Close But No Cigar

You’re nearly there Tan Sri, just a little bit further (excerpt; emphasis mine):

The alchemy of money
BY ANDREW SHENG

…When money was fully backed by gold, money was tied to real goods. But when paper currency was invented, money became a promisory note, first of the state – fiat money, supported by the power to impose taxes to repay that debt, and today, bank-created money, which is backed only by the assets and equity of the bank. The power to create “paper” money is truly alchemy – since promises by either the state or the banks can go on almost forever, until the trust runs out.

Today national money supply comprises roughly one-fifth state money (backed by sovereign debt) and four-fifths bank deposits (backed by bank loans and bank equity). Banks can create money as long as they are willing to lend, and the more they lend to finance bad assets, the more alchemy there is in the system....

...The dilemma of central banks today is also globalisation. In addition to the Fed controlling dollar money supply within the US borders, there are US$9 trillion of dollars created outside the US borders over which the Fed has no control. Money today can be created in the form of Bitcoins, computerised digital units that tech people use to trade value. But Bitcoins ultimately need to be changed into dollars. So as long as someone will accept Bitcoins, digital currency become convertible money....

...We got into a monetary crisis in which bad money drove out good. The reason was because the financial sector, in collusion with politics, refused to accept that there were losses in the system, so it printed more money to hide or roll over the losses. Surprise, surprise, there was no inflation, because the real economy, having become bloated with excess capacity financed by excess leverage, had in the short run no effective demand. So inflation at the global level is postponed.

But if climate change disrupts the weather and create food supply shortages, inflation will return, initially in the emerging economies, which cannot print money because they are not reserve currencies. In time, inflation will come back to haunt the reserve currency countries. But not before the emerging markets go into crises of inflation or banking first.

There’s the understanding that money = debt (or to be more precise, liabilities), that really underlays the modern monetary system. But there’s still a lot of old and incorrect exogenous money thinking here.

Point by point:

1. “When money was fully backed by gold, money was tied to real goods.” No, it wasn’t. Or at least not for any practical purpose. Anybody who thinks gold is a good hedge against inflation (i.e. it has a stable value relative to other goods) must read this paper. My own explorations in this area suggest that price volatility was an order of magnitude higher under the gold and US dollar standards, than under the fully fiat money system we have today. One must also question the utility of a monetary system based on real goods, when half of output (and income) is derived from services. And then there’s the niggling fact that under the gold standard, banks created money just the same way as they do today. Chartalism goes back to the early 20th century, even before the collapse of the first global gold standard.
2. “But when paper currency was invented, money became a promisory note, first of the state – fiat money, supported by the power to impose taxes to repay that debt, and today, bank-created money, which is backed only by the assets and equity of the bank.” If you actually study the historical development of money, for example some of the earlier writings of Milton Friedman, you’ll understand that money began as promissory notes. Metallic based currencies came later, as societies expanded beyond the village and tribe i.e. when trade expanded to include “strangers”. Barter systems only existed when more formal monetary systems (metallic or otherwise) broke down. On another note, the ability of governments to raise revenue via taxation and thus back confidence in its currency, is inherently tied to the ability of a nation to produce goods and services. It is only when money growth expands beyond that underlying capability to produce, do we get inflation. If you follow the interlinkages, “bank” money is essentially backed by confidence in the central bank, which in turn is backed by the government’s ability to tax. In other words, modern fiat money systems are actually backed by GDP (i.e. goods and services). Interesting sidenote: Frances Coppola comments in a Forbes article that episodes of hyperinflation occur not just from monetisation of fiscal spending, but also coincide with output collapses (i.e. GDP contractions).
3. “In addition to the Fed controlling dollar money supply within the US borders, there are US$9  trillion of dollars created outside the US borders over which the Fed has no control.” I have no idea how the last part is arrived at. Only the Fed and US banks can “create” US Dollar liabilities. Everybody else has to have US Dollar liabilities first, before lending out US Dollar assets. The reason why there’s so much USD “overseas” is because the US Dollar remains the world’s primary reserve currency. Also, since the Fed pegs interest rates, it doesn’t control USD money supply, even in the United States. If it tried, it has to give up control over US interest rates instead. And we know this because it’s been tried (see: the Paul Volcker Fed). Having said that, because of the extensive use of USD outside US borders, the Fed is the de facto global central bank – Fed interest rate decisions drive global capital and investment flows to a surprising degree. The idea that the Fed has no influence outside the US will sound insane to anybody who’s followed financial markets over the past two years.
4. “Surprise, surprise, there was no inflation, because the real economy, having become bloated with excess capacity financed by excess leverage, had in the short run no effective demand. So inflation at the global level is postponed.” True, and also false. Excess capacity will indeed be deflationary. But printing money is not necessarily inflationary either, even in a situation of full capacity. Helicopter money (HM) is inherently inflationary, but quantitive easing (QE) is not, and what we’ve had from major central banks since the Global Financial Crisis has been QE, not HM. For my take on it, try here; if you want someone else’s, try here. Long story short, inflation hasn’t been “postponed”, it was never invited to the party in the first place.
5. “…inflation will return, initially in the emerging economies, which cannot print money because they are not reserve currencies.” This argument shows some truly muddy thinking. What he’s talking about is supply side driven inflation, which has nothing to do with money, but a decline in output. In case you missed it, food inflation has been fairly strong globally over the past decade, never mind what has happened with other prices. This has little or nothing to do with monetary policy, and more to do with China and India climbing the prosperity ladder and changing diets. Weather related price changes in food supplies are in any case a recurring feature in the global economy. Secondly, primary product prices are determined globally, not locally. This makes domestic monetary policy basically irrelevant, so why printing money and reserve currencies are brought into this argument seems nonsensical. Thirdly, everybody “prints” money, not just those countries with reserve currencies. Malaysian banks issue Ringgit assets and liabilities, even when the Ringgit is non-convertible overseas. India for decades routinely financed its budget deficit through central bank monetisation, what it couldn’t raise from bond markets. Every time you use a credit card, you’ve created more money. Every time a central bank increases its FX reserves, it has printed money. Everytime a company grants trade credit, it’s created money. It happens everywhere. Fourth, this statement basically contradicts the rest of the article, where it is argued that printing money causes inflation.

Thinking about money as being endogenous really means you have to rethink a great deal of what economics textbooks taught us about money and monetary systems, and what conventional wisdom says. Most of what we thought of as true in an exogenous money world (the romanticised gold standard), will not hold under an endogenous money world (the real world). Details matter.