I want to make the case that thinking of money as a product specifically designed to be used as money and produced by a producer is often a useful perspective, and that this perspective remains useful for government created money. From this perspective, the Federal Reserve (a branch of the Federal government) is the producer of US dollars and the Chinese government is the producer of the yuán. This perspective grew out of my ongoing debate with Silas.
It is not difficult to imagine money which is not produced by anyone. An economy that uses pure gold in no particular shape uses money which is not anyone’s product. There might be gold miners, but they do not produce gold for use as money necessarily, and it could be the case that gold is simply found on the ground occasionally. It is also easy to see the drawbacks of such a money. If gold is in nonstandard lumps it must be weighed and purity tested for each transaction. It also means that people must keep a real resource that might otherwise be used for some productive purpose, so it may mean gold is not used in the optimal manner.
One can ameliorate some of these problems by using a similar but separate product specifically designed to be used as money. A sedan is serviceable for transporting lumber, but a product specifically designed for the task, such as a truck, is much better. Perhaps some bank or government will start minting standard weight and purity gold coins specifically to be used as money for a fee, and people will come to prefer using these coins to gold lumps, perhaps trading at a premium to gold lumps. Now these coins have become different product from gold lumps. The bank takes gold lumps and produces gold coins that have extra properties. These coins can meaningfully said to be the product of that bank or government and not the product of any other bank or government even if competitors produce very similar coins.
If such coins are to succeed it is important for it to bear the bank or government’s name or be otherwise branded. If the coins are not branded or brands are not respected, then it is easy for counterfeiters to ruin the product by producing similar but lower purity coins. However, it is important to distinguish between counterfeiting and merely competing products. A rival bank or government who mints their own coins with a different brand has produced a separate product, much as Gucci bags are not counterfeits of Chanel bags even if they look similar. If a competitor with a different brand produces lower quality coins, they will just ruin their product no one else’s.
This perspective applies very well to government monies. All government monies that I have seen bear a brand of that government (US dollars say “Federal reserve note”), and other people are not allowed to produce money with that brand. Some countries, including the US allow competitors, and some countries do not (link). Most central banks, including the Federal Reserve, turn a profit from their activities.
Most methods of improving a non-product money will involve making money into a product, for the same reason that most methods of improving wild tomatoes as a food source involve making tomatoes into a product. It is almost certainly optimal for most money to be product money.
One implication of this view is that it is meaningful to talk about the optimal level of money production by a bank or government, for the same reasons it is meaningful to talk about the optimal level of bread production by bread producers, there will be some level of production that maximizes welfare (and/or producer profits depending on your optimization criteria).
Another implication of this view is that government produced money is not necessarily special. It is possible that it is special because private producers can’t commit to appropriate production or because money production has some externality that private producers do not take into account, but this is something to be demonstrated rather than true a priori.
Common errors
One common trap people fall into is assuming that government paper money is fundamentally different from other kinds of money, say gold coin money, without stopping to examine the issues closely. If this is a strongly held belief for them, it can make reasoning about how government paper money is and is not different from other money difficult for them.
One common claim is that government paper money is fundamentally different from other kinds of money because it is “inherently valueless” or “not backed”. It’s possible for something like this to be true, but it’s also not necessarily so. It’s important not to try to reason too much from these ideas until we have a solid theoretical understanding of monetary economics and what it means to be “unbacked”. For example, it’s definitely not the case that government paper money is always worthless in the conventional economic sense, people often hold such money and use it how they would use any other kind of money, so people must value it.
It’s OK to have an intuitive distrust of government paper money, but it should remain merely intuition until concrete objections can be explained. It is important to start from the basics and not make distinctions, especially distinctions which have connotations, before you understand why there is a distinction to be made.
Readers with this kind of intuition may find it useful to think of a private producer of money that operates very similarly to how the US Federal Reserve system operates (the US Federal Reserve is profitable and contributes its profits to the general fund) instead of a government run supplier. This will help see the similarities and difference between different kinds of money and to stop seeing government money as inherently special.
Good Morning, Economics 
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April 27, 2011 at 1:13 pm
Kellen Cheney
Very good. Would it be a stretch to say that a Federal Reserve note, though fiat, has a de facto backing of debt since it is created by being loaned into existence, not just by the Federal Reserve system (not sure that I agree that the Federal Reserve is a branch of government) but also by the fractional reserve banking system?
April 27, 2011 at 1:54 pm
jsalvati
I don’t like to bring fractional reserve banking into the matter because as far as I can tell, it doesn’t fundamentally change monetary economics. You can think of bank created money as a technology for working with smaller amounts of Federal reserve money, analogous to ATMs.
Anyway, I don’t like the term ‘backed’ very much because really it comes down to expectations about money supply vs the demand for money, but in a sense you are correct. The bonds that the Fed gets when they trade newly minted money for bonds (open market operations) makes the Fed’s promise to keep the value of the dollar relatively stable more credible because it makes it easier for the Fed to do the reversed trade if necessary.
April 27, 2011 at 2:27 pm
Kellen Cheney
I agree with you on the “backing” issue. The problem I see, although I may be wrong, is that with compounding interest coupled with money supply vs the demand for money, larger and larger amounts of liquidity must be injected into the system. This doesn’t really give a lot of wiggle room to work with as debts compound higher and higher. It compromises the unit of storage in paper money as inflation eats away at savings faster and faster, even with reverse REPOing and any other currency manipulation tricks the fed may impose. That is the big problem I see with the way money is currently created in this system by being loaned into existence (quantitative easing aside since that is essentially interest free) and with fiat money as a unit of storage in the current system, but I could be wrong. I know I am not mentioning every aspect of the whole system, but that is how I view it in a nutshell. What are your thoughts?
April 27, 2011 at 3:38 pm
jsalvati
You are confused about how the monetary system works. I think this is perfectly understandable because I once was confused in (possibly) similar ways. One of the reasons I got interested in this topic was that it seemed like the process you described was inevitable and any kind of money creation should lead to hyperinflation, but the system seems pretty stable in practice.
The Fed is actually *profitable*. The fed creates a special product that people find useful (money). They do that by printing promises and trading them for bonds which they hold to make their promises credible. The money pays an interest rate i0 and the bonds usually pay a *higher* interest rate i1. This is the fundamental source of the Fed’s profits. The interest the Fed gets is its revenue, part of it is profit and part of it is used for expenses (employees printing presses etc.). The principle repayments the Fed should be used to maintain a quantity of bonds equal to the amount of money in the economy (in practice they are not, but it’s not terribly problematic because the government will give the Fed money if it really needs it (by necessity this will be a high inflation time)). The Fed can easily keep the money supply constant this way, continuing to earn a profit on the bonds it holds. If the Fed keeps the money supply constant, it receives more money from interest and principal payments than it needs to pay out in interest on money, expenses and bond purchases ( to maintain its stock of bonds). What’s leftover is it’s profit.
One interesting consequence is that it’s totally possible to have a private monetary system with a private central bank(s), and there have been. The only major issue is that the private money issuers might not be as credible about maintaining a reasonable value on their currency as the government is. I often find it useful to think of the Fed as a business that the government owns (like a government owned bicycle shop) rather than a fundamentally government-like activity.
Does clarify things for you? (don’t tell me it does unless it actually does; if I didn’t do a good enough job of explaining, I want to try harder).
I urge you not to use the word ‘liquidity’ when you mean ‘money’ (lots of economists do this and I don’t think it’s a good idea when they do it either). Liquidity is a technical financial term, and its economics are fairly complicated. It’s obviously related to the economics of money, but I think you can largely avoid it and still do a lot of interesting monetary economics.
April 28, 2011 at 3:52 pm
Kellen Cheney
I understand how the Federal Reserve and monetary system are supposed to work in principle and on paper, but I do not believe that is how it really works in the real world, especially in the last 3 years since Quantitative Easing began.
There seems to be a common theme or idea going around that this traditional “on paper” Federal Reserve idea can return and that Quantitative Easing is a transitory. That the Federal Reserve can continue debt monetization simply by rolling back and extending maturing debt, that there is some sort of viable exit strategy.
http://www.federalreserve.gov/releases/h41/Current/
Looking at the Federal Reserve holdings, there is nearly $184B in maturing securities on the fed balance sheet (mortgages, treasuries, etc). This is a over 1/10 of the ongoing debt monetization of $900B, or $1.84T. So you do the math for the ongoing Quantitative Easing Program if the 1 year maturing holdings were to be used..The Federal Reserve has no choice but to continue with QE3, then 4, then 5, then 6, then 7 and so on. It is already priced in, as there is no viable alternative and no one is going to pick up the slack in the treasury market if the fed were in “exit”. This is precisely why I think treasuries are in a bubble, as Mortgage Backed Securities (which is the wild card for roll-backs, but as you probably know it depends on the mortgage rates which depends on the 10 year yield) and other toxic assets were moved onto the Feds balance sheet. QE is now an essential part of the Federal Reserve and Treasury circle jerk with no viable alternative in sight. The housing debt bubble has simply been moved into government backed securities and treasuries (not just here in the US, but globally) Understanding this, you understand that it has simply become a huge ponzi and kite scheme. (I prefer Treasury and Fed circle jerk). Precisely why I think this system will eventually end in hyperinflation…The fed has fired all its bullets and is waving an empty gun around.
April 28, 2011 at 3:53 pm
Kellen Cheney
P.S. The $184B is supposed to say in maturing securities within the next year*
April 28, 2011 at 4:41 pm
Kellen Cheney
And when does the Federal Reserve ever keep the money supply constant? And how does the government merely “give” the federal reserve money when it needs it fast? This all seems hypothetical and not actually what is really happening. I think we have fundamentally different views on what the Federal Reserve is as an entity and how it is truly functioning, for instance I don’t view the fed as being owned by the government at all. More of a symbiotic relationship.
May 31, 2017 at 10:28 am
http://goanalyze.info/usaid.gov
Jeg har det på samme måde. Er meget betaget af farven men den virker næsten farlig at indtage? Men når der nu er skovbær involveret kan det vel ikke gå helt galt? :)-Christina
April 28, 2011 at 5:20 pm
jsalvati
OK, cool.
I’m not sure if/how this relates to the previous topic. But here goes:
As I read your expectations, they’re not very consistent with efficient markets. Market inflation expectations are actually lower than typical.
As a side note: I actually think that QE *should* be permanent, any QE done over the amount that could be permanent shouldn’t have been done in the first place. Basically, the Fed should have done regular monetary policy with slightly different instruments (other than the very short term bonds normally used).
Keep in mind that expected future changes in the Fed’s demand for bonds “being priced in” means it can’t be causing a bubble! The expected price conditional on expected Fed actions is the current price; that’s the EMH. If bond prices are high because people expect QE to be permanent, that’s not a ‘bubble’ that’s accurate pricing reflecting a new reality.
If QE is permanent, it doesn’t mean an accelerating money supply; it means the past increase in the money supply doesn’t go away. If you like we can go through the math on that, it really does work out. Even if you think QE was a bad idea, there’s no getting around the fact that it’s sustainable. By itself it’s not going to lead to an accelerating money supply.
As for the government owning or not owning the Fed. Consider a world where the government has a monopoly on shirt production. Regardless of how the government goes about producing shirts, I think its useful to think of their shirt production operations as a (poorly managed and monopolistic) business owned by the government; shirt manufacturing is a self sustaining business and not inherently a government activity so it’s productive to think about it independently of the rest of the government. I think viewing the Fed as a business owned by the government is useful for the same reasons. The analogy is fairly close in practice, the Fed is literally profitable and gives its profits to the US government like a corporation owned by the government would; the government also typically doesn’t micromanage the Fed the same way stock owners don’t micromanage the corporations they own.
February 24, 2012 at 6:06 pm
Anonymous
Wow its been a while…
You’re T shirt analogy was helpful. However I think the only way that analogy would work is if in addendum to; “I think its useful to think of their shirt production operations as a (poorly managed and monopolistic) business owned by the government; shirt manufacturing is a self sustaining business and not inherently a government activity so it’s productive to think about it independently of the rest of the government.” Is to add that the the t shirt factory is also the only business buying its own t shirts (save maybe 20-30%), Just like the fed buying roughly 70%-80% of it’s own debt. (of course this is overlooking middle men for the fed buying US debt, bond flippers and primary dealers.)
As for “If bond prices are high because people expect QE to be permanent, that’s not a ‘bubble’ that’s accurate pricing reflecting a new reality.” I guess that makes sense except for the new reality part. The expansionary monetary system will just keep expanding towards infinite until people completely lose faith in the system, which has happened with nearly every single fiat system in history.
I understand what you are saying about QE and other ZIRP not causing a large increase in monetary velocity and I agree. The banks are literally collecting interest on bank reserves and not lending; to keep the balance sheet of the fed expanding without a noticeable increase in inflation…but how long can that last? QE might not be increasing velocity, but it is certainly setting the stage a potential enormous increase in velocity.
If you don’t think treasuries are in a bubble, or that QE is also causing a bubble in the treasuries, just consider this analogy. Let’s say you are China, and you purchased almost $800B in US debt via explosive economic growth for a decade. You turn on the TV and see Ben Bernanke announce QE2, and the purchasing of $700B treasuries by pressing (ctrl + p), would you not think that was a bubble? As global demand for treasuries (except possible short term) notes continues to sink, and the fed fires up the printer and bond prices increase at the same time, that is not a bubble?
February 24, 2012 at 7:56 pm
John Salvatier
Is this … Silas? Alden?
1) I don’t think the fact that the Fed (the Fed as in the Federal Reserve, not the federal government) is a large holder of US bonds these days is super relevant. The Fed happens to use US government bonds as its raw material for producing its product (dollars), but it could use other assets too. The Fed could decide to manufacture dollars from a basket bonds from governments around the world or an SP 500 index based asset or Nominal GDP futures or physical gold bars. Additionally this decision is separate from its decision of what to “target.”
Thus I don’t think it’s useful to say the Fed is the largest consumer of its own product.
2)
I think of ‘Bubble’ as referring to something pretty specific: when because of irrational agents in the marketplace doing something stupid some asset is overvalued. I think you’re inadvertently conflating this process, which is clearly bad, with something like the “the price of asset A is higher than it would be if agent G did X instead of Y and I think Y is worse than X”. I’d much rather argue about the goodness/badness of G doing X vs Y directly than argue about it indirectly via arguing about whether asset A is in a bubble.