13. Money, Non-Money, and Reputation The Midnight Economist
disappointed, and irritated in his dismay.”
“So what’s new,” cried Mouse Karl with cruel candor. “All economists are always
unhappy.”
“He has special reason to be annoyed,” replied Adam. “On a trip some time ago, he
Karl. “I have heard you say that money is what money does,
and that what money does is to pay for things. The certificate can pay for a car rental, so the
certificate is money.”
Adam tried to be patient. “Anything with market value,” he said, “can be used in a swap
for something else. But not everything is money. Money is so-called generalized purchasing
inconveniences of transactions, it makes us more productive in our use of scarce resources.
From the view of the community, it is thus a pity when a firm substitutes non–money for money in
settling monetary obligations. The efficiency of the economy is thereby diluted–as is the
reputation of the firm which tries too hard, but unwisely, for short-term gain and temporary
advantage.”
Questions for Thought and Discussion:
1. If Russian citizens were paid in rubles but there was nothing in Russian stores to buy with the
rubles, would rubles really be money?
14. Banks, Money and Policy The Midnight
Economist
In recent months, many financial writers and officials have spoken with seeming earnestness
about a horrendous “credit crunch.” Since the reference pertains to borrowing from banks, the so–
called credit crunch is a “money crunch,” for banks create money when they make loans. And,
supposedly, there is a crunch because banks have quite abruptly–and mysteriously–begun to
lend much less than they could lend. And this has caused a recession. Is all this consistent with
analytic fundamentals?
1988.
It is not coincidence that growth of the money stock has followed a similar pattern. But
the slow growth of money since mid-1988 has not stemmed from some perversity of the banks,
which would be reflected in ballooning excess reserves. Virtually through 1990, there was no
change in the long-established pattern of very small--indeed, minimal--excess reserves. Even
with very recent modest increases in excess reserves, banks have continued to be essentially
fully loaned up.
Banks cannot lend on the basis of excess reserves they do not have. Nor have they kept
excess reserves low by greatly increasing conservative purchases of government and other
securities rather than by riskier lending. In fact, the ratio of loans made to securities bought has
increase appreciably bank borrowing of reserves and subsequent lending.
Why, then, the great enthusiasm over recent cuts in the discount rate? Is it possible that-
-perhaps for sensible reasons the Fed wishes to be perceived as following an expansionary
policy while actually remaining neutral?
Questions for Thought and Discussion:
1. Can banks be blamed for a sizable reduction in their willingness to lend if excess reserves in
the banking system are not rising?
15. Money and Open Market Operations The Midnight
Economist
Many have some notion that national money income is determined by the amount of money
spending on output, that the amount of spending is determined largely by the amount of money,
and even that the amount of money is subject to close control by the Federal Reserve.
But just how the Fed increases or decreases the amount of money is a widespread
mystery. Journalists commonly wander astray and occasionally they are joined in confusion by
purported business economists. The Fed does not appear to try very hard to instruct the amateur
economists in journalism and commerce.
An increase in reserves can come from bank borrowing from the Fed. And there has
been much amateurish attention paid to the interest rate charged by the Fed on its loans to
banks. The impression has been created that changes in this so-called discount rate are the
main means by which the Fed manages the money supply. That impression is incorrect.
Banks rarely borrow much of their reserves from the Fed regardless of the discount rate.
And they rarely borrow much more when the Fed lowers the rate or much less when the Fed
raises the rate. Since 1973, the discount rate has been jerked up and down again and again over
an enormous range, but the ratio of borrowed reserves to total reserves–like the ratio of excess
reserves to total reserves--has almost always been very small. Indeed, over the past three years,
borrowed reserves have been virtually zero.
the other.
If the real policy game is open market operations, why all the interest rate hocus pocus?
It has been suggested that the interest rate diddling has been mainly a diversion, to distract
Congress and the administration from silly, activist fiscal policy. But political tactics are in the
realm of abnormal psychology, where civilized people dread to tread.
Questions for Thought and Discussion:
1. Can a substantial increase in the money supply occur without Federal Reserve action?
16. Monetary Policy: Price Objective and Money Control The Midnight Economist
Maintaining perennial–and thus easily predictable–stability of the price level would not, directly
and by itself, solve our most basic economic problems. We could live poorly even with little price–
level fluctuation. But while a flourishing economy requires much more than absence of inflation,
we can do best in a hard world if not plagued by large and erratic swings in prices.
empirically justified administration of those policy variables—mainly, the money supply–which are
under our control.
Sensible, consistent, predictable monetary policy and its application will not generate
unwavering zero inflation. There are too many variables in addition to money which affect
inflation, and there are lags which are too long and too uncertain in the connections of cause-and-
effect, to guarantee that steady money growth will mean a steady inflation rate. But those same
complexities of the world–complexities of both social psychology and institutional mechanisms
make impossible the achieving of specified inflation by discretionary diddling with the policy tools.
Questions for Thought and Discussion:
1. Why would a more credible commitment by the Fed to a stable price level tend to reduce long
term interest rates?
17. Monetary Policy: Living and Learning The Midnight
Economist
Live and learn. But living is only a necessary, not a sufficient, condition for learning. For all of us,
learning is hard, and some seem actually to resist the losing of their virginity of ignorance. Rarely
has the learning been harder and the resistance more stubborn than in the area of monetary
analysis and its application to policy.
Still, most feel in their bones that the amount of monetary spending on goods is relevant
greatly fallen, and inflation has fallen from some 1.1 percent in 1980 to about 4 percent now.
As the price level follows the rate of money creation, interest rates follow the price level.
When past and current inflation leads to general anticipation of further inflation, market rates of
interest are bloated. Lenders will not lend unless the loan contract includes a premium which
compensates, at least in large part, for expected fall in the purchasing power of the dollars to be
later repaid.
Inflation has fallen greatly. Interest rates, too, have fallen–-but not as greatly.
Expectations of inflation have been reduced–but interest rates have not come down
markets.
Some of us have learned as we have lived that low inflation-adjusted interest rates
require money creation at a rate which not only is small but also steady.
Questions for Thought and Discussion:
1. Why has long-term inflation been called always and everywhere a monetary phenomenon ?
2. Why would an increase in the money supply, if it would not ever lead to an increase in
inflation, tend to decrease interest rates? Why do continued increases in the money supply tend
to increase interest rates?
18. Monetary Instability, Uncertainty, and Productivity The Midnight
Economist
For well over two hundred years, economists have realized that the amount of money in the
economy is not nearly as important as changes in the amount. The economy can readily adapt to
a constant money stock, and the size of that money stock makes little difference. But when the
amount of money changes, there are repercussions; the repercussions varied, with some prices,
interest rates, outputs and employments changing faster and changing more than do others;
these lagged and dispersed changes can hurt many people even as they may benefit a few.
both worlds: money has commonly been increased too fast and always increased too unevenly.
There are many changes. A world of innovation and mobility and effectively registered
community preferences is obviously a changing world. But adaptation to advances in knowledge
and to shifting desires is very different from adaptation to unpredictable changes in the amount of
money and to fluctuating degrees of inflation. Deliberately changing one’s tactics during the
game is one thing; being confronted with arbitrary changes in the rules and their interpretation or
in the dimensions of the playing field is something entirely different.
When we manage the money supply badly–aberrantly increasing it too rapidly and then
much too slowly, usually with inflation of a widely fluctuating rate–we unnecessarily add to our
burdens of uncertainty in an already hard world. Much of what we do today is based on
Questions for Thought and Discussion:
I. If money exists to lower transactions costs in a society, thereby allowing exploitation of
differing comparative advantages to raise our standards of living, how does greater volatility of
money growth affect money’s ability to facilitate mutually beneficial exchange?
19. A Target of Permanent Zero Inflation The Midnight Economist
Inflation is not required for prosperity; indeed, inflation can accompany slow growth of the
economy. Over the past century, we have flourished most with either very moderate inflation or
slight disinflation. This was the case from the 1890s to the first World War and in the 1920s,
when the price level was approximately steady or even fell a bit; it was the case also from the late
consequence compared to the major advantages of permanent establishment of virtually zero
change in the price level. Keeping the inflation rate around zero would minimize various social
and economic costs and increase productivity.
While some–through either deliberate shrewdness or unconscious good Iuck—can benefit
economically and politically from inflation, the community generally can hardly gain. Rapidly and
erratically rising prices do not increase the amount of our resources or improve the technology
Questions for Thought and Discussion:
1. Why can t an increase in the rate of inflation generate net gains for a society as a whole?
2. Why would an unexpected decrease in inflation benefit creditors at the expense of debtors?
Would an expected decrease in inflation have the same effect?
20. Money and Mouse Work The Midnight Economist
The makers of monetary policy are dumb for keeping such a tight lid on the money supply,
complained Mouse Karl.
It s true, acknowledged Adam, the money supply is smaller now than it was at the end of
last year. The Federal Reserve has long alternated between too little and too much money
growth. We would all benefit from a policy of stable growth of money at a prudent rate.
Not now! exclaimed Karl. The Fed ought to pour money into the economy. With a
I don t believe it, said Karl disbelievingly.
Don t forget the relationship between money and inflation, cautioned Adam. Past money
growth–say from two years ago–combines with today s real output growth to determine the rate
of inflation. So when earlier money growth exceeds current output growth by a wider margin,
monetary policy is more inflationary.
And with more inflation, continued Adam, interest rates rise as lenders add inflationary
premiums to compensate for the cheaper dollars repaid to them in the future. More important, the
uncertainties and distortions of greater inflation undermine incentives to make new investments in
the first place. Overexuberant money growth generates inflation, and inflation is the enemy of
investment.
Consider the period since 1970. During these years, the growth of real net fixed
Questions for Thought and Discussion:
1. If an increase in the money supply would have no effect on inflation, would it decrease interest
rates and increase investment?
2. If lenders and borrowers quickly anticipated that a current increase in money growth will lead
to inflation in the near future, how long will it take for long term interest rates to increase?
21. Highs and Lows with Sugar and Money The Midnight Economist
Use of much sugar temporarily suppresses hunger, but it does so by creating a sugar high.”
Hunger disappears and energy surges. But this euphoria is deceptive, for energy quickly
diminishes, fatigue follows and hunger for sugar returns. To relieve the renewed hunger, still
more sugar may be eaten, only to be followed by more highs and still further lows. Sugar
addiction may occur and bodily harm can ensue.
level of prices. So it is–if the community understands what is happening.
But if people are happily fooled by having more money, their “dollar high” leads them to
feel optimistic and expansive. Believing that demand for their kind of services and products has
unexpectedly and uniquely increased, they can be inspired to spend and lend faster, to work
harder and to invest more.
But people are not stupid; they learn. They discover that an increase in the aggregate
money stock is all that has basically happened. There has been no peculiar increase for their
assets and rising prices are off-setting their larger money incomes. So expansion plans are
scrapped and activity falls back to normal and even beyond: the artificial “high” has generated a
responsive low.”
Questions for Thought and Discussion:
1. How do the short-run and delayed long run-effects of monetary expansion compare with the
short- and long-term effects of sugar consumption?
2. Why is an increase in the money stock, like an increase in sugar consumption, unable to
increase real output in the long run?
22. Misleading Indicators The Midnight
Economist
We have great difficulty figuring out where we have been and understanding where we are. Still,
many are not deterred in trying to find ways of foreseeing where we are going.
Predictably, the dozen variables represented by the index do not always point in the
same direction or change direction at the same time. If they did, just one variable would be
enough. But, with a divided jury of variables, we have the problem at any time of deciding which
components of the index are to be taken most seriously.
The aggregate index can give false signals of imminent turning points in the economy. It
can give ambiguous signals. And it can give signals subject to misinterpretation: an increase in
prices of materials may reflect a discouraging supply shock rather than expanding demand.
Some of the difficulty in using the index stems from incorrect data–it has proved prudent to revise
the calculation in each of the first two months after its initial pronouncement, and the revisions
can be so great as to reverse the direction of change of the index.
Questions for Thought and Discussion:
I. Why is knowing “where we are going” important if active macroeconomic policies are to help
stabilize the economy? Why is knowing how far in advance and how accurately the index of
leading indicators predicts important for such stabilization policies?
23. A New Friend and Familiar Foolishness The Midnight
Economist
There have been many economic debates between Adam and Karl, the two mice who live in my
office. Recently, Karl had returned from shopping and was furious about the high price he had to
pay for a whisker brush. After Karl had fulminated about high prices and extolled the alleged
virtues of price and wage controls, Adam was about to respond when a large spider appeared
from behind a dusty volume.
My dear fellows,” began the spider, “history is a prolific teacher of the destructiveness of
price and wage controls. I know from personal experience, for I have lived many lives. Before
greed of merchants and speculators.”
“Right on!” exclaimed Karl. “Greed, avarice–that’s what makes prices high.”
“No,” responded Waldo. “The inflation which Emperor Diocletian condemned was
caused by excessive minting of new coins. For many years, to finance massive and growing
government expenditures, emperors had issued more and more coins, causing the money supply
to grow faster than the goods on which those coins were spent. Like a fly in a spider web,” said
Waldo, “the more coins minted by emperors to cope with rising prices, the more entangled they
became in inflation.”
“But what about the Edict?” asked Karl. “Surely the price and wage controls cures
inflation?”
“I remember well the disaster of the Edict,” answered Waldo. “Diocletian fixed the prices
Questions for Thought and Discussion:
1. Can trying to bring inflation under control by imposing wage and price controls be considered
a case of one government policy error compounding another?
2. Why is it so hard to effectively enforce wage and price controls that are far from their
equilibrium levels?