Part 13: Exported Inflation
If you think people are confused about monetary affairs inside the borders of the nation they live in, you should listen to their explanations of money outside the country, beginning with the idea of "money outside the country."
If you read the financial press, you will run across this phrase: "exported inflation." We never hear the terms "imported deflation" or "exported deflation."
Think about "exported inflation." Except for Keynesians, most people see general price inflation as a bad thing. How is it that the free market leads to a situation in which something that is bad for the entire world takes place, and the sole beneficiary is the United States? Why isn't a free market arrangement — international trade — beneficial for all parties?
My suggestion: let us look for something that is not free market or else stop talking about "exported inflation."
If someone hires an illegal immigrant — referred to these days as an "undocumented resident alien" — and pays him in cash, the immigrant may send some of this currency back home. He inserts paper money into an envelope, addresses it, sticks a stamp on it, and mails it to someone living in a foreign country. Paper money leaves the United States.
The person who receives this paper money probably does not report this to the tax collectors in her country. If she deposited it, she would have to report it, so she does not deposit it. She may not even have a bank account. So, she spends it.
She can spend it locally because, in her country, the U.S. dollar functions as an alternative currency to the depreciating monopoly money printed by the socialist plutocrats or generals who run her country. All over the third world, paper U.S. dollars function as a shadow currency.
Question: Whenever an illegal immigrant mails money home, does he export America's inflation? Think about this. The answer is not intuitive. That is because fractional reserve banking is not intuitive. The function of currency in a fractional reserve banking system is not intuitive. It is counter-intuitive. What seems logical isn't.
To pay the immigrant, a consumer of "services with an accent" goes to an ATM and withdraws a few hundred dollars. He then pays the worker. Let us call the worker "Manuel." That's short for Manuel Labor [lahBOHR].
Manuel spends most of this money locally. He sends some of it back home.
Let us follow the money. Manuel spends some of it for rent to his "cousin," who rents him and seven other "cousins" two bedrooms. This rental arrangement is legal because it's all in the family. Zoning laws against renting do not apply to families.
The home-buying, mortgage-paying "cousin" spends this money locally. The money winds up in cash registers. At the end of the day, the businesses deposit this currency into their bank accounts. The paper money re-enters the fractional reserve banking system. The total money supply does not change for long.
In contrast, the money sent abroad is not re-deposited into the American banking system. It is not immediately deposited into the foreign banking system, either. It circulates as currency — untaxed, barely depreciating, and highly appreciated by recipients. The foreign spender wins, the foreign seller wins, and the tax collectors on both sides of the border lose. This is surely productive from the private citizens' point of view. So, the arrangement continues, decade after decade.
For every dollar in currency withdrawn from the U.S. banking system that is not redeposited by a local business, at least nine dollars disappear through the contraction of money inside the fractional reserve banking process. This outcome is deflationary with a vengeance. Think of it as burning money — digital money. The lower the reserve ratio for the local banks inside the United States, the more powerful the deflationary process.
A good mini-book on this process is Modern Money Mechanics. It was published by the Federal Reserve Bank of Chicago over 30 years ago.
Do not forget this: when currency is withdrawn and not redeposited, the digital money supply shrinks dramatically.
The "foreign nation" imports physical dollars. This really means that either Manuel's wife or his father spends extra dollars. The fall in the digital money supply in America is much greater than the increase of the physical money supply abroad.
The dollar's international value rises because the supply of digital dollars has decreased. It will cost foreign importers of American goods — agricultural goods, for example — more in their local currency. The paper dollars coming in may raise dollar-denominated black market prices a little. They have an even greater effect on imports from America. Because they shrink the supply of digital dollars in American banks, they raise the price of digital dollars. They raise import prices. Meanwhile, America has lower prices because of the shrinking of its digital money supply. This is exported inflation. Because of millions of decisions, made mainly by illegal immigrants, America has sent a lot of its inflated money supply abroad. But it has done so only because of a non-market institutional arrangement: a government-licensed fractional reserve banking system that is protected by a government-licensed monopoly over money, a central bank. America does not have a free market in money.
This has been a major factor in holding down prices in the United States. A huge amount of currency is involved. This has been true for a generation. The Federal Reserve Bank of St. Louis provides an up-to-date graph of this.
The figure is approaching one trillion dollars. As the Federal Reserve Bank of New York says, the majority of this money is held outside the United States.
We know this from experience. The currency held outside of banks is $900 billion. The number of American households is 100 million. This means that every American household has $9,000 in currency stashed in mattresses or wherever. How about your household? No? Well, then, I must have $18,000. Sadly, I don't. Trust me. Then my neighbor must have at least. . . . You get the idea.
If all of this off-shore black market money were sent back and deposited in American banks, the U.S. money supply would multiply. By how much? With commercial banks holding a trillion dollars at Federal Reserve banks as excess reserves, this would depend on the decisions of thousands of bankers to lend or not to lend. In theory, if the banks lent out all the money, and the FED did nothing, the U.S. money supply could go up by five trillion dollars or more, depending on what percentage of the currency is outside the country. The higher the percentage, the greater the digital money supply here. We would have mass inflation overnight.
Because those foreigners who hold U.S. paper currency are not big businessmen (except for drug dealers), the money does not multiply inside foreign banks. If they deposited dollars, these dollars would be sent back to the United States by local banks. This does not happen.
The dollars serve as a shadow currency. The foreign money supply does not rise digitally. The foreign monetary unit does fall in price domestically. Why? Because local residents with dollars buy up goods and services. These goods and services are not offered for sale in the local currency. Prices denominated in the local currency therefore rise. Because of the reduced digital money supply in the United States, the purchasing power of the U.S. dollar rises. This is the result of hundreds of billions of exported physical dollars. American buyers of services get a good deal: lower wages paid. American sellers of these same services get a worse deal: lower wages paid. The tax authorities in both nations collect less revenue, because income recipients cheat the respective governments. The digital money supply falls in the United States more than it rises in the recipient countries.
This is the true story of exported inflation. Now let us look at the false story.
So far, I have been talking about physical currency. The situation is very different with respect to digital money sent abroad. That is because it is rarely sent abroad. Most of it stays in accounts in multinational banks inside the jurisdiction of the United States. Just like gold stored at 33 Liberty Street, New York City — the New York FED — ownership changes. I suppose bars of gold are moved from pile to pile, just for keeping up appearances. Digits don't move. They come and go simultaneously.
Let us say that an American-based oil company imports oil from Mexico. It pays the Mexican government's Pemex oil company ten million dollars. The money is transferred from the oil company's account in a New York bank to Pemex's account in a New York bank — maybe the same bank. The number of dollars stays the same.
Pemex may buy American-made drilling equipment. Or it may buy something else denominated in dollars. The number of dollars remains the same. Ownership of these dollars changes.
Because of this transaction, oil gets a little more expensive in Mexico and a little cheaper in the United States. Oil flows across the border. Money doesn't. From the Mexican government's point of view, it is better off: more dollars. In Mexico, the price of oil goes up. Mexicans who buy oil are worse off.
Even if the seller of oil were a private owner of oil, the price of oil would be a little higher in Mexico. Americans got the oil. The Mexicans who got the dollars must either buy something denominated in dollars or buy pesos with the dollars.
The terms of trade for each item changes. All parties involved in the transaction expected to be better off as a result. The border means nothing economically. The names of the digits mean nothing economically. The languages mean nothing economically. A swap between Jones and Smith is not analytically different from a swap between Exxon and Pemex. It all boils down to this: "Let's make a deal!"
What if Pemex decides to buy pesos in order to pay its workers? Pemex goes into the foreign exchange markets, which are digital. It buys pesos. This affects the demand for pesos: rising demand. It affects the demand for dollars: falling demand. At the margin, the price of pesos goes up; the price of dollars goes down.
The money supply has not risen. In terms of the price of pesos, the dollar is worth a little less. In terms of the price of dollars, the peso is worth a little more. This will change momentarily. "Let's make a deal!"
Let us now consider monetary inflation. The Federal Reserve buys T-bills. This increases the FED's balance sheet. It injects fiat money into the economy. If commercial banks do not offset this increase by adding to their excess reserves at the FED, this newly created money will multiply: fractional reserve banking.
This new money is in the form of dollars. The FED is not authorized to create pesos. If an American-based importer of Mexican goods gets his hands on some of this newly created digital money, he must buy pesos. He is not like our friend — or at least our employee — Manuel Labor. He must spend one type of digital money in order to buy another type of digital money. He goes into the foreign exchange market and buys pesos.
Here is where people get confused. This transaction does not export American inflation. Why not? Because the foreign exchange markets operate in terms of floating exchange rates. If more dollars are now being bid for the same amount of pesos, then the dollar as a currency unit falls in value. Why? Because the exchange rate set by the latest exchange at the margin is imputed by participants to all of the two currencies, which are not literally currency; they are digits.
There is no monetary inflation of pesos. There is monetary inflation of dollars. The dollar falls in price. People with pesos can buy extra dollars for the same quantity of pesos. The price in pesos of imports from America falls. Mexico does not suffer rising prices.
The phrase, "exported inflation," is correct with currency units sent by mail. It is not correct with respect to digital money sent by money wire.
If you understand this distinction, you are way ahead of 99% of the American population, and probably 98% of college graduates. You are ahead of maybe 90% of college graduates with degrees in economics or business. Why? Because to understand this difference, you must understand how fractional reserve banking works. Almost no one does.
I hope you do.
COPYCAT FOREIGN INFLATION
The idea that America exports inflation with its digital money has been wrong for well over half a century. Those who have relied on this false theory have never explained the difference between currency inflation and bank inflation. The two are completely different phenomena. Those who have relied on the "exported inflation" explanation for cheaper prices in the United States have not understood monetary theory or fractional reserve banking.
Under the fixed exchange rate system under the Bretton Woods agreement of 1944, the United States guaranteed to sell gold to foreign governments and central banks at $35 per ounce. That was the remnant of the gold exchange standard set up in 1922: the Genoa Agreement.
The Bretton Woods agreement established price controls for the major currencies. These price controls were exchange rates fixed by the participating governments. The International Monetary Fund supervised this system, although it has no independent power over sovereign national governments.
Gold reserves in the possession of the United States government peaked in 1958. When the United States began seriously inflating in the 1960s, foreign governments and central banks had to make a decision: to inflate or not to inflate. The Federal Reserve System had no authority in foreign nations.
If nations refused to inflate their domestic money supplies, they faced a problem: a glut of dollars. Remember, the word "glut" has no economic meaning apart from these words: "at some government-fixed price." Gluts are taken care of by reduced sales prices in a free market. Shortages are taken care of by rising prices.
Foreign currencies would have appreciated in a floating exchange rate system, meaning a market pricing system. But rates were fixed by international agreement. So, foreign countries began experiencing a dollar glut, meaning shortages — at a fixed price — of their currencies. When American importers went out to buy a foreign currency in order to buy goods in that nation, they could not buy all that they wanted at the official price. There was a shortage at the official price. Thus, exports began to fall in relation to the domestic economies abroad.
In those days, governments were pressured by exporters to keep the supply of domestic currency high enough for foreigners to buy the domestic firms' goods. The national governments could have pulled out of the IMF. They could have let the dollar-denominated price of their currencies rise. But domestic exporters would still have faced a problem: falling demand from Americans. American importing firms would not have been able to afford the foreign currencies at the new, higher prices.
Americans would have faced higher domestic prices and higher imported goods prices. That was because of Federal Reserve policy. This is what monetary inflation does.
Foreign nations did not "import" American inflation, if we are speaking of digital money (post-computer) or bank-entry money (pre-computer). Their governments and central banks deliberately inflated their currencies in order to subsidize their national export sectors. This was (and remains) a legacy of mercantilist economics.
When you hear about America's exported inflation, be sure you distinguish Manuel Labor from Exxon. Be sure you distinguish paper currency sent abroad from digits held in New York banks. In the first case, inflation is exported, and the result is deflation in America. In the second case, inflation stays at home. So does most of the money. Ownership changes. The money supply rises in the United States when the Federal Reserve buys any asset, but that money is not exported. It just changes hands, which of course are not hands. They are computers.
Digital money is in a computer. It does not matter where the hard drive is located. What matters is who owns the specific digits called dollars or pesos or yen. A change in ownership does not change prices in general. It changes only specific prices due to trade.
Bank-created inflation is not exported. It stays in the trade zone of the nation that creates the money. In today's floating exchange rate system, price inflation in the United States does not affect the price level (a statistical index) in any other country for very long or for very much. Bank-created inflation is not exported. It is merely copied. When foreign prices rise alongside America's rising prices, this is because foreign central banks are matching the monetary policies of the Federal Reserve. Domestic digital inflation is always a domestic bank—inflicted wound. Central banks compete with each other to debauch their domestic currencies. This is not free market competition. It is competitive plunder by government-licensed counterfeiters.
November 7, 2009
Copyright © 2009 Gary North