No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 277 INTRODUCTION In the last chapter we introduced money as a concept and traced the historical evolution from a commodity to fiat (paper) currency. We sketched the process of fractional reserve banking and saw the power of the Fed to greatly expand the money supply, and hinted at some of the dangers when the process goes into reverse. In an ideal world, there would be no central bank, no fractional reserve banking, and no corresponding boom/bust business cycles. Yet we live in a fallen world—a 2nd best world—and so this chapter will review money in our current economic system and how we can “make the best of a bad situation. ” Economist John Maynard Keynes, writing after WWI, gives us this apt warning on the dangers of monetary mismanagement: “Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but at confidence in the equity of the existing distribution of wealth….Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” Mmm—M&Ms (M1, M2, M3) In the modern world of debt based money, we already learned that there is a powerful player that initiates money creation in the US: the Federal Reserve. With its high powered money, the Fed can control the supply of money in the economy. But the Fed does this indirectly, through the banking process outlined in the last chapter. Before we begin looking at the specific tools of the Federal Reserve, let’s define the supply of money. This is especially necessary in light of both modern financial innovation and common money substitutes such as money market mutual funds (MMMFs) and debit cards. In this text, our definitions will be a little loose so you understand the main categories; however, more complete aspects can be found in the Figures referenced. Mmm—MONETARY AGGREGATES “Do you have any money?” If I ask this question, most of you might immediately think of the physical coins and dollar bills in your possession. Some of you might think a bit more broadly and reflect on how much money you have in your checking account. But if I pointed at a man and Money market mutual fund (MMMF): An investment vehicle whose portfolio includes highly liquid investments that can be easily sold, such as government Treasury Bills or large corporations short term debt (called commercial paper). MMMF’s offer slightly higher interest rates than a checking account, and do not officially carry a government guarantee, but offer check writing privileges.