Tuesday, November 9, 2010

Sarah Palin and the Fed

Well, everyone else is doing it, so I guess we shouldn't have a problem with Sarah sounding off about monetary policy. I wouldn't go asking her questions about it though, as I'm sure she didn't write this stuff. It's more or less coherent, though misleading about the rate of increase in the price of groceries.

I'm going to focus on this, which is a very standard sound bite that I have heard before:
I’m deeply concerned about the Federal Reserve’s plans to buy up anywhere from $600 billion to as much as $1 trillion of government securities. The technical term for it is “quantitative easing.” It means our government is pumping money into the banking system by buying up treasury bonds. And where, you may ask, are we getting the money to pay for all this? We’re printing it out of thin air.
You can forgive people for this view as, to some extent, it is propagated by the approach people often take in undergraduate money and banking courses, where "money creation" is treated as some kind of mysterious process. The Fed is no more "printing it out of thin air" than is any economic entity when it issues a liability. For example, General Motors could issue a corporate bond to purchase new capital equipment. A liability is issued, out of thin air, and an asset is acquired. How is that different from what the Fed is up to? Well, the corporate bond issued by General Motors is a promise to pay something specific in the future. The Fed's liabilities - currency and reserves, principally - are not promises to pay anything. However, the Fed can, if it chooses, sell the assets in its portfolio at any time, and retire the money it has issued. In this sense, the money issued by the Fed has something in common with stock issued by corporations, which is also not a promise to pay anything specific in the future. A corporation can issue dividends on its stock, at its discretion, but this is not required. Further, just as the Fed can retire money, a corporation can buy back its stock.

The Fed is just a financial intermediary and, as such, it behaves like other financial intermediaries. It issues liabilities (out of thin air) and buys assets, and it has to worry about the liquidity of its assets and liabilities, their maturity, their rates of return, etc. What makes the Fed different is that it has been assigned a monopoly on the issue of particular kinds of liabilities - circulating small-denomination pieces of paper, and the stuff that is used daily in interbank clearing and settlement (reserves). Printing things out of thin air is certainly not the Fed's distinguishing characteristic.


  1. I don't think we need to know about her utility function. Revealed preference seems to work fine here.

  2. This is a very fine post.

    It’s a subtle but large point, which is an interesting combination.

  3. I think you just addressed roughly 100 years of conspiracy theories in those 3 paragraphs.

  4. Currency and reserves are indeed a promise to pay future purchasing power, right?

  5. No, that's a matter of what you can get for these objects in exchange. The Fed hasn't promised anything. For example, when private banks issued currency before the Civil War, those notes were promises to pay something. They had a redemption value. If you returned the note to the bank, you could demand the face value of the note in gold. Return a Federal Reserve note to the Federal Reserve Bank and they won't give you anything other than a replacement.

  6. Is there any difference between corporate liabilities and the Feds liabilities due to the fact that those holders of corporate liabilities are much more knowledgable of the process than those that hold american dollars. It seems like if a company issued too much stock the stocks value would immediately plummet, while the Fed prints money out of thin air and the holders of dollars arent really aware of how the process effects the future value of the dollars that they hold? How is an inflationary monetary policy not a tax on the holders of dollars?

    Is there any good resources for understanding the processes that the Fed is responsible for. Admitedly most of what you hear on the internet is of the "printing from thin air" variety of explanations.

  7. Stephen:

    What you're saying has interesting implications:

    1. There is no such thing as fiat money. All money, including the US dollar, is backed by the assets of its issuer.
    2. By extension, there is no such thing as seignorage, since fiat money is money whose whole value is seignorage.
    3. The backing theory of money is right, and the quantity theory is wrong.

  8. "The backing theory of money is right...." I wonder if Professor Williamson has any opinion on the work of Bruce Smith, who wrote some articles about the US colonial money experience

    anon from tx

  9. another question, what is the difference between the Fed printing money out of thin air to buy up private assets and printing money out of thin air to buy government bonds? Surely monetizing the debt come close to the spirit of Palin's arguments.

  10. Ian,

    1. People make decisions about what assets to hold based on the information that they have, and that determines the prices at which assets trade. Some currency holders are well-informed, some are badly-informed, and the same is true of stockholders.

    2. "How is an inflationary monetary policy not a tax on the holders of dollars?" It is. Note also that a company can issue more stock and "dilute" the existing stock, i.e. drive down its value.

    3. Available resources: That's what I'm trying to do here. Also see Dave Andolfatto's blog page:


    4. The difference between the Fed buying government debt and buying, say, mortgage-backed securities, is debatable. Potentially the latter reallocates credit in the economy, which is an important issue. Why buy the debt of some private entity and not someone else's?

  11. Mike,

    "By extension, there is no such thing as seignorage, since fiat money is money whose whole value is seignorage."

    I don't think this is right. The Fed has been given a monopoly on the issue of a class of liabilities, and it can use that power to extract resources.

    "I wonder if Professor Williamson has any opinion on the work of Bruce Smith, who wrote some articles about the US colonial money experience"

    Of course. Bruce and I were friends and coauthors, and I know his work well. His work on colonial money is closely related to work that Sargent and Wallace were doing at the time. Bruce was particularly interested in cases where a government could issue money with the promise to retire it in the future, and this would not have inflationary consequences.

  12. Stephen:

    If you're right about seignorage, then we should see at least a few central banks whose assets are not enough to buy back the money they have issued (at par). I don't know of any such banks. Wherever I look, I see central banks whose assets are sufficient to buy back 100% of the money they have issued.

    Also, I was hoping you'd tip your hand more about Bruce's work. Do you think he was right in applying the backing theory to colonial money? Because of course the only way a government, or anyone else, can promise to retire money in the future is if they hold adequate backing against the money they have issued.

  13. Mike,

    1. This depends on what you mean by seignorage. You may think of it differently, but I think the usual notion is that seignorage is the revenue from money creation. In that case, the money can be 100% backed, but the central bank can be making a profit. I think of the income the Fed returns to the Treasury as seignorage. What do you think?

    2. The backing can come from future taxation. A government can issue money today, then levy taxes in future to retire it. Essentially the assets backing the money are the future tax liabilities of the private sector.

  14. Stephen:

    1. What I think is not currently organized and concise enough for a blog post. But a few points I think are important are: (a) Nineteenth century note-issuing banks typically claimed that note issue was not profitable, since printing and handling costs more than burned up the interest. Notes were mostly issued as a form of advertising. If this is also true for the fed then there's no seignorage, on your definition. (b) I don't think you would claim that private note-issuing banks could earn a seignorage profit, since competition from rival banks would compete the profit away. (c) Even monopolistic central banks face competition, from foreign central banks, and from private money-issuing institutions in their own country. (d) Every private bank that issues, say, a checking account dollar (on loan), has just taken a short position in paper dollars, and thereby stands to profit if the paper dollar loses value. But if the paper dollar has a seignorage premium that is competed away by those checking account dollars, then the private bank profits from the very inflation that it caused----a crazy world.

    2. I agree. So why do you call yourself a "New Monetarist" instead of a backing theorist?

  15. 1.(a,b) Yes, in the case of the "free-banking era," banks in the US, they certainly were not granted monopolies, and competition held down bank profits. I don't think we could think of the note issue as just a form of advertising, though. Basically, those were the bank's only liabilities. That was their business.

    c) Yes, Hayek was interested in that.

    d) I don't agree. The fact that the bank's contracts are denominated in dollars doesn't somehow make it a seignorage participant. In fact, typically, given that a bank is borrowing short and lending long, it tends to lose from unanticipated inflation.

    2. These are just names of course. You should feel free to call yourself a New Monetarist.

  16. (b) A minor point: Those old banks issued checking accounts and savings accounts, in addition to paper notes, so notes weren't even close to being their only liabilities.

    (d) Sorry, I didn't say that right. If I borrow dollars and use them to buy a house, then I'm short in dollars, and if the newly-created dollars that I borrowed compete away some of the central bank's seignorage profit, then I (not the bank) stand to profit from the very inflation that I helped cause.

    A bank that issues checking account dollars and lends them, while holding real assets that are not denominated in dollars, is also short in dollars, and stands to gain from the central bank's resulting loss of seignorage.

  17. Checks were not used much prior to the Civil War. The post-Civil War National Banking era involved note issue by National Banks, and this was a much different system than in the free banking era. The Canadian system prior to 1935 was quite interesting - restricted entry into banking, but few restrictions on how the notes had to be backed (unlike in the National banking era - the notes were backed by government bonds there).

  18. Stephen:

    "...it may seem curious that deposits came to dominate bank notes rather early in the (nineteenth) century, even before the establishment of the first commercial bank clearing house. But demand deposits do possess certain well-known advantages over bank notes."
    (Gorton and Mullineaux, JMCB 1987, p. 460)

    Granted, when we look at these early banks it's not always clear whether "deposit" means "checkable deposit", but I remember reading in Thomas Tooke's and John Fullarton's works that checks were widespread in Britain in the 1840's.