Weekly Standard: Putting the Toothpaste Back into the Tube

Federal Reserve chairman Ben Bernanke needs to spell out how he plans to head off hyperinflation.

So how is Fed chairman Ben Bernanke going to get all that toothpaste back into the tube? The Fed has been cranking money out like water over Niagara Falls. The monetary base has increased by a trillion dollars in just the last six months. And he's not done, furiously printing dollars (bank credits, really) and buying Treasuries in an attempt to flood the economy with dollars. When will it end? $3 trillion? $4 trillion? And then what? A functioning economy doesn't need all that cash sloshing around. Is runaway inflation our next crisis?

Let's go back to fundamentals for a second. Money is a placeholder of value--the price of a cold Heineken or the value of work already done, a hole dug, a piece of software written, whatever. When things work just right, prices seek the right level and we get a match between that cold beer and the sweat from working for it.

Money supply is how much money is floating around the economy to handle all the transactions. No one quite knows how much money is needed. The classic formula is the output of the economy equals the amount of money times the velocity of money, or how many times the same dollar is spent during the year. You buy the beer, the bartender buys beer nuts, the nut farmer buys a Ford pickup truck, the auto worker buys a cell phone, which you the programmer just finished writing the location-based service code for, so you are out celebrating buying a beer and on and on. Of course, no one really knows what the velocity of money is. If times are tough, you may hold off buying that Heineken for a few months, and when times are good you may party every night.

I like to think of the economy as a giant bucket filled with money (money supply) sloshing around the bucket (velocity). We all hope the bucket is filled to the rim. But, in normal times, the economy grows every year. Population increases, too, so the size of the bucket has to grow to handle the transactions of more people who like to eat and drink. So more money needs to be created to fill the bigger bucket. That's pretty straightforward.

But now the hard part. Someone is out there inventing something useful, refrigeration, steamships, ATM machines--something productive that increases the output per worker hour. Productivity increases the size and wealth of the economy above and beyond population growth. How much? Who knows? Still, more money needs to be created to fill the bigger bucket/economy. And to make matters worse, since no one knows what the velocity of money is, no one really knows how much money supply is needed so the economy will work just right. It's virtually impossible to fill the bucket up just to the rim. The Fed has to guess.

As we have all been taught, too much money chasing too few goods creates inflation, the price level goes up above and beyond what it should. That's bad, because you get less stuff for the same unit of work. On the flip side, with too little money chasing too many goods you get deflation, the price level goes down below what it normally would. Hey, you actually get more for your dollar. Woohoo! Except eventually someone is either going to cut your salary or you'll lose your job, because the price is dropping and the economy is smaller. That's bad, too.

Okay, there are lots more moving parts than just a simple bucket, including the size of government, regulations, and not least the taxing of the citizens/serfs. And I don't just mean income tax, state tax, sales tax, gas tax, property tax. One of the easiest ways to "tax" is to debase the currency, just print more and more of it and spend it on chariots and crowns and castles and the Department of Labor. This is why for many, many moons, gold and silver were the money supply. It's the only thing people would trust. They are rare earth elements, which means there is only so much of them. Hence stable money supply. Gold, even today, increases by about 1 percent every year from new discoveries. With a gold standard, money supply would grow 1 percent, which everyone used to think was just right.

But there are a couple of problems with that whole 1 percent business. The new wealth from more gold goes to the miner who found it, and then it starts circulating in the economy so others can use it. Doesn't seem quite fair. Plus, the 1 percent yearly increase in gold and therefore money supply basically covers population growth and completely ignores productivity and innovation, which get stifled because there's not enough money to increase output, even with new tools and inventions. So a gold standard implies a static world. No thanks.

Periods of rapid economic growth would often follow huge gold discoveries. The Spanish "found" Inca gold in the 1500s, which the British and French eventually stole or traded for, which funded the Industrial Revolution. The Gold Rush of 1849 funded the post-Civil War expansion. More gold, more money supply, more room for innovation.

Even without more gold, goldsmiths and money changers learned long ago to hold gold for their clients, maybe even paying them a small interest rate for the privilege of holding their gold, and then turn around and lend out money (often creating their own currencies) backed by that gold. And not $1 for each $1 in gold held. No, no, no. They might as well lend out ten times as much money as the gold they held, figuring not all the "depositors" would want their gold back at the same time. Money from nothing (and your checks for free). Sort of, anyway. This sleight of hand, called fractional reserve banking, was an easy way to increase money supply to again, make room for productivity and wealth creation. But increase by how much? No one knew, which is why there were occasionally bank runs and panics and depressions that followed easy credit, one of the hazards of this flimsy system. Sixteen of them since 1812. As American as apple pie!

But banking did increase the money supply beyond the amount of gold that could be extracted. In fact, since Adam and Eve, 160,000 tons of gold have been panned and mined from Mother Earth. At $35 per ounce under the gold standard, that came to $180 billion in value, not nearly enough to support all the value created by entrepreneurs; heck, Google is worth almost that much.

In the long run, the economy grew faster than population, ushering in railroads and interstate highways and even Carrot Top performing at the Luxor in Las Vegas. Now that's wealth. So something eventually went right. One something was the Federal Reserve, created in 1913 to control how much money is in circulation. The Fed would create a monetary base, originally backed by the gold in Fort Knox, that private banks would then lend against.

One of the tasks of the Federal Reserve is to serve as the lender of last resort, which they unfortunately learned after the stock market crash of 1929 and the bank runs that followed. Roughly 40 percent of banks failed, wiping out $2 billion in deposits. Some 30 percent of the money supply disappeared. So did a similar percentage of GDP, and unemployment hit 25 percent. You can see that lost money supply is not a good thing.

The other big something happened in 1933. The Federal Deposit Insurance Corp, the FDIC, was set up to insure depositors' money, relieving people of the need to line up to get their money out at the first sign of a bank's weakness. No more bank runs. Not many, anyway. (We can argue if the FDIC is really an insurance policy, as it undercharges banks for the privilege of insuring against bank runs, and you and I, the taxpayers, make up the difference. Still, it's a decent bargain--a backstop to panics, ordinary bank-run panics anyway!)

Twin bargains. Twin safety nets for fractional reserve banking, so we don't have to go back to the stifling days of gold. But that still means the Federal Reserve has to figure out how much money to create to fill the bucket--an almost impossible task.

The Fed has few levers. Interest rates are set in order to try to create just the right amount of money, with the Fed looking at prices, consumer prices and producer prices, as a surrogate for the price level. Prices are everything. Even though lower costs of computers and cell phones and LCD TVs are a positive for the economy and a wealth creator, as the productive use of technology always creates wealth, it is often interpreted as deflationary or at least dis-inflationary, and even as our technotoys get cheaper, interest rates may still be cut to "stimulate" the economy.

Sometimes, when too much money is created, it doesn't show up in consumer or producer prices, but flows into the stock market, or housing, and it appears to everyone as new wealth. Sometimes it is--Apple going from $15 to $100 was wealth creation based on the iPod and the iPhone, although the move of the stock to $175 was probably excess money creation.

But the run-up in house prices was worse. Incomes go up from real wealth, and some of that money goes into housing. But housing is often a false signal: Too much money, especially leveraged, can increase housing beyond what wealth created.

A shadow banking system--Lehman, Bear Stearns, Merrill Lynch--was borrowing short-term in money markets at, say 2 percent, and instead of the classic 10:1 leverage of banks, they were levering up 30:1, sometimes 50:1, creating money out of thin air well beyond the intention of the Federal Reserve. It didn't show up in prices, mainly because of a huge and productive tech sector as well as the waves of cheap Chinese laborers who were providing cheap shoes and toys and furniture to Wal-Mart, "hiding" the over-creation of money. But it did create a shadow economy of home builders, linoleum layers, decorators, Home Depot Expo salesfolks, and on and on.

And that was shadow wealth. The only real wealth is wealth that is productively created. The rest is just paper. After the collapse of the banking system, sunny and shadow, hoarding became the order of the day. The world rushed into U.S. Treasuries. Short-term rates as a result are almost zero. The dollar has been a safe harbor, jumping versus the euro and the yen. No one wants to spend money, on houses, on cars, or even, gasp, on big screen TVs. So the velocity of money has shrunk. To what? Well, no one really knows.

So to make up for lower velocity, to keep the economy from shrinking like a raisin, the Fed has been increasing the monetary base to increase the amount of money in circulation. But it's hard. Even with TARP funds, banks don't want to lend, so their 10:1 increase of Fed money isn't happening, let alone 50:1 Bear Stearns-style money creation. Bernanke has therefore been buying U.S. Treasuries, with cash, to increase the money supply. Which is pretty funny since he is also selling U.S. Treasuries out the back door to fund the $787 billion stimulus package and the $1.3 trillion Obama budget deficit.

The Fed can put all the cash it wants or thinks it needs into the economy, but someday, maybe soon, maybe in a year or two, the economy will start growing again. People will stop hoarding dollars. Their 2004 Taurus will be looking a little old. Baby needs a new pair of shoes. Banks will start lending again to businesses and maybe even to home buyers. As money starts getting spent, all that money's velocity starts increasing. Oops, there goes the price level. With so much money floating around, chasing too few goods, inflation is a-comin'. The Fed will have to start pulling all that extra money off the street and back into its vaults. And in just the right amount.

But how? Doing the opposite of what it is doing now. By raising interest rates. By sopping up dollars by not only selling Treasuries, but also selling all those mortgage-backed securities and other toxic stuff bought from Bear Stearns, AIG, Fannie and Freddie, and everyone else. By removing all the backstops it put in for the commercial paper and other markets to keep them functioning. But won't that have the effect of slowing the economy? Sure will. This is a tightrope act. Getting all that toothpaste back into the tube will require the skills of a surgeon and the moxie of a middle linebacker, and someone deaf, dumb, and blind to congressional meddling. And worse, this is something that has never been done before.

My suggestion: Lay out a blueprint for pulling the money back in. Tell Wall Street and Main Street exactly what you are going to do, and when and how your plan will be triggered. When economic activity rises by 2 percent, you are going to increase interest rates by 1 percent and "retire" another $500 billion. That will stop second guessing and congressional quibbling. And I'd get it out quickly, this summer. It's hard to keep a good economy down, especially with 50 billion extra Andrew Jacksons sloshing around the bucket.

Andy Kessler is a former hedge fund manager turned author who writes on technology and markets. His most recent book is The End of Medicine (Collins).

Comments

[Alexander Kolpakov]

I would honestly admit, that basically the mechanics of gold standard is much more complicated than You have explained as simple as "World With ~1% p.a. Money Supply Growth". There is a throughout analysis of this issue provided by Antal E. Fekete (www.professorfekete.com). I would be happy if You take a look on his articles and probably even give Your feedback, as Your qualified opinion is very valuable for me.
Kind Regards

[Jason]

I believe the PC revolution clearly demonstrates that prices do not have to consistently rise to keep the economy humming. Also small annual deflation rewards savers. The economy did fine for stretches in the 19th century with a true gold standard. Your call for Friedmanesque monetarism clearly has not worked in the past, why do you expect it to work this time. Congress and the Fed have learned their lesson?? Puhleeze.

[C. Santiago]

Andy -- there's something else to consider: all that money "created out of thin air" (your words) by the shadow banking system is quickly evaporating. Pffft.

Indeed, the credit losses that brought about the collapse of the shadow banking system are reducing the money supply (sunny _and_ shadow) by trillions of dollars. (Some estimates of the total eventual write-offs are higher than $3 trillion.) Could it be that the chart above may not be capturing these 'shadow money supply' dynamics?

I'm not sure, but it strikes as likely that the Fed so far has only partially offset the ongoing destruction of money, in which case the risk of inflation down the road is much lower than you suggest here.

Don't you think?

[David Anderson, CFA]

The Fed may be able to estimate the supply of money (and even that is highly questionable) but they cannot estimate the demand for money as the last twelve years show. Andy correctly addresses the velocity issue as the key issue. We risked deflation in the late 1990’s. The deflationary trend exposed the excesses of that economy and caused the recession of the early part of this decade. Then the Fed went overboard in 2003-2006 and created an inflationary boom concentrated in the housing industry. Inflation was just beginning to show up in the CPI when the economy hit a brick wall due to the liquidity issues caused by the failure of the banking industry.

As the most monetary of all commodities (all that ever existed is still in existence somewhere), the real economic function of the gold standard is to use the price of gold as a clearing price between the supply of money and the demand for money (the number of gold bars in the vault is irrelevant). What the Fed needs to do is manage the price of gold. If the price begins to increase above a certain targeted level the Fed should drain reserves from the system until the price settles back to the target. If the price decreases as it did in the late 1990’s, they should add reserves to the system until the price increases back to the target. Thus, the “supply” of money is allowed to expand and contract as dictated by demand for money and the need to maintain its purchasing power. The price of gold is the canary in the coal mine.

I believe the stable value of the dollar was one of the three keys to the success of the economy under the Clinton administration (free trade and the capital gains tax rate cut were the other two). The price of gold was reasonably stable in the $300-400 range from 1989 to 1997. Beginning with the economic recovery of the early 1990’s, inflation was significantly reduced as a factor in corporate and personal planning. Thus, PE’s were justified in reaching the highs attained the last time we were on a gold standard

While some may scoff at using a commodity price rule, it certainly can’t do any worse than the Greenspan/Bernanke standard has done over the last 12 years. What it would do is add a degree of predictability and certainty to monetary policy. For more information see Jude Wanniksi’s paper “A Gold Polaris”.

[Robert Dobb]

"one of the three keys to the success of the economy under the Clinton administration" ...

he signed into law the largest tax cut in history. The Tax Payer Relief Act of 1997.

The top capital gains rate fell from 28% to 20%. The 15% bracket was lowered to 10%, exempting from taxation profits on the sale of a personal residence of up to $500,000 for married couples filing jointly and $250,000 for singles.

The $600,000 estate tax exemption was to increase gradually to $1 million by the year 2006.

Family farms and small businesses could qualify for an exemption of $1.3 million, effective 1998. Starting in 1999, the $10,000 annual gift tax exclusion was to be corrected for inflation.

The economic bucket Andy speaks of, was enlarged. Money was freed up to slosh around the bucket.

Economic growth ensued. Inflation was put off into future years, as people wanted things that produced growth prospects. Not boring old gold.

That came later in the cycle.

[Jon Niebling]

Andy, I've been following your writing ever since you were a tech analyst at Paine Webber. Always insightful, keep up the good work. Your June 21, '07 Blackstone article was more right on than you get credit for. Onward...

[Vik Rubenfeld]

Andy, if the Fed can put the toothpaste back in the tube, does that mean they could use the money so collected, to pay off the massive Federal debt?

Thanks very much in advance for any info or thoughts.

[Bob Allard]

Great analysis for the laypeople out here trying to keep score. Your prescription at the end for the Fed(s) to get out in front of the issue and "telegraph the pass" is exactly the right idea, in my opinion. It is quite similar to what they are doing today with the Swine Flu issue: being forthcoming, explaining what we know, what we don't, what we plan to do, etc. Note that the market barely moved of of its trajectory on this worrisome issue. Thanks for your insights!

[C. Santiago]

Andy -- apropos, this blog entry posted yesterday at Zero Hedge made me think of your column. Zero Hedge articulates in much more detail (with facts and figures) what I suggested may be happening -- i.e., that our traditional money-supply statistics fail to capture the sharp contraction in the "shadow money supply," and therefore that the risk of inflation might be a lot lower than you suggest: http://zerohedge.blogspot.com/2009/05/chasing-shadow-of-money.html .

[חדרי תינוקות]

Andy it's awesome!! keep up your good work.I like to think of the economy as a giant bucket filled with money (money supply) sloshing around the bucket. We all hope the bucket is filled to the rim. Thanks once again Andy:)