Figuring Out What a Dollar Is Worth

There’s a lot to be said about the recent attack by conservatives on the Federal Reserve, though none of it is good.

Representative Ron Paul of Texas will head the committee that oversees the Fed when Republicans take over the House this month. That can’t be good; this is the same Mr. Paul who has in the past supported dismantling the entire Federal Reserve system.

What has really been striking, though, is conservatives’ constant focus on the evils of increasing the money supply. You hear it all the time from Republicans: the Fed is printing money! Danger! In the many comments sent to me by readers I have come across similar assertions that the true measure of inflation isn’t prices, but what happens to the money supply.

My reply: first, for those who care about, you know, being able to buy things (you can’t eat money, after all), it’s the prices of goods that actually matter. For the past three decades there has been remarkably little correspondence between the standard monetary aggregates, which measure the cumulative value of the money supply, and the inflation rate.

But here’s an even more basic question: What is money, anyway? It’s not a new question, but I think it has become more pressing in recent years. Surely money is not merely pieces of green paper bearing portraits of dead presidents. For one thing, a lot of that green paper is inert — transported outside the United States, to be kept in the hoards of drug dealers and such.

For another, checking accounts are a clear substitute, since no green papers are ever exchanged when you deposit your paycheck in the bank, for example.

In the 1960s, the economists Milton Friedman and Anna Jacobson Schwartz proposed broader money aggregates: the M1 category, which added checking accounts to the aggregates (which until then only dealt with the pieces of green paper in circulation), and M2, which added a broader range of deposits. And circa 1960 you could argue that those aggregates were good enough.

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But now we have a large shadow banking system in the United States — hedge funds, investment banks and so forth.

And with credit cards, electronic money and more all serving as mediums of exchange, it’s not clear that any single number deserves to be called “the” money supply.

So if a person is determined to view economic affairs through a sort of “paleo-monetarist” lens, he is going to have a hard time in the modern world, where the definition of money is increasingly vague. 

Backstory: At the Fed, New Signs of Progress

When the Federal Reserve announced in November 2010 that it would buy $600 billion in Treasury bonds through June 2011 in an attempt to stimulate the economy and reduce unemployment in the United States, some congressional Republicans decried the quantitative easing program.

But the Fed’s strategy of injecting money into the economy seems to be working, as it has improved economic growth expectations for the United States, quieting naysayers who argued that merely “printing money” was not an effective solution. The spread between yields on 10- and 30-year Treasuries has narrowed by more than a percentage point. This is a signal from the market that the United States’ economy is on track to recover, since the spread between these two long-term bonds narrows when investor confidence increases in the riskier 30-year bonds. The narrower spread also makes it unlikely that the Fed will have to resort to further quantitative easing in the near future.

But even if the quantitative easing program succeeds in restarting the sluggish economy, the Fed may face new challenges. Inflation is likely to rise as the economy revives, possibly undermining the bond market. The dollar, too, may weaken against other currencies if prices in the United States start to reflect inflation.

The greatest challenge may be political in nature, however. Republicans, some very critical of the Fed, will take control of the House of Representatives in January. And Republican Representative Ron Paul, who has in the past suggested that the Fed be abolished altogether, will head the committee that oversees it.

© 2010 The New York Times Company

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007).

Copyright 2010 The New York Times.

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