Not Worth A Continental

In late-18th-century America, something of minimal value was often described as being “Not worth a Continental,” which referred to the Continental Dollar, the American currency at the time of the American Revolution.

The continental was paper money. It had occurred to the colonists that, as their revolution was costing quite a bit to maintain, they could go into “temporary” debt to finance the war. Pretty soon it became clear that the debt could not be repaid. The printing of paper banknotes resulted in inflation. The solution? Print more of them. Further devaluation of the continental motivated the colonists to print more… then more… then still more. The Continental became worthless, either for trade or for repayment of debt.

The new country, the United States, then did something quite unusual. In its new Constitution, it created a clause to assure that this would never happen again. Under Article I, Section 10, the states were not permitted to “coin Money; emit Bills of Credit; [or] make any Thing but gold and silver Coin a Tender in Payment of Debts.”

This week, Federal Reserve Chairman Jerome Powell testified in front of the Senate Banking Committee in its semi-annual Report on monetary policy. In that discourse, Chairman Powell described one of the debates inside the Federal Reserve. The question was whether the 2% target for inflation was a maximum or an average. It was felt that during times of economic weakness, prices would not rise as fast, and therefore there could be some relaxation on the inflation target during times of economic boom such as we are experiencing now. This would average out over time. 

It’s interesting that this particular statement didn’t invite any discussion with the committee members. 

There seems to be a misconception among law makers that inflation is the increase of prices, when in fact, the increase of prices is actually the symptom of inflation. The real inflation is the inflation of the money supply. Every time a government prints money, there is inflation. When there is more money available, then people become more willing to pay more for goods and services. The increase in prices is the consequence of too much money in the system. Lord knows we’ve been pumping money into the system over the past 10 years like never before. Quantitative easing was the new buzzword for printing money. We went through 3 rounds of quantitative easing over the past decade. The fact is, much of the money never made it into the broader economy. It was held within the banking system to restore profitability to banks that otherwise would have needed to earn their profits the old fashioned way. 

Before the financial crisis, the fed balance sheet represented about 6% of GDP. Most of the demand for funds was for currency, and a small amount for reserves. After the financial crisis, the Fed balance sheet grew to about 25% of GDP. Most of that was to fund demands for reserves at banks, and the Fed also purchased assets. Assets is code for the Fed purchasing long term government debt. So when the US government borrowed money to bail out the financial system, the Fed printed the money, and the government issued bonds which the Fed purchased and earned interest on. Pretty good gig.

Banks made 237B in profits last year, some of which came from cash reserves given to banks using printed money by the Fed. The excess reserves held by the banks above their statutory requirements were in turn loaned back to the Fed and the banks earned interest on those excess reserves. Wait, what? The loan had zero risk, and was basically a license to print money for the banks. 

So here’s the bottom line. Inflation is a phenomenon of having too much money in the system. It causes prices to rise, albeit not uniformly.

If you’re going to be playing the finance game, it makes sense to know the rules of the game.