Thursday, February 07, 2013

Money Is Magic

-- Posted by Neil H. Buchanan

The Yap Islands are famous among economists for their stones.  Generally speaking, economists have no interest in anthropology or history -- or, for that matter, in any interdisciplinary discourse at all.  (See, for example, this full-throated hymn to the glories of economics and its supposed superiority over all other social sciences.)  The Yap stones, however, serve a useful role in explicating the logic of money (without challenging any of the key assumptions underlying orthodox economic theory), which allows economists to tell the story without guilt.

The Yap stones were a form of money.  Like any other commodity-based money, the stones were used to transact business, with the stones themselves not being fundamentally useful.  (They were shiny, so people liked them.)  Unlike other forms of commodity money, however, the stones were enormous.  Rather than putting a few seashells or gold coins in one's pocket, owners of Yap stones found themselves in possession of heavy stone disks that could be as much as 12 feet in diameter.  At some point, therefore, it made sense to carry out transactions while leaving the disks where they were.  A person could buy some food from another person, for example, and then they would both agree that one of the stones had changed hands (even though it had not changed location).  At that point, partial ownership of stones becomes possible as well, allowing a person to transfer ownership of any fraction of the stone as part of a transaction.

Much of the now-standard economic story on Yap stones might well be embellished, but the core idea is that the stones themselves can ultimately become irrelevant.  A person does not need to see the stones, so long as she thinks that everyone will agree that she owns the total amount of stones that she thinks she owns, and that she can use her ownership in the stones to buy things that she values.  The islands' money, which seems to be based on the most physically substantial of all commodities, turns out to be based on a group-think that allows people to say that they own something that does nothing useful, that never moves, and that might not even exist.

Turning to a more modern form of anthropology, consider The Beverly Hillbillies.  For those Dorf on Law readers who have never watched reruns of 1960's sitcoms, that show revolved around the Clampett family, who struck oil in their Tennessee hollow, making them multi-millionaires.  Every few episodes, their net worth would be mentioned, and the number was always rising.  (In current dollars, they would be billionaires.)  In one episode, they ask their banker if they can see their money, so their nephew Jethro can count it.  The banker, Mr. Drysdale, says that they can go to the vault and see a few hundred thousand dollars, but there is no way he can gather $30-$40 million in one place.  The Clampetts conclude that Drysdale has stolen their money.

In my last two Dorf on Law posts (here and here), I have gotten into some of the details (perhaps too deeply into the weeds, in fact) of how modern finance works.  The fundamental problem, however, is quite simple: Money is magic.  As one of my research assistants put it: "We really want to look into the safe, but there is nothing there." 

We are trying to figure out whether the President could avoid default, if the usual method by which the Treasury pays the government's bills becomes unavailable.  In my post last Friday, I discussed the possibility of having the President order the printing of currency, as a work-around when the Treasury's checking account at the Fed is empty.  I argued that the public's reaction to the introduction of "illegal money" into circulation would be catastrophic, because everyone would start trying to figure out whether they have "real dollars" (bills printed legally) or "funny money" (bills printed only on the President's authority).  I further suggested that the existence of any funny money would undermine people's confidence in the value of all money, because of the group delusion dynamic that underlies all money (whether fiat currency, gold, or other commodity-based monies).

Recall, again, why this would be illegal in the first place.  Congress has the authority to coin and regulate money.  It delegates that authority to the Fed.  Congress also authorizes the President to mint coins, and a lacuna in that law is the basis for the current confusion over whether platinum coins are different.  (They aren't.)  Setting that aside, however, Congress tells the President what kinds of coins can be minted, and in what amounts.  Similarly, it tells the President what bills can be printed by the Bureau of Engraving and Printing.  The President cannot, on his own authority, print more money.
This means that printing illegal currency would be both illegal (which is unsurprising, given that this entire analysis springs from asking what the President should do, when he has only illegal choices) and economically dangerous.  On Tuesday, I mentioned that there is also a fun logistical issue hiding in the background, which is worth thinking about here.

In the U.S. (as in all countries with modern financial systems), actual physical cash is less and less important as a means of transacting business.  Under a broad definition of the money stock (M2, for money geeks), there is currently about $10.5 trillion in money circulating in the U.S.  Only $1.1 trillion, or a bit more than 10%, is in the form of cash.  Everything else is electronic accounting entries that everyone accepts as being money.  The President's legal authority to print limited amounts of cash is actually not part of the process of deliberately increasing or decreasing the overall money supply, but is rather a mechanical matter of replacing old bills as they wear out.  (A one-dollar bill has a life expectancy of less than two years.)

Suppose that the President is faced with a binding debt ceiling, and he decides (ignoring my argument above, regarding public confidence in the value of money) that the least bad illegal path is to issue more currency.  If the impasse lasts for a month, he might have to print about $50-$100 billion.  With $100 bills being the largest currency in circulation (since 1969), and with $1 million in hundred-dollar bills weighing about 22 pounds, $50 billion would add up to 550 tons of currency.  One imagines the Treasury sending out pallets of currency to pay its bills, along the lines of the military planes that dropped billions of dollars into Iraq in 2003-04.

At this point, consider not just the sheer physical size of the mountain of money, but the scale of the effort to put that money into the hands of the government's obligees.  People prefer to use direct deposit, because they need not worry about having their checks stolen from the mail.  Now, we are talking about sending cash through the mail.  That obviously would not work, unless we turn letter carriers into Brinks Truck drivers.  It is easy to picture a new wild, wild West (yes, another reference to 60's TV), with concerns about how to guard cash suddenly becoming a major drain on the country's economic resources.

Of course, the government's obligees could agree to receive payment in other forms.  They could, for example, allow the payments to be made in larger bills.  Even though there is no official $1,000,000 bill, a military contractor who is owed $50 million in a given month might be willing to receive 50 illegal versions of those in a given month, rather than demanding 500,000 Benjamins (weighing half a ton).

But what could the recipient do with the million-dollar bills?  The bills are illegal, so banks would have no reason to accept them.  There is very little that one can do with a large-denomination bill otherwise.  (Maybe buy a Slushee at the Quik-E-Mart, and ask Apu for change?)  At that point, it would simply make sense for the recipient to agree to be paid later, with "real money."

When later comes, of course, the real money is as unreal as ever.  People would actually be happier with non-physical money, because what really matters is being able to write checks and use credit and debit cards as usual.  Moreover, this is now little more than a disguised default -- essentially the same as issuing scrip, which I discussed a bit last month (here and here).  That might be clever cover, but it would not change the fundamental fact of default.

Therefore, as I described in Tuesday's post, everything becomes much easier if the Fed plays along.  The Fed is the magician, creating money out of thin air.  Without that sleight of hand, people are left with stacks of paper (or worse).  None of the alternatives avoids default.

However, the Fed's credibility (and political independence) is on the line, because this is a magic trick that needs to be ignored to be most effective.  Having the Fed act illegally -- and even worse, having it openly engage in absurd tricks, such as the Big Coin gambit -- risks making it impossible for the Fed to do its real job.  That job is nothing less than making sure that the economy can function at all.  Which means that the Republicans' debt ceiling brinkmanship is even crazier than it looks.