# What does a central bank actually do?

Aug 26 JDN 2458357

Though central banks are a cornerstone of the modern financial system, I don’t think most people have a clear understanding of how they actually function. (I think this may be by design; there are many ways we could make central banking more transparent, but policymakers seem reluctant to show their hand.)

I’ve even seen famous economists make really severe errors in their understanding of monetary policy, as John Taylor did when he characterized low-interest-rate policy as a “price ceiling”.

Central banks “print money” and “set interest rates”. But how exactly do they do these things, and what on Earth do they have to do with each other?

The first thing to understand is that most central banks don’t actually print money. In the US, cash is actually printed by the Department of the Treasury. But cash is only a small part of the money in circulation. The monetary base consists of cash in vaults and in circulation; the US monetary base is about $3.6 trillion. The money supply can be measured a few different ways, but the standard way is to include checking accounts, traveler’s checks, savings accounts, money market accounts, short-term certified deposits, and basically anything that can be easily withdrawn and spent as money. This is called the M2 money supply, and in the US it is currently over$14.1 trillion. That means that only 25% of our money supply is in actual, physical cash—the rest is all digital. This is actually a relatively high proportion for actual cash, as the monetary base was greatly increased in response to the Great Recession. When we say that the Fed “prints money”, what we really mean is that they are increasing the money supply—but typically they do so in a way that involves little if any actual printing of cash.

The second thing to understand is that central banks don’t exactly set interest rates either. They target interest rates. What’s the difference, you ask?

Well, setting interest rates would mean that they made a law or something saying you have to charge exactly 2.7%, and you get fined or something if you don’t do that.

Targeting interest rates is a subtler art. The Federal Reserve decides what interest rates they want banks to charge, and then they engage in what are called open-market operations to try to make that happen. Banks hold reservesmoney that they are required to keep as collateral for their loans. Since we are in a fractional-reserve system, they are allowed to keep only a certain proportion (usually about 10%). In open-market operations, the Fed buys and sells assets (usually US Treasury bonds) in order to either increase or decrease the amount of reserves available to banks, to try to get them to lend to each other at the targeted interest rates.

Why not simply set the interest rate by law? Because then it wouldn’t be the market-clearing interest rate. There would be shortages or gluts of assets.

It might be easier to grasp this if we step away from money for a moment and just think about the market for some other good, like televisions.

Suppose that the government wants to set the price of a television in the market to a particular value, say $500. (Why? Who knows. Let’s just run with it for a minute.) If they simply declared by law that the price of a television must be$500, here’s what would happen: Either that would be too low, in which case there would be a shortage of televisions as demand exceeded supply; or that would be too high, in which case there would be a glut of televisions as supply exceeded demand. Only if they got spectacularly lucky and the market price already was $500 per television would they not have to worry about such things (and then, why bother?). But suppose the government had the power to create and destroy televisions virtually at will with minimal cost. Now, they have a better way; they can target the price of a television, and buy and sell televisions as needed to bring the market price to that target. If the price is too low, the government can buy and destroy a lot of televisions, to bring the price up. If the price is too high, the government can make and sell a lot of televisions, to bring the price down. Now, let’s go back to money. This power to create and destroy at will is hard to believe for televisions, but absolutely true for money. The government can create and destroy almost any amount of money at will—they are limited only by the very inflation and deflation the central bank is trying to affect. This allows central banks to intervene in the market without creating shortages or gluts; even though they are effectively controlling the interest rate, they are doing so in a way that avoids having a lot of banks wanting to take loans they can’t get or wanting to give loans they can’t find anyone to take. The goal of all this manipulation is ultimately to reduce inflation and unemployment. Unfortunately it’s basically impossible to eliminate both simultaneously; the Phillips curve describes the relationship generally found that decreased inflation usually comes with increased unemployment and vice-versa. But the basic idea is that we set reasonable targets for each (usually about 2% inflation and 5% unemployment; frankly I’d prefer we swap the two, which was more or less what we did in the 1950s), and then if inflation is too high we raise interest rate targets, while if unemployment is too high we lower interest rate targets. What if they’re both too high? Then we’re in trouble. This has happened; it is called stagflation. The money supply isn’t the other thing affecting inflation and unemployment, and sometimes we get hit with a bad shock that makes both of them high at once. In that situation, there isn’t much that monetary policy can do; we need to find other solutions. But how does targeting interest rates lead to inflation? To be quite honest, we don’t actually know. The basic idea is that lower interest rates should lead to more borrowing, which leads to more spending, which leads to more inflation. But beyond that, we don’t actually understand how interest rates translate into prices—this is the so-called transmission mechanism, which remains an unsolved problem in macroeconomics. Based on the empirical data, I lean toward the view that the mechanism is primarily via housing prices; lower interest rates lead to more mortgages, which raises the price of real estate, which raises the price of everything else. This also makes sense theoretically, as real estate consists of large, illiquid assets for which the long-term interest rate is very important. Your decision to buy an apple or even a television is probably not greatly affected by interest rates—but your decision to buy a house surely is. If that is indeed the case, it’s worth thinking about whether this is really the right way to intervene on inflation and unemployment. High housing prices are an international crisis; maybe we need to be looking at ways to decrease unemployment without affecting housing prices. But that is a tale for another time. # Tax incidence revisited, part 3: Taxation and the value of money JDN 2457352 Our journey through the world of taxes continues. I’ve already talked about how taxes have upsides and downsides, as well as how taxes directly affect prices and “before-tax” prices are almost meaningless. Now it’s time to get into something that even a lot of economists don’t quite seem to grasp, yet which turns out to be fundamental to what taxes truly are. In the usual way of thinking, it works something like this: We have an economy, through which a bunch of money flows, and then the government comes in and takes some of that money in the form of taxes. They do this because they want to spend money on a variety of services, from military defense to public schools, and in order to afford doing that they need money, so they take in taxes. This view is not simply wrong—it’s almost literally backwards. Money is not something the economy had that the government comes in and takes. Money is something that the government creates and then adds to the economy to make it function more efficiently. Taxes are not the government taking out money that they need to use; taxes are the government regulating the quantity of money in the system in order to stabilize its value. The government could spend as much money as they wanted without collecting a cent in taxes (not should, but could—it would be a bad idea, but definitely possible); taxes do not exist to fund the government, but to regulate the money supply. Indeed—and this is the really vital and counter-intuitive point—without taxes, money would have no value. There is an old myth of how money came into existence that involves bartering: People used to trade goods for other goods, and then people found that gold was particularly good for trading, and started using it for everything, and then eventually people started making paper notes to trade for gold, and voila, money was born. In fact, such a “barter economy” has never been documented to exist. It probably did once or twice, just given the enormous variety of human cultures; but it was never widespread. Ancient economies were based on family sharing, gifts, and debts of honor. It is true that gold and silver emerged as the first forms of money, “commodity money”, but they did not emerge endogenously out of trading that was already happening—they were created by the actions of governments. The real value of the gold or silver may have helped things along, but it was not the primary reason why people wanted to hold the money. Money has been based upon government for over 3000 years—the history of money and civilization as we know it. “Fiat money” is basically a redundancy; almost all money, even in a gold standard system, is ultimately fiat money. The primary reason why people wanted the money was so that they could use it to pay taxes. It’s really quite simple, actually. When there is a rule imposed by the government that you will be punished if you don’t turn up on April 15 with at least$4,287 pieces of green paper marked “US Dollar”, you will try to acquire 4,287 pieces of green paper marked “US Dollar”. You will not care whether those notes are exchangeable for gold or silver; you will not care that they were printed by the government originally. Because you will be punished if you don’t come up with those pieces of paper, you will try to get some. If someone else has some pieces of green paper marked “US Dollar”, and knows that you need them to avoid being punished on April 15, they will offer them to you—provided that you give them something they want in return. Perhaps it’s a favor you could do for them, or something you own that they’d like to have. You will be willing to make this exchange, in order to avoid being punished on April 15. Thus, taxation gives money value, and allows purchases to occur. Once you establish a monetary system, it becomes self-sustaining. If you know other people will accept money as payment, you are more willing to accept money as payment because you know that you can go spend it with those people. “Legal tender” also helps this process along—the government threatens to punish people who refuse to accept money as payment. In practice, however, this sort of law is rarely enforced, and doesn’t need to be, because taxation by itself is sufficient to form the basis of the monetary system. It’s deeply ironic that people who complain about printing money often say we are “debasing” the currency; when you think carefully about what debasement was, it clearly shows that the value of money never really resided in the gold or silver itself. If a government can successfully extract revenue from its monetary system by changing the amount of gold or silver in each coin, then the value of those coins can’t be in the gold and silver—it has to be in the power of the government. You can’t make a profit by dividing a commodity into smaller pieces and then selling the pieces. (Okay, you sort of can, by buying in bulk and selling at retail. But that’s not what we’re talking about. You can’t make money by buying 100 50-gallon barrels of oil and then selling them as 125 40-gallon barrels of oil; it’s the same amount of oil.) Similarly, the fact that there is such a thing as seignioragethe value of currency in excess of its cost to create—shows that governments impart value to their money. Indeed, one of the reasons for debasement was to realign the value of coins with the value of the metals in the coins, which wouldn’t be necessary if those were simply by definition the same thing. Taxation serves another important function in the monetary system, which is to regulate the supply of money. The government adds money to the economy by spending, and removes it by taxing; if they add more than they remove—a deficit—the money supply increases, while if they remove more than they add—a surplus—the money supply decreases. In order to maintain stable prices, you want the money supply to increase at approximately the rate of growth; for moderate inflation (which is probably better than actual price stability), you want the money supply to increase slightly faster than the rate of growth. Thus, in general we want the government deficit as a portion of GDP to be slightly larger than the growth rate of the economy. Thus, our current deficit of 2.8% of GDP is actually about where it should be, and we have no particular reason to want to decrease it. (This is somewhat oversimplified, because it ignores the contribution of the Federal Reserve, interest rates, and bank-created money. Most of the money in the world is actually not created by the government, but by banks which are restrained to greater or lesser extent by the government.) Even a lot of people who try to explain modern monetary theory mistakenly speak as though there was a fundamental shift when we fully abandoned the gold standard in the 1970s. (This is a good explanation overall, but it makes this very error.) But in fact a gold standard really isn’t money “backed” by anything—gold is not what gives the money value, gold is almost worthless by itself. It’s pretty and it doesn’t corrode, but otherwise, what exactly can you do with it? Being tied to money is what made gold valuable, not the other way around. To see this, imagine a world where you have 20,000 tons of gold, but you know that you can never sell it. No one will ever purchase a single ounce. Would you feel particularly rich in that scenario? I think not. Now suppose you have a virtually limitless quantity of pieces of paper that you know people will accept for anything you would ever wish to buy. They are backed by nothing, they are just pieces of paper—but you are now rich, by the standard definition of the word. I can even make the analogy remove the exchange value of money and just use taxation: if you know that in two days you will be imprisoned if you don’t have this particular piece of paper, for the next two days you will guard that piece of paper with your life. It won’t bother you that you can’t exchange that piece of paper for anything else—you wouldn’t even want to. If instead someone else has it, you’ll be willing to do some rather large favors for them in order to get it. Whenever people try to tell me that our money is “worthless” because it’s based on fiat instead of backed by gold (this happens surprisingly often), I always make them an offer: If you truly believe that our money is worthless, I’ll gladly take any you have off of your hands. I will even provide you with something of real value in return, such as an empty aluminum can or a pair of socks. If they truly believe that fiat money is worthless, they should eagerly accept my offer—yet oddly, nobody ever does. This does actually create a rather interesting argument against progressive taxation: If the goal of taxation is simply to control inflation, shouldn’t we tax people based only on their spending? Well, if that were the only goal, maybe. But we also have other goals, such as maintaining employment and controlling inequality. Progressive taxation may actually take a larger amount of money out of the system than would be necessary simply to control inflation; but it does so in order to ensure that the super-rich do not become even more rich and powerful. Governments are limited by real constraints of power and resources, but they they have no monetary constraints other than those they impose themselves. There is definitely something strongly coercive about taxation, and therefore about a monetary system which is built upon taxation. Unfortunately, I don’t know of any good alternatives. We might be able to come up with one: Perhaps people could donate to public goods in a mutually-enforced way similar to Kickstarter, but nobody has yet made that practical; or maybe the government could restructure itself to make a profit by selling private goods at the same time as it provides public goods, but then we have all the downsides of nationalized businesses. For the time being, the only system which has been shown to work to provide public goods and maintain long-term monetary stability is a system in which the government taxes and spends. A gold standard is just a fiat monetary system in which the central bank arbitrarily decides that their money supply will be directly linked to the supply of an arbitrarily chosen commodity. At best, this could be some sort of commitment strategy to ensure that they don’t create vastly too much or too little money; but at worst, it prevents them from actually creating the right amount of money—and the gold standard was basically what caused the Great Depression. A gold standard is no more sensible a means of backing your currency than would be a standard requiring only prime-numbered interest rates, or one which requires you to print exactly as much money per minute as the price of a Ferrari. No, the real thing that backs our money is the existence of the tax system. Far from taxation being “taking your hard-earned money”, without taxes money itself could not exist. # How much should we save? JDN 2457215 EDT 15:43. One of the most basic questions in macroeconomics has oddly enough received very little attention: How much should we save? What is the optimal level of saving? At the microeconomic level, how much you should save basically depends on what you think your income will be in the future. If you have more income now than you think you’ll have later, you should save now to spend later. If you have less income now than you think you’ll have later, you should spend now and dissave—save negatively, otherwise known as borrowing—and pay it back later. The life-cycle hypothesis says that people save when they are young in order to retire when they are old—in its strongest form, it says that we keep our level of spending constant across our lifetime at a value equal to our average income. The strongest form is utterly ridiculous and disproven by even the most basic empirical evidence, so usually the hypothesis is studied in a weaker form that basically just says that people save when they are young and spend when they are old—and even that runs into some serious problems. The biggest problem, I think, is that the interest rate you receive on savings is always vastly less than the interest rate you pay on borrowing, which in turn is related to the fact that people are credit-constrainedthey generally would like to borrow more than they actually can. It also has a lot to do with the fact that our financial system is an oligopoly; banks make more profits if they can pay savers less and charge borrowers more, and by colluding with each other they can control enough of the market that no major competitors can seriously undercut them. (There is some competition, however, particularly from credit unions—and if you compare these two credit card offers from University of Michigan Credit Union at 8.99%/12.99% and Bank of America at 12.99%/22.99% respectively, you can see the oligopoly in action as the tiny competitor charges you a much fairer price than the oligopoly beast. 9% means doubling in just under eight years, 13% means doubling in a little over five years, and 23% means doubling in three years.) Another very big problem with the life-cycle theory is that human beings are astonishingly bad at predicting the future, and thus our expectations about our future income can vary wildly from the actual future income we end up receiving. People who are wise enough to know that they do not know generally save more than they think they’ll need, which is called precautionary saving. Combine that with our limited capacity for self-control, and I’m honestly not sure the life-cycle hypothesis is doing any work for us at all. But okay, let’s suppose we had a theory of optimal individual saving. That would still leave open a much larger question, namely optimal aggregate saving. The amount of saving that is best for each individual may not be best for society as a whole, and it becomes a difficult policy challenge to provide incentives to make people save the amount that is best for society. Or it would be, if we had the faintest idea what the optimal amount of saving for society is. There’s a very simple rule-of-thumb that a lot of economists use, often called the golden rule (not to be confused with the actual Golden Rule, though I guess the idea is that a social optimum is a moral optimum), which is that we should save exactly the same amount as the share of capital in income. If capital receives one third of income (This figure of one third has been called a “law”, but as with most “laws” in economics it’s really more like the Pirate Code; labor’s share of income varies across countries and years. I doubt you’ll be surprised to learn that it is falling around the world, meaning more income is going to capital owners and less is going to workers.), then one third of income should be saved to make more capital for next year. When you hear that, you should be thinking: “Wait. Saved to make more capital? You mean invested to make more capital.” And this is the great sleight of hand in the neoclassical theory of economic growth: Saving and investment are made to be the same by definition. It’s called the savings-investment identity. As I talked about in an earlier post, the model seems to be that there is only one kind of good in the world, and you either use it up or save it to make more. But of course that’s not actually how the world works; there are different kinds of goods, and if people stop buying tennis shoes that doesn’t automatically lead to more factories built to make tennis shoes—indeed, quite the opposite.If people reduce their spending, the products they no longer buy will now accumulate on shelves and the businesses that make those products will start downsizing their production. If people increase their spending, the products they now buy will fly off the shelves and the businesses that make them will expand their production to keep up. In order to make the savings-investment identity true by definition, the definition of investment has to be changed. Inventory accumulation, products building up on shelves, is counted as “investment” when of course it is nothing of the sort. Inventory accumulation is a bad sign for an economy; indeed the time when we see the most inventory accumulation is right at the beginning of a recession. As a result of this bizarre definition of “investment” and its equation with saving, we get the famous Paradox of Thrift, which does indeed sound paradoxical in its usual formulation: “A global increase in marginal propensity to save can result in a reduction in aggregate saving.” But if you strip out the jargon, it makes a lot more sense: “If people suddenly stop spending money, companies will stop investing, and the economy will grind to a halt.” There’s still a bit of feeling of paradox from the fact that we tried to save more money and ended up with less money, but that isn’t too hard to understand once you consider that if everyone else stops spending, where are you going to get your money from? So what if something like this happens, we all try to save more and end up having no money? The government could print a bunch of money and give it to people to spend, and then we’d have money, right? Right. Exactly right, in fact. You now understand monetary policy better than most policymakers. Like a basic income, for many people it seems too simple to be true; but in a nutshell, that is Keynesian monetary policy. When spending falls and the economy slows down as a result, the government should respond by expanding the money supply so that people start spending again. In practice they usually expand the money supply by a really bizarre roundabout way, buying and selling bonds in open market operations in order to change the interest rate that banks charge each other for loans of reserves, the Fed funds rate, in the hopes that banks will change their actual lending interest rates and more people will be able to borrow, thus, ultimately, increasing the money supply (because, remember, banks don’t have the money they lend you—they create it). We could actually just print some money and give it to people (or rather, change a bunch of numbers in an IRS database), but this is very unpopular, particularly among people like Ron Paul and other gold-bug Republicans who don’t understand how monetary policy works. So instead we try to obscure the printing of money behind a bizarre chain of activities, opening many more opportunities for failure: Chiefly, we can hit the zero lower bound where interest rates are zero and can’t go any lower (or can they?), or banks can be too stingy and decide not to lend, or people can be too risk-averse and decide not to borrow; and that’s not even to mention the redistribution of wealth that happens when all the money you print is given to banks. When that happens we turn to “unconventional monetary policy”, which basically just means that we get a little bit more honest about the fact that we’re printing money. (Even then you get articles like this one insisting that quantitative easing isn’t really printing money.) I don’t know, maybe there’s actually some legitimate reason to do it this way—I do have to admit that when governments start openly printing money it often doesn’t end well. But really the question is why you’re printing money, whom you’re giving it to, and above all how much you are printing. Weimar Germany printed money to pay off odious war debts (because it totally makes sense to force a newly-established democratic government to pay the debts incurred by belligerent actions of the monarchy they replaced; surely one must repay one’s debts). Hungary printed money to pay for rebuilding after the devastation of World War 2. Zimbabwe printed money to pay for a war (I’m sensing a pattern here) and compensate for failed land reform policies. In all three cases the amount of money they printed was literally billions of times their original money supply. Yes, billions. They found their inflation cascading out of control and instead of stopping the printing, they printed even more. The United States has so far printed only about three times our original monetary base, still only about a third of our total money supply. (Monetary base is the part that the Federal reserve controls; the rest is created by banks. Typically 90% of our money is not monetary base.) Moreover, we did it for the right reasons—in response to deflation and depression. That is why, as Matthew O’Brien of The Atlantic put it so well, the US can never be Weimar. I was supposed to be talking about saving and investment; why am I talking about money supply? Because investment is driven by the money supply. It’s not driven by saving, it’s driven by lending. Now, part of the underlying theory was that lending and saving are supposed to be tied together, with money lent coming out of money saved; this is true if you assume that things are in a nice tidy equilibrium. But we never are, and frankly I’m not sure we’d want to be. In order to reach that equilibrium, we’d either need to have full-reserve banking, or banks would have to otherwise have their lending constrained by insufficient reserves; either way, we’d need to have a constant money supply. Any dollar that could be lent, would have to be lent, and the whole debt market would have to be entirely constrained by the availability of savings. You wouldn’t get denied for a loan because your credit rating is too low; you’d get denied for a loan because the bank would literally not have enough money available to lend you. Banking would have to be perfectly competitive, so if one bank can’t do it, no bank can. Interest rates would have to precisely match the supply and demand of money in the same way that prices are supposed to precisely match the supply and demand of products (and I think we all know how well that works out). This is why it’s such a big problem that most macroeconomic models literally do not include a financial sector. They simply assume that the financial sector is operating at such perfect efficiency that money in equals money out always and everywhere. So, recognizing that saving and investment are in fact not equal, we now have two separate questions: What is the optimal rate of saving, and what is the optimal rate of investment? For saving, I think the question is almost meaningless; individuals should save according to their future income (since they’re so bad at predicting it, we might want to encourage people to save extra, as in programs like Save More Tomorrow), but the aggregate level of saving isn’t an important question. The important question is the aggregate level of investment, and for that, I think there are two ways of looking at it. The first way is to go back to that original neoclassical growth model and realize it makes a lot more sense when the s term we called “saving” actually is a funny way of writing “investment”; in that case, perhaps we should indeed invest the same proportion of income as the income that goes to capital. An interesting, if draconian, way to do so would be to actually require this—all and only capital income may be used for business investment. Labor income must be used for other things, and capital income can’t be used for anything else. The days of yachts bought on stock options would be over forever—though so would the days of striking it rich by putting your paycheck into a tech stock. Due to the extreme restrictions on individual freedom, I don’t think we should actually do such a thing; but it’s an interesting thought that might lead to an actual policy worth considering. But a second way that might actually be better—since even though the model makes more sense this way, it still has a number of serious flaws—is to think about what we might actually do in order to increase or decrease investment, and then consider the costs and benefits of each of those policies. The simplest case to analyze is if the government invests directly—and since the most important investments like infrastructure, education, and basic research are usually done this way, it’s definitely a useful example. How is the government going to fund this investment in, say, a nuclear fusion project? They have four basic ways: Cut spending somewhere else, raise taxes, print money, or issue debt. If you cut spending, the question is whether the spending you cut is more or less important than the investment you’re making. If you raise taxes, the question is whether the harm done by the tax (which is generally of two flavors; first there’s the direct effect of taking someone’s money so they can’t use it now, and second there’s the distortions created in the market that may make it less efficient) is outweighed by the new project. If you print money or issue debt, it’s a subtler question, since you are no longer pulling from any individual person or project but rather from the economy as a whole. Actually, if your economy has unused capacity as in a depression, you aren’t pulling from anywhere—you’re simply adding new value basically from thin air, which is why deficit spending in depressions is such a good idea. (More precisely, you’re putting resources to use that were otherwise going to lay fallow—to go back to my earlier example, the tennis shoes will no longer rest on the shelves.) But if you do not have sufficient unused capacity, you will get crowding-out; new debt will raise interest rates and make other investments more expensive, while printing money will cause inflation and make everything more expensive. So you need to weigh that cost against the benefit of your new investment and decide whether it’s worth it. This second way is of course a lot more complicated, a lot messier, a lot more controversial. It would be a lot easier if we could just say: “The target investment rate should be 33% of GDP.” But even then the question would remain as to which investments to fund, and which consumption to pull from. The abstraction of simply dividing the economy into “consumption” versus “investment” leaves out matters of the utmost importance; Paul Allen’s 400-foot yacht and food stamps for children are both “consumption”, but taxing the former to pay for the latter seems not only justified but outright obligatory. The Bridge to Nowhere and the Humane Genome Project are both “investment”, but I think we all know which one had a higher return for human society. The neoclassical model basically assumes that the optimal choices for consumption and investment are decided automatically (automagically?) by the inscrutable churnings of the free market, but clearly that simply isn’t true. In fact, it’s not always clear what exactly constitutes “consumption” versus “investment”, and the particulars of answering that question may distract us from answering the questions that actually matter. Is a refrigerator investment because it’s a machine you buy that sticks around and does useful things for you? Or is it consumption because consumers buy it and you use it for food? Is a car an investment because it’s vital to getting a job? Or is it consumption because you enjoy driving it? Someone could probably argue that the appreciation on Paul Allen’s yacht makes it an investment, for instance. Feeding children really is an investment, in their so-called “human capital” that will make them more productive for the rest of their lives. Part of the money that went to the Humane Genome Project surely paid some graduate student who then spent part of his paycheck on a keg of beer, which would make it consumption. And so on. The important question really isn’t “is this consumption or investment?” but “Is this worth doing?” And thus, the best answer to the question, “How much should we save?” may be: “Who cares?” # The terrible, horrible, no-good very-bad budget bill JDN 2457005 PST 11:52. I would have preferred to write about something a bit cheerier (like the fact that by the time I write my next post I expect to be finished with my master’s degree!), but this is obviously the big news in economic policy today. The new House budget bill was unveiled Tuesday, and then passed in the House on Thursday by a narrow vote. It has stalled in the Senate thanks in part to fierce—and entirely justified—opposition by Elizabeth Warren, and so today it has been delayed in the Senate. Obama has actually urged his fellow Democrats to pass it, in order to avoid another government shutdown. Here’s why Warren is right and Obama is wrong. You know the saying “You can’t negotiate with terrorists!”? Well, in practice that’s not actually true—we negotiate with terrorists all the time; the FBI has special hostage negotiators for this purpose, because sometimes it really is the best option. But the saying has an underlying kernel of truth, which is that once someone is willing to hold hostages and commit murder, they have crossed a line, a Rubicon from which it is impossible to return; negotiations with them can never again be good-faith honest argumentation, but must always be a strategic action to minimize collateral damage. Everyone knows that if you had the chance you’d just as soon put bullets through all their heads—because everyone knows they’d do the same to you. Well, right now, the Republicans are acting like terrorists. Emotionally a fair comparison would be with two-year-olds throwing tantrums, but two-year-olds do not control policy on which thousands of lives hang in the balance. This budget bill is designed—quite intentionally, I’m sure—in order to ensure that Democrats are left with only two options: Give up on every major policy issue and abandon all the principles they stand for, or fail to pass a budget and allow the government to shut down, canceling vital services and costing billions of dollars. They are holding the American people hostage. But here is why you must not give in: They’re going to shoot the hostages anyway. This so-called “compromise” would not only add479 million in spending on fighter jets that don’t work and the Pentagon hasn’t even asked for, not only cut $93 million from WIC, a 3.5% budget cut adjusted for inflation—literally denying food to starving mothers and children—and dramatically increase the amount of money that can be given by individuals in campaign donations (because apparently the unlimited corporate money of Citizens United wasn’t enough!), but would also remove two of the central provisions of Dodd-Frank financial regulation that are the only thing that stands between us and a full reprise of the Great Recession. And even if the Democrats in the Senate cave to the demands just as the spineless cowards in the House already did, there is nothing to stop Republicans from using the same scorched-earth tactics next year. I wouldn’t literally say we should put bullets through their heads, but we definitely need to get these Republicans out of office immediately at the next election—and that means that all the left-wing people who insist they don’t vote “on principle” need to grow some spines of their own and vote. Vote Green if you want—the benefits of having a substantial Green coalition in Congress would be enormous, because the Greens favor three really good things in particular: Stricter regulation of carbon emissions, nationalization of the financial system, and a basic income. Or vote for some other obscure party that you like even better. But for the love of all that is good in the world, vote. The two most obscure—and yet most important—measures in the bill are the elimination of the swaps pushout rule and the margin requirements on derivatives. Compared to these, the cuts in WIC are small potatoes (literally, they include a stupid provision about potatoes). They also really aren’t that complicated, once you boil them down to their core principles. This is however something Wall Street desperately wants you to never, ever do, for otherwise their global crime syndicate will be exposed. The swaps pushout rule says quite simply that if you’re going to place bets on the failure of other companies—these are called credit default swaps, but they are really quite literally a bet that a given company will go bankrupt—you can’t do so with deposits that are insured by the FDIC. This is the absolute bare minimum regulatory standard that any reasonable economist (or for that matter sane human being!) would demand. Honestly I think credit default swaps should be banned outright. If you want insurance, you should have to buy insurance—and yes, deal with the regulations involved in buying insurance, because those regulations are there for a reason. There’s a reason you can’t buy fire insurance on other people’s houses, and that exact same reason applies a thousandfold for why you shouldn’t be able to buy credit default swaps on other people’s companies. Most people are not psychopaths who would burn down their neighbor’s house for the insurance money—but even when their executives aren’t psychopaths (as many are), most companies are specifically structured so as to behave as if they were psychopaths, as if no interests in the world mattered but their own profit. But the swaps pushout rule does not by any means ban credit default swaps. Honestly, it doesn’t even really regulate them in any real sense. All it does is require that these bets have to be made with the banks’ own money and not with everyone else’s. You see, bank deposits—the regular kind, “commercial banking”, where you have your checking and savings accounts—are secured by government funds in the event a bank should fail. This makes sense, at least insofar as it makes sense to have private banks in the first place (if we’re going to insure with government funds, why not just use government funds?). But if you allow banks to place whatever bets they feel like using that money, they have basically no downside; heads they win, tails we lose. That’s why the swaps pushout rule is absolutely indispensable; without it, you are allowing banks to gamble with other people’s money. What about margin requirements? This one is even worse. Margin requirements are literally the only thing that keeps banks from printing unlimited money. If there was one single cause of the Great Recession, it was the fact that there were no margin requirements on over-the-counter derivatives. Because there were no margin requirements, there was no limit to how much money banks could print, and so print they did; the result was a still mind-blowing quadrillion dollars in nominal value of outstanding derivatives. Not million, not billion, not even trillion; quadrillion.$1e15. $1,000,000,000,000,000. That’s how much money they printed. The total world money supply is about$70 trillion, which is 1/14 of that. (If you read that blog post, he makes a rather telling statement: “They demonstrate quite clearly that those who have been lending the money that we owe can’t possibly have had the money they lent.” No, of course they didn’t! They created it by lending it. That is what our system allows them to do.)

And yes, at its core, it was printing money. A lot of economists will tell you otherwise, about how that’s not really what’s happening, because it’s only “nominal” value, and nobody ever expects to cash them in—yeah, but what if they do? (These are largely the same people who will tell you that quantitative easing isn’t printing money, because, uh… er… squirrel!) A tiny fraction of these derivatives were cashed in in 2007, and I think you know what happened next. They printed this money and now they are holding onto it; but woe betide us all if they ever decide to spend it. Honestly we should invalidate all of these derivatives and force them to start over with strict margin requirements, but short of that we must at least, again at the bare minimum, have margin requirements.

Why are margin requirements so important? There’s actually a very simple equation that explains it. If the margin requirement is m, meaning that you must retain a portion m between 0 and 1 of the loans you make as reserves, the total amount of money supply that can be created from the current amount of money M is just M/m. So if margin requirements were 100%—full-reserve banking—then the total money supply is M, and therefore in full control of the central bank. This is how it should be, in my opinion. But usually m is set around 10%, so the total money supply is 10M, meaning that 90% of the money in the system was created by banks. But if you ever let that margin requirement go to zero, you end up dividing by zero—and the total amount of money that can be created is infinite.

To see how this works, suppose we start with $1000 and put it in bank A. Bank A then creates a loan; how big they can make the loan depends on the margin requirement. Let’s say it’s 10%. They can make a loan of$900, because they must keep $100 (10% of$1000) in reserve. So they do that, and then it gets placed in bank B. Then bank B can make a loan of $810, keeping$90. The $810 gets deposited in bank C, which can make a loan of$729, and so on. The total amount of money in the system is the sum of all these: $1000 in bank A (remember, that deposit doesn’t disappear when it’s loaned out!), plus the$900 in bank B, plus $810 in bank C, plus$729 in bank D. After 4 steps we are at $3,439. As we go through more and more steps, the money supply gets larger at an exponentially decaying rate and we converge toward the maximum at$10,000.

The original amount is M, and then we add M(1-m), M(1-m)^2, M(1-m)^3, and so on. That produces the following sum up to n terms (below is LaTeX, which I can’t render for you without a plugin, which requires me to pay for a WordPress subscription I cannot presently afford; you can copy-paste and render it yourself here):

\sum_{k=0}^{n} M (1-m)^k = M \frac{1 – (1-m)^{n+1}}{m}

And then as you let the number of terms grow arbitrarily large, it converges toward a limit at infinity:

\sum_{k=0}^{\infty} M (1-m)^k = \frac{M}{m}

To be fair, we never actually go through infinitely many steps, so even with a margin requirement of zero we don’t literally end up with infinite money. Instead, we just end up with n M, the number of steps times the initial money supply. Start with $1000 and go through 4 steps:$4000. Go through 10 steps: $10,000. Go through 100 steps:$100,000. It just keeps getting bigger and bigger, until that money has nowhere to go and the whole house of cards falls down.

Honestly, I’m not even sure why Wall Street banks would want to get rid of margin requirements. It’s basically putting your entire economy on the counterfeiting standard. Fiat money is often accused of this, but the government has both (a) the legitimate authority empowered by the electorate and (b) incentives to maintain macroeconomic stability, neither of which private banks have. There is no reason other than altruism (and we all know how much altruism Citibank and HSBC have—it is approximately equal to the margin requirement they are trying to get passed—and yes, they wrote the bill) that would prevent them from simply printing as much money as they possibly can, thus maximizing their profits; and they can even excuse the behavior by saying that everyone else is doing it, so it’s not like they could prevent the collapse all by themselves. But by lobbying for a regulation to specifically allow this, they no longer have that excuse; no, everyone won’t be doing it, not unless you pass this law to let them. Despite the global economic collapse that was just caused by this sort of behavior only seven years ago, they now want to return to doing it. At this point I’m beginning to wonder if calling them an international crime syndicate is actually unfair to international crime syndicates. These guys are so totally evil it actually goes beyond the bounds of rational behavior; they’re turning into cartoon supervillains. I would honestly not be that surprised if there were a video of one of these CEOs caught on camera cackling maniacally, “Muahahahaha! The world shall burn!” (Then again, I was pleasantly surprised to see the CEO of Goldman Sachs talking about the harms of income inequality, though it’s not clear he appreciated his own contribution to that inequality.)

And that is why Democrats must not give in. The Senate should vote it down. Failing that, Obama should veto. I wish he still had the line-item veto so he could just remove the egregious riders without allowing a government shutdown, but no, the Senate blocked it. And honestly their reasoning makes sense; there is supposed to be a balance of power between Congress and the President. I just wish we had a Congress that would use its power responsibly, instead of holding the American people hostage to the villainous whims of Wall Street banks.