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Hackernoon logoThe Financial System Laid Bare [My Two Cents] by@NoamLevenson

The Financial System Laid Bare [My Two Cents]

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@NoamLevensonNoam Levenson

Writer. Noamlevenson.com

A Pocket Economics Guide To Where Money Comes From

There’s a reason financial cons are everywhere. Because they’re easy.

I think financial cons thrive because money intimidates people. Their eyes glaze over when they hear the words ‘interest rates.’ Like yours probably do when you read “Modern Monetary Theory.”

And it’s made intentionally more complicated by those people whose job it is to convince others that finances are not to be self-managed — that our financial system is so complicated that only they can understand it. 

As long as the market is in the green, there’s no reason to challenge the status quo. If it works, don’t fix it. Trillions of dollars in government QE measures? Fine. $12.5 trillion in negative interest rates? I mean, the S&P 500 is at an all-time high…As long as those little green market arrows keep pointing up, then it’s smiley faces all around. “We’re making you money; don’t ask questions.”

That’s why understanding our financial system is important. So we can decide what’s normal for ourselves. So that we don’t succumb to, as Milton Friedman termed it, the “Tyranny of the Status Quo.” By understanding how money works, we free ourselves to make our own informed conclusions. We enable ourselves to make safer and wiser investments, decisions that anticipate the evolving nature of money. So we can decide for ourselves what’s normal.

So here’s the least painful guide to understanding how money works. The following series of articles will follow the current finance narrative. First, we’ll explore our current financial system. Next, we’ll analyze the proposals made by Modern Monetary Theory and the current debate over the future of finance. Then, we’ll apply these concepts to understanding Bitcoin and decentralized currencies, the economy and the potential consequences of MMT, and what it might mean for your investment portfolio.

Part 1: The Easy-To-Understand Guide To Our Financial System

Part 2: What is Modern Monetary Theory?

Part 3: MMT and What It Means For You, For Bitcoin, and the Future of Our Economy 

These articles are long. Maybe you’ve come to expect that from me. The research and economic debate out there is immense. These articles are long because I didn’t want to cut corners. I didn’t want to tell you what to think. I wanted to give you the information to make your own decision. Read it over a week. Read it all in one sitting. Use it to show off on open-mic night. Reference it as you read about policy, Bitcoin, or investments. I hope it proves valuable.

After you read this article, please go read Ben Hunt’s Epsilon Theory. It’s an extremely thought-provoking and fresh take on a narrative that most of us failed to even realize was a narrative. 

The money is in the banana stand! 
Source
 by 
San Sharma

Why Should You Care About Our Financial System?

Probably because you need to understand it to understand Modern Monetary Theory (MMT). And lately, everyone’s been talking about MMT. 

MMT is foundational to Alexandria Ocasio-Cortez’s Green New Deal. Vox recently covered it. Whether you’re an investor or a speculator, hold bitcoin or index funds, live in America or live internationally, MMT is central to it all. For good or for bad, this won’t be the last time you hear about this fundamental economic debate.

And the truth that no one talks about? MMT is already here. It’s been here for years. It’s a bit of a head-scratcher why it’s being sold as a radically new concept. Ben Hunt in his blog Epsilon Theory said it well. The reality is that MMT isn’t all that new — it’s just a more accurate description of the last 10 years of modern economic policy. 

You’re a critical thinker. I appreciate that. Here are the six reasons you should keep reading to understand our financial system and MMT:

  1. It will force you to reevaluate how you invest.
  2. It might make you buy Bitcoin and gold, or at least make you more open to it.
  3. It will make you far more critical when analyzing politics. 
  4. It might help keep you from getting blindsided as so many did in 2008.
  5. You will finally understand our financial system (or at least you’ll think you do).
  6. It will make you a delightful conversationalist at dinner parties (just kidding about that one).

But first, we need to lay some groundwork. Have you always wanted to understand how our financial system works but been a little overwhelmed at the prospect? Today’s your lucky day. 

Down the rabbit hole we go…
Wiki Commons
 by John Tenniel [CC0]

Congress shall have power to…coin money, regulate the value thereof…

Eric B. & Rakim — “Paid in Full” — 
Flickr
 by 
P Lo

That’s pretty straightforward. Congress has the right to print money and regulate its value. The government is chiefly engaged with maintaining the value of the dollar. By value, I mean the buying power of a single dollar, whether in goods or coffee or Reese’s Peanut Butter Cups. It does this by trying to control inflation and deflation.

Money — a grand quest to convince billions of people of the value of a single piece of paper. So far…it’s worked pretty well.

on a side note, I’m analyzing America’s monetary system since the dollar is the global reserve currency. Other countries manage their systems slightly differently, although the system as a whole is similar.

The Institutions

It takes players to make a team. Here are the players that make the Money Machine go round. 

The relationship between the Federal Reserve (the Fed) and the U.S. Treasury is slightly non-traditional. The U.S. Treasury is fully public while the Fed is a hybrid public/private institution. The reason for this divide is that the United States very intentionally wanted to separate monetary policy from elected officials as much as possible. It’s very dangerous when politicians have direct control over monetary policy. It might come as a surprise to you, but sometimes, politicians make irresponsible decisions for the sake of votes. If decisions regarding the value of money are determined by reelection platforms, things can get out of hand quick.

Thus, Congress was intentionally distanced from monetary policy with the creation of the Federal Reserve in 1913.

The U.S. Treasury

The U.S. Treasury is the financial arm of the U.S. Government. It is a fully federal institution. It performs a variety of tasks, including enforcing financial laws, collecting tax revenue through the IRS, and financing government spending. In the end, it is the U.S. Treasury that is responsible for writing checks to cover government expenditures.

If the United States is spending more money than it has, it needs to take on debt. It does this by issuing U.S. Treasury bonds and auctioning them off to the public. To avoid spurring economic volatility, the U.S. Treasury is extremely transparent and predictable with how much debt it issues. 

The Treasury is also the only entity that can print money, but it doesn't create money. Money is created by the Federal Reserve (read below). The Treasury prints legal tender (bills and coins) and sells them at face-value to the Fed. The Fed then issues that money according to its monetary policy. 

If the Treasury needs more money to finance government activities, it must either issue debt or Congress must authorize tax raises.

The Federal Reserve

The Federal Reserve serves as the checking account for the U.S. Government. Just like with any checking account, the U.S. Government uses the Fed to collect income and pay employees. The Fed is a nonprofit and thus, any money leftover (profits) from their operations (you’ll understand this further down) is transferred to the Treasury to fund the government. In 2017, the Fed transferred over $80 billion to the Treasury.

The Fed is comprised of layers. The layers work together to establish the monetary policy of the United States. Some layers are public and some are private. These layers provide checks on each other, ideally representing as many conflicting interests as possible. 

The structure of the Fed looks like this: 

  •  The Federal Reserve is led by seven presidentially-appointed individuals who serve for 14-year terms. They are confirmed by the Senate. 
  • The Fed is comprised of 12 Regional Federal Reserve Banks distributed throughout various cities across the country. They’re semi-public institutions. Board members for the Regional Banks are elected by private commercial banks in each respective region. Private banks hold stock in the Regional Banks although they have restrictions on what they can do with these shares. 
  • The Federal Open Market Committee (FOMC) is the branch of the Fed responsible for setting monetary policy. It is comprised of 12 members: all 7 of the Federal Reserve governors (appointed by the President), and a rotating selection of 5 of the regional Federal Reserve Bank presidents (elected by private banks). You can see how this balances power between the private and public sectors.

The Federal Reserve (the Fed) is in charge of managing the value of money. It creates money, not by printing it (only the Treasury can do that), but by debiting the correct accounts in its member banks.

Think of it like this: If I wire Bob $50 bucks, the only thing that changes is that Bob’s computer screen shows a number $50 larger. The Fed does exactly this, except when it debits a bank with $50, that money didn’t exist before. That’s how money is created.

Oh Debt. Do I love thee? Let me count the ways…

We all love debt. Debt is fundamental to the world. The entire world is built upon debt. Yuval Harari said it well in Sapiens as he discussed the importance of debt to the modern economy — 

“If you had a dream to open a bakery, and had no ready cash, you could not realize your dream. Without a bakery, you could not bake cakes. Without cakes, you could not make money. Without money, you could not build a bakery. Humankind was trapped in this predicament for thousands of years. As a result, economies remained frozen. The way out of the trap was discovered only in the modern era…Credit enables us to build the present at the expense of the future. It’s founded on the assumption that our future resources are sure to be far more abundant than our present resources.If credit is such a wonderful thing, why did nobody think of it earlier? Of course they did…The problem in previous eras was not that no one had the idea or knew how to use it. It was that people seldom wanted to extend much credit because they didn’t trust that the future would be better than the present.

Economies grow when people borrow. Monetary policy is (ideally) all about getting people to borrow money at a sustainable rate. Debt built our modern economy and it will continue to be our fuel.

And the most important type of debt? Federal debt —  Treasury Bonds. There are different types of bonds — some short term and some long term — but for the sake of the explanation, we’re grouping them together.

“Feed me,” says the U.S. economy — 
source

Why is federal debt so important?

Treasury Bonds are important because they’re widely considered to be the “safest” investments available. Federal debt is essentially seen as guaranteed returns. And everyone buys them. Almost every investment account has some form of Federal debt. Banks buy them. Countries buy them (Japan actually holds more U.S. Debt than China). They’re important because U.S. bonds are widely considered the safest investments in the world. They sell like hotcakes.

Japan passes China as the #1 US Debt holder! 🎉

Why does the Federal Government issue debt?

The government makes money through taxes. All roads lead to Rome and all taxes lead to the U.S. Treasury to finance the government budget. If the U.S. Treasury doesn’t have enough money, it must “borrow.” It does this by issuing Treasury Bonds and auctioning them to buyers who are essentially “lending” the Federal Government money. The government pays back the money (the principal) plus the interest rate. Anyone who has student debt knows that debt gets more and more expensive the longer one pays it off. The same holds true for the government. That’s why interest rates are higher for longer-term bonds.

How Much Is Money Worth?

We already established why debt is important to countries. But debt becomes a serious problem if the government begins to take on more money than it can reasonably recoup from taxes. This becomes a real problem if the government doesn’t have control over its money. Imagine a King trying to finance a war. He only has a certain amount of gold. He can’t print more. He can only borrow it or mine it. Eventually, he might default on his debt. 

It’s much better for him if he can print the money. This gives him much more control since he’ll never default on his debt. He’ll always be able to print more money.

Warren Mosler summed it up well in this debate. He said that “governments take control of the currency when taxes are no longer capable of supporting their spending ambitions.”

If a country is worried about running out of gold, the best thing it can do is convince everyone to use an artificial currency whose value it fully controls. That way it will never run out of money. 

What happens as the government begins printing money, is that it also becomes responsible for maintaining the price of money

The Price of Money

It might seem counter-intuitive, but money has a price. If we still used the gold standard, the value of money would be set by the market value of gold. In other words, money and gold would be interchangeable. But since nothing is backing the dollar, it’s up to the U.S. Government to establish and maintain the value of a dollar. 

The price of a dollar is known as the interest rate. It is simply the rate that someone must pay back in addition to the principal amount borrowed. It’s what you pay people tomorrow who give you money today. It’s the additional cost the Government pays on the principal value of Treasury Bonds. 

Governments control the price of money (interest rate) by adjusting the supply of money. Interest rates are always affected by the changing of the supply of money. When the money supply changes, it becomes more or less expensive to borrow. All monetary policy is based on this understanding. The Fed has several different methods, but the goal is always same: change the supply of money to change the interest rate. The subsequent effects are felt throughout every sector of the economy.

The best way to drop interest rates is to flood the lenders (banks) with money. By giving them more money (increasing the supply), the power shifts towards the borrower. The borrower will be able to borrow more easily since there’s a larger supply of money available. As supply goes up, demand drops and banks are willing to sell money for less. Interest rates drop.

Along the same line of thinking, to increase interest rates, the Fed simply makes it more difficult to obtain loans. It does this by reducing the money supply — by removing money from the lenders (banks). With less money available for loans, the power shifts to the lenders and they can charge more. As supply goes down, demand goes up and banks charge more for money. Interest rates rise!

Interest Rates ELI5 (Explain Like I’m 5)

Imagine a seashell stand. Sally sells seashells by the seashore for a dollar. If we remove seashells from the market (reduce supply), then the demand for seashells will increase and the price will go up (interest rate goes up). If we flood the market with seashells (increase supply), then the price of seashells will drop (interest rate goes down).

Inflation and Deflation

Why are countries so concerned with the value of money? Because the value of circulating money influences everything. Everyone owns dollars and as the value of their money fluctuates, they may be more or less willing to spend, save, or invest. 

The value of money further affects how many people are employed, how much people are spending, and the strength of the economy. If the value of money drops too severely, you might get an economic crisis like we see today in Venezuela. If the value of money rises too fast, no one will want to spend their money because they’ll be making money just by holding cash. The economy can stagnate severely if that happens. 

Inflation: the hangover of the financial world — Edvardmunch.org, Public Domain, 
https://commons.wikimedia.org/w/index.php?curid=55157228

Unfortunately, maintaining a steady price of money is not always easy. Central banks must contend with inflation and deflation.  Inflation is when money devalues and deflation is when money increases in value.

The unfortunate reality is that you can’t have your cake and eat it too. You can’t increase spending by increasing the supply of money without devaluing that money as well. In other words, you’ll create inflation. Too much of a good thing is no longer a good thing. Too much beer and you get hit with a nasty hangover. Inflation is the hangover of the monetary world.

Inflation & Deflation ELI5

Let’s take our seashell analogy again. Let’s remove one variable and imagine that every single person is employed (full employment). There’s a set amount of things to buy too. Let’s say it’s Snickers bars. If we give everyone 10 new shells, some of those shells will be spent buying more Snickers. If the amount of Snickers doesn’t increase, then the price of each bar will go up in relation to shells. People who have Snickers bars will charge more. That’s inflation. It’s also known as “too much money chasing too few goods.”

But now imagine that we remove some shells. Now there’s less money being spent on Snickers. If the supply of Snickers again doesn’t change, the price of each Snickers bar will drop. That’s deflation. This is also called “too little money chasing too many goods.” This is why, during the Great Depression, the U.S. government paid farmers to slaughter their livestock and burn their crops. This was like removing Snickers bars. It raised prices to counteract the effect of deflation.

Inflation — the value of a dollar decreases

If the supply of money increases faster than the value of money, inflation occurs. Dollar bills become less valuable. 

This means you can now buy less with your dollars than you could before. In a vacuum, if inflation increases by 10%, it’s effectively like prices going up 10%. Your dollar bill is now worth 10% less and you definitely wish you spent it last year.

Extreme inflation led the German Mark to be worth more as wallpaper than as money — 
source

The implications of inflation:

  • It raises the cost of things. Essentially, PRICES RISE.
  • It becomes easier to sell things to other countries (exports) because their native currencies increased in value against the dollar. If the dollar drops in value against the Euro, Europe will be able to buy more American goods.
  • It becomes more expensive for Americans to travel to other countries. Foreigners can afford to go to America more often. It helps domestic tourism.
  • Inflation encourages investing and spending. If the value of your dollar is decreasing when you do nothing, then you’re going to do something! You’ll find investments that deliver returns that are higher than the rate of inflation. You’ll spend money now since, next year, you’ll be able to buy less.
  • It costs less to borrow. Imagine you wanted to borrow $100 from me and you promise to pay it back in 2 years. I charge you 20% for the loan. So I’ll get $120 back. If the value of the dollar is decreasing (inflation), then I’ll gladly loan my money to protect myself from the loss of value. Thus, people and companies can more easily borrow money and invest it in hiring new employees or improving infrastructure.
  • Companies hire more people. Unemployment goes down!
  • People favor gold (and Bitcoin?) to protect against inflation.
  • As a bottom line, traditional economics holds that inflation encourages economic growth. It encourages people to spend and to hire.

Deflation — the value of a dollar increases

If the value of money increases faster than the supply of money, deflation occurs. Dollar bills become more valuable. 

This means you can now buy more with your dollars than you could before. In a vacuum, if the dollar deflates by 10%, it’s effectively like prices dropping by 10%. Your dollar bill is now worth 10% more and you definitely are glad you didn’t spend it yesterday. This might sound great, but there are serious consequences to too much deflation. 

  • You can buy more things with that dollar as time progresses. It encourages you NOT to spend now. PRICES DROP.
  • It becomes harder to sell things to other countries (exports). It makes it easier to import.
  • It’s less expensive for Americans to travel to other countries. But it hurts domestic tourism.
  • Deflation hurts investing and spending. Because technically money is increasing in value, people aren’t inclined to lend it out unless they can get a great rate. Borrowing becomes more expensive. Companies invest less, hire less, make less money. This is key.
  • Companies fire more people to account for decreased profits. Unemployment goes up!
  • As a bottom line, traditional economics holds that deflation hurts economic growth. It discourages people to spend and hire.

As you can see, the consequences of inflation and deflation are many. Creating a steady rate of inflation is one of the most effective ways of spurring economic growth (the Federal Reserve aims for an annual inflation rate of 2%). Inflation encourages people and businesses to spend and hire and expand. Deflation encourages people to hunker down and hoard cash. 

If either inflation or deflation runs out of control, economic catastrophe follows. Inflation leads to more inflation and deflation leads to more deflation creating troublesome spirals. Since governments aren’t happy waiting around for catastrophe, they create systems to help control inflation and deflation. This is where things get interesting.

Fiscal Policy v. Monetary Policy

Back to the shell analogy: it’s actually not as simple as we first laid out. When the government increases the supply of shells, it’s not actually giving people shells. Rather, it’s increasing the shells in the accounts of banks. This, in turn, affects interest rates which affect everything else. This is called Monetary Policy.

But there’s also another method: Fiscal Policy. This is when the government increases spending or raises taxes. 

Both serve to influence the supply of money. Higher taxes have the same effect as removing money from banks. High taxes and high-interest rates take money out of the hands of companies and consumers, slowing spending, and slowing inflation. Lower taxes and low-interest rates put money into the economy and accomplish the exact opposite. 

Opinions on how money is best managed aligns pretty well with people’s general political leanings. We’re nothing if not consistent. The Left generally looks at Fiscal Policy more favorably. The Right generally likes Monetary Policy more. 

Fiscal Policy: Managed by the government (Legislative Branch, Congress). This includes tax changes and authorization for government spending.

Monetary Policy: Managed by the Central Bank. Actions include changing interest rates and affecting the money supply by printing or withholding money.

These two policy forms influence the economy, change the supply of money, and thus, create or limit inflation. Because there are so many moving variables, it becomes very difficult to create a stable system for controlling inflation and deflation. We get a chicken and egg situation. The whole system loops and it’s hard to decide whether something is a cause or consequence. Economists will never stop debating this.

As I stated earlier, the reason that monetary policy is managed by the Fed is that it acts as a check on the power of government. When Congress is separated from monetary policy, things are generally more stable (however, this is hotly debated). This is why the Federal Reserve was created in the first place.

Monetary v. Fiscal Policy ELI5

Monetary policy and fiscal policy are two tools the Government has for managing the value of money. Every economic decision impacts inflation. Monetary policy is managed through the Central Bank. Fiscal policy is managed through the Legislative Branch.

Monetary policy or how does the government actually influence interest rates? 

Flickr
 by 
Marco Verch

Monetary policy is the Fed’s ballpark. And it’s the New England Patriots of money — it always controls the game. The Fed impacts the economy and influences inflation and deflation by managing the supply of money. Remember how supply and demand affect interest rates? Well, interest rates, in turn, affect inflation, or so goes conventional thinking. The logic is that by increasing the supply of money, banks will charge less to loan it out, but inflation will also increase because there’s more circulating money. In contrast, if banks have less cash, they’ll raise interest rates, people will borrow less, and inflation will drop. The Fed can set this chain of events in motion through three different operations — all dedicated to a unified goal: change the supply of loanable money.

  1. The Reserve Requirement Ratio — AKA, the money banks can’t lend
  2. The Discount Rate — AKA, the rate at which banks borrow money in order to satisfy the Reserve Requirement. 
  3. Open Market Operations (OMO)— AKA Buying Assets. Recently the Fed expanded this to include Quantitative Easing (keep reading). OMO is when the Federal Reserve buys and sells Treasury Bonds to private banks. These operations are how the Fed affects monetary policy (this will make more sense later). Note that the Fed never buys assets directly from the Treasury.

The Reserve Requirement Ratio 

The Reserve Requirement Ratio is the money that banks can’t lend out. Because the government wants to prevent bank runs (when everyone tries to withdraw their money at the same time), it forces banks to hold a certain percentage of their deposited funds in reserve. Banks love lending. It’s how they make money. If they could, they’d lend all their money out. But this would be dangerous because then they might not be able to cover withdrawals. This has happened. A LOT. In response, the Federal Reserve designates a certain percentage that banks must keep in reserve. Currently, this percentage is set at 10% of their total funds. 

Money kept in reserve essentially keeps money out of circulation since it’s money banks can’t lend. This lowers the circulating supply of money and thus increases the price. The interest rate increases and inflation drops (deflation).

If the Fed wants to encourage lending and thus inflation, it will lower the reserve requirement. If it wants to discourage lending and lower inflation, it’ll raise the reserve requirement.

The Discount Rate and IOER

When banks don’t have the money on hand to cover the reserve, they have to borrow the money. They have two available options:

  1. They borrow from the Federal Reserve at a designated rate. This is known as the Discount Rate. This rate is currently at 2.5%.
  2. Banks can also borrow from each other. This is known as the Federal Funds Rate. This is currently at 2.25%.

The Federal Funds Rate is always below the Discount Rate. Only desperate banks pay more to borrow from the government. On a side note, there’s also a secondary rate at which banks who don’t meet the Fed’s requirement borrow (set at 3%). But that’s pretty irrelevant for our discussion.

If the Fed raises the Discount Rate, the Federal Funds Rate increases as well. This makes borrowing money more expensive for banks. This expense is passed on to the public through the price banks charge to loan money to you and me. When the Fed “raises or lowers the interest rate,” what it means is that it is adjusting the Discount Rate. This, in turn, affects the price of money. It makes borrowing money more (or less) expensive. Banks loan money to people and charge what is known as the Prime Rate. This is the rate highly credible borrowers receive. This rate is about 4.75%.

As you can see, all these interest rates are intricately connected. Raising the rate lowers inflation. Dropping the rate raises inflation.

The Fed controls the Discount Rate which in turn affects the Federal Funds Rate which in turn affects the Prime Rate.

There’s one final Fed operation you should understand. As of 2008, the Fed began paying Interest on Excess Reserves (IOER). In other words, if a bank has more money than it needs for reserves, it can lend that money to other banks or the Fed. If the rate the Fed offers is better than the rate that private banks will pay, the bank will lend the money to the Fed. IOER ensures that the interbank rate never drops too low. 

IOER and the Discount Rate ELI5

A bank that has too little money at the end of the day must borrow. The Discount Rate puts a ceiling on how much it must pay to borrow. If it can get a lower rate from another bank, it’ll borrow from them instead of the Fed. The interbank rate will never go above the Discount Rate since banks will simply borrow from the Fed instead. Thus, the Discount Rate is a ceiling on the rate.

If a bank has too much money, it can either lend it to other banks or it can lend to the Fed. The Fed will pay a certain rate called the IOER. If it can get a higher rate from another bank, it’ll lend it to them instead. The interbank rate will never drop below the IOER rate because banks will simply lend to the Fed instead. Thus, the IOER sets a floor on the rate.

Open Market Operations (OMO)

This is the final method that the Fed uses to influence monetary policy. The Fed buys and sells Treasury Bonds on the open market from commercial banks. If it wants to increase the money supply to lower the interest rate and stimulate the economy (consequently, raising inflation), it will buy Treasury Bonds from the public to inject cash. In this case, the Fed is basically giving banks money, which, if you remember, benefits the borrowers. The Fed credits the banks with cash and removes bonds from their balance sheets accordingly. 

If the Fed wants to lower the money supply to raise the interest rate and lower inflation, then it’ll sell bonds back to the public. This takes money out of circulation. It will credit banks with bonds and remove cash from their accounts. Remember, the Fed acquires these bonds in the first place by buying them from the public, not from the Treasury.

The Fed earns money on these operations, both by buying low and selling high and from the interest earned on the bonds. All profits earned go back to the Treasury. 

Where does the Fed get the money for Open Market Operations?

When the Fed engages in OMO, it doesn’t actually print money. It just debits the accounts of banks with money and removes their ownership of bonds. Money today is simply a pixelated number on a digital screen. It’s not unlike a digital ledger (like Bitcoin). The Federal Reserve (a Central Bank) just manages a central ledger. That’s all it means.

But What Happens if Normal Monetary Policy Tools Aren’t Enough? 

If the world runs on debt, what happens if people aren’t borrowing and spending? What happens if the green arrows start pointing down? We can’t have that. That doesn’t get you reelected. That puts a crack in the glass. 

Sometimes, people don’t want to borrow because they worry that the future won’t be better than the present. Perhaps they worry that deflation might spiral and they’ll actually have to pay back more value than they borrowed. Maybe they fear a recession or they think that a war is on the horizon. Whatever the reason, sometimes, even with 0% interest rates people won’t borrow. This is called a Liquidity Trap and nothing is more frustrating for Central Banks. In 2008, this was exactly what was happening and the Fed couldn’t take it anymore. It began to do what Japan did in the early 2000s. It tried its hand at Quantitative Easing (QE).

When people don’t want to borrow, we make them. Not by force, but with incentives. Ludicrous, sexy incentives.

Make Debt Sexy Again

Sexy Incentives: What is Quantitative Easing (QE)?

Since Fed policies work by adjusting interest rates, when rates were already at 0% in 2008, the Fed needed another way to get people to borrow. It began engaging in QE: the act of buying up many different types of assets without the direct intent of adjusting interest rates. It bought mortgages, corporate bonds, and various other securities. This gave the Fed further control over rates, including longer-term rates, and riskier assets like corporate bonds. It also flooded the economy with huge amounts of cash. QE is like Open-Market Operations on steroids. It told people that the Fed was willing to do what it takes to make borrowing attractive again

Just to give you a sense of how hard governments have gone in their QE efforts:

Negative Interest Rates

If QE wasn’t sexy enough, some countries have started issuing negative interest rates to stimulate the economy. If it sounds crazy, it’s because it is extremely unorthodox. 

Negative interest rates essentially mean that banks lose money when they store their reserves with the Central Bank. The EU currently has set a -.5% rate meaning that a bank that saves $100 with the Central Bank, only gets $99.50 back.

This negative rate is passed along to consumers who receive nothing in return for saving their money in a bank. Factor in the rate of inflation and the fees banks generally charge and people are actually losing money when saving.

In contrast, you basically get paid to borrow money. 

The logic is that if people are actually losing money when saving, they’ll be more likely to borrow money and spend money, ultimately stimulating economic growth.

A negative interest rate is essentially artificially imposed inflation. Or at least it works in the same way. 

Happy Faces (Expansionary Monetary Policy) v. Sad Faces (Contractionary Monetary Policy)

  • Expansionary Monetary Policy is when the Fed increases the money supply by buying publicly held assets and easing interest rates.
  • Contractionary Monetary Policy is when the Fed decreases the money supply by selling assets to the public and tightening interest rates.

If the Fed wants to encourage economic growth, it will adjust overall rates by lowering the Discount Rate (reducing the cost of taking loans for the public), changing the Reserve Ratio, and/or buying back assets, thus pumping more “money” into the economy. More people will have money to spend, either because they just sold their assets, or because they can now get affordable loans from the bank. 

The hope is that people will use this money to invest in growing their businesses, increasing business profits, hiring new employees, and creating more wealth and more profits. But because there’s more circulating money, inflation also goes up. With a price rise, workers will now demand more money and spend more money, thus raising prices further. And so goes the cash-cow. Moo. This is also known as the Wage-Price Spiral. If left unchecked, it can just keep spiraling. 

At its extreme, we can get hyperinflation (defined as prices rising 50% PER MONTH…God help us). Try to imagine what that would be like. Every month your existing money is halving in value…!

That’s why the Fed raises rates and engages in contractionary monetary policy. No one really likes it since it makes everything slow down. No one likes sad faces. But sometimes they’re necessary. 

Contractionary policy also gives the Fed room to again expand monetary policy should the need arise. It must raise rates before it can drop them again.

But here’s the caveat. The Fed hasn’t engaged in contractionary policy in a while. Instead, they’ve just found new and innovative ways to make policy even more friendly and sexier. Why contract policy when you can just keep lowering rates and expanding open market purchases? 

Rates are already at 0? No problem! Time for negative interest rates.

Maxing out Open Market Operations? Not to worry. QE to the rescue!

The Takeaways of Monetary Policy (ELI5)

It’s all about encouraging borrowing by injecting or removing cash. Circulating cash encourages loan-taking, it encourages spending, it encourages GROWTH. Whether or not you agree with it, today we’re seeing the most proactive financial policy in history. It is the government actively stimulating the economy by buying things with unprecedented amounts of new money.

Monetary Policy: A Quick Review

Expansionary Monetary Policy: Fed drops interest rates through one of its three operations → cost of borrowing money decreases because the supply of money increases → people spend more → economy strengthens → unemployment drops because companies hire more people → inflation goes up (because there’s more circulating money).

Expansionary QE: The Fed buys lots of privately-held assets→ more circulating money → same as above

Contractionary Monetary Policy: Fed raises interest rates through one of its three operations → cost of borrowing goes up because the supply of money goes down → people spend less → economy weakens → unemployment goes up → inflation goes down.

Contractionary QE: The Fed sells its purchased assets → less circulating money → same as above.

Or so conventional thinking goes…

Now you understand monetary policy. It’s the process by which the Fed buys assets, changes interest rates, and modifies the reserve ratio to influence the amount of circulating cash in the economy. It’s based on Keynesian Economics, after John Maynard Keynes.

John Maynard Keynes — Source: 
Wiki Commons (Public Domain)

Fiscal Policy

The government has another tool for affecting the economy. It is called Fiscal Policy.

Fiscal policy is managed by Congress and the President (Legislative and Executive branches). It is the policy through which the government earns and spends money. It spends money on public projects and it makes money through taxes.

Government spending and taxation have the same kinds of effects as the tools the Fed employes. Both government spending — roads, schools, public works, military, R&D–as well as reduced taxation, pump money into the economy. Thus it has the same effect as expansionary monetary policy. 

Increased taxation or reduced spending has the opposite effect, slowing growth and limiting inflation. 

These policy changes are put forth by Congress and the President. The problem is that no one likes to cut taxes. And no one likes to cut spending. Contractionary fiscal policy has far more political consequences than contractionary monetary policy.

Traditionally, Fiscal Policy was used to fund government activities through traditional balance sheet accounting. Taxes in–spending out. People believed that’s how you build sustainable growth. Now? Taxes and spending are all about politics. Cut taxes. Increase spending. Get reelected

In subsequent articles, you’ll come to understand that modern monetary theorists are pushing the idea that monetary policy is made irrelevant by fiscal policy. If the government can encourage inflation by spending and/or cutting taxes, then it has no reason to play by the Fed’s rules. They say that fiscal policy is better than monetary policy, for one simple reason: with monetary policy, people get hurt. 

The Unintended Consequence of Monetary Policy: Unemployment

Here’s the teaser for Part 2. Our monetary system has some unintended consequences. The unfortunate truth is that monetary policy creates unemployment. Debt is what makes our modern economy go round and contractionary policy makes debt more expensive. This causes an economic slowdown and people lose their jobs.

That sucks. Especially if you’re the one losing your job. Generally, people believe this to be a necessary consequence of controlling money’s value. We can’t have rampant inflation. 

However, some believe a better system exists. A system founded on the principals of fiscal policy. One that allows us to have our cake and eat it too, controlling the value of money while also guaranteeing people jobs. MMT believes that fiscal policy can stimulate the economy by paying for a job’s act.

In Part 2, we’ll explore the nitty-gritty of MMT and understand why it’s defining the future of our economy. Stay tuned. 

Final Words 

Here’s the thing about money. It’s only worth what people think it’s worth. Our entire system runs on a well-crafted narrative (and somehow, people doubt Bitcoin?!).

The strength of the narrative is driven by a dialogue between the financial system and the people that it serves. Economic signals are transmitted with expectations of a certain response. The Fed can control the value of money because when they adjust the supply of money, we the people, respond accordingly

When the Fed increases the money supply, making borrowing easier, we increase our spending, dropping the value of money. When the Fed decreases the money supply, making borrowing harder, we decrease our spending, and the value of money drops. 

This relationship self-perpetuates. As long as we keep responding to the economic signals, the system will continue to work and we’ll continue to have faith in the signals and continue responding appropriately. As long as the system works and the Fed has everything under control, unprecedented financial action is entirely sustainable. Because everything is under control. Remember?

But narratives change. Narratives break. Imagine if we all decided that since monetary policy was so friendly, we had no reason to take economic risks. Why borrow today when you can wait for a better rate tomorrow? What if we just stopped responding to the signals in the way that was expected? Farewell monetary policy. 

The narrative about money is changing now. It has been for a while. That’s why unprecedented measures like QE and negative interest rates have become normal. Advocates of MMT are pushing to take it one step further. But their proposals depend on the strength of the narrative they’re offering. 

Now you have the framework to understand what they’re talking about. Think critically and keep reading.

Part 2 is all about MMT. 

A thank you to Giuseppe Gori for the helpful edits and contributions.

FOLLOW me on Twitter: @noamlevenson

I love getting questions or suggestions, so comment away! I do my best to respond to all thoughtful comments.

I received no compensation for this article.

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