The Death of Money (33 page)

A standoff in the battle between deflation and inflation does not mean that price
stability prevails. The opposing forces may have neutralized each other for the time
being, but neither has gone away. Collapsing growth in China and a reemergence of
the sovereign debt crisis in Europe could give deflation the upper hand. Conversely,
a war in the Middle East followed by a commodity price shock, surging oil prices,
and panicked gold buying could cause dollar dumping and an inflationary groundswell
that the Fed would be unable to contain. Either extreme is possible.

This dilemma is reflected in a difference of opinion at the Federal Open Market Committee
(FOMC), the Fed’s policy-making arm, between those who favor reduced money printing
and those who favor a continuation or even expansion of the money supply through Fed
asset purchases. The group that favors reduced money printing, so-called tapering,
led by
Fed governor Jeremy Stein, contends that continued money printing is having only limited
positive effects and may create asset bubbles and systemic risk. Since money is practically
free because of zero-rate policy, and since leverage magnifies returns to investors,
the inducement to borrow money and take a chance on rising asset prices is hard to
resist. Leverage is available to stock traders in the form of margin loans and to
home buyers in the form of cheap mortgages. Since rising stock and home prices are
based on cheap money rather than economic fundamentals, both markets are forming new
bubbles, which will eventually burst and damage confidence again.

Under certain scenarios, the outcome could be worse than a bursting bubble and might
include systemic risk and outright panic. The stock market is poised for a crash worse
than 2000 or 2008. Business television anchors and sell-side analysts are only too
happy to announce each new “high” in the stock market indexes. In fact, these highs
are mostly nominal—they are not entirely real. When the reported index levels are
adjusted for inflation, a different picture emerges. The 2008 peak was actually below
the 2000 peak in real terms. The nominal peak in 1973 was followed in 1974 by one
of the worst stock market crashes in U.S. history. Past is not necessarily prelude;
still, the combination of extreme leverage, economic weakness, and a looming recession
all put the stock market at risk of a historic crash. Any such crash would result
in a blow to confidence that no amount of Fed money printing could assuage. It would
trigger an extreme version of Fisher’s debt-deflation cycle. In this scenario, deflation
would finally gain the upper hand over inflation, and the economic dynamics of the
early 1930s would return with a vengeance.

Another factor that could contribute to a worst-case result is the hidden leverage
on bank balance sheets in the form of derivatives and asset swaps. The concern here
relates not to a stock market crash but to a counterparty failure that triggers a
liquidity crisis in financial markets and precipitates a panic.

The pro-tapering group around Fed governor Stein understands that reduced money printing
may hurt growth, but they fear that a stock market crash or a financial panic could
hurt growth much more by destroying confidence. In their view, reduced money printing
now is a way to let a little air out of the bubbles without deflating them entirely.

In opposition to this view are FOMC members like Fed chairwoman Janet Yellen, who
see no immediate inflation risk due to excess capacity in labor markets and manufacturing,
and who favor continued large asset purchases and money printing as the only hope
for continued growth, especially in light of the recent tightening in fiscal policy.
For Yellen, the money printing should continue until persistent inflation above 2.5
percent actually emerges
and
until unemployment is 6.5 percent or less. Yellen favors continued money printing
even if inflation rises to 3 percent or more so long as unemployment is above 6.5
percent. She regards the risks of financial panic as remote and is confident that
inflation can be controlled in due course with available tools if inflation does rise
too far.

Yellen’s confidence in the remoteness of inflation and in the Fed’s ability to control
inflation, if it does emerge, is based on her application of conventional general
equilibrium models that do not include the most advanced theoretical work on complexity
theory, interconnectedness, and the sudden emergence of systemic risk. On the other
hand, her understanding that inflation was not imminent due to slack in labor and
industrial capacity made her economic forecasts consistently more accurate than those
of her colleagues and the Fed staff from 2011 to 2013. These forecasting successes
added to her credibility inside the Federal Reserve and were important in her selection
as the new Fed chairwoman. As a result, her views on the need for continued money
printing carry great weight with the Fed staff and the FOMC.

It is not surprising that the FOMC members are deeply divided between the contrasting
views espoused by Stein and Yellen. Stein is no doubt correct that systemic risk is
building up unseen in the banking system through off-balance-sheet transactions and
that new bubbles are emerging. Yellen is undoubtedly right that the economy is fundamentally
weak and needs all the policy support it can get to avoid outright recession and deflation.
The fact that both sides in the debate are correct means both sides are also incorrect
to the extent that they fail to incorporate their opponents’ valid points in their
own views. The resulting policy incoherence is the inevitable outcome of the Fed’s
market manipulation. Valid price signals are suppressed or distorted, which induces
banks to take risky positions that serve no business purpose except to eke out profits
in a zero-rate environment. At the same time, asset values are
inflated, which means that capital is not devoted to its most productive uses but
instead chases evanescent mark-to-market gains in stocks and housing. Both continued
money printing
and
the reduction of money printing pose risks, albeit different kinds.

The result is a standoff between natural deflation and policy-induced inflation. The
economy is like a high-altitude climber proceeding slowly, methodically on a ridgeline
at twenty-eight thousand feet without oxygen. On one side of the ridge is a vertical
face that goes straight down for a mile. On the other side is a steep glacier that
offers no way to secure a grip. A fall to either side means certain death. Yet moving
ahead gets more difficult with every step and makes a fall more likely. Turning back
is an option, but that means finally facing the pain that the economy avoided in 2009,
when the money-printing journey began.

The great American novelist F. Scott Fitzgerald wrote in 1936 that “
the test of a first-rate intelligence is the ability to hold two opposed ideas in
the mind at the same time, and still retain the ability to function.” By 2014, the
Federal Reserve board members were being put to Fitzgerald’s test. Inflation and deflation
are opposed ideas, as are tapering and nontapering. No doubt, the Fed board members
start with first-rate intelligence; they are now confronted with opposing ideas. The
question is whether, as Fitzgerald phrased it, they can “still retain the ability
to function.”

■
Confidence

Former Federal Reserve chairman Paul Volcker joined the Fed as a staff economist in
1952 and has witnessed or led every significant monetary and financial development
since. As the Treasury undersecretary, he was at President Nixon’s side when the dollar’s
convertibility into gold was ended in 1971. Appointed Fed chairman by President Carter
in 1979, he raised interest rates to 19 percent in 1981 to break the back of the borderline
hyperinflation that gripped America from 1977 onward. In 2009 President Obama selected
him to head the Economic Recovery Advisory Board, to formulate responses to the worst
economic slump since the
Great Depression. From this platform, he advanced the Volcker Rule, an attempt to
restore sound banking practices that were abandoned with the repeal of Glass-Steagall
in 1999. The Volcker Rule finally got past the big bank lobbyists in 2013. Volcker
correctly perceived the riskiest facet of the banking system and deserves much credit
for working to fix it. No banker or policy maker knows more about money, and how it
works, than Volcker.

When pressed about the dollar’s role in the international monetary system today, Volcker
acknowledges the challenges facing the U.S. economy, and the dollar in particular,
with a kind of been-there-done-that attitude. He points out that circumstances are
not as dire as they were in 1971, when there was a run on Fort Knox, or in 1978, when,
because international creditors had begun to reject the U.S. dollar as a store of
value, the U.S. Treasury issued the infamous Carter Bonds, denominated in Swiss francs.

When pressed harder, Volcker is candid about China’s rise and acknowledges talk of
the dollar being knocked off its pedestal as the world’s leading reserve currency.
But he just as quickly points out that despite the talk, no currency comes close to
the dollar in terms of the deep, liquid pools of investable assets needed for true
reserve-currency status. Volcker is no fan of the gold standard and believes a return
to gold is neither feasible nor desirable.

Finally, when presented with issues such as bonded debt, massive entitlements, continuing
deficits, and legislative dysfunction that suggests the dollar dénouement has already
begun, Volcker narrows his gaze, hardens his demeanor, and utters one word: “Confidence.”

He believes that, if people have confidence in it, the dollar can weather any storm.
If people lose confidence in the dollar, no army of Ph.D.s can save it. On this point,
Volcker is certainly right, yet no one can say whether confidence in the dollar has
passed the point of no return due to Fed blunders, debt-ceiling debacles, and the
precautions of the Russians and Chinese.

Unfortunately, there are growing signs that confidence in the dollar is evaporating.
In October 2013 the Fed’s Price-adjusted Broad Dollar Index, the best gauge of the
dollar’s standing in foreign exchange markets, stood at 84.05, an improvement on the
all-time low of 80.52 of July 2011
but approximately equal to prior lows in October 1978, July 1995, and April 2008.
Demand for physical gold bullion, a measure of lost confidence in the dollar, began
rising sharply in mid-to-late 2013, another sign of a weaker dollar. The foreign currency
composition of global reserves shows a continuing decline in the dollar’s use as a
reserve currency from about 70 percent in 2000 to about 60 percent today. No one of
these readings indicates an immediate crisis, but all three show declining confidence.

Other indications are anecdotal and difficult to quantify but are no less telling.
Among them are the rise of alternative currencies and of virtual or digital currencies
such as bitcoin. Digital currencies exist within private peer-to-peer computer networks
and are not issued by or supported by any government or central bank.
The bitcoin phenomenon began in 2008 with the pseudonymous publication of a paper
(by Satoshi Nakamoto) describing the protocols for the creation of a new electronic
digital currency. In January 2009 the first bitcoins were created by Nakamoto’s software.
He continued making technical contributions to the bitcoin project until 2010, at
which point he withdrew from active participation. However, by that time a large community
of developers, libertarians, and entrepreneurs had taken up the project. By late 2013,
over 11.5 million bitcoins were in circulation, with the number growing steadily.
The value of each bitcoin fluctuates based on supply and demand, but it had exceeded
$700 per bitcoin in November 2013. Bitcoin’s long-term viability as a virtual currency
remains to be seen, but its rapid and widespread adoption can already be taken as
a sign that communities around the world are seeking alternatives to the dollar and
traditional fiat currencies.

Beyond the world of alternative currencies lies the world of transactions without
currencies at all: the electronic barter market. Barter is one of the most misunderstood
of economic concepts. A large economic literature is devoted to the inefficiencies
of barter, which requires the simultaneous coincidence of wants between the two bartering
parties. If one party wanted to trade wheat for nails, and the counterparty wanted
wheat but had only rope to trade, the first party might accept the rope and go in
search of someone with nails who wanted rope. In this telling, money was an efficient
medium of exchange that solved the simultaneity problem because one could sell her
wheat for money and then use the
money to buy nails without having to barter the rope. But as author David Graeber
points out,
the history of barter is mostly a myth.

Economists since Adam Smith have assumed that barter was the historical predecessor
of money, but there is no empirical, archaeological, or other evidence for the existence
of a widespread premoney barter economy. In fact, it appears that premoney economies
were based largely on credit—the promise to return value in the future in exchange
for value delivered today. The ancient credit system allowed intertemporal exchanges,
as it does today, and solved the problem of the simultaneous coincidence of wants.
Historical barter is one more example of economists developing theories with scant
attachment to reality.

Mythical history notwithstanding, barter
is
a rapidly growing form of economic exchange today, because networked computers solve
the simultaneity problem. One recent example involved the China Railway Corporation,
General Electric, and Tyson Foods. China Railway had a customer, a poultry processor,
that filed for bankruptcy, resulting in the railroad taking possession of frozen turkeys
pledged as collateral. General Electric was selling gas turbine-electric locomotives
to the railroad, and China Railway inquired if it could pay for the locomotives with
the frozen turkeys. GE, which has an eighteen-person e-barter trading desk, quickly
ascertained that Tyson Foods China would take delivery of the turkeys for cash. China
Railway delivered the turkeys to Tyson Foods, which paid cash to GE, and then GE delivered
the locomotives to China Railway. The transaction between GE and China Railway was
effectively the barter of turkeys for turbines, with no money changing hands. Cashless
barter may not have been part of the past, but it will increasingly be part of the
future.