Over the weekend, Dave Winer posted a blog entry which suggested that it would be fine to pay off America's debts simply by printing money. I wouldn't normally bother responding to something like this, but Dave has a quite a bit of standing with some people, and it would worry me if no one bothered to counter what he's saying.
That's because what he's suggesting is a dangerous course, one which should only be used in the direst of emergencies, and which could potentially end up withe U.S. economy heading into Zimbabwe-style hyperinflation. More importantly, to me at least, it's a path that the British goverment is reported to be considering, too.
Dave's argument boils down to this: because inflation is so low at the moment, to the point of some commentators suggesting they'll head into deflation, it doesn't matter if you grease the economic wheels by printing more money to pay off government debt.
This, in fact, was the path that the Japanese government took in the early 2000's. During a banking liquidity crisis, it first tried to lower interest rates to encourage lending. When that didn't working, it boosted lending from the Bank of Japan to banks, to give the economy a jolt. When that didn't work, it printed more money and used to buy Japanese government bonds – effectively, with money that had previously not existed.
This process – known, in typically opaque economist-speak as quantitative easing – is one of the strongest tools that a goverment has to fight off deflation. But it carries with it danger, for reasons that it takes a bit of economic theory to understand.
In a modern economy, money consists ot two elements:
- The monetary base. This is all the cash in circulation, plus government reserves and money lent to commercial banks.
- The money multiplier.
Money multiplier is something that comes about because of our system of banking, known as fractional reserve banking (FRB). In an FRB system, banks are only required (by law) to keep on hand a percentage of their deposits, while being able to lend everything else out. Although it sounds counter-intuitive, the money multiplier effectively means that banks can lend out more money than they have on deposit under certain circumstances, with the total amount lent dependent on the amount it is required by law to hold. A loan a bank makes to someone else is an asset – and like any asset, it can borrow on the basis of it. A deposit, on the other hand, are a loan to the bank made by you, which means it's a liability. Like I said, it sounds counterintuitive – but that's the (very simplified) way that FRB works.
Effectively, the money multiplier, as the name suggests, multiplies the money supply in proportion to the amount of money lent by central banks to commercial banks, and the amount banks are required to hold in reserve.
(If you want to see a dramatic indication of the effects that the money multiplier has on the amount of money in an economy, look at the Wikipedia graph of the U.S money supplier by the most common measures since 1960. While the monetary base – M0 – has increased a bit, total money supply (M2) has increased massively in proportion. As Wikipedia puts it: "In January 2007, the amount of central bank money was $750.5 billion while the amount of commercial bank money (in the M2 supply) was $6.33 trillion.")
At present, and in a time of recession, the money multiplier is low. Banks keep their funds close to their chests, which is why even though central banks are lending more money to them, under better terms. But the dangerous part comes when the economy rebounds: at that point, governments have to act to reduce the money supply if inflation is not to result – and that means cutting back the monetary base.
Get it wrong, and you'll end up with hyperinflation. Wait too long to claw back that money, and the banks will up their lending, upping the money multiplier and vastly increasing the money supply. Do it too early, and the money you've printed won't have the required effect.
I'm not an economist (Dave asked for one to correct him – and then left comments off, annoyingly). But Rebecca Wilder is, and she puts the potential for trouble like this:
price stability (rising inflation). American consumers are not savers
and love to spend; and although some suggest that the American saving behavior has
changed, the evidence is far from concrete. Unless saving rises
permanently – the economy transitions to a world where consumption is
less than 70% of GDP – consumers will be more than happy to swoop up
the new bank lending and spend that new easy money."
So there you have it. Printing money as a response to deflation is risky – and, some would argue, taking too many risks is what's landed us in the mire in the first place.
(There's an additional effect of paying off debt with newly-minted money, of course: your currency will drop in value, as foreign lenders see the value of your currency fall as the money supply increases. This means imports are more pricey – and, particularly for America, that means the price of oil will rise, especially if oil pricing moves to a more stable currency (like the euro) in response. But if I go into this aspect in any depth, I'll end up with a 2000 word essay, rather than a blog post)