Before taking the current job, I had one interview and a follow-up with Extensive Enterprises (they took over the old Bear Stearns offices downtown). I had almost reached the elevator after the second interview when the COO caught up with me in a hurry.
“I actually wanted to talk with you a bit more before you left,” he said.
“Sure thing, Mr … Xamot?”
“No, I’m Tomax, actually. Xamot heads up Marketing and Relations.”
“Right, Tomax. Is that Greek?”
“Corsican.” He steered me toward a private elevator off a back hallway – a glass-walled cage that looked out over the entire city. We began our slow descent.
“So, what are you spending your stimulus check on?” he asked with a conversational chuckle.
“Hadn’t planned that far ahead yet, actually. I figured I might just invest it.”
“You don’t want to do your part to help stimulate the economy?” He put the weirdest emphases on certain words.
“I’d rather preserve the check’s value against inflation.”
“Inflation!” He hissed like he’d suffered a paper cut. “Why is inflation such a big deal?”
“Okay,” I began, “a lot of times, when people want to see how wealthy a country is, they look to see how many dollars it has. This can be dollars of goods produced per citizen, also known as GDP per capita, or the average value of the companies based in that country which sell public stock, also known as a stock index. Or any method of your choice.”
“I like exports over imports myself.”
“Yeah, you and Lou Dobbs. But dollars aren’t just a method of measuring wealth, like the pressure gauge on a barometer. Dollars are also an actual trade good. People exchange dollars for other goods all the time.
“You look at a supply and demand graph in any Intro. Econ textbook and you see price, in dollars, on one axis and quantity, in units, on another. But nobody ever thinks about the supply and demand for dollars.”
“Hmm,” Tomax said. “Could you elaborate?”
“You have a given amount of liquid money on hand,” I explained. “Cash in your wallet, plus whatever you can draw from an ATM or write a check against. Let’s say $100,000. You also have a house full of stuff: a flat screen TV, an Italian leather couch, some imported rugs, a boxster in the garage, etc. At any point, you can trade that stuff for dollars, or those dollars for stuff. The fact that you have $100,000 and a set amount of stuff currently – as opposed to, say, $80,000 and …”
“And a hovercraft with a giant snake’s head on it,” he suggested.
“… is a function of your current desires,” I concluded. “Think of it as the intersection of Money and Stuff on the supply and demand graph in your head.”
“I see. So how does this tie in to inflation?”
“It works the same way on a national level. The total amount of dollars available as liquid cash – hard currency, checking accounts, savings accounts, traveler’s checks – is about seven trillion, seven hundred billion dollars – what the Federal Reserve calls M2. The total amount of stuff available is … well, everything on the planet, really. At every second of the day, people exchange dollars for stuff or stuff for dollars.
“Dollars,” I continued, pulling one out of my wallet to illustrate, “are banknotes issued by the central bank of the United States: the Federal Reserve. The Fed has at its disposal a variety of tools to put more dollars into the market:
- They can buy or sell Treasury bonds – which would put dollars into or take dollars out of circulation, respectively.
- They can raise or lower the discount rate – the interest rate that U.S. banks can charge each other for interbank loans. Raising it tightens the dollar supply; lowering it expands the dollar supply.
- Or, they can change the reserve requirement – the percentage of dollars that a bank has to keep on hand to honor outstanding accounts.
The Fed typically only uses the first of these three.
“The problem: the Federal Reserve can, and does, increase the supply of dollars without actually creating any more stuff. So now you have more dollars chasing fewer real world goods. The purchasing power of the dollar declines overall.”
The elevator dinged as it hit the 30th floor. A man dressed identically to Tomax stepped on board. “Ah, Professor,” said Tomax, “you’ve met my brother Xamot, haven’t you?”
“Last time I was here,” I said, shaking his hand. “I was just telling Tomax about how inflation reduces the purchasing power of the dollar.”
“I’d heard that,” Xamot said. “But doesn’t it level out over time? The economy adjusts to the new equilibrium between dollars and goods, and we all trundle on.”
“It levels out,” I replied, “but not all at once.
“Let’s say the U.S. orders up one hundred billion dollars worth of bomber jets. The DoD cuts Boeing a check for $100,000,000,000.00, which Boeing can cash out and use to pay its employees, suppliers, distributors and the like. But the DoD doesn’t have one hundred billion dollars – they spent what they got in taxes long ago. The DoD has now added to the U.S. national debt by one hundred billion dollars. Fortunately, every bank in the world cashes their checks, so no one starves this month.
“Now, the supply of dollars has increased by one hundred billion dollars. But this rising tide doesn’t lift every boat. Even though the dollar has just lost a bit of purchasing power, not everyone knows it yet. The employees and customers of Boeing got their hands on that hundred billion first. They get to spend it on food, gas, clothes, cars, industrial materials, investments, whatever. The people they buy from then get to spend it on food, gas, clothes, etc. So that hundred billion trickles out to the economy slowly. Some people profit from it; some people get screwed by it.”
“What does the Federal Reserve …” Tomax began.
“… have to do with all this?” Xamot concluded.
“The U.S. government finances its debt through Treasury securities – which, as I said before, the Fed sells. You exchange cash for the T-bill, which is a promise to pay back that cash plus interest on a future date.”
“I’m still not sure what the big problem with inflation is,” Tomax said. “Sure, direct beneficiaries of government spending get the new cash before anyone else does. But so many people benefit from government spending that the effect has to be pretty broad.”
“It’s like a perpetual motion machine,” Xamot said. “So long as people keep exchanging cash for T-bills, the U.S. debt remains guaranteed, and money keeps pumping along.”
“You’re forgetting one thing,” I corrected. “Overseas investors.”
“Oh,” Tomax and Xamot groaned.
“Overseas investors buy a lot of Treasury securities. They also buy a lot of dollars. Sometimes they pay for these dollars with goods produced in their countries, like clothes from Singapore or cars from Japan. But people in other countries have a demand for dollars and a supply of stuff, same as Americans do. If foreign investors simply refuse to buy Treasury securities, this means they no longer have as high a demand for dollars. When the demand for dollars drops, compared to the demand for euros or yen or rupees, economists call this a weakening dollar.”
The elevator let us off on the ground floor. Tomax and Xamot exchanged a meaningful look. Then Xamot drew a gun, backed up ten feet and pointed it at me.
“Is that a laser pistol?” I asked.
“You’ve found out our plan,” Xamot snarled. “Our master plan to bankrupt the U.S. and destroy the world economy! Whether you’re a spy sent by G.I. Joe or you just figured it out on your own, we can’t let you spoil our scheme. Terribly sorry, Professor.”
Xamot had me dead in his sights. At ten feet away, I couldn’t hope to close the distance and knock the gun out of his hand in time.
So I kicked Tomax in the crotch.
“Guh!” Xamot and Tomax moaned simultaneously, doubling over in pain. I picked the laser pistol out of Xamot’s limp fingers.
“Seriously, guys,” I said, exiting the lobby. “You really ought to do something about that.”
# # #
The Federal Reserve creates easy credit, by targeting a lower Fed funds rate and expanding the money supply. A certain industry – whether it’s housing or domestic manufacturing or savings and loan houses or Internet companies or housing – borrows this easy credit and expands quickly. Once investors start losing confidence, though, this industry stops expanding. Then it contracts, and drags down every company tied into it.
How the Fed gets championed as the solution to this problem, instead of part of the problem, I’ll never understand.
The moral of this story: you can’t create wealth out of thin air. An expansion of credit is not the same thing as a growing industry. Government spending is not the same thing as investing. Money on paper is not the same thing as food in the fridge. At the closing bell, if it doesn’t point to liquid cash or something you can touch, think twice about it.
I’m not suggesting a return to a barter economy or a withdrawal from the modern economy. But remember the rosy figures Enron posted simply by switching some numbers around in their accounting. Or just consider how many years it would take to pay down the U.S. national debt if the federal government did nothing else. If it’s not real wealth – the clothes on your back, the house you sleep in, free time with the ones you love – it’s bookkeeping. And the world’s short on honest bookkeepers.