Understanding Monetary Policy

Not long ago I had a stimulating discussion on the nature of monetary policy with a person who knows more about this stuff than I ever will, and who certainly knows that I'm probably using the terminology incorrectly. I hope the reader of this short essay will excuse (and/or correct) the misappropriate terms and dwell on the principle issues raised.

Some people seem to hold the opinion that government control of the monetary supply can be used to control the national economy, and that the government can control the money supply by selling or repurchasing securities, but he did not provide supporting factual evidence. I am here offering my reasons for disagreeing with this position. I have identified two separable, but related, propositions:

A. Government Sale of Securities Controls Money Supply

On the face of it this looks like a reasonable proposition: If the government sells $1,000,000 in securities, it has removed $1,000,000 in cash from circulation. Similarly, buying back securities adds more cash to the money supply. I believe this is a foundational premise of so-called "supply side economics," but it carries with it considerable assumed baggage, most notably that government-printed cash enjoys an exclusive monopoly on monetization. It was interesting recently to watch a video which showed a particularly distressed country where the government-printed cash had been replaced by American cigarettes as the medium of exchange. In another movie the phrase "$1 million in cash and bearer bonds" was bandied about in such a manner as to make it clear that these securities were considered to be the negotiable equivalent of cash by the general public.

I claim rather more strongly that the choice of currency is ALWAYS by mutual consent of the buyer and seller, and may be tied to the national currency only so long as it is convenient so to do. When everybody (or at least the two parties in the negotiation) agrees on the value of the national currency, that makes things easy; otherwise any other currency -- whether it be dollars, rubles, gold, or cigarettes -- works just as well. People can even use products that are not widely available for trade: it makes commerce somewhat more clumsy, but we recognize the possibility with a defined word, "barter". In view of this alternative, the sale of government securities has no necessary effect at all on the money available for buying and selling goods and services on which the economy is based. All that has happened is that the government has traded one size and color of paper with numbers on it printed by the government, for another. The value is necessarily the same, and the holder of government securities can barter them almost as easily for other goods and services as he could the cash he paid for it. The total wealth in the system that is available for commerce has not changed at all. Not even the total measured in dollars (or rubles or whatever) has changed. The only thing that has changed is the color and size of the pieces of paper (but not the sum of the numbers printed on them). Of course the face value of a government bond may make it as hard to use to buy a loaf of bread as a $10,000 Federal Reserve Note, but given comparable worth of products, there's not a big difference between the two.

If on the other hand the government (or anybody else, for that matter, but not so strongly) were to sell consumable goods and services for those dollars, that would effectively remove those dollars from circulation -- just as soon as those goods and services were in fact consumed, and provided of course that the seller did not turn around and use those dollars to buy something else. At that point the wealth represented by those dollars has passed into government hands and out of circulation. Thus taxes amount to the removal of money from the economy, just as welfare pumps money into it, precisely because there is no quid pro quo, no tangible products nor services, in exchange for the cash.

Similarly, the only way to really control the money supply in a real (as opposed to fictitious) way, is to increase the creation of wealth by productivity. This comes down to a very intrinsic measure of wealth, namely labor. Labor invested in extracting from the ground consumables (food, fuel) that people wish to consume actually adds the value of that labor to the economy. That people must wish to consume those products is a necessary part of the equation; it is also necessary that it require labor, so that people are willing to trade their own labor (perhaps indirectly, by means of some currency equivalent such as wages) in exchange for those goods. In the so-called frictionless economy, labor is the only real valuation of money. Of course some labor is necessarily more expensive than other, because of the amortization of training (which is the same as ordinary labor, but at a deferred compensation).

B. Money Supply Controls the Economy

The real economy is not frictionless. Real people may have mistaken opinions about valuation, so they may let the lack of government-approved currency limit their ability to engage in commerce. However, this is not an inherent limitation of the system, but only of their understanding. Enterprising businessmen will make do with whatever their lot and do well. As already noted above, when meaningful cash is in short supply, any other product of agreed value works very nearly as well. When people were worried about "global financial collapse" stemming from massive technological failure due to presumed Y2K bugs in computer programs, many of them thought gold might make a suitable alternative currency; others more perceptively bought up toilet paper to use as currency. My own stated opinion was that the government would not let the banks close: even if their computers failed (which of course they worked very hard to prevent); they would open their doors and transact business -- in pencil and paper, if necessary. The point remains, however, that people were thinking about alternative forms of currency, just as they did in Russia and Chile and other countries where the economy no longer supported the official government-printed currency.

More particularly, however, the state of the economy is based in a large part on what businesses choose to do with their potential, and what consumers choose to do in terms of buying goods and services. If people have faith in the future, then they will buy up the means of production and expand their businesses, and their customers will buy their products -- thus proving the producers right. And if they are worried about the future, then they will sit on their cash and/or not borrow against the future, and thus limit the sales of products that fuel the economy by putting cash in the hands of the business owners to pay more wages and buy more production tools, all of which has a regenerative effect, positively or negatively as the case may be. It has nothing at all to do with the money supply, and everything to do with the general perception of the citizens. We saw this effect very clearly in the months leading up to and during the Iraq war: the money supply did not change, yet people stopped betting on the future, and the economy took a downturn. There was a similar effect shortly after Bush was elected: the news media uniformly played down his leadership skills, and the American people heard no voices to the contrary. Without any change in the money supply (Bush did not have enough time in office to effect any changes), the economy went south. When Clinton was elected -- again before and without any actual changes in the money supply -- the popular mood was elevated by the euphoric press adulation, and the economy got better.

I find it particularly curious that the same people strongly support government intervention in the money supply (especially given their mistaken opinion about its effect), while generally opposing government intervention in the economy as a whole. I am at a loss to see a fundamental difference between these two types of government involvement.

I invite any reasoned rebuttal to these points.

Tom Pittman (TPittman@IttyBittyComputers.com)

First draft: 2003 May 25
Rev. 2003 December 29