Zimbabwe suffers from inflation of about 231 million percent a year. (Roughly, 5.5% a day.) There are many reasons for this, the most obvious being that the government keeps printing money. Like other goods, the value of money depends on the interaction of supply and demand. If the world is flooded with dollars, dollars fall in value.
The traditional first step toward slowing or stopping inflation is to stop printing money. Zimbabwe's central bank had a different idea... they'll keep the presses running, but the money will be printed with a built-in expiry date.
Very clever, even if didn't work.
Friday, February 6, 2009
Do banks create money?
(This is Tuesday's post, delayed due to midterms.)
There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.
The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.
Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.
Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:
"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"
The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.
There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.
The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.
Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.
Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:
"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"
The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.
Thursday, January 29, 2009
Overlapping generations... of jellyfish
So there's an immortal jellyfish...
Theologians and philosophers must be having a field day. Economists? I'm worried about whether the jellyfish pension system is fully-funded or pay-as-you-go.
Theologians and philosophers must be having a field day. Economists? I'm worried about whether the jellyfish pension system is fully-funded or pay-as-you-go.
Tuesday, January 27, 2009
A fun-to-read primer on banking and finance
19th century citizens were as bewildered and dismayed by 'modern' finance as we are. Enter Walter Bagehot, man of letters and editor of The Economist, who decided to clear up the confusion by writing a down-to-earth guide on what really goes on in the money market. His classic, 'Lombard Street', is surprisingly relevant and brisk reading today. The full text is available online.
For modern audiences, I recommend the following chapters:
1. Introductory - this chapter shows how a money market, for all its faults, can be of benefit to a country. It also explains how fractional reserve banking works.
2. A general view of Lombard Street - explains how reserves are managed by the central bank and other banks. This is done for both gold-standard and unbacked, fiat currency.
5. The mode in which the value of money is settled in Lombard Street - the title says it all. This short chapter explains how the value of money is determined in a money market, and goes into detail about exactly how much power the central bank has in this regard.
6. Why Lombard Street is often very dull, and sometimes extremely excited - this chapter explains business cycle fluctuations: booms and busts, good times and recessions. All from the point of view of the money market, of course.
The rest of the (short) book, while very interesting, relies too much on the particular circumstances of the time and country in which it was written for me to be able to recommend it as general reading.
For modern audiences, I recommend the following chapters:
1. Introductory - this chapter shows how a money market, for all its faults, can be of benefit to a country. It also explains how fractional reserve banking works.
2. A general view of Lombard Street - explains how reserves are managed by the central bank and other banks. This is done for both gold-standard and unbacked, fiat currency.
5. The mode in which the value of money is settled in Lombard Street - the title says it all. This short chapter explains how the value of money is determined in a money market, and goes into detail about exactly how much power the central bank has in this regard.
6. Why Lombard Street is often very dull, and sometimes extremely excited - this chapter explains business cycle fluctuations: booms and busts, good times and recessions. All from the point of view of the money market, of course.
The rest of the (short) book, while very interesting, relies too much on the particular circumstances of the time and country in which it was written for me to be able to recommend it as general reading.
Friday, January 23, 2009
An early beer ad
Advertising jingles are not new. Watkin's Ale is a beautiful beer ad from 1580, often played in concert by early music groups. Then, as now, sex sells: the ballad is a description of how a maiden surrendered her virtue for Watkin's Ale, finding it a fair trade.
Thursday, January 22, 2009
The economics of a simpler time - a reading list for reformers
It's not unusual for people fed up with the current world economy to suggest that we move back to a simpler time - one without easy credit, strict controls on interest rates (or their abolishment), a gold-backed currency, and without a focus on growth or rampant consumerism.
This is not an impossible dream. The option IS on the table... with a catch. Whatever benefits there may be from such a move come at a cost. If a country, culture or society is to make such a decision, it is very important to know exactly what the benefits and drawbacks of a 'simpler' system are.
As it happens, some of the finest economic minds in history lived during such an age, and left detailed analyses of their world to posterity. Anyone seeking economic reform or an overthrow of the current system will be well-served by reading what they have to say. (When doing so, keep in mind that some things HAVE changed. The 19th century did not have access to air travel, refrigeration or the internet.)
Here's my suggested reading list, with a few comments:
1. Thomas Malthus, 'Principles of Political Economy'. Reverend Malthus is best known for his essay on population, but he was a remarkably capable economist with a strong focus on sustainability, centuries ahead of his time. This is an outstanding basic economics text, covering a wide variety of subjects with humility and an enjoyable style of writing.
2. David Ricardo, 'Principles of Political Economy and Taxation' - Ricardo wrote this book under protest. Despite that, it turned out to be an important early investigation of what determines rent and taxes. Some of it is just plain wrong, but all of it is thought-provoking. Also, it's very short. It makes an excellent companion to Malthus, since the two refer to each other.
3. John Stuart Mill, 'Principles of Political Economy' - If you only read one book on economics, this should be it. Beautiful writing, clear exposition, an impressive scope... and he did it all without equations.
Some of you may wonder why Adam Smith didn't make the cut.
I quite enjoyed the Wealth of Nations - enough to re-read it several times. However, despite having some wonderful passages, as a complete text, it's mostly of historical interest. The book is too wordy for its own good, and extremely repetitive. The topics Smith covers are better dealt with in Mill and Malthus, who also correct a few of the pioneer's most obvious errors. Smith had a few specific axes to grind with respect to events that were important at the time and are now obscure, leading to very long stretches of boredom for the modern reader.
The Everyman edition of the Wealth of Nations, which I own, includes notes on the side of each paragraph summarizing its content. If you buy such a print edition, then Smith makes fantastic bathroom reading... flipping the book open to a random page and reading a paragraph or two at a time is a joy. Reading it through, though, as a cohesive work? Not so much.
This is not an impossible dream. The option IS on the table... with a catch. Whatever benefits there may be from such a move come at a cost. If a country, culture or society is to make such a decision, it is very important to know exactly what the benefits and drawbacks of a 'simpler' system are.
As it happens, some of the finest economic minds in history lived during such an age, and left detailed analyses of their world to posterity. Anyone seeking economic reform or an overthrow of the current system will be well-served by reading what they have to say. (When doing so, keep in mind that some things HAVE changed. The 19th century did not have access to air travel, refrigeration or the internet.)
Here's my suggested reading list, with a few comments:
1. Thomas Malthus, 'Principles of Political Economy'. Reverend Malthus is best known for his essay on population, but he was a remarkably capable economist with a strong focus on sustainability, centuries ahead of his time. This is an outstanding basic economics text, covering a wide variety of subjects with humility and an enjoyable style of writing.
2. David Ricardo, 'Principles of Political Economy and Taxation' - Ricardo wrote this book under protest. Despite that, it turned out to be an important early investigation of what determines rent and taxes. Some of it is just plain wrong, but all of it is thought-provoking. Also, it's very short. It makes an excellent companion to Malthus, since the two refer to each other.
3. John Stuart Mill, 'Principles of Political Economy' - If you only read one book on economics, this should be it. Beautiful writing, clear exposition, an impressive scope... and he did it all without equations.
Some of you may wonder why Adam Smith didn't make the cut.
I quite enjoyed the Wealth of Nations - enough to re-read it several times. However, despite having some wonderful passages, as a complete text, it's mostly of historical interest. The book is too wordy for its own good, and extremely repetitive. The topics Smith covers are better dealt with in Mill and Malthus, who also correct a few of the pioneer's most obvious errors. Smith had a few specific axes to grind with respect to events that were important at the time and are now obscure, leading to very long stretches of boredom for the modern reader.
The Everyman edition of the Wealth of Nations, which I own, includes notes on the side of each paragraph summarizing its content. If you buy such a print edition, then Smith makes fantastic bathroom reading... flipping the book open to a random page and reading a paragraph or two at a time is a joy. Reading it through, though, as a cohesive work? Not so much.
Tuesday, January 20, 2009
An interesting discussion abou the US economy
In October of last year, MIT rounded up five of its researchers to give a panel discussion on the state of the economy, and how it got there. The whole sold-out session is online, courtesy of MIT's TechTV.
I think it may be a bit too jargon-filled for non-economists to absorb in one sitting, but it's at just the right level for 1st and 2nd-year economics undergraduates. Thanks to Michael Picard for the link.
For non-economists, my favourite explanations of the sources of the crisis remain This American Life's two brilliant episodes, The Giant Pool of Money and Another Frightening Show about the Economy. Be warned, though, that the announcer had laryingitis during the first of the episodes.
I think it may be a bit too jargon-filled for non-economists to absorb in one sitting, but it's at just the right level for 1st and 2nd-year economics undergraduates. Thanks to Michael Picard for the link.
For non-economists, my favourite explanations of the sources of the crisis remain This American Life's two brilliant episodes, The Giant Pool of Money and Another Frightening Show about the Economy. Be warned, though, that the announcer had laryingitis during the first of the episodes.
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