Money Talks: Fixing A Broken Monetary System

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2:00Hello, and welcome to Money Talks. I'm your host, Elizabeth Spires. I'm the co-host of Slate Money and a contributing writer to The New York Times. And today I'm joined by Matt Sukerke and Steve Hanke, the authors of Making Money Work, How to Rewrite the Rules of Our Financial System. So guys, introduce yourself. Matt, you first. Thanks. I'm a fellow at the Johns Hopkins Institute for Applied Economics, where Professor Hanke is the co-director and founder. And I'm a visiting fellow at Durham University Business School in the United Kingdom. And Steve? I'm a professor of applied economics at Johns Hopkins University in Baltimore and a variety of other odds and ends.

2:38I'm actually in my 56th year at Johns Hopkins. Oh, congratulations. I'm the senior man around. So you two have written a provocative book about the global monetary system and how it could be reformed. And we're going to be talking about all of that coming up on Money Talks.

3:01So Steve and Matt, we are taping this in the middle of a broad tariff war and an environment where the dollar is being weakened by the current administration's policies. And you have just written a book about reforming monetary policy in the U.S. and really rethinking the way that we think about money and in particular the quantity of money. What do you mean by that? The first thing is most people don't realize that commercial banks produce most of the money in the economy. Roughly around 80 % of the money supply is actually created by commercial banks. When they make a loan to somebody, they credit the checking account of the recipient of the loan, and that checking account is counted as part of the money supply, broadly measured.

3:48If you increase substantially the money supply as occurred in 2020 after the pandemic hit, what happens? The first thing with a lag that happens is asset prices start going up. So we saw the stock market go up, real estate prices go up, land values go up. And then next, the real economy starts churning a little bit more rapidly. And then next, with a lag of maybe 12 to 24 months, you end up with inflation. And of course, we did have inflation after they goosed the money supply. And we could anticipate that using the quantity theory of money. And that's the fundamental kind of theoretical framework for the book.

4:34It's the quantity theory of money. Money matters, and we want to make money work better. You know, a lot of people have misconceptions about money generally. So when you're talking about commercial banks producing most of the money supply, a lot of people think of the relationship as being the other way around. You use deposits to make loans, and what you're saying is the process of originating the loan actually creates the deposit, which expands the money supply. So when we're talking to people who don't have a rigorous understanding of economic theory, and you're explaining all these things contributed to inflation in the last five or six years, I think most people do understand that the money supply expanding was a factor.

5:15But how do you divide out that and other things like external supply shocks, some of the other effects of COVID, for example? Well, let's put it this way. Inflation is always and everywhere a monetary phenomenon. The last inflation burst that we had, it wasn't transitory. It wasn't a supply chain shock. It wasn't an oil price increase that resulted from the conflict in Ukraine. Those are all kind of ad hoc factors that change relative prices. But the general level of the price is determined by changes in the money supply. To get your handle on this kind of ad hoc theory, let's go back to the 70s and Japan.

5:58This is one of my favorite examples. And we had two oil crises in the 1970s, one in 1973. And when that occurred, everybody said, we're going to have inflation in Japan because oil prices are going up. Well, they did have inflation. But the reason they had it is that the Bank of Japan accommodated the relative price increase in crude oil with an increase in the money supply. Now, 79, Japan, another oil crisis. And the Bank of Japan did not increase the money supply to accommodate the price rise in oil. And they didn't have inflation. Yeah, I like to think of inflation as money getting out of sync with real growth.

6:44As Steve mentioned, when banks create money, it's as a counterpart to lending. And when you underwrite a loan, that's based on the idea that some sort of growth is going to happen in the future, which gives you a surplus to repay the loan. So in normal circumstances, if banks are doing their job, they're not going to create more money than the growth there is to kind of catch it in the future. Now, when you have interventions by the government in response to an oil price shock or in response to COVID, like Steve said, then money is created at a much faster rate than what the economy can accommodate.

7:22So in COVID, we created 20 % new money supply or something of that order of magnitude. And there was no way that the economy was going to grow 20 % bigger in the next year or two. Rather than the monetary policy that we pursued, what should we have done? This comes in exactly to what Matt was talking about. The government essentially ignores the money supply. They should have been growing the money supply, putting in place monetary policies that allow the money supply to grow at about 6 % per year. That supply of money is consistent with hitting the price target of 2%. And then real growth in the economy, what Matt was talking about.

8:02The potential, let's say it's a little over 2 % for real growth. And then the last thing is, as the economy grows, people have a demand for more money. So they want more money in their portfolios and so forth. That grows also at about 2 % per year. So 2 plus 2 plus 2 is 6. And if you were growing the money supply at 6%, you will be able to hit the inflation target at 2%. You'll be able to fuel the economy so it runs at its potential of about 2%. And you'll also be able to accommodate the ongoing increase in the demand for money as we get wealthier and more prosperous. And the major source of money supply in COVID was quantitative easing by the Fed.

8:50And it wasn't because they thought they needed to get more money into people's hands. It was because they wanted to lower long-term interest rates sufficiently to get to what they thought was a neutral rate of interest. We spent a lot of time in the book about why interest rate policy is not an effective way to control economic growth and why it leads to distortions throughout the economy, not least in asset prices. But with the Fed not monitoring the aggregate quantity of money, quantitative easing got out of control. And now we have this long tail of quantitative tightening to resolve, for which the Fed has no discernible plan.

9:27The increase in the money supply, the rate of increase actually peaked out a little over 18 percent year over year. Now, that's the highest rate of growth in the money supply we've had since the Fed was founded in 1913. So it was quite dramatic, actually. And the Fed wasn't paying any attention to it. And once the money supply got out of control and inflation got out of control, then the Fed threw everything in reverse. And now we actually have had a contraction in the money supply since the summer of 2022. And that kind of contraction has only occurred four times since the Fed was founded in 1913.

10:09So we're kind of on a roller coaster. And the down part will lead, I think, and Matt thinks, to a big slowdown in the economy this year, probably a recession. And the regime uncertainty is so severe, by the way, that a lot of businesses aren't even issuing forward guidance on the profits and earnings that they expect, which is highly unusual. I mean, they're just kind of paralyzed. They don't know what to do. Regime uncertainty is a very nice way of saying what one of our analysts we had on called the one fucking man theory, which is just the idea that Trump will come in and with very little predictability, make these changes and everybody's subjected to them, even if they, under normal circumstances, would maybe be able to hedge or manage the risk better.

10:57Adding on to that, I'd like to say the impulsive man. That makes sense. Yeah. So what policy changes would you recommend that would facilitate that 6 % a year? Well, we outline a new operating model for the Fed, and it's designed around the way that the Fed was operating de facto, but not officially, in the years immediately after the global financial crisis. And you'll remember that the banking system was in a very diminished state. They were working through a lot of problematic loans, and it was clear that the banking system needed to rebuild its capital. And so the Fed put into place a system that was focused on limiting banks' release of capital.

11:36You couldn't buy back stock. You couldn't issue dividends to shareholders. And the way that they did that was through a stress testing regime. You needed to be able to prove that with very high confidence, you'd be able to survive a negative downturn. And while the Fed was monitoring bank capital, an unusual thing happened. The money supply grew at a very steady rate for about 10 years. And while everybody was calling for this explosion of inflation because they were looking at the Fed's balance sheet, We instead were concentrating on the rate of broad money growth, which we saw was very consistent.

12:09And, you know, it was no surprise to us that the Fed consistently met its inflation target during that period. And we experienced, you know, moderate growth, two and a half, 3 % a year. So what we propose is that the Fed formalize this system, that we look at the way that banks accumulate and release their capital as a way of controlling the growth rate of money because they're responsible for most of it. You mentioned in the book that one of the problems with this is that the banking system is just addicted to land and real estate. It is. And most of it is stapled to investment banks, too. I wanted to connect this to your comment about tariffs earlier, is that the United States is the other side of its trade balance for the last 50 years.

12:54It's been the beneficiary of foreign capital flowing in consistently. We have so much capital that we don't need to economize it. And the banking system is really the most powerful instrument that any modern economy has to economize savings. What do I mean by that? Usually, if you want to invest in a project that's not going to bear any yield or give you any output until the future, somebody in the economy needs to give up consumption today in order to pay the people who are working on that project for the future. But if a bank creates the finance that's needed, nobody needs to give up consumption.

13:29So if you look at Japan, if you look at South Korea, Taiwan, the Asian tigers, they were able to grow at extraordinary rates after the Second World War and through the end of the 20th century from a very small base of savings because they were relying on this engine of bank finance to build their economy. But in the United States, we were receiving reserve inflows from Asia and from Europe, from the world's central banks trying to build up their reserves. And instead of economizing savings through the banking system, we got used to funding things with real dollars. And that's done on the investment banking side of the house.

14:06And because we were drowning in this international flow of money, the banking system wasn't under pressure to continue creating the money supply. We were in fact turning savings into money through money market funds and through this chain of shadow bank intermediation that has been really well discussed. So coming back to my point, the banking system has been thrown off its mark of producing the money supply regularly and consistently because on the one hand, it's stapled to an investment bank where there is a different set of objectives and where you can make more profit using savings rather than economizing them.

14:42And it's also tucked into this operating model at the Fed where impulses are moving through interest rates rather than through quantities. So what are the flaws in the banking system that should be addressed? There ought to be incentives in place that encourage banks to split their business model along the investment bank and commercial bank lines. If those businesses were split, there would be less public interest in holding large amounts of capital at investment banks because they can't damage the money supply. The banking system would be under less pressure to hold lots of capital because it doesn't need to absorb losses from an investment bank.

15:19But short of splitting the banks, there's a lot that can be done in terms of reforming bank regulation. We talk about changing credit risk weights, so real estate investments are not so favored as they are under the current machine. And we talk about unwinding some of the liquidity rules that went into place with Basel III. So what are your primary critiques of Basel III? Without being glib, my main critique is that it's just not very imaginative. It's really built around making sure that the exact same kind of crisis doesn't happen again. It's not wrong, but it's a major retrograde movement from Basel II, which achieves consistency at the cost of, you might say, reason.

15:59Bank regulations don't change very rapidly. It's not like a federal open market committee meeting that's occurring, what, four times a year. It's a slow, very complicated thing. You get into Basel and you say, well, what do we think about Basel? The thing is so complicated that probably the people in Basel don't even know what Basel is. And one thing we do talk about with regard to Basel III, because the U.S. hasn't signed on to that, the U.S. has an opportunity to have really a superior system to the Basel III. And that gets into different ways to measure risk weights and capital requirements that are more suitable to a modern banking system.

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19:55Most transfers arrive in under 20 seconds. Join millions saving billions on hidden fees. Be smart. Get wise. Download the Wise app today. T's and C's apply. Well, this isn't really about the book, but one of, Steve, your opinions that I find interesting and probably agree with is that the external trade imbalance is homegrown. So, you know, there's some irony to Trump's tariff policy is being pegged to the way he thinks about trade balances. And I'm not sure if he just doesn't understand the dynamic. A lot of his supporters would say that he's playing 3D chess with the tariffs. But I think he fundamentally thinks that the trade imbalances are a function of bad foreigners taking advantage of the U.S.

20:42And you argue that, no, this is a problem that we created ourselves. There are various ways to explain it. But I think the best way is to think of it in terms of GDP. It's the fact that U.S. consumption, U.S. investment, U.S. government spending since 1974 has always exceeded the value of GDP. And what do we do to make up the gap? We spend on importation. That's where the trade deficit comes from. So that's the homegrown part. There are other ways to explain it. The other way is simply that savings are less than investment. The gap to equate savings and investment has to come from capital importation.

21:27As Matt said, we've been able to import that pretty easily and cheaply. And that capital importation, that capital surplus, the other side of that coin is a trade deficit or a current account deficit. So I don't anticipate that you could tell Donald Trump any of this and it would sort of sink in. But I think there are a lot of things in your book that if you advised Jay Powell to do, he would at least consider. So what would be core things that you would want Powell to internalize? The first would be to put the quantity of money on his radar. There's been a consistent deletion of information about the quantity of money from the statistics that the Fed publishes going back at least 20 years.

22:09And then the second would be the Fed has this dual role as the maker of monetary policy and as a bank regulator, along with the FDIC and the OCC. and we would suggest leaning more on the bank regulator side to achieve policy aims rather than the short-term interest rate. The only thing I would add that's consistent completely with what you're saying, Matt, is that it just isn't the data that they release that you can't even hardly find monetary statistics anymore. No one pays any attention to them. But down in the bowels of the Fed, there are a lot of research people, and those research people all use macroeconomic models are generally called post-Keynesian models, and those models don't contain a monetary aggregate.

22:55There is no measure for money in the models. And this has been going on for about 30 years in macroeconomics. And Matt and I are arguing, no, you've got to focus on what really makes the economy hum or not hum, and that's what's going on with the money supply. That should be front and center. Money dominates, but at the Fed, it's just simply excluded. And by the way, That's one reason why the Fed was unable to predict the inflation that they were going to gin up in 2020, 2021, 2022. They never got it right because they never were looking at the money supply. And the reason they weren't is that the models, the macroeconomic models they use, they just don't include money.

23:39To what extent does the public need to be educated about this in order to drive policy changes? Is it just a matter of convincing policymakers, people working at the Fed, or does this need to be a sort of larger policy conversation that we need to decide at a much broader level? I think it has to be a larger policy consideration. The general person in the street, if you told them that the Fed doesn't pay any attention to changes in the money supply and they don't think it's important, they're shocked. If you ask average people, they know right away that changes in the money supply have a big impact in the economy.

24:16And we've talked about the supply of money in general in the aggregate, but something we spend a lot of time on in the book is disaggregating the money supply and seeing how it grows at different rates in different regions of the economy. And one of the big drivers of that is fiscal policy, because it's oriented towards transferring dollars from one sector to another. And there's also a major difference in which sectors absorb money as holders of government debt versus the ones that turn it immediately into purchasing power and consumption. And this is something that you really can't even see in the data, but we have reason to believe that it explains why we see such differences in relative prices in the economy or relative rates of inflation.

25:02There's a lot of debate about why cost of education and healthcare and housing are growing so much faster and there are explanations in terms of cost disease or you name it. But these are also the regions of the economy that get lots and lots of money. Healthcare spending, education spending, all of this is tax preferred. It's got money going in from the government, but not coming back out through taxes. similarly through real estate. So every time there's a political discussion about what do we support in our budget priorities, we're also implicitly having a discussion about how fast inflation moves in different regions of the economy.

25:39This is a very important part of the book, actually. We kind of have three things. One, getting money back on the radar screen, and that's the old quantity theory of money with our new additions to that. The second thing is to focus on commercial banks and bank regulation. And the third thing is what we call neutrality. That's what Matt's been talking about, that you want the supply of money going into the system in kind of a non-distortionary way. Now, let me give a concrete example of what Fed policy can do if it's not neutral. At the start of COVID in February of 2020, billionaires in the United States held wealth that was equal to 14.1 % of GDP.

26:25Now, that number is 21.1%. This happened because the money supply was accelerated in 2020. And with a lag, of course, the next thing that happens, asset prices go up. Land, real estate, the stock market, all those things boom. Who owns assets? Rich people own assets. Billionaires own a lot of assets. They made out like bandits. The biggest distortion in the distribution of income in the United States since World War II occurred because of the Fed. Changes in the money supply were important. They changed asset prices, inflation, real economic activity, and this income distribution thing comes into the thing.

27:15Again, billionaires, wealth is a percent of GDP. It's skyrocketed and now is 21.1%. And of course, the little guy, he's probably in debt. He's not benefiting from the asset price explosion. I think a couple more lessons for the general public that come out of the book. One is that the growth of real estate-based wealth is not some kind of natural law. We explain it as being kind of an accident of tax policy and bank regulation. And then I think a second important one, which mostly is for people younger than me, is that the best way forward isn't a technological solution. It's not through cryptocurrencies or DeFi or whatever the buzzword is at the moment in the fintech world, but it's really about fixing this social technology that's been developed and refined over hundreds of years, and that actually works pretty well.

28:09It's not common to find successful fiat money systems, but until recently, we had one of them. There have been a few important historical examples of them, and they're worth preserving and defending. And I think we go a long way in explaining the principles that make them work. Well, I think that's probably all the time we have. Is there any point that you really want to get in that I haven't asked you about? No, no. I think this has been a fantastic interview. We've covered more of the book with you than with anyone we've spoken to. Well, thank you for joining. Thanks for inviting us, Elizabeth.

28:46Really appreciate it. And that's it for Money Talks. Thank you, Steve and Matt, for joining. And thanks to Jessamyn Molle of Seaplane Armada for producing. We'll be back on Saturday with our regular edition of Slate Money.

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