﻿If there is a crisis, the government comes up with a stimulus plan to revive the economy.
The latest? A 1.9 trillion dollars package to help overcome the effects of the pandemic. Ever
wondered how it is possible to get that much money so fast? One of the reasons is that no physical,
finite matter backs the dollar. Its value is based only on the full faith and credit of the United
States. This makes it much easier to increase the debt and resort to expansionary policies.
Critics consider this damaging and see an economic crisis looming and inevitable. Defenders believe
the economic damage would be bigger if nothing was done. Meanwhile, debts skyrocket and some people
even advocate going back to the Gold standard. How did we get here? Let’s take a look.
Since officially abandoning the gold standard in 1973, the dollar is what economists call
fiat money. The word "fiat" comes from Latin and is often translated as a decree,
but in summary, the term means that the money is not backed by a physical asset,
like gold or silver. Pretty much every currency in the world is Fiat money and their value
fluctuates in relation to each other. Having a currency with no backing makes it easier to
control the supply of money. For example, this is helpful in moments of crisis and recession,
when the governments resort to measures to inject money and revive the economy.
Where there’s an upside, there are also downsides: some see this as the disadvantages of the system.
To understand both sides of this problem, let’s take a closer look at where the
trillions of dollars that are part of corona relief packages come from.
To afford this amount of money, the government needs to increase its debts dramatically.
One of the ways of doing that is issuing bonds. Government Bonds are debt securities,
an instrument used to raise money and support spending obligations.
Bonds are basically a document in which a lender like a bank agrees to lend money to the government
and in return, the debt can be repaid at a later date, with interest. Depending on the country
the bonds are issued in, they vary on interest rates and dates that need to be repaid.
In the case of the United States, the Treasury Department sells the issued bonds during auctions
throughout the year. Issuing bonds is a standard procedure. In normal circumstances, there is a
market to absorb the bonds without a big fuss. But when we are talking about sudden trillions of
dollars, things are not that simple. And the role played by the Federal reserve, also known as Fed,
is what makes things controversial. In theory, the Fed is independent and its
main goal is to promote maximum employment, stable prices, and manage long-term interest rates in the
United States. But in extraordinary cases, such as the relief packages,
the Fed also functions as a buyer, buying most of the government bonds issued. In the First Corona
Relief package during Donald Trump’s presidency, the Fed signaled its willingness to essentially
buy an unlimited amount of government debt. The Fed is not allowed to buy bonds directly
from the government. It needs to buy on what is called open market operations.
It can be bought from the so-called primary dealers. This includes the big banks and brokers,
like J.P Morgan, Goldman Sachs, and others. For example, once the Fed buys the equivalent of one
trillion dollars in bonds from these institutions, it injects the same amount of money into the bank
reserves, facilitates lending and increases the money supply in circulation. It’s direct
money being injected into the economy. Money that didn’t exist until the Fed bought the bonds.
Moreover, the Fed is no ordinary bondholder. By law, it has to pay its profits to the Treasury.
At the end of the day, when the treasury pays interest on bonds,
this money generated by bonds that becomes a profit goes back to the government.
At the same time that the Fed acts on open market operations, it also cuts its benchmark interest
rate, reducing the cost of borrowing. When businesses and people borrow more, it also
increases the amount of money in circulation. For the critics, these measures to stimulate the
economy are just loopholes in the system, an unofficial way of an endless supply of money,
without actually printing it. There is risk to long-term stability and can lead to inflation,
devaluation of the dollar and eventually collapse of the economy.
But is the Fed over-stimulating the economy with open market operations?
To understand the situation, it’s possible to look into the Fed’s balance sheet,
which consists of assets (like bonds) and liabilities owned by the bank. The total
amount went from 4.1 trillion dollars in the last week of February 2020,
to 7.5 trillion in the first week of February 2021. Not all of these are government bonds,
but this number gives us an idea of how much the Fed has been acting during this crisis.
Since the dollar is fiat money, there are no limits to issue debt and also no limits
for the fed to act and buy the bonds, supplying the government with more money. And more dollars
available can also affect its value. If the United States had a currency backed by something,
the Fed would not be able to expand the money supply to such an excessive amount.
For example, if the Fed tried to do that while on the gold standard, it would cause the dollar value
to fall due to oversupply, compared to its gold parity and compromise the basis of the system.
For the pessimists, this is putting us on a trajectory of crisis and the collapse is
inevitable. So again, in a nutshell: This is how the cycle of collapse would work:
Everything starts with the currency backed by a physical asset. In the Dollar case, until 1973,
it was Gold. The precious mineral gave value to currency and created a level of confidence that
led to the expansion of commerce and credit. But with the currency attached to gold,
there is a limit on how much credit is possible to generate. Plus the system
is affected by the amount of gold mined in the world and very exposed to speculation,
as the country needs to always keep currency value in parity with the gold reserves.
This limitation led to the idea that gold backing the dollar was not beneficial. The country then
leaves the system. The fiat model comes in through a decree (remember what FIAT means?). What follows
is euphoria. The system is flooded with liquidity. Stimulus packages, increasing spending in many
areas, increase in trade. This leads to abuse. Government starts spending more than it should
and monetizes even more of its debts to fund its obligations. Slowly, the economic growth
starts to decline and confidence starts to fade. Inflation begins rising. All confidence is lost.
Hyperinflation follows and the economy collapses. A new government creates a
new system with a new currency backed by a physical asset. The cycle begins anew.
Critics believe we are at a stage where the government is starting to lose its confidence.
Inflation inevitably will start to rise and be followed by hyperinflation and collapse.
But is there any truth behind this pessimist view?
Well, there isn’t a consensus. But it’s fair to say that the majority of economists would disagree
with the forecast. One of the most critical of these views is Nobel Prize Laureate and New
York Times columnist Paul Krugman. As proof that pessimism is unfounded, he points to the aftermath
of the 2008 financial crisis. From the start of the economic crisis until 2014,
the FED’s balance sheet also grew exponentially, more than 4 trillion
dollars. And still, inflation stayed low. Krugman believes that the risks aren’t greater
now. He believes that for the most part, the funds that the Fed injected into the economy simply
piled up either in the bank reserves or in cash held by individuals and are not harmful.
The Fed's latest bond-buying spree is an evolution of what began finding acceptance, considered
normal during the 2008 financial crisis. Ben Bernanke, former chair of the Fed during that
time, also hit back at the critics. For him, what the Fed was doing wasn't printing money to
finance government borrowing, but a temporary measure that would be reversed. Eventually,
the FED sells the bonds it acquired and things go back to normal.
Although they believe the practice isn’t harmful to the economy long term,
it’s important to point out the growing level of debt in the United States. According to the
Congressional Budget Office, 2020 was the first year since 1946 that the country’s debt exceeded
the size of the entire economy. The US had a total debt held by the public of 21,019 trillion, the
equivalent of 100.1 percent of GDP. In 2021, the number is projected to hold 22,4 trillion dollars,
102.3 percent of GDP. They also project that the debt will represent 107 percent of GDP by 2031
when it should surpass 35.3 trillion dollars. Does that mean that there is no way out of the
crisis and a collapse is about to happen? It’s impossible to predict, but generally speaking,
there are no signs that the financial market is worried about the growing deficit. The fact is:
despite the huge debt, the U.S. government is not financially constrained. It has no problem
borrowing money and borrowing is very cheap, with the 10-year interest rate barely above one
percent. Funnily enough, the market sees this as a positive sign and the country would be able to
keep going and borrowing forever under the current circumstances. Moreover, with expected 3.7% GDP
growth in the next decade, any debt would tend to melt away as a share of GDP over time.
For now, it seems like the full faith and credit of the United States is more than
enough for investors. We will have to wait and see for how long.
So that’s it for this video. We hope you liked to learn more about fiat money and
its impact on our lives. Since you made it to the end, click around and watch more.
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