Economics Is Platinum: What the Trillion-Dollar Coin Teaches Us

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By Evan Soltas

The dream of my colleague Josh Barro is dead: The U.S. Treasury Department and the Federal Reserve have nixed the idea of minting a trillion-dollar platinum coin to circumvent the debt ceiling.

Yet the platinum-coin debate, for all its absurdity, was in fact packed with the basic principles of monetary economics. Here are five lessons that the trillion-dollar coin should teach us about how money really works:

1. Governments with sovereign power over monetary policy need not default.

Fiscal conservatives frequently offer a warning about the federal government's large deficits. Keep spending and going into debt, they say, and sooner or later the U.S. will end up like Greece.

The trillion-dollar coin debate shows exactly why the U.S. is not -- and cannot be -- like Greece. The U.S. sets its own monetary policy. Greece, as a member of the euro zone, does not. Greece's debts are denominated in euros, so if it cannot balance its budget and cannot secure funding from lenders, then Greece will be forced into default. The U.S. government can never be so forced, because it has an unlimited capacity to monetize its own debt.

The debt ceiling replicates the event we are told to fear: a sudden decision of creditors to turn off the faucet of lending. The fact that, in the last resort, the federal government can hammer out platinum coins -- or just print money -- means that lack of funds cannot compel the U.S. government into default. It makes the funds.

2. The dollar is a social construct meant to provide a "medium of exchange" among other roles.

Monetary economists see money as playing several essential roles in the modern economy, one of which is the "medium of exchange." Money is a social construct in this capacity, as Chris Hayes, the host of MSNBC's weekend morning show "Up," argued strongly in his opening monologue on Saturday.

"The simple truth," he said, is that it the government "creates money simply out of thin air." The "genius" of the trillion-dollar coin, he added, is that it "illustrates the uncomfortable foundational reality of modern capitalism: Money is nothing more than a shared illusion."

We participate in the illusion of money to replace the barter economy, which suffers from the problem that all barter exchanges require a "double coincidence of wants," the rare condition of two people having goods or services the other demands. Money, as the medium of exchange, reduces these high transaction costs under barter. (There is mixed anthropological evidence, however, supporting the canonical story.)

But the form of money holds value and the illusion works, only because of mutual expectations that the currency will function as a medium of exchange in the future. When one thinks about it, green pieces of paper are strange things to trust. To pull back the curtain of illusion even further, think of money transactions as a strange form of barter in which one party surrenders valuable goods or services to another party for nothing of any intrinsic worth. That would be a highly risky exchange but for the deep trust in the norm of money.

The platinum coin idea feels so disturbing because money itself is just as much of a contrivance as the coin is. If it feels dangerous and unnatural for the Treasury to will a trillion dollars into existence, it really is no different than how the federal government creates money every day.

3. Fiat currencies are the ultimate social constructs.

The U.S. dollar is yet more purely a social construct through its status as a fiat currency. There's no anchor other than a social norm that maintains the value of money.

Under a fiat monetary system, the central bank creates and destroys money by changing the quantity of bank reserves. It creates money out of nothing. It manages the social construct.

A trillion-dollar platinum coin is a shockingly physical, even crude, illustration of fiat money as nothing more than a convenient invention. If the U.S. had minted a trillion-dollar coin, its value would not come from anything else in the short run. The government would not have to back the dollar with gold, or anything else -- it would have created a trillion dollars from nothing.

In the long run, though, many but not all economists think money is approximately "neutral.” The coin’s expansion of the money supply would have no permanent effect on real variables such as production or employment, and the additional demand it provided would be offset by inflation.

4. Expansions of the monetary base do not necessarily cause price inflation.

This is one of the platinum coin's major lessons, because so many leading economics commentators failed to understand under what circumstances such a coin would cause inflation.

Just minting the coin and leaving it in a vault in the Treasury would not cause inflation. The federal government could even spend the coin without necessarily causing inflation by transferring it to the Federal Reserve, crediting it as bank reserves, and then raising reserve requirements by an equivalent amount.

Even though the monetary base would have expanded by a trillion dollars, that would cause no inflation, all else equal. (You can check this using the "equation of exchange," because as the monetary base increases by some fraction, the velocity of money would fall inversely as that share of the money supply is not exchanged.)

This is worth knowing because it undermines almost every critique arguing that the Federal Reserve's quantitative-easing programs are recklessly inflationary. The monetary base has expanded by more than threefold since the start of the recession in December 2007, but there has been no acceleration of inflation. Why? Because the velocity of money has declined as banks hold $1.5 trillion in excess reserves at the Fed. Nor do markets doubt the Fed's commitment to price stability. They trust it will eventually withdraw the expansion of the monetary base.

The trillion-dollar platinum coin, in other words, would not be inflationary for the same exact reasons that the Fed's recent monetary easing has not been.

5. To maintain an independent monetary policy, the government must finance its budget deficits through debt auction rather than seigniorage.

Barro has touched on this point in a prior post. Mature governments do not cover their spending with new money because such behavior would undermine the independence of monetary policy, something they have learned to protect because it tends to provide price stability.

Those trillion-dollar coins, if used as a regular tool of public finance, would have large impacts on the money supply and the price level. Governments issue public debt rather than money to avoid such an outcome. It’s why monetization should be a tool in fiscal emergency only.

(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)

Read more breaking commentary from Bloomberg View at the Ticker.

-0- Jan/14/2013 21:20 GMT