Understanding Money
Jude Wanniski
September 25, 1998

Supply Side University Lesson #3

Memo To: SSU Students
From: Jude Wanniski
Re: Understanding Money

I'd planned in any case to devote this lesson to money, as I did in last year's fall semester, but this is an unusually good week to think about "money." All week the financial markets around the world heaved, the value of capitalizations on stock markets rising and falling by hundreds of billions of dollars. They seemed to be doing so on the slightest bits of news of whether the central bank of the United States, the Federal Reserve, would next Tuesday lower its overnight lending rate of 5.5% as little as a quarter of a point, or stand pat with that number as it has for 18 months. How could it mean so much to stock markets in Japan and Hong Kong, London and Paris, Sao Paolo and Buenos Aires? All the Fed is pondering is the interest rate the Fed tries to maintain for the "money" that its member banks lend to each other in order to meet reserve requirements the so-called "federal funds rate." That is, each bank has to have at the close of each business day a required percentage of cash on hand or at its checking account at the U.S. Fed in relation to money it has on deposit. So what if the rate is 5.5% or 5%? What's the big deal?

If you read the financial press or watch the experts scratch their heads on the television business shows, they never tell you why it is such a big deal, because they don't know. On a recent PBS Jim Lehrer "NewsHour," the chief economist of the AFL-CIO was on hand to argue that the Fed should cut the funds rate at the next meeting of the Federal Open Market Committee, the FOMC. When asked why, he said that it would make it easier for people to buy big-ticket items like cars and refrigerators, but that he would defer on that question to the other guests, one of whom was a former member of the Fed with a Ph.D. in economics. Instead of answering the question, the Ph.D. went off in another direction, as if everyone should know that a lower federal funds rate would make it easier for people and businesses to borrow money -- which is the conventional view of the average Ph.D. economist. If it were true, why is money so tight in Japan, where the overnight interest rate has now been cut to 0.25% and still there is no business activity to end the recession?

In the supply model, you will learn that monetary policy is working at its best when the Federal Reserve keeps the dollar as good as gold at a fixed rate of exchange and the financial markets understand that the Fed will add or subtract liquidity on a daily basis in order to keep the gold price from fluctuating. There is a question of how do you find the correct starting point in the dollar gold price. What is the optimum price of gold? We can discuss that in another lesson. Here, it is enough to say that if the government chooses an exchange rate that is even close to optimum today I would put that rate somewhere between $325 and $360 it then tells the market that it will put more money into the banking system if that fixed price should begin to fall, and it would subtract money if the price should begin to rise. Because the price is now roughly $290, in my framework you can see that the Fed is starving the world of liquidity, and the financial markets around the world are heaving because of that fact not the quarter point of the federal funds rate. The presumption is that if the fimds rate were lowered, the Fed will have to add liquidity bank reserves that can be transformed into deposits and currency and as a result the price of gold would rise. If the price of gold rises, the prices of other commodities will also rise, and as long as not too much liquidity is added (which would cause gold to rise above $360) there would be no renewed inflation. People who now can't pay their debts will be able to pay them, and their creditors will be happy instead of bankrupt. As the price of gold rises or falls from the optimal rate, inflation or deflation occurs, and whatever the direction, bad things happen as a result of the disruption of debtors and creditors. These are things I propose to discuss in this lesson and in several others as the semester proceeds. At this point, if you doubt what Pm saying, stay with us for the sake of discussion, but jog your own assumptions with the following questions: When Alexander Hamilton in 1791 linked the dollar to gold, was he doing gold a favor, or the dollar? When Richard Nixon broke the link to gold in 1971, was he hurting gold and helping the dollar? If Greenspan and the Fed cut the federal funds rate little bit and only a teenie bit of liquidity is added and the gold price scarcely budges, will that be good for the world's financial markets, or disappointing? We have a laboratory available for us in real time, which is why this is such a good time to think about money. You will not get a formal degree in economics by attending SSU, but I certainly expect you will be able to manage your own investments and make more money as a result. Note the fact that the Fed probably is being forced to lower the funds rate in order to rescue the Long Term Capital Management hedge fund from collapse, which would threaten its creditors. The $90 billion hedge fund had been making lots of money based on the theories of two Nobel Prize winning economists, neither of whom know anything about monetary deflation and did not see it coming.

Now turn to the paper I wrote in March of 1995, "A Gold Polaris," which is always available in the SSU library. It might help to download it into hard copy so it could be read carefully as a key part of this lesson. It is a long paper so it will take a while to read and absorb, but it will give you a foundation for understanding money. Make sure you read the Appendix, which describes how the Federal Reserve actually creates or destroys money. The term "liquidity" is one you should master, as we will bring it up with some frequency. It simply means non-interest-bearing debt of the U.S. government, which is what we use as "money." It is liquid in that it can buy things or pay debts or taxes, which you cannot do with interest-bearing debt, which has to first be sold in order to become liquid. This is really what the Fed does, quite simply managing the mixture of U.S. debt that pays interest, i.e., bonds, and that which pays no interest.

The term "liquidity" is required in order to cover two types of non-interest-bearing debt. One is currency, the other is what the banks have left over in "reserves" after selling bonds to the Fed. We can also think of this as "ink money," in that the Fed buys government bonds without having any "money." It simply credits a bank's account with cash, as it has the power to create money out of thin air, so to speak. It can "monetize" government debt. It is important to note that it is not necessary for a bank to lend reserves to customers even though the Fed has increased its reserves by buying its bonds. If the bank sits on the reserves, making no loans, there are no deposits created, and no new money "created." The stuff we are taught as children as being "money" dollars, nickels and dimes is only part of the money in the economy, really a small part of all the money involved in the many trillions of transactions that take place every year. You will learn more about this in "A Gold Polaris."