Inflation Comes from Spending Money, Not Creating It

A lot of people think that the act of creating money will somehow create inflation all by itself.  That is as ridiculous as saying the mere act of growing more food will solve world hunger(there's so much more to it).  Inflation is a complicated topic with few absolutes and a lot of misunderstanding.  In this post I want to debunk the myth that just by someone creating money, that it can cause inflation.

First of all, let's say that the federal government printed off 500 billion dollars in new bills.  You might think that this would automatically create inflation.  But what if the government took all that money, loaded it up into a rocket ship, and sent it to the moon?  Think that would cause inflation?  How about if they took the money and put it in a vault in Fort Knox - do you think that would cause inflation?  No, of course not.  The money was created, but never put into the economy.  If inflation is defined as "too much money chasing too few goods" then the key word most people forget to consider is "chasing".  Money sitting on the moon or in a vault in Fort Knox aren't chasing after any goods.

How about some more examples.  For instance, what about the federal government put money in a bank vault.  Would that cause inflation?  Not directly.  Because even though the money has been handed over to someone, it didn't take any resources out of the economy.  It moved money, but it wasn't in exchange for anything.  For something to be inflationary it must either add to aggregate demand without adding to equivalent aggregate supply, or take away aggregate supply without removing equivalent aggregate demand.  If the federal government gave dollars to a bank all day everyday, it wouldn't cause inflation as long as all the bank did with it was to put it in a vault and never spent it or lent it out.  The same thing goes if the federal government gave that 500 billion dollars to a person for free.  Unless that person spends the money, it won't be inflationary.

Of course, many of the things I've described will precede money being spent, and will indirectly cause inflation.  For instance, giving a person money will precede them spending it and causing inflation.  Giving money to a bank will precede them lending it out to someone who will then spend the money.  So while it is often the case doing those things can cause inflation, it's important to know that the act of creating the money doesn't necessarily cause the inflation until the money is spent.  Let's take a look at some real life examples where this distinction becomes important.

If the federal government sent  a hundred dollars to every citizen in the country that would be around 30 billion dollars created.  However, if everyone took that money and stuck it into their savings account, it wouldn't cause any inflation because it wasn't spent.  When people later take that money and spend it, it may cause inflation, but it won't affect aggregate demand or supply until people spend the money.  Another example would be if the federal government gave money to banks in exchange for their government bonds, it wouldn't automatically cause inflation.  It might lower interest rates, but unless those lower rates translate into more bank loans that are then spent into the economy, it isn't going to cause inflation.

A lot of people thought that the Fed's so-called  "Quantitative Easing" was going to cause massive inflation because more money was being pumped into banks.  It could have, but only if that money had translated into banks making more loans.  Since it didn't(or at least no significant) increase loans, it didn't do much to help the economy or increase inflation.  As this example demonstrates it's important to distinguish between what actually causes inflation, and things that have been observed to indirectly cause it.  Because otherwise, we'll all run around like Chicken Littles worrying about hyperinflation while the economy continues to tank.

What Happens if the U.S. goes into default?

Some people think that this is going to be like when the federal government shutdown in 1994.  For those who remember it, it meant things like national parks were closed, several agencies were shutdown, and many federal workers got an unpaid layoff.  While those things had a negative impact on the economy, a failure to raise the debt will be disastrous in comparison.

Why this will be different all comes down to the two different kinds of government spending.  Mandatory and Discretionary.  Mandatory spending are things that get automatically spent based on current rules.  For instance, when you're 65, you get social security.  Congress doesn't have to pass a special law for that to occur.  Discretionary spending is programs and agencies that must be renewed every year.  For instance, the commerce department only gets a budget to hire so many people every year.  During a shutdown over the federal budget it's employees go home, but any bills it already agreed to pay are honored.  Same with Social Security.  People who work for Social Security during a budget showdown will be sent home, but the people on Social Security will continue getting their checks in the mail.  This is not true over a problem with the debt limit.

With the debt limit, once it's reached, no new government checks will be issued.  So everything that happens during the 1994 shutdown will happen plus more.  States and local governments won't be re-imbursed for education expenses.  Social Security payments will be missed.  People won't be able to exchange their U.S. bonds for cash.  Now you can start to see why this is going to be so bad.  States and local governments will be hurt, retirement plans that depend on U.S. treasuries will be hurt, doctors won't get reimbursed for their medicare patients, and worse anyone who depends on social security just to scrape by will be devastated.  All of the things that the federal government has already committed to paying for (via law) will now go unpaid for.

So is the U.S government going to default?  Even though all limits on the Federal Government's finances is self-imposed, it is still possible to volunaterly default.  So, Whether or not there will be a default, is entirely a political, not financial question.  Not raising the so-called debt limit is one of the ways to voluntarily default.  Unfortunately, the geniuses in Washington may be about to do that for the first time in the history of our country.  My guess is that the chances of a voluntary default seem about 50-50.

So what should we expect and what should be done in preparation for a default?  I would expect that most of the federal government will shutdown.  Officially, people and departments will still be "in business", but it won't be able to pay its employees or contractors so they'll all have to be sent home.  This poses a problem for those in the armed forces.  My guess is that if you're in the armed forces you won't get sent home nor get payed for a while.  However, when the deficit limit is raised, you will get your full back pay.  In fact, I'm pretty sure that goes for any government assistance to states, cities, or people.  You're going to go without pay for a while, but the politicians raise the debt limit, all back pay will be honored.  The reason is that, by law, these groups are owed this money.  I'm not a lawyer, but I'm pretty sure that means the back pay will have to be redeemed.  However, I wouldn't hold out hope for getting payed interest for the late payments.

As unprecedented as a voluntary default is, I think most of what's going to happen is fairly predictable:  Most government workers will be sent home without pay and there will be a delay in sending out government checks.  The only wild card is what's going to happen to the bond market?  U.S. treasury securities have always been a no-brain safe investment.

If banks and investors can no longer turn in those due U.S. securities, what's going to happen?  First of all, I am 99% sure that those bonds will eventually be honored once the debt limit is raised.  In the meantime, what's going to happen.  I am not certain.  A lot in the media think that it means that interest rates on everything is going to go up.  But, these are the same people that think the federal government can run out of money.  So, I'm not going to just take their word for it.  The theory is that the U.S. bond market sets the overnight interest rate.  Banks (for the most part) set their long term interest rates on how cheaply they can get more money to lend today.  Therefore if the interest rate for long term bonds goes up, then all interest rates rise.

There's a couple problems I have with this.  First, it assumes that interest rates on U.S. bonds are going to rise.  I'm not entirely convinced of that yet.  First of all, the Federal Reserve can still flood the market with cash by buying U.S. treasuries as they have been.  Second, if the government guarantees that all bonds will eventually be honored, there's no reason to believe that the overall price is going to go up.

On the other hand, maybe interest rates will rise.  I've learned to never underestimate the irrationality of the financial markets.  Also, if the credit rating agencies like Moody's and the S&P actually downgrade U.S. bonds (another irrational move, if you ask me), there could be a rash of sell offs as pension plans and etc have to sell them off because they are required to have a certain amount of highly rated bonds.  If that happens, that's going to flood the market with U.S. bonds making them worth less and sellers would have to offer a higher interest rate to sell them - which then increases the interest rate.

My bottom line prediction for the U.S. bonds is that default will temporarily raise interest rates, but they will quickly fall again once the whole debt limit is settled.  How hi they rise will depend on the Fed's action as well as if the credit rating agencies officially downgrade U.S. bonds.

The Useless Quantity Theory of Money

"If the government creates money all it'll do is cause inflation and we'll all suffer." This is one of the deadliest lies we've been told for the last 40 years. For centuries, philosophers and economists thought that any increase in money would always increase prices. John Maynard Keynes pretty much set the record straight on that about 80 some years ago. But the idea has been resurrected in the last few decades and is now mainstream again. It's this rationale that conservatives use to justify destroying social programs, budget cuts, and the basis for the current debt "ceiling" discussions in Washington. What makes the idea so insidious is that it makes sense on the surface. With most things, the more of something there is, the less it's worth. But unlike most things, money has no intrinsic value. That makes it fundamentally different. Below I will show you the modern re-emergence of this theory and why it is bullshit.

Money has no value until it is spent. What that means is that only at the time of purchase does it have an effect on inflation. For instance whether a single dollar bill is spent 4 times, or 4 dollar bills are spent once, the effect is the same. To give an example of what I mean, let's look at two scenarios:

One day, a cold man buys a coat from a coat shop for a dollar. Now let's say the owner immediately gives that dollar to one of his employees as their salary for the day. The employee then turns around and buys a coat as well. The shop owner then takes that dollar and buys lunch at a cafe. The owner of the cafe then takes that dollar to the shop and buys a coat. Finally, the shop owner takes the dollar to the owner of a billboard and buys advertising. The billboard owner then takes that dollar and buys a coat with it. On the way home the shop owner buys a book with his dollar from the bookstore.

In the second scenario. Let's change the order. The cold man, the cafe owner, the employee, and the billboard owner all come in to the coat shop in the morning and buy a coat for a dollar. At the end of the day, the shop owner takes those 4$ and pays his employee's salary of 1$, buys dinner at the cafe, buys his billboard ad, and gets his book. That's 8$ worth of activity from 4 single dollar bills.

In both scenarios, the end result is the same. 4 people have coats, the shop owner has payed his one employee, gotten a meal, has advertising, and bought a book. That's 8$ worth of activity from a single dollar bill in the first scenario, and 8$ worth of activity from 4 single dollar bills in the second scenario. How is that possible? Doesn't more money always mean higher prices? In short, No. The rate that money is spent also has an impact on prices. As far as prices and demand is concerned, a single dollar being spent 10 times has the same effect as 10$ being spent once.

This is something that economists have know for a long time. They even have a fancy, glazed-eye inducing formula to represent it.  They eventually boil the formula down to this. MV=PQ. In their own convoluted way, what economists are trying to say is that, All existing Money(M) multiplied by the average number of times it is spent(V) is equal(=) to the amount of goods in the economy(Q) * the average price of those goods(P).

For example, if in a small town there are only 10 physical dollars(M) and each dollar is spent 3 times(V) then that means there was 30$ worth of activity. So if there were only 3 things bought(Q) in that village(say a toaster, a coat, and a lighter), then their average price would have to be 10$(P). If there were 6 things bought, then the average price would have to be 5$. M times V must always equal P times Q. M * V = P * Q. This equation is non-controversial among all economists. It is logical and self-evident.

This finally brings me to the lie we've been told for decades. Some guy, decades ago, took that equation MV = PQ and said something to the effect, "well, if you 'assume' that the velocity of money is constant and that the economy cannot(or will not) increase the amount of goods, then any increase in the money supply will only serve to increase prices". 

Algebraically, it makes perfect sense. If you assume that 'V' and 'Q' are constant, then making M bigger would HAVE to make P larger. Thus was born the Quantity Theory of Money. You probably see the problem with this already. 'V' and 'Q' are most certainly not constant! (Funnily enough, that same guy still managed towin a Nobel prize in economics.)

'V' or the velocity of money is not constant. That's why during the start of a recession the federal government can run huge budget deficits and still see 'P' or prices go down. When people feel insecure about the economy, households save money in case of a layoff, and businesses don't risk new investments. The rate money is spent goes down and in the case of 2008, completely eclipsed the increase in the money supply created by budget deficits.

The other assumption that 'Q' is constant is also bullshit. An increase in money or spending rate can make the number of goods in the economy(Q) go up instead of prices. Think of a car factory being inundated with requests for more parts. Instead of increasing prices they could add a third shift. As long as there are enough unemployed workers to hire for the third shift, the increase of MV will affect quantity(Q) and not prices(P). Q would increase instead of P as long as the ability to increase supply exists. If there aren't enough workers (or some other constraint), then the factory would have to raise prices. This situation would exist when there is almost no one who is unemployed to be hired for the third shift. You might be asking "why wouldn't the factory just increase prices and reap all those profits?" The answer is that if the factory just increased prices they would be susceptible to some other factory adding a third shift and keeping their prices low - or as economists like to put it, "firms increase quantity before prices to maintain their marketshare".

Now you should be able to see the absurdity about worrying about rising prices when unemployment is so high. High unemployment means that 'Q' isn't at it's highest. Therefore increasing 'M' via federal budget deficits will have very negligible effects on 'P'. Instead new jobs will be created and we can enjoy the increased goods without increased prices. Only when the economy is maxed out will budget deficits start increasing prices. It is at that point that we can start worrying about budget deficits and debt "ceilings". Worrying about them before that happens is stupid.

I've tried to show in the most logical way I am capable, of why we shouldn't fear increasing the amount of money at times like this. Now that you've seen the basis for the "Quantity Theory of Money" and the assumptions that it relies on, I hope you can see why it's bullshit. While it may be "technically" true if it's assumptions are true, the assumptions are rarely, if ever true.

Wait... Can we "afford" to kill Bin Laden?

We got the bastard. Osama bin Laden is dead. But, imagine if we applied the same litmus test to military expenditures as conservatives want to apply to social security and Education....

Picture Obama and his national security team debating if the united states has enough money to pay for the operation to kill Osama Bin Laden? Before executing the plan did they ask themselves questions like, "Will this crowd out investment?" "What will be the effect on the budget?" "Who will pay for it?" "Sure it'll put soldiers to work, but those are government jobs, not REAL jobs." "Can we afford this?" Of course they didn't ask themselves those questions. They asked themselves, "Is this worth doing"? They decided "yes". Then they asked "can we do it?" They looked and found that they had soldiers with guns and helicopters with fuel and said "Yes we can". Then they gave the order.

They did what any government should do before venturing on a public good project. They asked "Should we do it?" Then they asked "Can we do it?" And the "can we do it?" has nothing to do with money or deficits. The only thing that should be considered is if the country has the resources to accomplish it. I get so sick of politically motivated calls for "austerity" and cries of "going broken" when everyday we make decisions the correct way: Are the resources there?

Our leaders are so used to thinking in terms of money, they forget what it represents. Resources. Since the government can create and spend however much money it needs, it's never constrained by revenue or "borrowing". The only thing it's constrained by is available resources. If it exceeds resources, it shows up as inflation. This simple concept somehow got lost in Washington D.C.

Let's apply this resource attitude to areas other than military. Should we have small class sizes? "Yes". Do we have enough teachers to hire so that we can have small class sizes? "Yes" - as evidenced by the huge numbers of unemployed teachers. This is something we can do. It has nothing to do with "do we have enough money?" We can afford to hire these teachers until there are no more competent teachers to hire. When that happens, THEN we'll have a resource constraint and inflation will occur.

Should we fix crumbling bridges? "Yes". Do we have the resources? Do we have enough concrete and construction workers? "Yes" We have so many out-of-work people in the construction industry that can do it. We also have huge concrete companies that are or are going out-of-business. In other words, we have the resources.

Let's do a counter-example. Should we give everyone a big screen 3D tv? "probably not". Do we have the resources? They aren't 300 million 3D T.V. sets. That means that even if the federal budget was in surplus, we couldn't "AFFORD" to give one to everybody. It will cause inflation as more money chases after an inadequate amount of goods.

I'm not saying we shouldn't spend on the military. We should use our military when it's needed. That's what it's therefore. I am saying is that as long as our economy continues to be recessed. Idle people(unemployed) and idle resources(Capital) are sitting around begging to be used. But we don't, because we're afraid of fictional budget restraints(budget deficits). We have an army of unemployed waiting to be used. Why not use them for the public good? There are several needs in this country. Let's use our other "army" to make all our lives better. Go America!

Money is not a Durable Good

Saving money and giving it to your children is something that can be done by an individual that benefits the individual child.  It's not something that we as an entire nation can do collectively.  If everyone saves a hundred dollars and gives it to their descendants, it does not improve the overall society at all.  This is also true at the government level when the government can create money at will, anyways.  It doesn't make sense for a government entity to "save" money with the intent of spending it later if it can create money at will.

There's a lot of caveats to this, but before we get to them, I want to make sure my overall point is clear.  Let's say you have an island of 1,000 people who use their own currency called "Isles".  Let's say someone came by and dropped a big 'ol pile of Isles onto the population.  They'd all have more money, but would they be better off?  Of course not, they have more money, but no wealth was created.

Now let's say that one year the people living on the island have a really good year and everyone has lots of food and luxuries.  Always mindful of the future, they decide to plan for years when there won't be lots of food and luxuries.  To do this, they all decide that everyone in the village is going to put some of their Isles money into a chest, lock it, and bury it for future use.  Now let's say 5 years later, the villagers have a lousy fishing season and must work extra hard in other areas.  Then, someone remembers the chest they saved and they all rejoice and open the chest and take out the money out and pass it around.  They'd all have more money, but are they better off'?  Of course not, they have more money, but no wealth was created.

None of the two scenarios change at all whether or not there is a government entity involved. One more look at our fictional island nation.  Let's say that the government wants to save resources a bad fishing season.  Therefore it decides to tax more than it spends for a couple years.  During this time the economy of the island goes into recession because of the extra tax burden, and the island has less wealth and more unemployment.  Now a few years later there really is a bad fishing season.  The islanders are not even worse off than in the last scenario.  Not only does the extra money not help them, but there was already a lack of good from the recession.

The only way the scenario of a generation saving money can help, is if it gets a gluttony of foreign currency from a neighboring island.  This isn't as easy as it sounds.  First of all, the people would have to agree to only sell goods to the neighboring island and not buy anything from it.  Second, the parent generation will have to hope that the money foreign money is still worth as much when they give it to their kids.  Third, once the kids try to spend it, they must find willing sellers on the neighboring island.  Of course, all of these things could happen, but the parent generation would have to put in a whole lot more work than the child generation would get back - if they get it back.

The point of this is that, as a society, one generation cannot make the next generation better off by saving money.  This only works on the individual or small community scale.  In fact, one generation can't really make themselves better off by saving money.  Money is not wealth nor is it a durable good.  Some of the things we create as a country will still be around and appreciated by the next generation when they grow up.  Money, is not one of them.

The Purpose of Taxes

The story of taxation usually goes like this:  You earn your dollars, then give some portion of it to the government.  The government then takes your money and buys tanks, builds roads, and gives food to the poor.  For local and state governments, that is a true story.  However, for the federal government, which creates the currency, this story remains just that: A story.  Despite what most people in Washington believe, the government doesn't need your tax dollars to fund it's activities.  Since the federal government can create money at will, then how does it make sense to say that it needs your taxes to fund all the things that it does?  Obviously, it doesn't.  So what is the purpose of taxation? The purpose is two-fold:  To control inflation and maintain demand for the currency.

Taxes are needed to regulate inflation.

Since you already know that government spending is constrained by inflation, not revenue, then this should make sense.  If everything else were to remain equal, then taxes would always have to rise with spending to regulate inflation.  If the government kept injecting large amounts of spending without taxation you would eventually see inflation.  However, there are several reasons that inflation and budget deficits don't always correlate.

There are many reasons that they do not always correlate.  A high savings rate is a good example.  If people are saving dollars instead of buying items it can cause deflation.   Another is fluctuations in foreign exchange markets.  In fact, we are currently living in an age of astronomical budget deficits, and yet we are still seeing very low inflation.

The other reason for federal taxes is to maintain demand for the currency.

Once a currency has already been established, this reason isn't as obvious.  To understand this concept you we must go back to the launch of a brand new currency.  Let's say Ireland decided to dump the Euro and create a new currency called 'quid'.  The Irish government would make a bunch of quid and then try to use it hire someone to sweep the streets of Dublin.  What they would find is that no one was willing to word for quids, no matter how many were offered because everyone would still be using Euros.

Ireland finds that it must artificially create a demand for quid.  They do this by declaring that all taxes must be paid in quid.  Suddenly, people need quid.  People are now willing to work for the government in exchange for quid.  They can make the quid they need to pay their taxes and then sell their excess quid to people who don't work for the government, but must still pay their taxes in quid.  In exchange for their quid, the workers could get Euro's(an example of a foreign exchange market) or goods and services(a plain old money transaction).  The amount of Euro's and goods they get for their quid is negotiated by the market.  After a time the currency will take hold and the Irish government will find it can pay for anything it wants in quid.  As long as people MUST pay their taxes using quid, there will be a demand for quid.

Upon reading this I hope that you come away with a better idea of what taxes are really used for.  Most people believe that the federal government must tax people to fund itself.  When you point out that's silly because the government can create money at will, many people will start to think you're suggesting doing away with all taxation(which would be equally silly).  That's why it's important to know and to explain to others the purpose of taxes:  Regulate inflation, and maintain the currency.

The Debt Limit is Obsolete

As I discussed yesterday, the debt limit is the congressional limitation on the amount of bonds that the U.S. treasury can have outstanding at a given time.  Two significant things happened in the 1970s that made the debt limit obsolete.  One is the Congressional Budget and Impoundment Control Act of 1974.  It formalized the budget process for the president and congress.  And even though it's been amending several times, the current budget process still uses the same blueprint.  Also, the United States went completely off the gold standard in 1971.

At the time when it was first created, having a debt ceiling made sense.  It put a check on the executive branch to keep it from spending and borrowing without regard to congress.  It also protected our Gold Reserves from being over leveraged.  Gold Reserves were extremely important because we were (for the most part) on a gold standard so that the dollar could maintain value at home and overseas.  These two reasons for maintaining a debt limit no longer applies.

The Congressional Budget and Impoundment Control Act of 1974 created a new check on executive power.  It laid out a formal budgeting process that must be passed by congress every year.  Otherwise, the government must "shutdown" until congress acts to re-instate it.  Also, by statute, the President could no longer refuse to use or try to shift unused funds from one area of government to another.  Funds allocated by congress to build a road must be used to build that road or the President and executive branch would be committing a crime.  This budget process provides sufficient check on the executive branch from trying to (legally or "semi-legally") re-allocate congressional funds.

In 1971, the United States went off the Gold Standard and never looked back.  Unlike past times when the U.S. went off the gold standard, it wasn't temporary.  While there is a group advocating to go back to the gold standard, it's small and doesn't have a lot of momentum behind it.  For all points and purposes we are no longer on the gold standard and won't be going back.  So what this means is that o matter how many dollars are issued by congress, treasury, or the Fed, they cannot be redeemed for anything but more dollars.  While that has several implications, but none of them is the possibility of any bank losing gold reserves.

So what does it all add up to?  The debt limit has lost its usefulness.  The only purpose it serves is one more thing congress has to do when budget deficits increase.  You might say it offers a chance to get the public and congress to face large budget deficits.  However, that already happens every year thanks to the yearly budget process.

Congress should "raise" the debt limit one last time, but instead of raising it just eliminate it.  If removing it does create a problem, congress can always add it back.