The Magazine

Putting the Toothpaste Back into the Tube

Federal Reserve chairman Ben Bernanke needs to spell out how he plans to head off hyperinflation.

Apr 27, 2009, Vol. 14, No. 30 • By ANDY KESSLER
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So how is Fed chairman Ben Bernanke going to get all that toothpaste back into the tube? The Fed has been cranking money out like water over Niagara Falls. The monetary base has increased by a trillion dollars in just the last six months. And he's not done, furiously printing dollars (bank credits, really) and buying Treasuries in an attempt to flood the economy with dollars. When will it end? $3 trillion? $4 trillion? And then what? A functioning economy doesn't need all that cash sloshing around. Is runaway inflation our next crisis?

Let's go back to fundamentals for a second. Money is a placeholder of value--the price of a cold Heineken or the value of work already done, a hole dug, a piece of software written, whatever. When things work just right, prices seek the right level and we get a match between that cold beer and the sweat from working for it.

Money supply is how much money is floating around the economy to handle all the transactions. No one quite knows how much money is needed. The classic formula is the output of the economy equals the amount of money times the velocity of money, or how many times the same dollar is spent during the year. You buy the beer, the bartender buys beer nuts, the nut farmer buys a Ford pickup truck, the auto worker buys a cell phone, which you the programmer just finished writing the location-based service code for, so you are out celebrating buying a beer and on and on. Of course, no one really knows what the velocity of money is. If times are tough, you may hold off buying that Heineken for a few months, and when times are good you may party every night.

I like to think of the economy as a giant bucket filled with money (money supply) sloshing around the bucket (velocity). We all hope the bucket is filled to the rim. But, in normal times, the economy grows every year. Population increases, too, so the size of the bucket has to grow to handle the transactions of more people who like to eat and drink. So more money needs to be created to fill the bigger bucket. That's pretty straightforward.

But now the hard part. Someone is out there inventing something useful, refrigeration, steamships, ATM machines--something productive that increases the output per worker hour. Productivity increases the size and wealth of the economy above and beyond population growth. How much? Who knows? Still, more money needs to be created to fill the bigger bucket/economy. And to make matters worse, since no one knows what the velocity of money is, no one really knows how much money supply is needed so the economy will work just right. It's virtually impossible to fill the bucket up just to the rim. The Fed has to guess.

As we have all been taught, too much money chasing too few goods creates inflation, the price level goes up above and beyond what it should. That's bad, because you get less stuff for the same unit of work. On the flip side, with too little money chasing too many goods you get deflation, the price level goes down below what it normally would. Hey, you actually get more for your dollar. Woohoo! Except eventually someone is either going to cut your salary or you'll lose your job, because the price is dropping and the economy is smaller. That's bad, too.

Okay, there are lots more moving parts than just a simple bucket, including the size of government, regulations, and not least the taxing of the citizens/serfs. And I don't just mean income tax, state tax, sales tax, gas tax, property tax. One of the easiest ways to "tax" is to debase the currency, just print more and more of it and spend it on chariots and crowns and castles and the Department of Labor. This is why for many, many moons, gold and silver were the money supply. It's the only thing people would trust. They are rare earth elements, which means there is only so much of them. Hence stable money supply. Gold, even today, increases by about 1 percent every year from new discoveries. With a gold standard, money supply would grow 1 percent, which everyone used to think was just right.

But there are a couple of problems with that whole 1 percent business. The new wealth from more gold goes to the miner who found it, and then it starts circulating in the economy so others can use it. Doesn't seem quite fair. Plus, the 1 percent yearly increase in gold and therefore money supply basically covers population growth and completely ignores productivity and innovation, which get stifled because there's not enough money to increase output, even with new tools and inventions. So a gold standard implies a static world. No thanks.