You give me a bushel of apples and I give you an IOU. This IOU promises to pay back your bushel of apples, or something else to your liking, in the future. We make this trade, apples for IOU, because you have too many apples and I want apples today. We’re both better off. Apples get consumed that would otherwise be left to rot on the ground.
Why would I take your IOU? Because I trust you. Or you put up some collateral. Or I have legal recourse. Or it’s the Christian thing to do. Or a myriad of other reasons. Why would you give an IOU? Because your apples have not yet blossomed. Because you need apples today to sell apple cider tomorrow. Or you’re hungry and have no other means to get apples. Or a myriad of other reasons.
The Money Supply
We’ve just increased the money supply. Before it was zero. Now it’s a bushel of apples. I could give you an IOU for future delivery of a bushel of apples or for no reason at all. I could give you an IOU for an IOU you received from someone else. The money supply equals the number of IOUs in circulation. The money supply is limitless. We magically expand the balance sheet of the economy (assets and liabilities increase by the same amount) simply by two individuals agreeing to give and take an IOU, for whatever reason.
IOUs are contracts. We design new contracts to encourage new trades. Some bear interest. Some have collateral. Some pay dividends based on the success with which I’m able to use the apples in my cider business. Some have voting rights in my cider business. Some track in value with the supply of apples, going up in value when apples are scarce, down when apples are plentiful. Some are convertible to bushels of pears. Some expire. Derivatives. Detachable movie tickets. Whatever. Each IOU contains a bundle of these rights. Rights bundles are limited in variety only by what suits our needs for trade.
Societies worry about IOUs. When an IOU is deemed less trustworthy, holders demand repayment. Issuers are forced to hold fire sales. The economy tanks. There’s no way to control the quantity of IOUs. I can walk over to my neighbor’s house at Encino and hand him a piece of paper containing many zeros. There’s no way to foresee the next innovation in rights bundles. My piece of paper contains a promise about my first born child. How do we as a society regulate this gelatinous supply of money to avoid fire sales?
Regulators can try to stifle innovation in IOUs traded by financial institutions. They’ll be quickly outflanked. In a global financial world you have no control and you can’t compensate government regulators enough to outwit the financial wizards on Wall Street or in the City. Think whack-a-mole.
The Fed can step in and replace worrisome IOUs with another deemed more trustworthy: trading public for private IOUs. Essentially a loan guarantee. Retroactive, not ideal, but it keeps the economy afloat.
Instead, the Fed should proactively manage confidence in IOUs. Confidence can collapse overnight, leading to a rush for repayment, illiquidity and unstoppable global meltdown. The Fed needs to stay one step ahead of any potential collapse.
Collapse can come down any number of avenues, e.g.:
- the reputation of the issuer
- the soundness of underlying or derivative collateral
- the state of the global economy
- the state of the market in which the IOU is commonly traded.
The Fed must track all avenues. If too many IOUs are being issued the Fed can send a signal to lower prices now, before an inflationary bubble can build. Similar actions are taken for prices too low, issues too low, etc. Each avenue of collapse calls for a unique response. There’s an unlimited number of avenues.
This is not easy. How do you know if a market is ripe for expansion or contraction? If expansion then it’s alright that many more IOUs be issued at a stable price to support the expansion. Low‑priced IOUs can even signal the need for expansion. And vice-versa. It won’t be perfect but having the Fed manage confidence in IOUs is doable.
On Wall Street
The Fed needs to be in the market with its own financial institutions who compete with private firms. These Fed-run institutions are for-profit, global, managed and staffed by private individuals. Market‑compensated, industry-savvy professionals. We make money while looking out for the good of the American people. Should an IOU become overheated we step in and issue more of the same, flooding and cooling down the market. Or we sell hedge contracts to allow smart money to bet against the market. You need to be in the market (day-by-day) to know how to calm the market: to mimic financial innovations and see early warnings of risks to market confidence. And you need exceptional flexibility, smarts, and financial resources to craft timely (proactive) responses.
What’s to keep Fed-run financial institutions from becoming part of the problem? From compounding rather than short-circuiting collapses in confidence? They specialize in counter-cyclical investments. They look to gain on negative news. They’re short traders in long markets. If the market’s betting IOUs will increase in value, they bet on a drop. Most of the time they’re going to lose money but when they win it’ll be big: more than enough to offset a multi-year string of loses. This is a role only governments can play. They make a robust counter-cyclical market, dampening but not crushing enthusiasm for financial innovations.
Banks don’t get to spend money received in exchange for their IOUs, nor will our Fed-run financial institutions. This is not the U.S. Treasury. Fed-run financial institution are profit-making, which is occasionally paid out to its owners, the American people, in the form of dividend checks.