Money. Doing it Right this Time.

@Countrygrl

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Essentially, you are off the topic of money itself, and on the topic of how should banks and finance be regulated. And you should recognize where those topics diverge. In this thread I'm trying to give an overview of money. Not a critique of capitalism or regulation.
Fair enough.
 
Then where the hell did the theory of market rationality come from? :lol:

Someone saw a bell curve, then saw market distributions, thought they looked pretty together and decided it was a fact :p To know how markets are irrational look at 401k funds. A business is pooling its workers 401k plans. To decide which money manager manages their plan they will make decisions about whether they want something like a "large cap growth fund" or a "mid cap blend fund". Then when an asset manager gets the client and starts investing, and finds that his superior investing strategy changes the technical designation of the fund type, the client will pull the fund from them because they are demanding it fit into a style box.

It's silly because the client wants A) their money preserved and B) growth. But those are the same. All money is at risk and the best way to preserve the most at the end is to get the most in the most sustainable way. If a manager sees that right now mid caps are hurting and his blend strategy should go to value stocks, he might go from midcap blend to large cap value just to preserve his clients money and make more in the long run. But the advisory boards tasked with choosing which asset managers to use don't care about that. They are irrational and control huge fortunes (something like 800 billion to 7 trillion dollars giving a quick preliminary search).

On one hand this is great because people like me will be able to profit from market inefficiencies. On another, these are peoples' retirements in play, or school endowments, etc.

So yeah, markets are irrational. They di great in aggregate. But the aggregate includes an elite few who can capitalize on a subpar many.
 
What is inflation?

Inflation is defined as the rate of change of the general price level. Here is a picture, one that any student who's had intermediate macro has burned in the back of their retinas:



This is "price inflation." It looks at the evolution of prices, specifically (in this case) consumer, investor, and government prices. One can also think of inflation solely in terms of consumer prices (the CPI or PCE price index), investment prices (GPDI price index) or even government prices (for which there's no go-to index because nobody cares).

Why is price inflation bad? Recall that the price of something is what you have to give up to get it. In the case of money, the price of money is one over the price level, on average. Be careful: the interest rate is not the price of money. The interest rate is the price of credit, which is not the same thing.

So if you have a fixed level of money, a higher price level means you have less "real money": your dollar doesn't go as far. In econo-speak we say that your stock of money divided by the price level is your stock of "real balances". It's how much money you have, adjusted for how far each dollar gets you.

Now it's easy to see why ceteris paribus a rise in the price level is bad: it reduces your real balances. So inflation is "bad" because, all else equal, it reduces your purchasing power. Note that I have left wages out of the equation, but wages are themselves a price; namely the price of labor. If your metric of inflation includes inflation in factor prices, everything gets more muddled.

One key question in monetary economics is determining the optimal rate of inflation. Here are a few conclusions:
  • If there is no uncertainty, the optimal rate of inflation is slow, steady deflation.
  • Under uncertainty, the optimal rate of inflation is either zero or low and positive.

Why else is inflation bad? The argument I made above applies to everyone but mainly applies to fixed-income persons. Suppose you have a wage income and suppose inflation is reliably 2% ever year. Then you can index your wage growth to inflation and protect yourself against the rise in consumer prices. However, if inflation is variable, it's more difficult to plan for such contingencies. Hence, inflation is worse when it is variable, and less bad when it is stable.

What causes inflation?

In the long run, the rate of inflation is directly proportional to the rate of growth of the money supply. We have good theory and good evidence for this proposition.

In the short run, inflation today is primarily determined by (1) expectations of future inflation, (2) past inflation (called "inflation inertia") and (3) slack in the economy (a weaker economy is generally consistent with lower rates of inflation).

The relative weights you give to those three factors basically depends on how you view the Phillips Curve. I put a lot of weight on (1). Old Keynesians would put the most emphasis on (2) and (3).


Core and Headline inflation

The popular CPI is published each month in two forms. Headline inflation is a weighted average of inflation, month-over-month, of a basket of around 3,000 commodities. Core inflation is headline inflation, less food and energy. We exclude food and energy prices because they are particularly volatile at a monthly frequency and aren't very informative about the direction of future inflation. It's not that we hate poor people (who spend a lot of money on food and gas), it's that those prices just don't provide a lot of useful information at such short time horizons.

If you sit down and do the algebra, the "weighted average" comes out to the typical consumption of someone around the 70th or 80th percentile of income. No, I don't think that's a good metric and I would love a "median CPI" which targeted the consumption pattern of the middle of the income distribution. We do have some imperfect metrics like that out there.

To my Internet Austrian friends:
"Inflation means growth in the money supply!"

Yes, if you live in 1920. We don't live in 1920 anymore and definitions have changed. Move on.

What inflation is not
For 90% of people, inflation is "the price of gasoline", period. I'm sorry, that's not inflation. That's a change in relative prices. Inflation happens to the general level of prices across a broad swath of goods.

I haven't said anything yet about asset price inflation
Because it's a bigger subject than I can comfortably fit in this post.


(This post is partly inspired by comments seen in the "$7 TRILLION!!11!" thread.)
 
People, including and led by, a lot of people who should have been experts in the field, convinced many people that housing prices would rise forever. So millions of people were fooled.

But you cannot separate the housing bubble from the fraud and mismanagement of the mortgage industry.

Never forget this one thing about banking: The job of the banker is to say no. The job of the banker is to reject any loan application that is not entirely sound.

And one of the biggest distinguishing traits of the housing bubble was that the mortgage originators flat out did not care whether any of the loans ever got repaid. And so committed any fraud they could to make any loan they could.
This is an extremely important statement that I happen to subscribe to.
You really nailed down one of the main causes of the mess we are currently in.
Simply stated, bankers did not say no, looking at the very short term without any regards for the consequences of their decisions in a longer term.
People have been sold the idea of unlimited continous raise of assets value and in some cases some financial institutions believed in the same fairy tale too.

This is at all effect a failure of the financial system and regulators.
Not a failure of money itself but a failure of how money are lent out to people.

I would also like to note how the use (or misuse) of Credit default swap gave a false sense of security to some bankers and an opportunity for wild speculation for others.

Let me know if I risk to go OT from the money topic, but I don't think we can talk about money without talking about how to lend/borrow it, and how derivative financial tools effect it.
 
Awesome post, Integral.
 
wolfigor, that's fine. I intend to write more on central banking. But I didn't post it yet because I wasn't really happy with how my post came out. But I will be getting back to it when I have a bit more time.
 
What do people think about local currencies that are restricted to, for a example a town?

What I have read about it, it tends to be very good for the local economy in question
 
Integral said:
In the long run, the rate of inflation is directly proportional to the rate of growth of the money supply. We have good theory and good evidence for this proposition.

According to which measure of the money supply? M0? M1?

Does inflationary pressure ever emerge prior to an expansion of some monetary aggregate?
 
Would it not have prohibitive transaction costs? Every transaction between a party in the town and a party outside will have to convert their currencies, or the town will largely abanond the local currency and just use an outside one. If there isn't a peg, instability of prices would also become an issue.

Not to mention the direct costs of printing and maintaining a money supply.
 
Awesome post, Integral.
Thanks! I have updated it slightly with a few more "reasons why inflation is bad".

According to which measure of the money supply? M0? M1?

Does inflationary pressure ever emerge prior to an expansion of some monetary aggregate?
Broad money, so M2. But yes, the "choice of M1 or M2" can often be abused to obtain results one would "like".

Inflation without monetary expansion...the best example would be supply shocks? Take the 70s, you had inflation spikes driven by a rise in factor prices (oil) on the supply side.

The "inflation is always and everywhere a monetary phenomenon" only works in the long run; it works in the short run in the case of demand shocks, but not supply shocks.

I mean, a demand shock is basically monetary in nature, when you get right down to it.

I plan to answer questions about monetary policy and asset prices in a few weeks, after exams have been written. :)
 
What do people think about local currencies that are restricted to, for a example a town?

What I have read about it, it tends to be very good for the local economy in question

Say1988 largely got it. Recall that money is a medium of exchange. It can't do that job if people don't accept the money everywhere. If people frequently have to change one money for another to make transaction, then that adds significantly to transactions costs.

That was really the whole impetus behind the Euro in the first place. There are many cross border transactions in the Eurozone because people, goods, and services, travel so freely there. Having a dozen different moneys was getting in the way of that. So the Euro was created to lower transactions costs, and hopefully increase total commerce. (Other problems with the Euro weren't properly foreseen, and we can discuss those separately if you like).

A strength the US economy had that Europe did not have prior to the Euro was that we had one currency across a whole large nation. (Not to mention the post WWII worldwide acceptance of the US$)

And yes, it is also true that having many local moneys would increase the basic costs of just producing the money itself.

Recall that having the greatest possible choices of transactions, as well as the lowest transactions costs, maximizes the benefits of having transactions at all.
 
I've heard stories of small Italian towns introducing their own form of currency and of people in Greece using some form of online "credits" instead of euros. I don't know how big these things are though.
 
Things like that can happen when the local people have some reason for evading the larger economy. A famous example is the Capitol Hill Babysitting Co-op, which demonstrates both the incentive for such a system, and its drawbacks.

Barter exchanges are another way of evading the economy at large. And many people like to participate in them. But they don't scale up well.
 
Thank you for your posts Integral, could you put an optimum currency area on your list?
 
What is inflation?

One key question in monetary economics is determining the optimal rate of inflation. Here are a few conclusions:
  • If there is no uncertainty, the optimal rate of inflation is slow, steady deflation.
  • Under uncertainty, the optimal rate of inflation is either zero or low and positive.

Is there a simple explanation why this has been determined the optimal rate of inflation? And what is the uncertainty? The uncertainty of measuring inflation?
 
Central Banking

4 years ago, as the financial crisis was just gaining momentum, George F Will, a leading conservative political columnist in the US, wrote this article.

Folly and the Fed
By George F. Will
Thursday, August 16, 2007

Exactly a century ago, panic seized financial markets. The collateral for perhaps half of the bank loans in New York consisted of securities whose values had been inflated by speculation. Then on Sunday night, Nov. 3, 1907, a 70-year-old man gathered some fellow financiers at his home at 36th and Madison in Manhattan. The next morning, a New York Times headline proclaimed:

"BANKERS CONFER WITH MR. MORGAN

Long Discussion in His Library

Not Ended Until 4 o'Clock This Morning."

Both the Times and The Post ["BANKERS IN CONFERENCE. Money Stringency and Remedial Measures Discussed in Morgan's Library."] noted that bankers shuttled between meetings at Morgan's mansion and the Waldorf-Astoria (then at Fifth Avenue and 33rd Street) in a newfangled conveyance -- an automobile. Working 19 hours a day, and restricting himself on doctor's orders to 20 cigars a day, J.P. Morgan seemed so heroic that the president of Princeton University, Woodrow Wilson, said the financier should chair a panel of intellectuals who would advise the nation on its future.

Six years later, however, under Wilson as the nation's president, the Federal Reserve System was created, ending the era when a few titans of finance could be what central banks now are -- the economy's "lenders of last resort." Central banks have been performing that role during today's turmoil in the market for subprime mortgages -- those granted to the least creditworthy borrowers.

....

The Federal Reserve's proper mission is not to produce a particular rate of economic growth or unemployment, or to cure injuries -- least of all, self-inflicted ones -- to certain sectors of the economy. It is to preserve the currency as a store of value -- to contain inflation. The fact that inflation remains a worry is testimony to the fundamental soundness of the economy, in spite of turbulence in a small slice of one sector.

...


Now note the dichotomy. On the one hand Will describes how the Federal Reserve was created as the "lender of last resort", and on the other hand says that the mission of the Fed is to "control inflation", but not to worry about economic growth.

It is particularly this type of disinformation that informs a lot of the criticism of the Fed.



What is a central bank, and why have one?

Central banks started off as the government's bank. It is where governments deposited their tax revenue until they spent it. And it assisted the government in borrowing money. America's first 2 central banks, named creatively the First and Second Banks of the United States, did more than that, and loaned money commercially to businesses and for internal improvements. However, there were controversies about them, and Andrew Jackson managed to kill the Second Bank of the United States. The US didn't have a central bank again until 1913.

Not having a central bank didn't cure the cronyism that was one of the common criticisms against the Banks of the US. The government still had to deposit its money someplace. And so they chose a collection of politically well connected private banks. This gave those banks a huge windfall and advantage over other banks.

This period from 1837 to 1913 was a chaotic one in the US. There was just so much going on that you can find some of anything you happen to look for. Economically there was both great growth and frequent severe crashes wiping out much of that growth. There was money printed by private banks backed by gold, and sometimes money backed by nothing. And sometimes outright counterfeiting, but the counterfeit money was accepted none the less because people simply needed the money so badly they didn't much care where it came from.

By 1907 the system had gone as far as it could. JP Morgan, in the events Mr Will described above, was able to get all the major bankers to act as a lender of last resort, and help the economy as a whole. But also realized that it wouldn't be enough to do that again. And so the creation of the Federal Reserve was organized.

Now, to be clear, the Fed was created to be the "lender of last resort" to stabilize the economy when no one else, and no organizations, could. Everything else is secondary to that.

That is mainly what a central bank is for. But it is not all of what they do. The design of the Fed gives it control of the currency. And therefor the money supply. And that inherently ties the Fed into the role of controlling, or not, the rate of growth of the economy and inflation.

And so the roles of the Fed became:
  • Lender of last resort
  • Promote economic growth and purchasing power
  • Regulate the banks
  • Stabilize the economy
  • Maintain price stability
  • Act as a clearing house for checks between banks

Sometimes some of these goals are in conflict with others.

The US Federal Reserve has an extremely strange structure. This is a result of the political compromises needed to get the legislation passed at all. There has been from the time of the proposal of the creation of the First Bank of the US a belief among some that the US Constitution does not allow the authority for Congress to create a central bank. Most have disagreed with that belief. But it has had enough power at times to result in some odd political choices. For example, not all of it is part of the US government. The 12 regional Federal Reserve Banks are owned by the member private commercial banks in those regions. So the presidents of the regional Fed banks are not government employees.

The committee that decides on the monetary policy of the Fed, called the Federal Open Market Committee, includes 12 members. The chairman, currently Ben Bernanke, who you should have heard of, is appointed by the president and confirmed by the Senate for 4 year terms. The vice chairman and the other 5 appointed members, IIRC, are appointed to 12 year terms. This means that no one president can "stack the board" because he won't be in office long enough to do so. The other 5 members are the president of the New York Fed (by far the most important of the regional Fed banks) and 4 presidents by rotation from the other Fed regional banks.

The president of the United States can fire none of these people. Removing them requires either out-waiting their term or impeachment, which would be like impeaching a judge by Congress.

The reason for such an odd structure is to give the Fed's governing board both a great deal of isolation from the politics of the moment and broad input from around the country. That is the model of what is called an "independent central bank". Why independence? Because otherwise you get a bank that makes short term decisions for political gains without regard to the long term consequences.

Seriously, would you want Congress making monetary policy?

Money has such a huge effect on the economy that the incentive to manipulate it for political gains is overwhelming. Even with the independence designed into the Fed, efforts to influence the Fed's decisions are commonplace. A central bank that was too much subject to political interference, or directly politically controlled, would have much too strong of incentives to do what the current political leaders wanted, regardless of consequences down the road. That would mean both periods of much higher inflation than we have now, as well as periods of stagnation due to political majorities that wanted to crush inflation at all costs. And overall greater instability. Just keep in mind the current debate, where the majority in the House of Representatives wants government policy to help throw the current president out of office, regardless of the affect on the country. And this is why we have a central bank that in insulated, in the short run anyways, from the politics of the moment. And why Congressional proposals to hamper the Fed, audit it, restrict its freedom of action, prioritize inflation targeting above all other considerations, is such a disastrous idea.

Now meeting these competing demands is very difficult. In fact, it would probably be fair to say that the central bank essentially never "gets it right" in any one time period. Instead they manage a scattershot around right, and try to get the average right in the long run. Why aren't they getting it "right" all the time? Imperfect information. Remember MV=PQ? How many of those variables do they have next month's number for?

None of them.

Based on past experience and careful analysis of all available information they think they've got a pretty good guess at it. But it is a constantly moving target. And there are constantly external factors that throw the variables off projections, if even by only a tiny margin. And that is why the Austrian Economics criticism that "If only money was right, we wouldn't be having these problems" is essentially useless. Worse than useless really, extremely dangerous. Perfect is unattainable. So given that you know you are going to be wrong, you try to shoot for wrong in the direction that has the less harmful consequences.

TL; DR version



Why do we have a central bank?
The markets and the government both recognized that the economy was too unstable and wasn't working well enough without one.
What does a central bank do?
It acts as a lender of last resort to protect and stabilize the economy.
 
Thank you for your posts Integral, could you put an optimum currency area on your list?
Will do, especially given that the Euro crisis is a big deal right now.

Is there a simple explanation why this has been determined the optimal rate of inflation? And what is the uncertainty? The uncertainty of measuring inflation?

Sure, I'll expand on that a bit. By "uncertainty" I am talking about measurement uncertainty. Yes, that was confusing in my post, now that I look back on it.

In economics, "optimal" anything is the thing which maximizes the representative consumer's utility. Okay, so that's a massive cop-out answer.

Holding money has costs and benefits. The benefit is that money makes transactions easier: no need to barter. The cost is that holding money means that on the margin you aren't holding interest-bearing assets, so you're missing out on some interest. Milton Friedman looked at the issue in this way and concluded that one way to mitigate the "cost" without giving up the "benefit" was to increase the rate of return on money. Now the rate of return on money is (the negative of) the rate of inflation. So we set the rate of return on money equal to the real interest rate: that implies slow, steady deflation. That's where the optimality of slow, steady deflation comes from. But it is not the end of the story.

Basically, the transactions cost of holding money is really, really small empirically. It's not really worth considering in the grand scheme of things. Now why might the optimal inflation rate be zero or positive? Four things to consider.
1. We are really bad at measuring inflation and probably overstate it somewhat. So aiming for positive CPI inflation means that "real" inflation is actually close to zero.

2. Downward wage rigidity. So suppose you're a firm and demand for your good declines. In general one response to this event is to downsize: lay off some workers and/or cut real wages a bit. But suppose you can't cut real wages because of labor contracts or other such rigidities. Then if inflation is slightly positive, you can cut real wages by holding nominal wages constant and "waiting it out" for inflation to do the cutting for you. Hence inflation "greases the wheels" of the labor market somewhat. I don't think this is a particularly strong argument but it is a major one in the literature.

3. Debt-deflation traps. Deflation tends to be "bad" because it increases the real value of debt. So low and positive inflation will reduce the proportion of times that we slip into such traps. This is potentially a very strong argument.

4. ZLB. Low inflation implies, usually, low interest rates. If you think that monetary policy usually works through interest rates, then a bit of inflation gives the central bank a cushion to lower interest rates in the face of recession. I think this is an awful argument on its own terms (though can be made very strong), but it's perhaps the primary justification of low-but-positive inflation rates out there.

--

Queue
- Asset prices and monetary policy (rolling together some questions)
- Optimal currency areas (esp the Eurozone)
- Insidious I's: Why inflation and interest rates are misleading ways to think about monetary policy (while they can be a starting point, they should never be the ending point)
- Where do Recessions Come From? Oil and Money (if Cutlass finds it within-bounds for the thread. Half of it will be about money! :) )


--

Edit: Excellent post on central banks, Cutlass.


--

Edit edit: I will, at some point in the undetermined future, begin blogging about money and monetary policy. At that time these long posts will be reposted there.
 
Integral said:
In economics, "optimal" anything is the thing which maximizes the representative consumer's utility. Okay, so that's a massive cop-out answer.

Holding money has costs and benefits. The benefit is that money makes transactions easier: no need to barter. The cost is that holding money means that on the margin you aren't holding interest-bearing assets, so you're missing out on some interest. Milton Friedman looked at the issue in this way and concluded that one way to mitigate the "cost" without giving up the "benefit" was to increase the rate of return on money. Now the rate of return on money is (the negative of) the rate of inflation. So we set the rate of return on money equal to the real interest rate: that implies slow, steady deflation. That's where the optimality of slow, steady deflation comes from. But it is not the end of the story.

If in economics, the business is about optimization of utility for consumers, then why do economists with power do so many manipulative things to the money supply that are counter-intuitive to this point? Economics has become much more about sociology than it has about pragmatic optimization of utility. Contemporary economic theory, particularly today, has little more to do with anything other than getting people to spend at all costs, whether they have the money or not.

Your point about deflation seems to run against the stream that I've read so frequently on this board about deflation. It wasn't long ago where I brought up the point to the board that an economy will be naturally deflationary (through competition and gains in efficiency) and it was poo poo'd by everyone: Mise, Cutlass, JerichoHill (who I'm pretty sure is an economist), and yourself.

The mantra espoused was that in a deflationary environment people don't invest and debtors get killed (you mention this in number 3). A slow deflationary economy wouldn't make the monetarists and Keynesians of the world very happy. Debt spending would slow, and they'd be less able to manipulate the economy for their own interests.

Inflation should be zero. It shouldn't favor savings, nor should it favor debt. This is the only way for banks, lenders, and investors to accurately price risk within the marketplace and reduce speculation.

Integral said:
We exclude food and energy prices because they are particularly volatile at a monthly frequency and aren't very informative about the direction of future inflation. It's not that we hate poor people (who spend a lot of money on food and gas), it's that those prices just don't provide a lot of useful information at such short time horizons.

I have come to believe that this is a misguided view on inflation. The more everyday costs of everyday items increases, it reduces the consumers ability to purchase from the rest of the basket of goods. So when energy and food inflate, the demand for other goods will be reduced, resulting in a deflationary environment for the rest of the basket of goods. This is particularly true when inventories are high. This seesaw between food and energy and other discretionary items muddles the real picture of what is taking place if you choose to ignore food and energy.

Month over month changes may not provide useful insight into what is happening, but quarter over quarter, or year over year adjustments are exceptionally important. You need to keep in mind that as prices for food and energy continue to increase beyond real wages that it will continue to swallow up more and more real income, and also swallow up more and more people from having zero, or near zero, discretionary income. To me the inflationary pressures on energy and food represent a far greater potential to negatively impact an economy than you seem to believe. I think the stagflation crisis was proof positive of this.
 
Cutlass said:
Because otherwise you get a bank that makes short term decisions for political gains without regard to the long term consequences.

Seriously, would you want Congress making monetary policy?

Except this isn't how the Fed has functioned for three decades now. In most cases the fed is acting as a surrogate for what congress and the president wish to see happen. The notion of independence is tenuous at best.

If the Fed was responsible for LONG TERM decisions then they wouldn't have focused on monetary policy which fostered gross debt accumulation as a means of growing the economy from the 80s onward. Nor would they focus on liquidity injections to solve a structural economic crisis.

There's nothing really wrong with the Fed as an entity. The problem with the Fed is usually the people piloting the ship.
 
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