year for consideration.

Another reason some are making the case to eliminate cash as another “outdated relic” is monetary policy and the advent of negative interest rates. Banks in the Eurozone, Sweden, Denmark, Switzerland and Japan already have to pay to deposit funds at their respective central banks. If negative rates should ever filter down to bank depositors, it would incentivize everyone to convert deposits to currency. Large corporations and institutions with billions of dollars in deposits can’t easily convert them to physical cash; it would have to be stored in warehouses and vaults, incurring storage and security costs. Some large banks already impose a fee on large corporate deposits. Individuals could more easily convert deposits to cash and put it under the mattress, but at the risk of theft. Conversion of deposits to cash and hoarding of cash would diminish the effectiveness of monetary policy. The ability of a central bank to implement negative-interest-rate policies would be made less effective by cash hoarding. For example, the amount of SF1000 bills has increased by 17% since the Swiss Central Bank imposed negative interest rates on bank reserves in December 2014. Even though bank depositors don’t yet pay negative interest rates, this shows the sensitivity of big-bill cash hoarding to the possibility.

While there hasn’t been much progress toward a cashless society in the U.S., some countries such as Sweden and South Korea have seen the use of currency diminish. South Korea, for example, is a checkless society although bank notes are available. Every major building there has an ATM machine which allows one to pay bills via wire transfer to any other bank with no fee. The technology certainly exists to have a cashless society in the U.S. and elsewhere using mobile phones, online banking and more sophisticated ATM machines. Digital transactions would be cheaper, faster and provide more transparency. Those engaging in illicit activities would not like it or if worried about “big brother” overseeing their activities. There would have to be a central bank system to provide trust and stability unlike Bitcoin and several other private digital currencies. But don’t expect currencies to fall by the wayside any time soon; currencies have been around for 4,000 years and probably will be for many more decades. People like the security of having physical cash at their disposal as Yogi undoubtedly did.