Follow the Dollars
I discovered the eminent economist William Vickrey, a 1996 Nobel laureate, in an odd way. Although I’ve written about Wall Street and money for many years, my academic background was not in economics, but in American literature. So when I was looking for a pungent epigraph for “Up From Gold,” my 2012 book on the development of our modern dollar-based economy, I thought of a quip by Gertrude Stein (the doyenne of American writers in 1920s Paris, famous for “a rose is a rose is a rose”). As I remembered it, she said, “Economics is simple. First there is money in someone’s pocket, and when you look again, the money is in someone else’s pocket. That’s economics.”
When I Googled the quote to test my memory, up popped William Vickrey’s 1992 presidential address to the American Economic Association, in which he offered a snappier version: “As Gertrude Stein remarked, ‘The money is always there, it’s the pockets that keep changing.’ ”
When he died in 1996 at the age of 82, Vickrey was promptly forgotten by most of the economics profession; a small following keeps his memory and his ideas alive. A maverick all his life — a Quaker and conscientious objector — he often disagreed vehemently with what he described in his 1992 address as “the great bulk [of economists] close to the seats of power.” His Gertrude Stein quote came as he was denouncing a “callous tolerance for unemployment” within both the government and the economics profession. He blasted the “monetary authorities” for their “remoteness from the grim realities of unemployment,” and he derided the theory of a “non-accelerating-inflation rate of unemployment,” or NAIRU, which assumes a trade-off between unemployment and inflation.
At the time, most economists believed that 5 to 6-percent unemployment was “necessary” to restrain inflation. Some of them even referred to a “natural rate of unemployment,” a phrase that Vickrey called “one of the most vicious euphemisms ever coined.” In words that still reverberate, he told his colleagues, “It is high time we gave human values a deserved priority instead of staying mesmerized by figures on balance sheets. . . . What is urgently needed is to bring the economy rapidly to a point of genuine full employment and keep it there.”
Most Americans instinctively agree with Vickrey and can’t understand why, seven years after the economy collapsed, despite Federal Reserve efforts (the “QE2” quantitative easing, etc.), and despite assurances from policy makers that their focus is on jobs and jobs, unemployment remains a drag on economic growth. Is there an explanation for this? There is, and Gertrude Stein’s imagery helps us find it.
The money that moves through the economy is, for all Americans, dollars, whether in paper or bank deposit form. This is true for all individuals, including economists, and for all corporations or other business entities. Buyers of, for example, Bitcoins measure their gains or losses in dollars. Owners of gold value their holdings in dollars. All players in the economy use their dollars to buy goods and services, and “the economy” is nothing more than the sum total of all the movements of dollars from one pocket to another in exchange for something else.
This process seems obvious today, but, as I related in “Up From Gold,” it took 500 years to create our modern banking system and complete the extraordinary conversion from a gold-based economy to a dollar-based economy. In fact, the conversion was not fully accomplished until the 1960s, yet understanding the implications of so fundamental a change is crucial to understanding our economy.
The difference between using dollars and using gold is that you can dig more gold from the earth, or ship it from overseas mines, but you can’t create dollars in the same way. The German Treasury in the 1920s literally printed marks and paid government employees with them, thereby destroying both the currency and the economy. The U.S. Treasury is prohibited by law from printing money or selling bonds directly to (that is, borrowing dollars directly from) the Federal Reserve. All paper dollars printed by the Bureau of Engraving and Printing are distributed to banks, at their request, to have on hand when existing depositors want to withdraw “cash.”
Nonetheless, there is clearly more wealth, and more dollars, in the nation today than there was 50 years ago. So how does the total number of dollars grow?
The answer is that dollars increase when an economic player, whether an individual, a business, or a corporation, borrows from a bank. This process is rarely explained in official publications, but think of it this way. You and all other economic players know how much money you have; you can envisage a pile of physical dollars that represents your total wealth today. If you borrow a dollar from my pile, yours is a dollar higher and mine a dollar lower, but the economy’s total number of dollars hasn’t changed. If you borrow a dollar from a bank, however, you have not diminished my pile or any other player’s, yet your pile is higher. The total number of dollars in the economy has increased.
It is also true that when you repay that dollar to a bank, the number of dollars in the economy shrinks. Again, this process becomes clear when we ask where you find the dollars to repay your loan. You can only get them by selling goods or services to other players in the economy, who transfer dollars from their pockets to yours. You then return those dollars to the bank that created them, the bank tears up the note you signed, and the created dollars disappear. The economy has grown, but the number of dollars has not.
Dollars do increase over time, but only through additional borrowing by a growing population, in a growing economy. The wealth of the nation, in the form of useable and productive assets, increases through the economic activities that borrowing makes possible, and with that increased wealth, and the larger economy, additional borrowing is possible. The absolute amount of borrowing can increase as long as the economy grows as well.
What I’ve described represents the whole economy, including the U.S. government (that is, the Treasury), which, like all players, borrows from other players, or taxes them, without increasing the total dollars in the economy. The difference lies in the relation of the Treasury to the Federal Reserve.
In the first place, the Fed is a bank — or more precisely a national system of banks. It is not, however, like the familiar banking corporations we all keep our money in. The Fed has just one main customer, the U.S. Treasury. The Fed receives taxes and borrowed money for the Treasury and maintains its accounts. All the checks the Treasury issues are written on its accounts at the Fed, just as your checks are written on your banking corporation.
I’ve said that the Treasury cannot borrow directly from the Federal Reserve, and when it borrows from you or me, the total amount of dollars in the economy does not change. However, the Fed can buy Treasury bonds from economic players who lent money to the Treasury and received the bonds. As a bank, the Fed creates the dollars it puts into the pockets of bond owners when it buys bonds from them. The dollars the Treasury previously received when it sold the bonds went into the pockets of players providing goods or services to the government, and those dollars continue to exist in those pockets. Now the Fed creates new dollars to put back into the pockets of the original bond buyers.
In other words, when the Federal Reserve buys Treasury bonds from players in the real economy, total dollars in the economy do increase. This is the full meaning of QE2 and other phrases. It is the action that commentators are in fact describing when they speak of the Fed “pumping money into the economy.”
The answer to our original question — why Fed actions have not restored the economy and significantly reduced unemployment — now becomes clear. The economic players from whom the Fed buys Treasury bonds haven’t spent the increased dollars on goods or services, because they bought the Treasury bonds in the first place as investments, and they count the bonds or the dollars in their assets. The vast majority of government bonds that are traded are exchanged among those investors — including pension funds, hedge funds, etc. — with dollars changing pockets among them constantly. When the Fed steps in and buys government bonds, it is simply acting as another trader among all the asset traders — and not the largest one. The Fed’s major announcement last year that it would buy up to $100 billion of Treasury bonds per month should be seen in the context of the whole market. Outstanding Treasury bonds now total over $17 trillion, of which some $300 billion to $400 billion trade daily.
In essence, through its purchases of Treasury bonds, the Fed creates more dollars to circulate among asset traders. To reduce unemployment, the government will have to put more dollars into the hands of those who will spend them on goods and services. Their additional buying will encourage more business borrowing and an expansion of the nation’s productive capacity.
Malcolm Mitchell is editor and publisher of Investment Policy magazine. He lives in New York and East Hampton.