“Cook, little pot, cook!” Why you can have too much of a good thing

Ronnie Lipschutz, CLNI 91, Spring 2009

What are the sources of the current economic crisis?

Money!

http://video.google.com/videosearch?hl=en&q=joel%20gray%20money&gbv=2&ie=UTF-8&sa=N&tab=iv#

Global capitalism has long moved goods & money around the world

It’s not a new phenomenon

This is now having some unfortunate consequences

Bankruptcies, bailouts and boondoggles…so what happened?

Money is a transferable store of value that we can use in exchange

• It is portable (as opposed to having to carry around things for barter)

• It may have “intrinsic “value” in the sense that it is made of “valuable” stuff

• It becomes the basis of pricing goods• Makes it easy to compare values• Should possess enduring value

Why do we accept money in exchange for things?

• Consensual agreement on the value of its contents or its intrinsic value

• People seem willing to accept money as payment for stuff

• It becomes the basis for all kinds of transactions and assessments

• Someone is willing to guarantee its value

A reserve currency is the equivalent of metal content, which everyone accepts as legal money

The country providing the reserve currency can exercise seigniorage and print as much as it wants to

The 19th century gold standard

Countries had to peg their money supplies to their gold supplies (or silver, if that was the monetary base)

The 20th century gold exchange standard

Dollars were backed by gold at $35/oz, but not exchangeable for gold by U.S. citizens

Note that the money supply grew to about $500 billion by 1970

Today it is in excess of $10 trillion (perhaps much more)

Decline and fall

Because gold supplies were limited, money supplies could not expand, limiting trade and economic growth; the dollar supply was backed by only $10 billion in gold in Fort Knox (at $35/oz)

The market-based exchange standard

When too many dollars were backed by too little gold, exchange rates came under pressure; Nixon eliminated gold backing which allowed the supply of dollars to grow with fewer constraints

Inflation undermines value of money

• Price of a Mounds• 1920-45: 5¢• 1945-70: 10¢• 1970-80: 25¢• 1980-90: 50¢• 1990-2008: 75¢+

Inflation can arise from two sources

Too much money chasing too few goods—people are willing to pay more

Deliberate increase in the money supply to increase liquidity or reduce debt

Asset inflation can also occur

If too many people try to liquidate their dollar-based assets too rapidly, the price can collapse

Under the classical understanding of economic accounts•Consumers spend savings or surplus income—not equity

•Consumers stop spending when these are exhausted, or they borrowfunds in credit markets

•The government gets revenues from taxes

•If spending exceeds taxes, the government must borrow from credit markets

•To pull funds into credit markets, interest rates must be sufficiently high

•If interest rates are too high, they will squelch consumer spending and other economic activity

•The economy will go into recession, employment & income will decline, and tax revenues will go down

•How can the economy be restored?

•Through Keynesian pump-priming or

•Fiscal discipline—squeeze the economy

This pattern began to change in the 1990s

• Cheap imported goods low wage pressure low inflation

•Dollar flows abroad China & others buy Treasury bonds loans to government for defense & wars

•Foreign reserve overhang unpayable IOUs declining dollar investment in other currencies

•Low inflation Low interest rates consumer borrowing rising real estate prices assetinflation

•Housing bubble higher returns than Treasury bonds Mortgage bundling selling & speculation

•To maintain inflow of dollars requires higher interest rates; to reflate the economy requires lower interest rates

What gives value to money today?

What it can buy? What others are willing to pay for it?

And, of course, there has to be money to spend (credit crunch)

And what is going to happen?

• Banks are sitting on vast quantities of CDOswhose market value is highly uncertain

• Institutions have guaranteed trillions in credit default swaps that they cannot redeem

• So, everyone is sitting on their money to see whether they are insolvent or if they can get their hands on more

• The more money in the system, the more liquidity, but also inflation becomes a threat