Asset Price Inflation, Commercial Culture, Crony Culturalism, Debt Monetization, Distribution of Wealth, Federal Reserve Act, Fiat Money, Full Faith and Credit, Gresham's Law, Inflation, Jörg Guido Hülsmann, Mises Wire, Redeemability, Tyler Cowan
The money we use every day has roughly zero intrinsic value. That includes paper, coins made from base metals, and electronic bookkeeping entries that can be drawn on via plastic cards and communication devices. We take it for granted that all of these forms of payment will be accepted in transactions. The dollars we use in the U.S. are backed only by the “full faith and credit” of the U.S. government, which is quite a bit of nothing when it comes right down to it. This form of money is called “fiat money” because it derives value essentially by decree, including the government’s willingness to accept your dollars in payment of taxes. It’s a fine thing that such a level of trust exists in society, and most important is trust that the next seller will accept your dollars in trade.
An old maxim in economics known as Gresham’s Law holds that “bad money drives out good”, particularly when the “good money” and the “bad money” are assigned the same legal value in exchange. The good money, having greater intrinsic value than the bad money, will quickly disappear from use as a medium of exchange. Like any asset, the good money will be held as a store of value, but not used in routine transactions.
In the past, our “good money” consisted mainly of claims on precious metals. However, the U.S. government stopped redeeming dollars in gold in the 1930s, silver in the 1960s, and silver coins stopped circulating at about the same time.
What’s so “bad” about fiat money, given that we trust its usefulness in the next transaction? The lack of intrinsic value places its issuing authority, the Federal Reserve in our case, in a position of tremendous power and responsibility as the keeper of the “full faith” of the U.S. government. However, the Fed is privately owned (by banks), and no one at the Fed is elected. The members of its Board of Governors are appointed by the President to 14-year terms. The lengthy terms are hoped to keep the Fed independent and immune to political manipulation. Ostensibly, the Fed conducts policy in the objective pursuit of price stability and full employment. (Never mind that the two goals may be incompatible.)
The Fed, as the authority responsible for the nation’s fiat money, has traditionally allowed the money supply to grow by issuing “new money” in exchange for federal debt obligations, like Treasury bonds. The Fed buys the bonds, and the payment becomes a seed for new money growth. For the Treasury, which raises funds to finance government activities by collecting taxes and borrowing, this mechanism is quite convenient. The Fed can act to “accommodate” the government’s needs, essentially printing money to fund deficits.
Does it happen? Absolutely, although in the past few years, the Fed has demonstrated a more subtle variation on this theme, and one that is cheaper for the government. That will be the subject of a future post. The key point here is that with the cooperation of the monetary authority, the government avails itself of the so-called printing press. Thus, it is not answerable to taxpayers for any expansion in its spending. The government can commandeer resources as it sees fit, with no restraint from the governed.
That’s the key point made by Jörg Guido Hülsmann in a post on the Mises Wire blog, “How Fiat Money Destroys Culture“. On that note, I’d say first that enabling the displacement of private commerce for government-directed activity is a sure-fire prescription for degrading the culture. Government is not and never will be a font of creativity. Capitalism and markets, on the other hand, deliver an astonishing degree of cultural wealth to every segment of society. The freedom to create and share art, cuisine, customs and technology, without interference by government, is the very essence of culture. Some might object that government often serves as a conduit for bringing cultural works to the public, and that government can and does direct resources to the arts. There is an extent to which that’s true, of course, but it may be a deal with the devil: public sector support for new art is often subject to strings, politicization, and favoritism. That’s crony culturalism, to coin a phrase.
Hülsmann discusses other cultural repercussions of fiat money. By enabling the government to compete for resources with the private sector, and by swelling the quantity of money relative to goods and assets, fiat money puts upward pressure on prices. This might manifest in the prices of goods, the prices of assets, or both, and it might be very uneven. This changes the distribution of rewards in society in fundamental ways.
Price inflation penalizes those who hold currency. Hülsmann says:
“In a free economy with a natural monetary system, there is a strong incentive to save money in the form of cash held under one’s immediate control. Investments in savings accounts or other relatively safe investments also play a certain role, but cash hoarding is paramount, especially among low-income families. … By contrast, when there is constant price inflation, as in a fiat-money system, cash hoarding becomes suicidal.“
Price inflation also rewards those in debt. Strictly speaking, this is true only when inflation accelerates unexpectedly, since lenders tend to demand sufficient interest to offset expected inflation. Hülsmann blames the widespread growth of debt financing in modern society on fiat currency. There is an element of truth to this assertion, but it strikes me as an exaggeration, given the advances in financial markets and technologies over the past century or so. We are much better at allocating resources inter-temporally than in 1900, for example, so the growth of consumer and business debt over the years should be viewed in the context of future earning power and enabling technology. Still, there are those for whom these markets and technologies are out of reach, and the destructive effect of inflation on their ability to save should not be minimized. This contributes to greater dependency at the lowest levels of the socioeconomic spectrum, a very regrettable kind of cultural change.
Growth of the money stock tends to reward many at the top of the socioeconomic spectrum, partly because it is associated with stock market appreciation. Again, when the Fed buys government bonds, or mortgage bonds, or any other asset, it always finds willing sellers, usually brokers/dealers and banks. Successful bidding by the Fed for assets is the first step in lifting asset prices (and reducing yields). But market participants tend to know all this in advance. Therefore, private traders will bid up asset prices in advance, assuming that the Fed has indicated its intentions. Other assets, being substitute vehicles for wealth accumulation, will also be bid upward, as a given amount of income produced by an asset is valued more highly when competing yields are low. After the Fed completes a round of asset purchases, the process can repeat itself.
Goods inflation and higher asset prices generated by continuing debt monetization and distorted interest rates tend to skew the distribution of wealth toward the top and away from the bottom. Moreover, if cost and pricing pressure build up in goods markets, those with the greatest market power always fare best. Thus, debt monetization has the potential to be a very inegalitarian process, and one not based on fundamental economic criteria such a productivity. This too represents a damaging form of cultural change.
A more accurate form of Gresham’s law might be the following: government ambition drives out “good money”. The existence of fiat money creates an avenue through which the expansion of government can be funded without approval by current or future taxpayers. This ultimately leads to a stagnant economic environment and a stagnant culture: government displaces private activity, the economy’s growth potential and vibrancy deteriorates, and society’s ability to support all forms of culture declines. To add insult to injury, the process of monetizing government debt punishes small savers and rewards the privileged. The distribution of cultural rewards will follow suit.