One of the most influential thinkers of the 20th century, Milton Friedman developed economic theories that have shaped U.S. political debate for five decades. In a 1970 paper and lecture titled “The Counter-Revolution in Monetary Theory,” he famously stated that “inflation is always and everywhere a monetary phenomenon.”
In other words, Friedman believed that while rising prices for a single item (such as hand sanitizer circa March 2020) might be caused by a spike in demand and/or a depleted supply, economy-wide inflation is primarily driven by changes in the amount of readily available money. Printing more money, without a corresponding increase in the overall output value of the economy, necessarily decreases the currency’s value, with prices rising in response.
If Friedman was right, the U.S. could be tiptoeing on an economic minefield over the next several years. Due to the combination of decreased tax revenues in the wake of the 2017 Tax Cuts and Jobs Act (TCJA) and the need to pump out massive amounts of economic aid during the COVID-19 pandemic, federal deficits are ballooning, with the national debt climbing exponentially as a result.
Such large-scale borrowing by the federal government could set the printing presses churning out bills like there is no tomorrow. Given that there will, in fact, be a tomorrow, it is a good time to take a closer look at both the theories and the realities of monetary growth and inflation.
The Gold Standard: When US Money Meant Something Real
As World War II wound down and its massive economic impact became clear, leaders from over 40 countries met in New Hampshire to hammer out a plan to prevent a global financial collapse. Under the resulting Bretton Woods system (named for the site of the summit), the countries fixed their currencies to the U.S. dollar, which in turned was fixed to the price of gold. Specifically, the “gold standard” stated that the value of one dollar was 1/35 of the value of an ounce of gold.
With the U.S. holding most of the world’s known gold reserves, the system provided temporary stability, but with plenty of complications. Continually adjusting the supply of U.S. currency to match changes in the supply or value of gold, as the Bretton Woods agreement required, limited American economic policy flexibility, along with that of all participating nations.
One of the inherent hazards of the system was the potentially devastating impact of a widespread run on gold. If people and governments around the world exchanged their U.S. dollars for gold all over a short time, it would destroy the entire basis of major currency exchanges. Various measures to restrict gold sales were implemented, but fears of a catastrophic run still grew.
Worse, the belief that the gold standard and traditional management of the economy by the federal government would together serve as a bulwark against large-scale inflation in America proved to be wholly false. By 1971, the era known as the Great Inflation, which lasted into the early 1980s, had begun.
Among the measures considered by the Nixon Administration to stabilize the economy was the implementation of wage and price controls. However, such micromanagement of domestic economic activity and currency value is not particularly compatible with an international, gold-based monetary agreement. When Nixon officially ended the gold standard on August 15, 1971, a troublesome question loomed large:
If the currency of the world’s largest economy no longer has a set value in relation to a commodity universally viewed as precious, what is it actually worth?
Printing Money Without a Basis and Friedman’s Great Fear
The official term for currency created with no clear link to a valuable commodity is fiat money—basically, money by decree. In essence, the modern U.S. dollar is a dollar because the federal government says it is a dollar.
The value of fiat money is wholly determined by the balance (or imbalance) of supply and demand. U.S. dollars will have value only so long as Americans, foreign governments, and international banks all recognize them as valuable, and thus desire more of them.
Fortunately, with or without a gold standard, the U.S. dollar remains a preeminent global reserve currency, meaning that many countries keep a substantial portion of their monetary reserves in dollars. Among many, many complex factors, the sheer size of the American economy is considered a reasonable guarantee of our currency’s enduring value.
Herein lies a huge advantage that the U.S. has over nations with smaller economies, and a key to the prevalence of hyperinflation among struggling countries. For a country whose currency does not serve as a global reserve, expanding the money supply swiftly lowers the currency’s value, because supply massively outpaces global demand. As the money loses values, domestic prices must climb to compensate; a vicious cycle rapidly emerges.
In the end, the success of any decree (monetary or otherwise) depends on the power of the one issuing the fiat. Even in these shaky times, America’s economic power remains vast. Yet does this mean that the U.S. can just churn out new bills by the trillions without consequence? No. No matter how great the demand, if the supply exceeds it, devaluation and inflation will result. In this sense, Friedman’s warning still rings true to at least some degree.
Impacts of Fiscal and Monetary Policy on Inflation
Fortunately, a government can influence the money supply without recklessly firing up the presses. Federal management of the economy divides into two realms: decisions made by the national bank (monetary policy) and congressional taxation and spending decisions (fiscal policy).
Fiscal Policy: Congressional Power of the Purse
In theory, Congress can exert considerable influence over the money supply through taxation and spending legislation. Reducing taxation makes more money available to the citizenry and businesses (“increased liquidity” in financial jargon). Having more cash flowing through the system can lead to business expansions and greater consumer spending, and thus general economic growth. Some leaders claim that thanks to that growth, tax cuts ultimately pay for themselves. However, evidence supporting that claim is spotty at best.
If the economic engines start running too hot (an inflationary trigger), Congress can pump the brakes by raising taxes. Directing the additional revenues toward paying down government debt effectively squeezes the money supply, cooling things down. However, as anyone who has been paying attention for the last, say, 230 years knows, elected officials are much more likely to spend than save.
Present-day economists argue that the right kind of government spending, even at the cost of mounting debt, can serve the overall health of the economy. Returning to theory, well-targeted spending could potentially support the flow of capital through the markets, without actually altering the overall money supply.
For example, taxation might gather up money currently being held by those who have no need to spend it, and, through infrastructure projects, convert those funds into paychecks for those more likely to patronize businesses. Of course, following this path too far in practice leads into the political minefield of wealth redistribution, where many noble intentions have gone to die.
Monetary Policy via the Federal Reserve
If Friedman was right that inflation is all about the money supply, then the Federal Reserve, America’s central banking system, has the greatest power to prevent it. As with fiscal policy, the primary tool at the Fed’s disposal—interest rates—can shrink or swell the available money supply without actually pumping new currency into the system.
Lower interest rates tend to send money into motion by encouraging both consumers and businesses to borrow and spend. If the amped-up activity starts trending toward an inflationary boil, the Fed bosses can raise rates, nudging everyone toward curbing spending and sequestering funds in savings.
Once again, the principles are simple, their application exceedingly complex. One of the many hurdles to overcome in current monetary policy is interest disparity. At present, preferred borrowers can take on debt at very low rates. However, with anywhere from half to three-fourths of U.S. income earners (depending on one’s data source) living paycheck to paycheck, the average American consumer is not seen as a great lending risk these days.
Higher risk means higher interest rates, well above 15% in many cases. As a result, tweaking prime interest rates might only affect some segments of the economy, rather than shaping the money supply as a whole.
Implications of the Trend Toward 0% Interest
For all its legendary tendencies toward profligate spending, the American government does not default on its debts. As a result, the U.S. still boasts an AA or AAA bond rating, even as the national debt soars into numbers that mortals can scarcely comprehend. Such lofty ratings mean a continuing ability to borrow at the best available rates, raising the question, how low can they go?
Traditional thinking would say there is an interest rate floor somewhere not too far below 1%. Yet many national banks around the world have defied that conventional wisdom in the last couple of years, with some lending money at 0% interest. Zero interest has long been the Impossible Dream for borrowers, as it offers a strong likelihood the people and businesses will make money by borrowing.
To understand why, imagine that Jane borrows $15,000 in 2020 at 0% interest, and repays the loan over five years. With no interest, she will pay back to the bank the exact amount she borrowed, $15,000. However, if even fractional inflation occurs over five-year period, the value of the dollar will diminish slightly. Hence, the total value of Jane’s payments will be less than $15,000 in 2020 dollars. Simply by repaying a loan, Jane will effectively turn a profit.
It therefore comes as no surprise that President Trump has been badgering the Fed to push interest rates down further and further, perhaps even down to 0%, so that the U.S. government can refinance its massive debt at a bargain-basement rate. Unfortunately, here again, the practice presents challenges that are not obvious from the theory.
First, the government’s borrowing does not consist of traditional loans like mortgages. The primary borrowing mechanism is bond sales, and most bonds have a fixed term for maturity. Convincing our foreign creditors to cash in their current, immature bonds in order to purchase new ones at 0% interest would indeed require legendary deal-making capabilities.
Secondly, if the Fed does bring the prime lending rate down to the 0% vicinity, there will be no wiggle room left if the economy continues to sag under the weight of the current pandemic and needs further stimulation. If Friedman was right at all about the causes of inflation, it cannot be wise to strip the Fed of much of its monetary control power.
Conclusion: Friedman’s Best Idea, With or Without Inflation
In today’s lingo, if one were to create Facebook pages for Printing Money and Inflation, the appropriate description of their relationship would be, “It’s complicated.” Nevertheless, digging a little deeper into Friedman’s teachings reveals one lesson that will never lose its relevance. Beyond all questions of theory—his own included—Friedman consistently argued for an approach in which economic policies are judged by their results, not their intentions.
Interestingly, Robert F. Kennedy, who would be seen by many as the political antithesis of Friedman, expressed a similar view in a 1962 speech at Japan’s Nihon University, stating that America’s greatest successes come from favoring “experiment over ideology.” True experimentation does not mean recklessly trying any half-baked idea that comes along, but carefully tracking the results of every action undertaken and adjusting accordingly.
With our current ability to gather and analyze data to a degree past generations could not have fathomed, these sentiments are more relevant now than ever. The key question to explore with respect to not only printing money but all influences on the money supply is not who is right, but what works.
As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com
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