Enough of This “Out of Thin Air!” Stuff

Have you ever said something like “Let me buy you a beer next week”?
I’m sure you have. We all issue promises of this sort. And we frequently use such promises as a form of currency. For example, we might say something like “Hey, why don’t you give me a beer now…and let me buy you a beer next week?”

I have just described a simple credit exchange. Societies rely heavily on promising-making and promise-keeping. It is the foundation of all financial markets.

I’d like to point out something about the promises you make. They are made “out of thin air.” The promises that other people make are also made “out of thin air” (including politicians like you-know-who). Oh, some may write the promises down in the form of IOUs or other legal documents. But really, as Chamberlain discovered on his return from Germany, we know the intrinsic value of paper (promises).

The fact that promises are made “out of thin air” does not mean they are worthless. The value of a promise is determined by the perceived (and ultimately, actual) credibility of the promise-maker to make good on his/her promises. The relevant concern of those who rely on financial agencies is the credibility of they claims they make. The fact that financial agencies issue promises “out of thin air” is a red herring. And if the charge is made with exclamation, well…forgive me for suspecting that the motive is to arouse impassioned anger, rather than rational discourse.

The Fed creates fiat money (yes, out of thin air). But fiat money in itself does not constitute a promise against anything in particular (on the other hand, there are those who argue that it is a promise to discharge a tax obligation). In a gold standard regime, a Fed note would constitute a claim against gold. But we do not presently live in a gold standard regime. So what sort of promise underlies fiat money?

Apart from any intrinsic value determined by its ability to discharge a tax obligation, the value of fiat money ultimately hinges on its scarcity. More precisely, it depends on how its supply is managed over time. Or even more accurately: it depends on the expectation of how its supply is to evolve over the indefinite future. This expectation hinges critically on the credibility of the money supply manager.

In our current regime, the Fed is (implicitly) promising to keep inflation centered around 2% per year. The actual inflation rate dipped considerably below this number during the past recession and it is now considerably higher (owing largely to the boom in commodity prices). But if one draws a trend line through these ups and downs, we’re basically sitting close to 2%.

Now, we can argue at length about whether 2% is the right number. The Fed calls 2% “price stability,” but clearly it is not price stability in a literal sense. The real rate of return on non-interest-bearing money is -2%. This is currency debasement; albeit, at a rather slow rate relative to the 1970s or Zimbabwe’s recent experience. Price-level stability requires an inflation rate of 0%. The Friedman rule suggests that a moderate deflation is desirable.

Anyway, back to my main point. Which is that condemnations of the Fed based on charges of creating money “out of thin air” are off the mark. The discussion should instead center on whether the Fed, as currently construed, is an institution that can be trusted to make good on its promises. This is the same question one would ask of any agency, public or private.

And if the Fed is abolished, and then what? What replaces it? A gold standard? Here is what one person wrote to me on the subject:

And yes, a gold standard would be fine by me. Is there an argument against the gold standard that I don’t know about? Also, as an example of hyperinflation, how about when Roosevelt rounded up everybody’s gold in 1933, and then debased our currency by 50% ?

I think this highlights a point that I have been trying to make for some time now. The “gold standard” is nothing more than a promise made “out of thin air” by the government. Look at how easily Roosevelt abrogated that promise in 1933. What makes people believe that the same thing cannot happen again? (Related arguments apply to so-called “free banking” regimes.)

Sure, we might say that such acts are or should be prohibited under the Constitution. But the Constitution is also a document that has been fabricated “out of thin air.” I have been told by some that the existence of the Fed is itself a violation of the Constitution. So you see how easy it is to violate that venerable document.

Imagine that it is somehow possible to make the gold standard credible and absolute. If this is possible, then it must also be possible to make a fiat money standard credible and absolute. Just replace the gold with fiat tokens. As a bonus we would have an efficiency gain (commodity monies are better utilized as commodities, rather than exchange media).

So, please, enough of this “out of thin air!” stuff. It’s tiresome for those who know better, and distracting for those who do not. Let’s divert attention to more substantive issues.

For example, the Fed has a legislated monopoly over the supply of small-denomination paper. Is this a good idea? What if we keep the Fed as is and allow free-entry into the business of money creation? If an unfettered private money system works well enough, it might drive Fed notes out of circulation. On the other hand, perhaps the demand for Fed paper will remain. Government paper (in the form of US Treasuries) drove out private money (AAA tranches of MBS) in the repo market in the past financial crisis. Now, isn’t that interesting?

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About David Andolfatto 95 Articles

Affiliation: Simon Fraser University and St. Louis Fed

David Andolfatto is a Vice President in the Research Division of the Federal Reserve Bank of St. Louis. He is also a professor of economics at Simon Fraser University.

Professor Andolfatto earned his Ph.D. in economics from the University of Western Ontario in 1994, M.A. and B.B.A. from Simon Fraser University. He was associate professor at the University of Waterloo before moving to Simon Fraser University in 2000.

His current research is focused on reconciling theories of money and banking. His past research has examined questions relating to the business cycle, contract design, bank-runs, unemployment insurance, monetary policy regimes, endogenous debt constraints, and technology diffusion.

Visit: MacroMania, David Andolfatto's Page

2 Comments on Enough of This “Out of Thin Air!” Stuff

  1. David – do you think the idea you’re suggesting sound a bit interventionist considering what has happened?

    I’m simply curious if you considered why your illustration suggests TARP funds. The issue I see is that the cause of exotic mortgages was through deregulation of Glass Steagall – a consolidation of financial services into mega conglomerates. Derivatives onlyserved to speed up the reaction.

    Thus the concept of too big to fail became real dialogue in the daily discussion. Am I mistaken?

  2. “So, please, enough of this “out of thin air!” stuff. It’s tiresome for those who know better, and distracting for those who do not. Let’s divert attention to more substantive issues.”

    When you’re talking about money, there is nothing more substantive than the substance of money, and to assert otherwise is to negate the concept of substance as such.

    If the ultimate grounds of reality are not to be found in natural substance, but in arbitrary assertion, then this leads to an endless regress in the search for a new material to function as the ultimate ground in a new hierarchy of substantiality.

    And since one man’s arbitrary assertion is as good as another’s, no basis need exist for agreement.

    How well a given money can work as money is determined by the natural kind of thing it is.

    The law of identity applies to money, just like everything else.

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