By James H. Nolt
If you take standard economics courses, such as macroeconomics or money and banking, you will be taught that prices are regulated by government-controlled central banks using their power over something called “the money supply.” Such textbooks rarely mention what happened before central banks existed (the U.S. Federal Reserve system was only created in 1913) or before they were nationalized and came under governmental control, as occurred with the Bank of England only in 1946. Furthermore, some of the key processes described for typical central bank operations are purely mythological.
Central banks do have some influence (not control) over modern economies, but less for reasons of special legal privilege and more because they have large resources. That is, if you understand the power of big banks in general, you will also understand the power, interests, and influence of central banks in particular. Few of the powers they exercise are unique to central banks.
Insofar as a central bank acts as the collective agent of the other large banks (assuming all are in rough agreement), apparent central bank powers are magnified by collaboration with other bankers. Insofar as it is opposed by a faction of private banks, its power to act is seriously constrained, and its policies may be defeated, as happens often to the central banks of smaller countries and sometimes to those of larger ones.
What is money? One thing everyone agrees is that coins and paper currency held by the public are money, but in modern economies, that is a small portion of the total. Economists define several species of money. The most commonly used is M1, which includes currency plus demand deposits, more often known in checking accounts, and other accounts that can be accessed by an ATM card. The balances in checking accounts are typically much larger than the currency stock. When news reports say “the money supply” increased by 2 percent last quarter, they are usually talking about M1.
Economists also define and governments often report other measures of money that are narrower than M1 (like M0), but mostly broader, such as M2, M3, etc. If you compare across Internet websites and even economics textbooks, you will find that definitions of these various species of money are remarkably vague and inconsistent in what they emphasize. Part of the reason for this is that different central banks have slightly different definitions, but a larger reason is that few people, even economists, really grasp the intent behind these definitions, i.e., what they are trying to capture. All definitions of money in fact fail to capture what they intend to show.
The purpose of economists’ definitions of money is to capture the quantity of a mythological substance called money that is the means of payment for all currently produced goods and services, in order to complete the equation that embodies the “quantity theory of money.” The equation is M x V = Y x P, or, in plain English, the stock of money (M1 or whatever) times the velocity of money (the number of times on average each unit of money makes a purchase in a year) equals national income (equivalent to national output or GDP) times the price level. If the price level is greater than one, that is inflation; otherwise, deflation.
There are two huge problems here that few are taught in economics classes. However money is defined, it is not the means of payment for most transactions and, on the other hand, money is used to buy things other than current output, such as financial assets, assets not produced this year, etc.
Keynes, in his Treatise of Money, tried to address this second problem by distinguishing financial circulation, money used to buy financial assets, from the more mundane sorts of money used to buy ordinary products and services. Unfortunately, he dropped this complication in his later and more famous book. Economists have since followed suit. But the intent behind different definitions of money remains embedded in those definitions because, for example, the "money" you might have in a brokerage account to buy stocks and bonds is not counted as money in M1, but it is counted in the broader M3. Similarly, certain small savings accounts are included in M2, whereas large accounts are included in M3. The implicit theory behind this is that rich people will spend more of their "money" on assets, which does not directly stimulate output, whereas ordinary people spend most of their money on current output.
But the fact is that most transactions are made with credit, not money. Credit cards are not money. Businesses use a much broader variety of credit than consumers do, and have done so for centuries. Economists, when pressed, say that credit payment does not matter because debts must eventually be settled using money.
But that is not true either. Many loans are not settled with money, but rolled over with fresh credit. Often the final reckoning does not come until an economic crisis hits. Of course, there must be some relationship between income and expenditure. Few people or institutions can bullishly buy on credit without limit indefinitely, but the limits are rather elastic, certainly more flexible than taught in economics. Consequently the "money supply," however measured, is not a very interesting artifact of economies in which credit is far more important than money.
Credit expands and contracts more dramatically than money, so the focus of macroeconomics should be on the supply and demand for credit, not the money supply. Nevertheless, only a handful of critics outside the mainstream teach much that is useful about credit. The daily focus is on the Wizard of Oz in the foreground, the great and powerful central bank "regulating the money supply," not on the main actors behind the curtain, banks and other businesses expanding or contracting credit according to their private strategies.
What central banks like the Fed actually do day to day is not regulate the money supply, but influence the bill market by open market operations, which involve buying and government bills. Like any large bill trader, a central bank can influence the price of bills by its operations, but it is not the only player in the market. Its influence can be gamed or overcome by other powerful players if they take a contrary position, as George Soros and associated famously did in their 1992 defeat of the Bank of England's effort to peg the pound to a basket of European currencies that would become the euro.
The yield on government bills does influence other aspects of the economy, but there is no direct and reliable link between open market operations and inflation, unemployment, or any other macroeconomic variables. The effects of central bank policy depend on the state of the business cycle, or, in my terms, the dynamics of the private struggle between bears and bulls.
Next week I will explain why the worldwide policies of "quantitative easing" in the aftermath of the 2008 crisis did not have the effects advertised either by proponents or the most vocal critics.
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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Wikimedia Commons]