By Richard Duncan, 2022 (512p.)
If someone asked me what book I would recommend that could help improve their understanding of monetary policy, I would say The Money Revolution (2022), by Richard Duncan. Not because it’s a recent book, but because it does the best job of explaining how monetary policy and credit work, how we got to where we are, and why its not the end of the world. Duncan has some radical ideas and strong opinions, and he doesn’t hold back from taking his punches and sticking his neck out. His book came out in January, so it’s not entirely updated for the recent inflation panic, but in its pages, Duncan is clearly on the camp that inflation is a transitory instead of a structural issue. “Milton Friedman taught that inflation is always and everywhere a monetary phenomenon”, he writes, [but] “events following the financial crisis of 2008 have demonstrated that Friedman was mistaken.” I personally find his arguments persuasive, but I also found his historical accounts to be clear and well structured, as well as accurate and very informative. They were certainly easier to read than Friedman and Schwartz’s classic, A Monetary History of the United States (1963). Duncan is clearly well versed and credible on the topic, even if the last part of the book takes a wild turn that I am certain will upset and alienate many, but will also plants some seeds in Washington. His recommendation is that America should use its power to create wealth even more aggressively in order to ensure its hegemony. The Fed can and should create credit to invest in technology, and according to Duncan, this can be done at practically no cost. Keynes argued something similar back in the 1930s, and I think its fair to say the last century has gone pretty well, all crashes considered.
I became aware of this book after reading Martin Wolf’s review in the Financial Times back in April (link). “Richard Duncan,” writes Wolf, “a well-known heterodox thinker on money and markets, ends up in a very radical position indeed in The Money Revolution.” Wolf compares Duncan’s idea with Irving Fisher’s Chicago Plan in the 1930s (link), because Duncan proposes increasing bank reserve requirements to offset increases in Fed credit creation. I can see this being a controversial topic because it would reduce the (profitable) role that banks play in credit creation, but to Duncan’s point, the trouble with credit creation is not the creation itself, but what the credit is used for – and history shows that bankers are not known for being the best allocators. To the contrary, in fact, banks are behind most of the worst crashes. Martin Wolf had written an opinion piece on this topic in the FT in 2014 (link), where he argued for stripping the private banks of their power to create money. Wolf basically dismisses Duncan’s idea as modern monetary theory (MMT), then concludes it will never happen. I was intrigued enough by Martin’s review to buy Duncan’s book, but having read it, I must say that Martin did a disservice to the book. That’s because Duncan’s seemingly crazy solution only comes up towards the end (in Part III), and by then the book had already gone down as a must-read. I actually got the impression that they were two separate books, and this suspicion was confirmed by how much repetition there was in the final part.
I turned to Google to learn more about Richard Duncan. His website (link) describes him as an author (of four books), an economist and consultant, as well as a speaker. “Since beginning his career as an equities analyst in Hong Kong in 1986, Richard has served as global head of investment strategy at ABN AMRO Asset Management in London, worked as a financial sector specialist for the World Bank in Washington D.C., and headed equity research departments for James Capel Securities and Salomon Brothers in Bangkok. He also worked as a consultant for the IMF in Thailand during the Asia Crisis.” Duncan currently publishes Macro Watch (link), a bi-monthly video newsletter that costs $500 per year. He has appeared frequently in the media for more than a decade, but I wasn’t able to find any CNBC videos, even though he mentions them in his bio. He studied literature and economics at Vanderbilt University (1983) and international finance at Babson College (1986). Between his studies, he also spent a year traveling around the world as a backpacker.
On July 23, 2022 (a Saturday), Richard posted an interview he did with a podcaster (link). I didn’t listen to the podcast, but at the top Duncan writes (in bold letters), that “the main theme running through our conversation is the perfect storm being created for the economy and the financial markets by the partial reversal of Globalization that is now underway.” Basically, he sees a high probability that the US will enter a severe recession. Duncan could be right about the economy, but his view has arguably become consensus. On July 15th he published another (link) blog post concluding: “The bottom line is that investors should anticipate more pain ahead.” His June 29th post (link) was titled “Prepare For A Very Hard Landing.” I went back in time through his posts and learned that Duncan turned bearish in late September 2021, when he publish a Macro Watch titled, “The Liquidity Tsunami Is About To End Abruptly.” The fact that Richard Duncan was a raging bull on US assets during the bull market before turning bearish right at the top, makes it seem like he nailed it. In some respects he did, but I went back and found a March 26, 2021 post (link) titled “Surging Money Supply Growth Won’t Cause Inflation.” He also published a book ten years ago titled The New Depression: The Breakdown of the Paper Money Economy (2012), that was clearly ill-timed. And not to question the timeliness of his recent calls, but here is a video of him making basically the same recommendation (i.e. press print) ten years ago (link).
Back to the contents of Duncan’s excellent book, my favorite part was when he ran through the history of how the two world wars differed in terms of how they were financed by the US. I also liked how he frames Nixon’s closing of the gold window in 1971 as the breakout point for the global economy. Several times he points out that the world economy was transformed as a direct result of the US Fed’s credit creation. “Much of Asia, in particular,” he claims, “underwent an industrial revolution in the course of only a few decades. Hundreds of millions of people around the world were pulled out of poverty because of the United States trade deficits and the money that the central banks of the trade surplus countries created to finance them.” I’m sure this is not a popular opinion in Asia, but I tend to agree. It’s a win-win model that despite all the saber rattling, seems unlikely to be discontinued.
So all told, this was an excellent book that I would highly recommend, even for those who are not inclined to think like Richard Duncan. If anything, the information in his book make us better equipped to disagree with his more radical views. If you like macro and want to know more about monetary theory, this is a must-read, even if it shouldn’t be the only thing you read on the topic. On that front, here is a Top 10 list of other books I would recommend:
- Lords of Easy Money (2022) – by Christopher Leonard: Interesting book, but I didn’t agree with the angle, and thought the examples given to argue why easy money is wrong, were weak. Some good background on Jay Powell.
- 21st Century Monetary Policy (2022) – by Ben Bernanke: Great book with a very relevant review of how the Fed thinks, with particular focus on Powell and deflation. Makes it seem like the arrival of inflation is a welcomed phenomenon instead of a problem.
- The Great Demographic Reversal (2020) – by Charles Goodhart: I review this book when it came out and was perhaps more critical of it than I should have been, as he predicted labor shortages when most were worried about mass unemployment.
- Three Days at Camp David (2021) – by Jeffrey Garten: Excellent book that provides an hour-by-hour account, and precious context on the zeitgeist of the time, around the days that preceded the closing of the gold window.
- Greenback Planet (2011) – by H. W. Brands: One of Brands’ weaker books, but still offered good context of ho0w US money dominance was build and sustained.
- Why Minsky Matters (2015) – by Randall Wray: Written by one of Minsky’s students, this book does a decent job of explaining Minsky’s complex ideas without equations, which is something that Minsky himself was not very good at.
- The View From the Fed (2019) – by the Ashfield Journal of Economic Studies: This is a compilation of Jay Powell’s speeches available on the Kindle for $1.99. It was a surprisingly good read and very useful for understanding ow Powel thinks.
- Progressive Monetary Policy in a time of Uncertainty (2020) – by the Ashfield Journal of Economic Studies: This is a compilation of Lael Brainard’s speeches. They are not nearly as good as Powell’s, but are more recent, and useful in understanding how much they feared deflation..
- Courage to Act (2015) – by Ben Bernanke: He’s a great writer and this book tells his side of the story well. It is more of an autobiography than his latest, 21st Century Monetary Policy (2022).
- How Much is Enough: Money and the Good Life (2012) – by Robert Skidelsky: This was an outstanding book by an excellent author and in my opinion, one of the preeminent thinkers of our time. I intend to write a review about it, but it’s definitely a must-read.
A momentous and irreversible turning point occurred five decades ago when dollars ceased to be backed by gold. Afterwards, a worldwide credit bubble took shape that fundamentally changed the structure of the global economy and the rules that govern how it functions.
…very rapid credit growth has had [a huge impact] on the US economy and economic growth is now dependent on credit growth. …there are effectively no longer any limits as to how much money the United States government can borrow.
PART I: Money
[The Fed] has evolved from being the relatively passive lender of last resort established by the Federal Reserve Act of 1913 to becoming the US government’s most powerful economic policy tool today.
CHAPTER 1: The Power of the Fed
By making a loan to a bank or buying a debt instrument from a bank, the Fed injects additional money into that bank, and, by extension, into the banking system and the economy as a whole. It is important to understand that when the Fed makes such a deposit, it is not transferring funds that were already in existence. Instead, it is creating credit.
The ability to create Federal Reserve Credit, either through discounting operations or open market operations, is the Fed’s “superpower.” It can be used to stop a banking panic by supplying credit when no one else will. It can also be used to finance a war, as Chapters 2 and 5 will show. When used properly, it can prevent a great depression, as will be demonstrated in Chapter 12. Finally, under certain circumstances, such as those that prevail today, Federal Reserve Credit can be deployed to radically accelerate economic growth, induce a new technological revolution and alleviate many of humanity’s most pressing problems.
Today, the public often speaks of the Fed “printing” or creating money. It is true that the Fed does create base money when it extends Federal Reserve Credit by making a deposit into the reserve account that a commercial bank holds at the Fed. However, rather than thinking in terms of the Fed creating money, it is less confusing, and, therefore, more useful to think of this process as the Fed creating and extending Federal Reserve Credit.
Over time, as the following chapters will show, the requirement that the Fed hold gold to back Federal Reserve Notes and the Federal Reserve Credit it created was eliminated. However, until it was, the Fed had to ensure that it always held sufficient gold to meet this statutory obligation.
…if the Fed wishes to reduce the amount of Federal Reserve Credit in the financial system in order to slow the economy to reduce inflation, it sells US government securities that it had bought in the past.
…in March 2020, the Fed reduced the required reserve ratio to 0%. Consequently, at present, banks are no longer legally required to hold any reserves.
Since 2008 the Fed has employed much more aggressive tactics: Quantitative Easing to stimulate economic growth and quantitative tightening to guard against inflation.
The Fed has a number of tools that allow it to control the level of credit in the US economy. Here, only the Fed’s traditional tools will be described. They are: (1) adjusting the discount rate; (2) conducting open market operations in order to adjust the federal funds rate; and (3) adjusting the required reserve ratio.
CHAPTER 2: 1914 to 1920: World War I
During the two years and seven months between the beginning of the war in August 1914 and the United States’ entry into the war in April 1917, American companies made very large profits selling commodities, supplies, and weapons to England, her allies and to non- belligerent nations. They were paid with gold. When the United States entered the war, the Fed’s responsibilities changed. Its principal responsibility became to ensure that the US government could borrow as much money as it required to fight and win the war.
CHAPTER 4: 1930 TO 1941: The Great Depression
The Fed was severely criticized for not preventing the banking crisis of the early 1930s and the Great Depression that resulted from that crisis. In its own defense, the Fed claimed that the Federal Reserve Act placed limitations upon it that had made it impossible for the Fed to take the steps required to contain the crisis. The Glass- Steagall Act of 1932 lessened those limitations and expanded the Fed’s powers to create Federal Reserve Credit. However, the huge inflow of gold into the United States beginning in 1934 made the Fed’s enhanced powers superfluous– at least during the rest of that decade.
Friedman and Schwartz argued persuasively in A Monetary History of The United States that the Fed could have prevented what was still a recession in 1930 from becoming the Great Depression by 1932 if it had bought government bonds through open market operations earlier and much more aggressively than it eventually did. That would have injected large amounts of Federal Reserve Credit (i.e., newly created base money) into the economy and the financial system. Had it done so, the Fed’s total assets would have expanded rather than contracting by 20% between November 1929 and February 1931.
The 41% devaluation of the dollar on January 31, 1934, almost immediately resulted in a surge in foreign investment entering the United States. After all, for foreign investors with gold, the dollar devaluation made everything in the United States 41% cheaper.
Between the end of 1933 and the end of 1941, the gold stock of the United States increased by 463%, from $ 4 billion to $ 18.7 billion, while the gold reserves of the Fed, in the form of gold certificates from February 1934, rose by 450%, from $ 3.8 billion to $ 20.8 billion.
One final development during the 1930s deserves attention, particularly as it represents a precedent the Fed would be wise to adopt today. As discussed above, the devaluation of the dollar in January 1934 was followed by an unprecedented inflow of gold into the United States. That gold was acquired by the Treasury Department.
…today, banks in the United States are once again inundated with excess reserves, this time as the result of the large-scale open market purchases (i.e., Quantitative Easing) the Fed conducted in response to the financial crisis of 2008, and, more recently, the much larger purchases of government securities and mortgage- backed securities in response to the coronavirus crisis. The Fed began paying the banks interest on those reserves in 2008 in order to control the federal funds rate. With that rate now close to 0%, the cost of paying interest on reserves is not very high at present. However, when the Fed eventually does hike the federal funds rate again, the costs to the Fed (and, therefore, US taxpayers) could climb to tens or even hundreds of billions of dollars a year. The experience of 1936 and 1937 demonstrates that a much less expensive alternative exists. The Fed could simply raise the required reserve ratio high enough to absorb all the excess reserves in the banking system and, thereby, save US taxpayers vast sums of money each year.
CHAPTER 5: 1941 to 1945: World War II
It must be noted that, although the Fed’s primary mission was the same in both World War I and World War II, the method the Fed employed to accomplish that purpose was not the same. During World War I, the Fed had used discounting operations to finance government debt indirectly. As described in Chapter 2, the Fed had lent money to commercial banks at an interest rate that guaranteed that the banks would make a profit if they bought government securities. This enabled the government to sell as much government debt to the banks (and to the banks’ customers) as necessary to finance the war. During World War II, on the other hand, the Fed bought government securities directly through open market operations. The Fed’s holdings of government securities increased from $ 2 billion in 1941 to $ 24 billion when the war ended in 1945.
Recall that when the Fed acquires a government bond, it pays for it by making a deposit into the reserve account at the Fed of the bank from which it acquires the bond. That transaction adds to that bank’s level of reserves and, by extension, to the level of reserves of the entire banking system. In other words, by acquiring government securities, the Fed supplied the banking system with sufficient reserves to meet their legal reserve requirements, despite the extraordinary drain of reserves brought about by the large increase in Federal Reserve Notes in circulation. … As the end of the war approached, efforts to rebuild the global financial architecture got underway. The Bretton Woods system was created at the United Nations Monetary and Financial Conference held at Bretton Woods, New Hampshire, in July 1944. Its purpose was to establish a rule- based system to regulate international trade and monetary relations so as to promote balanced growth in international trade. The conference was a tremendous success. Never before had an “international monetary system” been created by an agreement between nations. The gold standard had simply emerged over the course of centuries because gold had proven to be the most reliable medium of exchange. Simply returning to the gold standard was not an option. By the end of the war, the victors held most of the world’s gold. Gold was not distributed widely enough around the world to allow international trade to recommence. The United States had by far the largest gold holdings, followed by France. Moreover, the United States had become the largest creditor nation in history.
However, the Bretton Woods systems imposed constraints on the Fed. If the Fed undertook expansionary monetary policy (i.e., created too much Federal Reserve Credit), it could result in gold leaving the United States. For example, if the Fed created too much Federal Reserve Credit, the US economy would strengthen, employment would rise, consumption would increase, US demand for foreign products would grow, ultimately leading to an increase in imports entering the United States and a deterioration in the country’s trade balance. A trade deficit would have to be settled by sending dollars abroad. The recipients of those dollars had the right to exchange them for US gold. If the US lost too much gold, there would not be enough gold left in the country to allow the Fed to meet its obligation to hold gold backing for Federal Reserve Notes and for the Bank Reserves held at the Fed. Furthermore, if the trade deficit persisted for long enough, the United States would lose all its gold, at which point it would become impossible for the United States to allow other countries to convert any more dollars into gold. The same outcome would occur if the Fed reduced interest rates to a level substantially below the interest rates of other large countries. Dollars would have left the United States to profit from the higher interest rates offered abroad.
CHAPTER 6: 1945 to 1971: The Bretton Woods Era
The Bretton Woods era can be divided in two halves. The first half was characterized by fiscal and monetary restraint. The second half was not.
The breakdown of the Bretton Woods system completely and permanently severed the link between dollars and gold, unleashing a new era of purely fiat money that transformed the world. This chapter describes how these events were reflected in the evolution of the Fed’s balance sheet.
Between 1946 and 1958, the government’s budget was more or less in balance. The cumulative deficit during those 13 years was just $ 4 billion. In 1959, however, the government ran a large budget deficit of $ 13 billion. Afterwards, deficits were the norm rather than the exception. The cumulative deficit during the 13 years between 1959 and 1971 was $ 95 billion. Chart 6.2 shows the government’s budget deficits each year from 1946 to 1971. Presidents Truman and Eisenhower believed in balanced budgets. Between 1946 and 1952, the Truman administration ran a small budget surplus, despite very large military expenditures related to the Korean War. The Eisenhower administration was also quite fiscally conservative, at least up through 1957. The recession of 1958, however, resulted in a large budget deficit the following year. The Kennedy and Johnson administrations ran budget deficits every year between 1961 and 1968, with a particularly large deficit in the final year. President Nixon also produced a very large budget deficit in 1971.
The Fed’s holdings of US government securities not only increased sharply in absolute dollar amounts, but they also increased sharply relative to the total amount of government debt outstanding. In 1961, the Fed owned 10% of all such securities. By 1971, it owned 17% of the total. In other words, by 1971, the Fed had monetized 17% of the government’s debt. This fact is all the more startling given the very large increase in US government debt outstanding during those years (see Chart 6.4).
A higher rate of inflation during the second half of the decade also explains part of the increase in the demand for cash, since higher prices required a greater volume of currency.
During the 1960s, Federal Reserve Credit grew every year, with the rate of growth accelerating throughout the decade. Such a rapid and prolonged increase in Federal Reserve Credit was unprecedented. The significance of this development must not be overlooked. Astonishingly, Federal Reserve Credit grew more in 1971 than it did in 1944, at the peak of World War II.
President Johnson had asked Congress in 1968 to end the Fed’s obligation to back dollars with gold certificates in the hope that such a change would calm those fears and restore international confidence in the dollar. Confidence in the dollar was not restored, however. The rest of the world was not convinced that the United States would tighten fiscal and monetary policy enough to swing the US balance of payments from deficit back into surplus. The run on the dollar continued and US gold reserves continued to shrink. On August 15, 1971, President Nixon unilaterally declared the United States would no longer abide by its commitment to allow other governments to convert dollars into gold. By that time, the US simply did not have enough gold left to allow dollar convertibility to continue. Nixon’s announcement was the death knell of the Bretton Woods system. The regime in which all currencies were directly or indirectly pegged at a fixed exchange rate to gold disintegrated. Fixed exchange rates gave way to a new system of floating exchange rates. Soon thereafter international trade ceased to balance and cross- border capital flows ballooned. Credit growth exploded. This Money Revolution fundamentally changed the nature of the global economic system that had emerged under the gold standard. A new era, financed merely with fiat money, got underway. This new monetary regime quickly transformed the global economy. … Government securities became the Fed’s only major asset and Federal Reserve Notes became its only major liability. All the other items were relatively insignificant.
CHAPTER 7: 1971 to 2007
Had the Fed not bought so much government debt, either other investors would have had to buy those bonds, or the government would have had to run smaller budget deficits. If other investors had bought the bonds, then they would have had less money to invest in other bonds or in equities, meaning that bond prices would have been lower and that interest rates would have been higher, while stock prices would have risen less or fallen. If the government had run smaller deficits, there would have been less economic growth. Either way, the public would have been far worse off.
Before going any further, it is important to emphasize that the explosion of Federal Reserve Notes in circulation after 1971 would have been entirely impossible if the Fed had still been required to hold 25% gold backing for the Federal Reserve Notes it issued, as had been the case up until 1968. In 2007, the Fed would have had to have held $ 193 billion worth of gold certificates to back $ 774 billion of Federal Reserve Notes. It held only $ 11 billion worth. Its holdings of gold certificates had not changed since 1971.
The number of Federal Reserve Notes per capita surged from $ 160 in 1960 to $ 260 in 1971 and then to $ 2,600 in 2007– and to $ 5,350 in 2019. That is $ 5,350 of cash for every man, woman, and child in the United States (see Chart 7.8). The demand for cash soared even though credit card use became widespread during the 1970s and should have lowered the demand for cash. Why? Some of the increase can be attributed to inflation. A higher price level requires more currency to conduct transactions. However, inflationary pressures abated after 1980, when Federal Reserve Notes per capita amounted to just $ 550. Therefore, inflation can account for only part of the increase in the demand for physical dollars. A more important factor is that a growing number of Federal Reserve Notes began to be accumulated outside the United States due to the widespread international acceptance of dollars as a store of value and a medium of exchange. For instance, Panama, Ecuador, and El Salvador have adopted the dollar as their currency; and many other countries are partially “dollarized.” Drug lords are known to stockpile $ 100 bills. And it is very likely that dollar bills are used for a variety of other criminal transactions around the world, as well. No one knows how many dollars are held abroad, but estimates range from between 40% and 70% of the total. In 2007, there were $ 800 billion Federal Reserve Notes in circulation. In 2019, there were $ 1.8 trillion. If 40% of those $ 1.8 trillion of Federal Reserve Notes were held overseas, the per capita amount remaining in the United States would be $ 3,300. If 70% were held abroad, US per capita holdings would be $ 1,650. Either of those figures would still represent a very large and difficult to explain surge in cash holding per capita within the United States relative to the level of 1980, which was $ 550. The author is unable to find a satisfactory explanation for why, at the time of writing, more than 2 trillion non- interest bearing physical Federal Reserve notes are currently in circulation.
Conclusion In 2007, the Fed had little in common with the institution created by the Federal Reserve Act of 1913. No one doubted that it was a central bank. Gold had become irrelevant to its operations. It had gained the power to create an infinite amount of credit. It could control interest rates at any level it chose. It was free to monetize some or all of the government’s debt. And, it could even create wealth by extending Federal Reserve Credit and pushing up the price of property and stocks. The following chapters will show that during the years after dollars ceased to be backed by gold, the Fed oversaw a phenomenal expansion of credit in the United States that supercharged the global economy and pulled hundreds of millions of people out of poverty. Unfortunately, the credit structure that existed in 2007 was built on weak foundations. In 2008, it began to collapse. If it had, it would have decimated the entire US financial sector and destroyed most of the country’s savings and wealth. That did not happen because in 2008 the Fed created and extended more Federal Reserve Credit in one year than it had during its near- century of existence prior to 2008, as shown in Chart 7.9. And that was only the beginning. Fed policy ensured there would be no replay of the Great Depression.
PART II: Credit
Most surprisingly, this extraordinarily aggressive combination of fiscal and monetary stimulus did not cause inflation. Milton Friedman taught that “Inflation is always and everywhere a monetary phenomenon.” Events following the financial crisis of 2008 have demonstrated that Friedman was mistaken.
There are three lessons to be learned from the decades- long surge in credit that led to the crisis of 2008 and from the policy response that successfully resolved that crisis. First, following the Money Revolution described in the first two parts of this book, our economic system requires credit growth to generate economic growth. Without credit growth there will be a depression. Second, there are limits as to how much the private sector can borrow. Third, it is possible for the US government to borrow many trillions of dollars and for the Fed to create trillions of dollars to help finance that debt over a short space of time, without causing high rates of inflation.
the US government will have to continue to borrow heavily during the years ahead to keep the economy from collapsing into a new depression. This begs the question: How should the government spend the money it will be forced to borrow?
Part Three will show that rather than threatening US prosperity, the circumstances brought about by the Money Revolution have opened up extraordinary opportunities that the United States must grasp and fully realize.
CHAPTER 8: Credit Creation by the Banking System
The Fed’s power over the economy stems from its ability to create or destroy credit.
The money that a central bank creates is called base money or the monetary base. As explained in Part One, the US monetary base is comprised of the reserves that commercial banks hold in their reserve accounts at the Fed, and currency. “M1” and “M2” are broader measures of money that include money that the banking system creates. M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (i.e., checking account deposits). M2 is defined as M1 plus savings deposits, small- denomination time deposits and retail money market mutual fund shares.
Since bank deposits are considered to be a kind of money, by extending credit, the banking system can create an amount of money that is a multiple of the initial deposit. The multiple, known as the money multiplier, can be calculated as follows: The money multiplier = 1 ÷ the required reserve ratio Therefore, if the required reserve ratio is 20%, as in the example above, the money multiplier is 5 times (1 ÷ 20%) and the banking system can create an amount of money that is five times the initial deposit: $ 100 X 5 = $ 500. If the required reserve ratio is 10%, the money multiplier is 10 times (1 ÷ 10%) and the banking system can create an amount of money 10 times the size of the initial deposit. The lower the required reserve ratio, the more credit the banking system can create.
Bank Reserves expanded by 48% between 1921 and 1928, while bank credit and bank deposits increased by 45% and 60%, respectively. The credit expansion during those seven years is the principal reason the Roaring Twenties roared.
Note that bank credit did contract once between 1970 and 2007, during 1990 and 1991. The United States experienced a recession as a result.
In 1948, the required reserve ratio peaked at 26% on net demand deposits and 7.5% on time deposits. It was reduced time and again thereafter. For instance, in 1990, the required reserve ratio on non- transactions accounts was cut from 3% to zero, while in 1992, the requirement on transaction deposits was reduced from 12% to 10%. Finally, in March 2020, the Fed reduced the required reserve ratio to 0%, thereby entirely eliminating the requirement for banks to hold any reserves against their deposits.
Of course, had the banking sector acted prudently, it would have been careful to only create as much credit through extending loans as their customers could realistically afford to repay. The bankers did not act prudently, however. Up through 2007, the banking system created credit on an extraordinary scale with little to no concern for the ability of their customers to repay even the interest on the credit that the banks provided to them so freely.
CHAPTER 9: Credit Creation by the Financial Sector
Just Like the Banks As explained in the previous chapter, when commercial banks extend credit, either by making a loan or by acquiring a debt security, they create deposits. Loans and investments appear as assets on the banks’ balance sheets, while deposits are recorded as liabilities. Those deposits are considered to be one type of money and they are counted as part of the money supply. Bank deposits make up by far the largest part of the monetary aggregate, M2. When non- bank creditors within the financial sector extend credit by making a loan or an investment that also sets off a process that results, not only in credit creation, but also in the creation of liabilities that finance additional credit creation. The extension of credit creates new assets and new liabilities within the broader financial sector. If the credit is extended as a loan, that loan is recorded as an asset on the balance sheet of the entity that extended the loan. Similarly, if the credit is extended through the acquisition of a bond, then the bond is recorded as an asset on that institution’s balance sheet. What the recipient of the loan or the seller of the bond ultimately does with the money they receive determines the kind of liability that is created within the financial sector. If they deposit the money into a commercial bank and leave it there, it becomes a deposit liability of a commercial bank and, consequently, part of the money supply. On the other hand, if they use the money to buy a new bond issued by Fannie Mae2, for instance, that money makes it possible for Fannie to obtain additional financing; and that financing is recorded as a debt liability on the balance sheet of Fannie Mae. It adds to the total liabilities of the financial sector, but it does not increase the money supply, since, unlike commercial bank deposits, the liabilities of the GSEs are not considered to be “money” and are not included as part of the monetary aggregates. Nevertheless, the liability that has been created on Fannie Mae’s balance sheet enables Fannie Mae to extend more credit. Therefore, the key to understanding how the broader financial sector creates credit, just as commercial banks do, is to look at the liabilities of the non-bank creditors in the same way that we look at bank deposits. Both allow the creation of more credit. The only difference is that bank deposits are considered to be money and part of the money supply, whereas the liabilities of non- bank entities within the broader financial sector are not considered to be money or part of the money supply. … When the federal government or state and local governments borrowed from the private depository institutions by issuing bonds, that borrowing served only to finance government expenditure. On the other hand, when the GSEs issued bonds, their borrowing served to finance new lending by the GSEs themselves, which allowed credit creation to occur outside the commercial banks and within the broader financial sector.
From the early 1970s, however, new investment channels such as mutual funds and money market funds emerged that offered different ways for the public to save and invest. Money that would have traditionally stayed in commercial banks as deposits began to flow out of the banks and onto the balance sheets of other credit providers within the financial sector. Expressed differently, deposits that had been created by commercial banks did not all remain as deposits within the banks or even as other kinds of non- deposit liabilities at the banks. Instead, those deposits began to be withdrawn from the banks and placed with other financial sector institutions where they were recorded on the balance sheet not as deposits, but as debt securities or mutual fund shares. Although the deposits of the financial sector continued to grow, the non- deposit liabilities grew much more.
Again, the original extension of credit by the banks set off the process of money and credit creation, with the ABS issuers acting as intermediaries to make it appear that the risky assets were not on the books of the banks. The more credit that was extended in this way, the more deposits (money) flooded back into the banks, financing still more lending. In this way, leverage increased throughout the economy and drove asset prices higher.
CHAPTER 10: Credit Creation by Foreign Central Banks
“I don’t know whether, to what extent you can attribute anything to anything….” – Alan Greenspan, in a conversation with the author on January 18, 2017
One of the most extraordinary failures of the economics profession in the twenty- first century has been its inability to understand that foreign central banks have played a leading role in destabilizing the US economy by injecting trillions of dollars of central bank credit into the United States during recent decades. By 2007, foreign central banks had financed approximately 8% of all US debt and had injected nearly six times more credit into the United States than the Fed had.
The rest of this chapter will show that the majority of the credit entering the United States from abroad between 1970 and 2007 was created by foreign central banks. It will show that foreign central banks created the equivalent of trillions of dollars, used that new money to acquire US dollars in order to hold down the value of their own currencies and then invested those dollars into dollar- denominated assets.
The truly radical break from the past only began during the early 1980s, however, when the US began running very large trade deficits for the first time. By 1987, the US Current Account deficit had reached 3.3% of US GDP. By 2006, it had grown to 6% of US GDP or to more than $ 800 billion. These were trade deficits on a scale the world had never before encountered. … Had the Bretton Woods system lasted, it would not have been possible for other countries to provide $ 6.5 trillion in capital to finance the US Current Account deficit during those years. The rest of the world did not have $ 6.5 trillion worth of gold, far from it. … Other countries were able to lend the United States $ 6.5 trillion between 1970 and 2007 because their central banks were free to create as much money as they desired; and they chose to create enough new money to finance the United States’ enormous trade deficit.
The US Current Account deficit sends dollars to the countries that have a current account surplus with the United States. That is because the foreign companies that sell their goods in the United States are paid in dollars. Those companies take the dollars they earn back home and convert them into their own currency. This process would push up the value of the currencies of all the trade surplus countries if left to market forces. To prevent that, the central banks of many of the trade surplus countries buy most of the dollars entering their countries. The amounts are very large, in total, roughly the same size as the entire US Current Account deficit. Nevertheless, the central banks of the trade surplus countries can afford to buy all the dollars entering their countries because they can create all the money they need to do so.
Had they not financed the US Current Account deficit in this way, that deficit could not have persisted. In that case, the United States would have had to buy less from the rest of the world and the economy of the rest of the world would have grown much more slowly.
Not all foreign exchange reserves are made up of US dollars. Central banks also acquire euros, pounds, yen, and other currencies. The exact currency breakdown of total foreign exchange reserves is unknown because China, the largest holder of foreign exchange reserves, keeps the composition of its foreign exchange reserves a secret. For all the other countries that do report the composition of their reserves, dollars make up 61% of the total. … China has run an extraordinarily large trade surplus with the United States for three decades. China’s cumulative trade surplus with the US between 1990 and 2007 was $ 1.7 trillion (with that figure increasing to $ 5.7 trillion by 2019). Given that Chinese companies are paid in dollars when they sell their products to the United States, it is very likely that the great majority of China’s foreign exchange reserves are comprised of dollars. That strongly suggests that the dollar accounts for a larger portion of total foreign exchange reserves in the world than the 61% indicated by the countries that do report the composition of their foreign currency reserves. Therefore, here it will be assumed that dollars make up 70% of all foreign exchange reserves.
If the Fed had created more money than it was already creating, it would have risked causing much higher rates of inflation in the United States. When other central banks created the money that financed the US budget deficits, that avoided the inflationary pressures that would have arisen in the United States if the Fed had had to create more dollars to finance the budget deficits.
The world economy was transformed as a direct result of these developments. Much of Asia, in particular, underwent an industrial revolution in the course of only a few decades. Hundreds of millions of people around the world were pulled out of poverty because of the United States trade deficits and the money that the central banks of the trade surplus countries created to finance them.
For 11 years in a row, from 1997 to 2007, the capital inflows (i.e., the surplus on the Financial and Capital Account) were larger than net government borrowing (which is quite similar to, but not exactly the same size as, the US government’s budget deficit). That meant that the US government was not selling enough new bonds to absorb all the dollars that the central banks of the trade surplus countries had acquired and needed to invest during those years. Therefore, those central banks had to find some other dollar- denominated assets in which to invest those dollars. Their options were relatively limited. They could buy US corporate bonds, the bonds issued by Fannie Mae and Freddie Mac, US equities, US property or other real assets in the United States, or they could buy existing US government securities that the government had sold in earlier years. They did some of all these things. The result was that US asset prices rose and US interest rates fell. When there is heavy demand for bonds, bond prices rise and that causes bond yields (i.e., interest rates) to fall.
During those years, the Clinton administration ran rare government budget surpluses. That meant the government sold no new government securities. Instead, it repaid some of the government securities that had financed the budget deficits in earlier years, thereby retiring government securities and compounding the problem the foreign central banks faced in finding suitable investments for the money they had created. The NASDAQ bubble was the result. This was similar to the 1920s, when the US government paid down its debt, forcing money out of government bonds and into stocks. That reduction in government debt outstanding contributed to the stock market bubble of the late 1920s and the crash in 1929. Money is fungible. That means regardless of where the foreign central banks invested their money in the United States, it affected the price of every asset class. For instance, if they bought government bonds that had been issued in earlier years, whomever they bought those bonds from had cash that they had to invest somewhere else– somewhere else like NASDAQ.
Between June 2004 and July 2006, the Fed hiked the federal funds rate 17 times, pushing up short- term interest rates. Long- term interest rates, which matter much more for the economy than short- term rates, barely budged, however. The Fed pushed up the federal funds rate by 425 basis points, but the yield on 10- year government bonds was only 36 basis points higher in July 2006 than it was when the Fed began hiking nearly two years earlier. Chart 10.13 shows the movement in the federal funds rate and the 10- year bond yield during this period. Normally when the Fed pushes up short- term interest rates, long- term interest rates move up as well. That did not happen in the mid- 2000s because the central banks of the trade surplus countries were creating so much money and buying so many long- term US government securities, thereby supporting the price of those bonds, that the yield on those securities would not rise. Bond yields rise when bond prices fall. In short, the central banks of the trade surplus countries were monetizing so much US government debt that the Fed lost control over US interest rates and, therefore, lost control over the US economy. Unable to make long- term interest rates rise, the Fed was powerless to stop the property bubble from inflating. In 2008, that bubble popped and nearly dragged the world into a new Great Depression.
In any case, there can be no doubt that the injection of $ 4.3 trillion of foreign central bank credit into the United States by 2007– an amount that financed 8% of all the outstanding debt in the United States that year– had a profound impact on the US economy. That money drove up asset prices and helped inflate the economic bubble that imploded in 2008.4
CHAPTER 11: Credatism
Creditism is a more appropriate name than Capitalism for the economic system that prevails in the world today. Credit creation, not capital accumulation, is the force that powers the global economy in the twenty- first century.
Credit Creation, Not Savings It is important to understand that credit creation, not savings, financed the surge in lending and borrowing that has driven economic growth since the early 1970s. If the economy had had to rely only on savings, then there would have been far less growth and the economy would be a great deal smaller today than it is.
Credit, adjusted for inflation, grew by less than 2% nine times during those 57 years. Every time, the United States fell into recession. That tells us that Creditism requires credit growth to generate economic growth.
CHAPTER 12: 2007 to 2016: Crisis and Response
“As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression.” – Ben Bernanke
After Lehman Brothers’ bankruptcy, however, the Fed’s policy response to the crisis was very effective. Using various types of discounting operations, it found the means to extend Federal Reserve Credit to practically every type of financial institution that requested it. The Fed injected so much liquidity into the financial system so quickly that the financial system did not collapse. This successful outcome demonstrates that a central bank can, by creating money on a large enough scale, stop a liquidity crisis even in a financial system suffering under trillions of dollars of seriously impaired assets.
This program became known as Quantitative Easing or QE for short. It proved to be so effective in reflating the economy that the Fed enlarged and extended the initial phase of QE; and later launched a second round in 2010 and a third round in 2012. Financial commentators referred to these successive rounds of Quantitative Easing as QE1, QE2, and QE3.11
Many people mistakenly believe that Quantitative Easing has no effect on the economy. They point to the buildup in Bank Reserves that occurs when the Fed carries out Quantitative Easing and they argue that QE is ineffective because all the money the Fed creates simply gets stuck in the banks as reserves and, therefore, does not provide any stimulus to the economy. This idea is mistaken, however. It grows out of a misunderstanding of what Bank Reserves actually are. Here a short explanation of what reserves are will help dispel this misunderstanding.
When the Fed gets its pennies back, it destroys them. But it is free to create them again any time it wants.
Hopefully, this explanation clears up the misunderstanding about Bank Reserves once and for all, because Quantitative Easing is the country’s most powerful economic policy tool. It is important to understand that QE works. It is not possible to understand the government’s policy response to economic crises in the twenty- first century without understanding that QE does effectively stimulate economic growth.
The Fed was not the only central bank acting to reflate the US economy, however. Other central banks also pumped liquidity into the US economy by creating money and buying US dollar- denominated debt.
The monetization of US government debt by foreign central banks has not been recognized by the economics profession; and, if it has been understood by those behind the “smart money” in the financial markets, they have kept that information to themselves. The sooner this fact is commonly understood, the better. Total foreign exchange reserves peaked at more than $ 12 trillion during 2014, rising from less than $ 2 trillion at the turn of the century. That means that the central banks of the trade surplus countries created the equivalent of $ 10 trillion in just 14 years. It is likely that approximately 70% of that amount, or $ 7 trillion, ended up being invested in US dollar- denominated assets, primarily Treasury bonds. That dwarfs the $ 3.6 trillion the Fed created during the first three rounds of Quantitative Easing. That new central bank money profoundly impacted US interest rates and, consequently, the rate of economic growth in the United States and all around the world. Its extraordinary impact further exemplifies the significance of the Money Revolution that occurred once money ceased to be backed by gold five decades ago.
CHAPTER 13: Creditism Between the Crises
By the end of 2018, Federal Reserve Credit outstanding had contracted by more than $ 400 billion from October 2017 when Quantitative Tightening began, as shown in Chart 13.13.
CHAPTER 14: Pandemic
At last, on March 23, the Fed said the magic words, “The Federal Reserve will continue to purchase Treasury securities and agency mortgage- backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.” Financial market participants understood correctly that the words “in the amounts needed” meant “whatever it takes.” 10 The stock market bottomed that day. The S& P closed on March 23, 34% below the peak it had reached on February 19. Its subsequent recovery was spectacular. The S& P 500 set a new, all- time record high less than five months later on August 18, even as the unemployment rate remained above 10% and the economy remained in a severe crisis.
To put the significance of that two- week total of $ 943 billion into perspective, consider that between the time the Fed began operations in 1914 and 2007, the eve of the crisis of 2008, the Fed had extended a total of only $ 902 billion of Federal Reserve Credit over 93 years. The Fed topped that by $ 41 billion during just these two weeks in March 2020.
Looking Ahead At the time of writing, July 2021, the worst of the pandemic in the United States appears to be past. The 7- day average number of daily COVID- 19 cases, which peaked near 260,000 in early January 2021, has since fallen to 26,000, while the 7- day average number for deaths has declined from a peak of 3,352 to 284 over the same period.
The Fed is expected to carry on its asset purchases at this level for most of the rest of 2021, before gradually bringing QE to an end through “tapering” by December 2022.
Therefore, unless a severe new wave of the pandemic occurs, it seems likely that this multitrillion- dollar experiment to support the economy through the pandemic will come to a close in late 2022. There is also every reason to believe that it will be judged to have been an extraordinary success. By the end of the second quarter of 2021, the size of the US economy exceeded its pre- pandemic peak and the unemployment rate had dropped back to 5.9% from a post- World War II record high of 14.8% in April 2020.
Recall that Federal Reserve Credit was already expanding before the pandemic.
Economic textbooks teach that money creation on that scale should have caused very high rates of inflation or even hyperinflation. It did not. Chapter 15 will explain why it didn’t.
CHAPTER 15: Inflation
The NASDAQ bubble formed when the government ran budget surpluses and paid down some of its debt between 1998 and 2000.
To be fair, it is usually argued that money supply growth always results in inflation with a lag. Milton Friedman wrote in Money Mischief, “over the past century and more in the United States, the United Kingdom, and some other Western countries, roughly six to nine months have elapsed on the average before increased monetary growth has worked its way through the economy and produced increased economic growth and employment. Another twelve to eighteen months have elapsed before the increased monetary growth has affected the price level appreciably and inflation has occurred or speeded up.”
When Bretton Woods broke down, everything changed. Money was no longer backed by gold. Central banks were free to create as much money as they dared. Currencies were no longer pegged. They floated. Trade between nations no longer had to balance– so long as the trade deficits could be financed with money borrowed from abroad. In short, the orthodoxy that had governed economic policy making for more than a century was thrown out the window and a new paradigm began to take shape.
Both oil shocks pushed the United States into painful recessions. Because the economy was weak, the government budget deficits were much larger during the 1970s (averaging 1.9% a year) than they had been during the 1950s (0.4% a year) and 1960s (0.7% a year).
Both money supply growth and inflation would have been very much higher still had foreign central banks not stepped in and begun buying US government debt on a very large scale. At the beginning of the decade, the “rest of the world”, i.e., foreign buyers, owned $ 10 billion worth of US government securities, 3% of the total outstanding. By the end of the decade, they owned $ 116 billion or 16% of the total.
Some central banks began creating their own currencies very aggressively in order to buy US dollars in order to hold down the value of their currencies relative to the dollar, so as to support export- led growth for their economies. Once they accumulated the dollars, they had to invest them in US dollar- denominated assets. That explains why the “rest of the world” began buying so many US government bonds during the 1970s. The emergence of large- scale money creation by the central banks of the trade surplus countries was to have an extraordinary impact on the global economy during the decades that followed.
Under the gold standard or the Bretton Woods system, countries could not import more than they exported for very long because they were required to pay for their trade deficits with gold. Trade deficits drained money (i.e., gold) from their economies, caused severe economic slumps, unemployment, and deflation. Before long, spending fell, imports declined, and trade came back into balance. All that ended when the Bretton Woods system collapsed.
This new arrangement of financing trade deficits by borrowing newly created money from the countries with large trade surpluses completely transformed the global economy. Its impact was far greater than any other economic development over the last 40 years. The economics profession has still not grasped the significance of this radical break from the past. That is why most economists failed to anticipate the crisis of 2008 and why contemporary economic theory remains unable to explain many of the most important economic developments that have occurred subsequently.
The Fed likes to take credit for bringing down inflation after 1980. And it is true that Fed Chairman Volcker did bring inflation down by provoking a harsh recession with very high federal funds rates from 1980 to 1982. However, after that, the Fed has had very little to do with bringing down the inflation rate. Base money grew at an average annual rate of more than 9% between 1983 and mid- 1987. So, inflation didn’t come down because the Fed reined in money supply growth. The Fed didn’t rein in money supply growth.
Inflation came down because the US began buying more and more goods from low wage countries and that drove down wages and prices in the United States. In other words, inflation came down because of a deflationary supply shock– a deflationary labor supply shock.
After the US began running large trade deficits, US capacity constraints no longer mattered– only global capacity constraints mattered. Globally, there are no labor constraints. Hundreds of millions of people will work for less than $ 10 per day. Consequently, after the early 1980s, rapid money supply growth in the United States no longer resulted in high rates of inflation. Once the United States began running large trade deficits, the deflationary supply shock that resulted from globalization and a near infinite pool of ultra- low- cost labor held US wages and prices down, regardless of how large the budget deficits or the money supply growth became.
The conclusion that must be drawn from these developments is that a paradigm shift has occurred in the way our monetary/ economic system functions now that money is no longer backed by gold.
During 2016, the monetary base contracted by 12% when the Fed entered into reverse repurchase agreements to absorb Bank Reserves. That was the largest contraction since 1937. During 2019, the monetary base shrank by 13% due to Quantitative Tightening, which began in October 2017 and ended in August 2019. Despite these exceptionally large declines in the monetary base, prices did not fall. The monthly inflation rate between January 2016 and July 2019 averaged 1.9%.
The elevated inflation of mid- 2021 is unlikely to persist for long. The supplemental demand provided by the government’s large fiscal stimulus packages has already begun to fade, and no other large government spending programs on the scale of the first three are expected. Therefore, the growth in consumer demand will slow during the quarters ahead. Demand will cool just as supply begins to expand as the supply bottlenecks stemming from the pandemic are overcome. The combination of weaker demand and increasing supply is likely to cause price pressures to abate.
A new Great Depression was prevented by a policy response involving trillions of dollars of fiscal stimulus financed with trillions of dollars of money created by the Fed. Yet, despite this unprecedented fiscal and monetary stimulus, the average annual rate of inflation since mid- 2008 has been 1.7%, below the Fed’s 2% inflation target. These facts strongly support the idea that we are living in a new economic environment that opens up tremendous opportunities that did not exist in the past. Part Three describes those opportunities and the extraordinary benefits they offer if we make the most of them.
PART III: The Future
Most crucially, Part Three shows that the Money Revolution opens up unprecedented opportunities for the United States to radically accelerate economic growth, enhance human well- being and strengthen US national security by investing aggressively in the Industries of the Future.
The Money Revolution of the twentieth century means that it is now possible to turn today’s dreams for a better world into reality– not generations from now, but in our own lifetime. The financing is available. Only sufficient imagination is lacking. The goal of this book is to overcome that impediment, so that the first American Century need not be the last.
CHAPTER 16: America Must Invest
The cost is very close to zero. The rewards include a vast improvement in health and well- being, as well as greatly enhanced national security. It would be extraordinarily foolish for the US government not to fully exploit the opportunities open to it at this unique moment in history.
An artificial intelligence arms race has begun. Within 20 years AI is likely to reach parity with human intelligence. After that it will accelerate at an exponential rate. The country that gets there first will have the rest of the world at its mercy. The US government must ensure that the United States is that country. Pax Americana has not been flawless. However, it has overseen a 75- year period of general peace and facilitated an extraordinary expansion of prosperity around the world.
There is no doubt that the government could invest multiples of what it is investing now.
CHAPTER 17: Inadequate Investment
Investment in intellectual property as a percentage of GDP has increased sharply since 1950. It is now at a record high of 4.7% of GDP, as shown in Chart 17.9.
Investment in China accounted for 42% of Chinese GDP, whereas US investment made up only 20% of US GDP. Its much higher rate of investment explains why China’s economy is growing much more rapidly than the US economy. Investment creates capital and capital generates income. Chart 17.13 shows that China has been investing more relative to the size of its economy since 1970.
CHAPTER 18: R&D: The Future Depends on It
Out of the $580 billion total R& D investment in 2018, the business sector carried out $ 422 billion of the R& D, or 73% of the total. The Federal Government carried out $ 58 billion (10%), Higher Education $ 75 billion (13%), and other Non- Profit Organizations $ 24 billion (4%). See Table 18.1.
In the United States, 17% of all R& D expenditure is for basic research. In China, only 6% is spent on basic research. In China, 84% is spent on experimental development; whereas, the US only spends 64% on experimental development. This suggests China is utilizing the knowledge derived from other countries’ basic research to conduct its experimental development, which it then turns into products that it sells to the countries that funded the basic research in the first place. In 2017, China actually spent more on experimental development, $ 416 billion, than the United States, $ 348 billion.
The Carnegie Endowment for International Peace published a report in October 2019 stating:… some international relations analysts and historians point out that AI technology could bring about a “Second Great Divergence” of productivity– allowing countries and firms that are the earliest and most successful adopters to leap ahead of other peers– following the First Great Divergence brought about by the Industrial Revolution. 7
CHAPTER 19: America Cam Afford to Invest
Reagan proved deficits don’t matter. Former Vice President Dick Cheney1
Orthodox economic theory, as taught at universities, holds that large government budget deficits financed with money creation by a central bank inevitably cause high rates of inflation. In June 2021, the most recent data available, the inflation rate in the United States was 5.4%. A fall in prices one year earlier, when the economic impact of the pandemic was at its peak, explains much of the large increase in the Consumer Price Index (CPI) in mid- 2021. For instance, although the price level was 5.4% higher in June 2021 than in June 2020, it was only 6.0% higher in June 2021 than in June 2019, meaning that the average increase in consumer prices over two years has been a much less concerning 3.0%. Moreover, supply bottlenecks and other temporary factors have played an important role in pushing consumer prices higher during 2021. For example, a shortage of semiconductors has disrupted the production of new cars, which, in turn, has driven up the price of used cars by more than 40% year- on- year. The increase in the price of used cars alone accounted for one- third of the increase in the CPI during the second quarter of 2021. Soon, the spike in used car prices will not only end but be reversed, resulting in disinflationary pressures during the quarters ahead. The forces that have pushed prices higher during 2021 are largely transitory. They will not persist. If inflationary pressures begin to abate, as seems probable, despite an expected $ 6.4 trillion increase in government debt between the end of 2019 and the end of 2021, financed largely by what is likely to be $ 4.7 trillion of money creation by the Fed over the same period, what lesson must we learn from this extraordinary experiment?
As mentioned in Chapter 16, the nation will not know how much it can invest over 10 years without causing unacceptably high rates of inflation until it tries.
Every country’s economy (GDP) is made up of four parts: (1) personal consumption expenditure, plus (2) private investment, plus (3) net trade (i.e., exports minus imports), plus (4) government spending. For example, in 2022, if, in line with the investment schedule presented above, government spending were to increase by $ 65 billion relative to what the government had planned to spend that year, then the economy would be $ 65 billion larger that year than it would have been if government investment had not increased by $ 65 billion (all other factors remaining unchanged).
CHAPTER 20: Monetize the Debt
The Fed has the power to create money, as this book has shown again and again. It has exercised that power in a dramatic fashion during four great national emergencies: World War I, World War II, the financial crisis of 2008 and the COVID- 19 pandemic of 2020. It should use that power now to finance a multitrillion- dollar investment program targeting the Industries of the Future over the next 10 years. If it does, the entire investment program could be carried out at no cost whatsoever to the American taxpayer.
Seigniorage and Bank Reserves It is amazing how much money you can make when you make the money. The Federal Reserve is one of the world’s most profitable institutions. Luckily for US taxpayers, the Fed is required to hand over all of its profits to the US Treasury Department every year. Between 1914 and 2020 the Fed gave the Treasury Department $ 1.6 trillion, as shown in Chart 20.1.
If the Fed were a corporation, in 2020, based on its remittances to the Treasury of $ 86.9 billion, it would have been the most profitable corporation in the world. Apple, which was the world’s most profitable corporation in 2020, would have come in second place with $ 57.4 billion of earnings.
The Fed is required to hold Treasury securities for the dollars it issues. So, in essence, the Fed provides the banks with dollars in exchange for government bonds. The Fed makes a profit in the process because it earns interest income on the government bonds it acquires but pays no interest on the currency it issues. This process is known as seigniorage.
Before us is a once- in- history opportunity for the US government to invest in new industries and technologies on an enormous scale at essentially no cost. The deflationary forces of globalization, in combination with the ability of central banks to create money without gold backing, makes this possible. It is an opportunity that we must not let slip past us.
What are the negative consequences that could result from such a large increase in government debt and Federal Reserve Credit? Three possibilities immediately jump to mind: A sharp increase in consumer price inflation (CPI). A new round of steep asset price inflation that would significantly worsen income inequality. The loss of confidence in the US dollar, imperiling its status as the world’s preeminent reserve currency. The following paragraphs will discuss– and dismiss– each of those concerns in turn.
At the time of writing, it appears likely that inflationary pressures will abate during the second half of 2021 and into 2022. No further stimulus bills are expected. That suggests that demand will weaken once consumers have exhausted the relief money they received from the government during the first months of 2021.
When semiconductor supply bottlenecks are overcome and the production of new cars returns to normal, the price of used cars and trucks is very likely to fall sharply. That deflation in used car prices will offset a significant part of any remaining inflationary pressure that persists into 2022.
In fact, between the crisis of 2008 and the start of the pandemic, the Fed struggled to prevent deflation. Policymakers would have welcomed higher inflation, since the economic damage caused by deflation is far greater than the damage caused by inflation. There was very little inflation following the crisis of 2008 because the deflationary pressures stemming from globalization outweighed the inflationary pressures that would have been expected to arise from such a large increase in government debt and such a large increase in the monetary base. This subject was discussed in greater detail in Chapter 15. Therefore, so long as globalization survives, a jump in government debt and in the Fed’s total assets resulting from a large investment program would be unlikely to cause a worrying rise in US consumer price inflation. However, as mentioned in Chapter 16, if the large- scale investment program did begin to push inflation to undesirably high levels at any time, the investment program could be slowed down until the supply bottlenecks responsible for the inflation had been overcome. Then the investment program could reaccelerate.
The policy response to the pandemic has produced a similar outcome. The S& P 500 Index bottomed on March 23 when the Fed announced “QE Infinity.” By the end of August, it had recovered all of its losses and began to set new highs. The new money that the Fed would create to finance the investment program between 2022 and 2031 is likely to continue driving asset prices higher. Should that occur, income inequality could become more extreme. Great income inequality is undesirable because it undermines democracy. Therefore, if the investment program threatens to exacerbate it, legislative action should be brought to bear to reverse it. Significantly higher tax rates could be imposed on the highest income brackets; and capital gains exceeding $ 1 million, for instance, could be taxed at significantly higher rates. Inheritance taxes on estates above $ 50 million dollars could also be raised enough to prevent income inequality from worsening. The wealthiest Americans would have no grounds to object to paying higher taxes on the additional wealth they accumulated as the direct result of government policy, additional wealth that was entirely unconnected to any effort made on their part.
A Threat to the Dollar Standard? There simply is no alternative to the dollar standard, nor will there be any time within the foreseeable future. First of all, all the other major central banks in the world are creating enormous amounts of their currencies in response to the pandemic, just as the Federal Reserve is. In fact, some were doing so even before the pandemic began. The Bank of Japan was the pioneer of Quantitative Easing and it has been conducting QE for decades. As of March 31, 2021, the BOJ’s assets amounted to 131% of Japan’s GDP. The European Central Bank total assets amounted to 62% of the Euro Area’s GDP at the end of 2020, while the People’s Bank of China’s total assets equaled 38% of China’s GDP.
the dollar has remained the principal international reserve currency during the half century since money ceased to be backed by gold because the United States’ enormous annual trade deficits have flooded the world with dollars. For example, between 2014 and 2018, China’s trade surplus with the United States averaged approximately $ 1 billion per day. 10 Chinese companies sold their goods in the United States. They were paid in US dollars. Once China had the dollars, it had to invest them in US dollar- denominated assets, like US government securities. Consequently, China’s stockpile of dollars grew by more than $ 1 billion a day. China could have exchanged some of those dollars into some other currency, euros, for instance. However, whomever China bought the euros from would then have owned the dollars and they would have had to invest them in US dollar- denominated securities. Dollars are like farmland. When a farmer sells the farmland, it does not disappear. Someone else owns it. The same is true for dollars. Therefore, the gigantic pool of dollars that currently exists in the world is going to continue to circulate around the globe for generations to come. Moreover, as long as the United States continues to have a large trade deficit every year, that stockpile will become larger and larger. And, all those dollars will have to be invested in US dollar- denominated assets if they are going to generate any investment income.
There will never be a return to a gold standard unless civilization collapses and we return to a Mad Max world in which trade can only be conducted through barter.
As for Bitcoin, its value lies primarily in its usefulness in allowing wealthy individuals to move large sums of money around the world illegally, in the (mistaken) belief that their Bitcoin transactions are going undetected by national and international authorities. The authorities are watching; and those individuals who use Bitcoin for this purpose who lack sufficient political influence are likely to eventually be brought to account. If the Bitcoin mania were to become too widespread among the general public, it would be outlawed. No one should doubt the power of the US government to put an end to the possession and trading of Bitcoin by any American (and for that matter, by most other nationalities) anywhere in the world. The government arrests people who counterfeit money, just as it arrests Americans who don’t pay their taxes, regardless of where in the world they live. Bitcoin is certainly no threat to the dollar, nor will it ever be.
…the labor and industrial constraints that had caused inflation and held economic growth in check simply no longer exist.
Policymakers are captive to outdated economic theories that most of them never really understood in the first place.
This is not the early twentieth-century world of Ludwig von Mises, when gold reserves limited how much credit could be created. Nor is it Milton Friedman’s 1960s, when the size of the US workforce and the depth of industrial capacity within the United States dictated how much the US government could spend without setting off an inflationary firestorm.
About the Author
Since beginning his career as an equities analyst in Hong Kong in 1986, Richard Duncan has served as global head of investment strategy at ABN AMRO Asset Management in London, worked as a financial sector specialist for the World Bank in Washington D.C., and headed equity research departments for James Capel Securities and Salomon Brothers in Bangkok. He also worked as a consultant for the IMF in Thailand during the Asia Crisis. Richard is now the publisher of Macro Watch, a biweekly video- newsletter he launched in 2013. To learn more about Macro Watch, visit his website: http:// www.richardduncaneconomics.com/