 Demanding the Supply of a Stable Currency
Nathan Lewis
Provided as a courtesy of Agora Publishing & DailyReckoning.com
Sep 4, 2007
"All fluctuations in
a currency's value, which can be noted in the foreign exchange
market and currency's exchange rate with gold, are the result
of the mismatch of supply and demand."
Despite claims to the contrary,
proper currency management is simple. A currency's value is determined
by the balance of supply and demand. The currency is supplied
by the issuer of currency, which today are central banks. The
currency is demanded by anyone worldwide who wishes to hold the
currency.
Whenever supply is growing
relative to demand, the currency loses value. Whenever supply
is shrinking relative to demand, the currency gains value. When
supply maintains an equal relationship with demand, stable currency
value results.
Everybody knows that if a central
bank increases supply (i.e., "prints money") willy-nilly
and far in excess of demand, the currency's value will fall.
However, this is not the only means by which inflation can take
place. If demand shrinks and supply does not shrink accordingly,
the result is that supply grows relative to demand and the value
of the currency falls. It is possible for the currency's value
to fall even when supply is shrinking-if demand is shrinking
even faster.
A fall in supply relative to
demand will push the currency's value higher. This can happen
through a contraction of supply, but it is also common to find
that the demand for a currency can increase sharply. This will
raise the currency's value even if supply is stable or growing.
All fluctuations in a currency's
value, which can be noted in the foreign exchange market and
currency's exchange rate with gold, are the result of the mismatch
of supply and demand.
Money is supplied by institutions
with the power to create money. In the past, private commercial
banks created money. At other times, money has been created by
government treasury departments or ministries of finance. Today,
money is created by central banks, although central banks were
not created for that purpose.
Today, money is rarely printed
in the first instance, but rather comes out of a very special
checking account at the central bank that nobody puts any money
into. The central bank will buy something on the open market,
usually either domestic government bonds or foreign currencies,
and will pay for the purchase with its magic checking account,
creating an increase in the seller's bank account. In a normal
transaction, A has a bond and B has $1,000, and afterward, B
has a bond and A has $1,000. The amount of money in circulation
does not change. However, if A sells the central bank a bond,
A's account is credited with $1,000, but no account is debited.
New money enters circulation. This money ends up as bank reserves,
which can be redeemed for paper banknotes on demand. If the government
does not have sufficient paper currency in its vaults, it prints
new currency to meet this request. Thus, increasing the money
supply by buying bonds with the magic checkbook is equivalent
to printing money.
Supply can be reduced through
the opposite process. If the central bank sells a bond to A,
A's account is debited, but no account is credited. The money
simply disappears. One can imagine the issuer of currency "running
the printing press backward." Central banks today have enough
bonds or other assets to buy back the entire supply of money
available. The U.S. Federal Reserve, for example, can buy up
every single dollar in the world. Thus, it can supply any amount
of money, from zero to infinity.
Even if a central bank, or
government, did not have enough assets to purchase currency,
it could issue new bonds or eliminate currency taken in from
tax revenues.
The central bank is in a nice
position here. It can buy things with money it simply creates
out of nothing. The profit inherent in producing money is known
as seignorage, a word signifying that it has long been considered
the right of kings. However, it does not have to be done by governments.
Many of the early commercial banks, in eighteenth-century Scotland,
for example, specialized first in printing paper money (replacing
metallic coinage) and only later diversified into making loans.
As private institutions, they profited from money creation in
the same way that governments profit today.
Today, the interest income
from the roughly $800 billion of government bonds held by the
privately owned Federal Reserve is remitted to the U.S. Treasury,
after deducting the operating expenses of the central bank. (At
least, that is the official story.)
The money that is created by
the Fed's magic checking account is known as base money and consists
primarily of Federal Reserve Notes (i.e., paper currency, dollar
bills) and bank reserves, which are deposits of commercial banks
with the central bank and are recorded electronically at the
central bank. Only the Fed can create base money, and the Fed
can create no other type of money except for base money. Paper
bills make up the majority of base money. At this time, the U.S.
Federal Reserve counts about $812 billion of base money, with
$750 billion in bills and coins, and $62 billion in bank reserves.
During the 1990s, U.S. base money grew at an average rate of
7.14 percent per year.
The term base money is used
because upon the base of base money sits a much larger pyramid
of credit. A bank deposit is not money, but is actually a kind
of debt instrument, a bond that must be repaid at the request
of the lender, called the depositor. As a bond, it pays interest.
While the amount of base money available is determined to the
dollar by the central bank (at least insofar as bills are not
destroyed or lost by their holders or created by counterfeiters),
the amount of existing credit can change according to a nearly
infinite number of factors.
Thus it is incorrect to say
that "banks create money." Only the Federal Reserve
creates base money. Banks can only create credit, which does
not alter the supply of base money, but which may have an effect
on the demand for base money. Actually, anyone can create credit,
simply by making a loan. Credit is not money.
 Nathan Lewis
email: nathan@newworldeconomics.com
Nathan Lewis was formerly the Chief
International Economist of a firm that provides investment advice
to institutional investors. Today, he is part of the investing
team at an asset-management company. He has written for the Financial
Times, Asian Wall Street Journal, Daily Yomiuri, Japan Times,
Pravda, Dow Jones Newswires, and other publications. He has appeared
on financial programs in the US, Asia, and the Middle East.
This essay
is an excerpt from Nathan Lewis's new book, Gold: The Once
and Future Money. Click Agora or Amazon to get your copy today.
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