Wednesday, April 27, 2011

In the Blink of an Eye, Part III: Inflation

As we've seen so far in this series, a proposal to change government securities into cash — that is, currency — by simple fiat would, in theory, change nothing. There would be no elimination of the national debt, for regardless what form the obligation takes, the issuer still has to make good on it. Whether you call a piece of paper a "Treasury Note," or a "Federal Reserve Note" ultimately makes no difference. Recall in 1963 when all Silver Certificates were changed by fiat into Federal Reserve Notes. The notes still read "One Dollar (or Five) In Silver, Payable To The Bearer On Demand," but the promise had been negated, reduced to "legal tender for all debts public and private." The backing was changed from silver, to government debt.

The difference between what happened in 1963 and the proposal to transform all government securities from investments to currency should be obvious. Silver Certificates and Federal Reserve Notes were/are both forms of "current money," that is, "currency." They are, in fact, small denomination government securities — promissory notes — used to facilitate day-to-day transactions. As one of the participants in the original discussion that started this series responded,

Eliminating interest payments on the national debt would not eliminate the debt, though it should deter persons, corporations, and other governments from buying Treasuries and increasing the debt. This would be true especially now that the prospective downgrading of the U.S. government's creditworthiness would reduce the demand simply to park money in government notes and bonds.

Interest payments should be eliminated only on money created for investment in productive wealth by discounting and rediscounting, and, in fact, it would be good to permit money creation only for this purpose, because creating money for consumption or for speculation would be inflationary. One third of the wealth in America (as part of our GDP) consists of buying and selling money, mostly speculative, which has no real value at all. A two-tier system to differentiate productive wealth from non-productive (and therefore counter-productive wealth) would be a good compromise.

Naturally, we could go on for pages (and we have) explaining the statements in the above response in greater detail, pointing out how we would have used a slightly different word because the one used might give the wrong impression, blah, blah, and showing how much more intelligent we are than any mere commentator, and so on. It's more important, however, to get at the truth and clarify possible misunderstandings — like the ones expressed in the response to the response:

You misunderstood me. When the Federal Reserve and Treasury Department denote all outstanding treasury bills and notes as cash, but no longer bearing interest past the date of the conversion, all bond holders have been paid in full for their bonds in cash, with any additional payment necessary to bring the interest due current to the date of conversion. Thus the federal debt is eliminated — by fiat, yes, but that is how money is created. There is no default, because every bondholder is paid in full, 100 cents on the dollar, plus all accrued interest.

I am not suggesting that the Federal Reserve and Treasury Department could (or should) do this without explicit legislation. But I would much rather hear Congress debating such a bill than worrying about cutting necessary government services in a hopeless effort to pay off the national debt. We need to stop worrying about false economic issues and focus, as you suggest, on a more equitable economy, and one that operates within the limits of our natural environment in a way that is sustainable over the next thousand years.

There are a number of misconceptions in this rebuttal, some of which we've already covered. What we need to focus on right now, however, is the claim in the original proposal that repaying the debt by changing one form of money into another would not be inflationary. We disagree.

"Treasuries," while as fully "money" as any other type of negotiable instrument, whether issued by the State or a private person, are not usually current money, that is, they do not ordinarily circulate as currency in day-to-day transactions. They may very well be (and frequently are) used in large transactions, but not as a medium of exchange you typically carry around in your wallet. The holders in due course of government securities view the instruments more often as investments than as "money," per se, holding them for the interest income, not as media of exchange.

If, then, the interest provision was taken away, the character of the instruments as investments would be removed, and they would be construed as mere "cash," useful only as a store of value and medium of exchange. That being the case, all holders in due course who viewed the instruments as investments would immediately exchange them for interest-bearing securities or dividend-paying equity shares on the secondary market in order to maintain their incomes.

The effect of pouring an estimated $14.3 trillion (the size of the national debt according to the "National Debt Clock" as of this morning, 04/27/11) into the stock market can only be imagined. Prices of debt and equity instruments would skyrocket. Seeing greater speculative "returns" in the stock market than could be realized by engaging in productive activity, businesses and private individuals would put their money into the stock market instead of into the production of marketable goods and services, just as happened to a much lesser degree in 1929 — why work when all you have to do is borrow money to purchase secondary debt and equity instruments that are sure to go up in value? — a self-fulfilling prophecy . . . up to a point.

As production of marketable goods and services declined in response to the flight of capital from the productive sector to the secondary markets, prices to the consumer would begin to rise rapidly. As happened in Germany and Austria-Hungary following the First World War, hyperinflation would very likely kick in — hyperinflation being a condition in which the price level rises faster than money can be created. This would be due to the backing of the currency (the general wealth of the economy under Currency School assumptions) being transformed from the present value of existing marketable goods and services, to the speculative value of secondary debt and equity. The only difference would be that, following World War I, Germany's and Austria-Hungary's productive capacity was taken away in "reparations," while under this scenario the productive capacity of the United States would be starved for credit and simply unable to function — the difference between murder and suicide.

Ironically, the situation in Central Europe after the Great War is substantially no different from the situation today — or eighty years ago. This is a result of the shift in focus from productive activity (which, naturally, takes a relatively long time to realize adequate gains in return for producing marketable goods and services) to gambling in the stock market that embodies a "get rich quick" approach to "investment." (Cf. George Randolph Chester's "hero" of Get-Rich-Quick Wallingford: The Cheerful Account of the Rise and Fall of an American Business Buccaneer. New York: A. L. Burt Co., 1908.) The value of the currency falls, and real money income deteriorates rapidly. As Harold Moulton observed back in the 1930s,

The abundance of funds for investment in short-term liquid securities, and its scarcity for uses which involve loss of liquidity, point to a weakness in the financial structure of modern society; namely, the dissociation of the saving process from the productive utilization of funds. This difficulty is only accentuated, not created, by the depression. The unwillingness of many investors to part with their money except on the basis of a maximum assurance that they can get it back on demand, coupled with inability on the part of borrowers to make any productive use of purchasing power without immobilizing it, creates a perpetual problem. For, unless a connection is maintained between these savings and the growth of real capital, the saving process will exercise a perpetual downward pull on the money income of the community. (Harold G. Moulton, The Recovery Problem in the United States. Washington, DC: The Brookings Institution, 1936, 384.)

That is, diversion of funds — existing accumulations of savings or new money backed only by the State's promise to pay — from either consumption or investment and into speculation, as provided the trigger for the Great Depression of the 1930s (so distinguished from the Great Depression of 1893-1898, and the current "recession"), causes a decline in real income. Paradoxically, the decline in real income accelerates as the rate of inflation increases.

What then happens is the baffling phenomenon of "stagflation." Stagflation is a weird combination of a decline in real income (effective deflation) due to lack of productive investment, at the same time the price level is rising in response to an increase in the volume of currency (inflation). This results from the conviction on the part of politicians that you can spend your way out of a deficit by creating massive amounts of effective demand in the form of currency ("cash") and pumping it into the economy, whether by "Quantitative Easing," or transforming money held as an investment into effective demand for secondary debt and equity.

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