Wednesday, April 22, 2009

Money, inflation, and why we want some (but not too much)

First, let us recall what money is. Money is toilet paper with pictures of dead people on it used to facilitate the exchange of goods and services in an economy, not something that has any inherent value. Money is not wealth. Goods and services and assets purchased with money are wealth. Money has value only insofar as it is involved in economic activity. Money that is stuffed inside a mattress essentially has value only as a substitute for cotton as mattress stuffing, as far as the economy is concerned, because it is otherwise doing nothing to foster economic activity.

The goal of a central banker is to have sufficient inflation to draw capital out from mattresses and put it to use (because in an inflationary environment it would otherwise lose value if left under the mattress), but not sufficient inflation to cause drastic declines in the value of the unit of money (and thus distortions caused by people trying to dump money as fast as possible rather than investing it wisely into goods and services and future production). Money has value to an economy only when used to foster economic activity as a token of exchange. Otherwise it is just funny shaped toilet paper with pictures of dead people on it. We have ample evidence that 0% or less inflation (i.e. deflation) reduce economic activity by turning money into mattress stuffing (either real or virtual), at which point it ceases to have any meaningful contribution to economic activity.

The EuroZone has set a goal of 2% inflation for the European Central Bank. That appears to be a good target for maintaining money supply velocity and thus economic activity. Milton Friedman won a Nobel for his equations describing the effects of monetary inflation upon economic activity, and thus far the evidence appears to support his thesis — capitalism works best with a small, constant, predictable amount of inflation, because otherwise the token of exchange (currency) loses its ability to contribute effectively to economic activity.

So the next time you hear someone say, "we should just let banks fail!", understand this: Banks are special in that banks actually create and destroy money via lending and not lending as part of the operations of fractional reserve banking. As I’ve previously pointed out, capitalism relies on having a stable (actually, very slightly inflating) money supply, deflation is poison because it kills current economic activity (since nobody spends anything other than what’s necessary since they expect their money to be worth more in the future), as is hyperinflation for the opposite reason (since it again leads to the collapse of banking and thus of the ability to leverage current assets into future economic growth as people withdraw their money from banks to spend it before it becomes worthless). If we do not come up with a solution to the banking problem and as a result manage to collapse the money supply therefore triggering monetary deflation, we face an even bigger disaster — possibly even the collapse of capitalism as an economic system. Given the unrequited history of failure of alternatives to capitalism (the training of economic systems via tokens simply is more efficient than any planned economy ever could be, see: neural network theory), that would be a major problem indeed for all of us.

-- Badtux the Economics Penguin


  1. My Frosty Friend,

    How do we keep banks solvent without the taxpayer underwriting the losses of the burst housing bubble?

    Consider that the banks seem to be keeping the bad assets off the market. (Previous post - your site)The banks will have no incentive to put assets up in a garage-sale auction (Geithner plan) since no hedge fund is going to bid these troubled assets at anything close to face value. (Where the troubled assets are most concentrated, the real estate prices have fallen 20% or more.) Face value seems to be what the banks are valuing this junk at. (Last month Fed rules allowed banks to use creative standards in valuing this crap on the books.) Unless the Geithner plan is a Trojan horse intended to allow the banks to slough these off on the taxpayer at face value with the intention the hedge funds will be unable to move them. (God, I hope that's not the plan.) But how the hell is this supposed to play out?

  2. Forced bankruptcy or nationalization. Those are the only two alternatives left. My take on the Geithner plan is that it is intended as part of the plan of saying to Congress and the American people, "look, we tried everything else, this is all that is left." I.e., the Obama team building political support for nationalization or forced bankruptcy. Will it work? Of course not. It's far too small for that. But more on that in another posting.

    - Badtux the Economics Penguin

  3. A banking system is needed. These specific banks are not necessarily needed, however. Indeed, arguably private banks aren't particularly needed at all (though as a practical matter I'd prefer to have some, just not run by the current bunch of people).

    I would also argue that 2% inflation is too low. Given a choice I'd go for about 4%. 2% puts too many sectors of the economy into real deflation.

    Overall, however, agreed.


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