Don’t be selfish; spend your stimulus check (Monetary Policy)

Macroeconomics 120

I finally got my stimulus money! Now, the question is, what am I going to do with it? I’ll tell you one thing: the government strongly prefers that I spend it, rather than save it.

If I spend $600 on a virtual reality headset, that money is passed to another company, who uses the money to do things like pay their employees, who then have money to pay their electricity company, who then can keep the current flowing, so I can actually use my VR headset. And don’t forget taxes! Spending money creates tax revenue for state and local governments, too. If someone in that sequence decides to save the money instead of spend it, it breaks the chain. Selfish, right? To quote Kelly from The Office, “I have a lot of questions. First of all, how dare you.“

The goal is for each stimulus dollar to be spent many times over, to multiply. The saying “you have to spend money to make money” is literally true, depending what your definition of “make” is. More on that later.

If the government could tell in advance who is going to spend the money and and who would save it, they would just send the checks to the spenders. Discrimination? Yes, that’s the point of targeting lower income earners and families with young children. It’s a broad, inefficient brush, but it’s the best one in the federal government’s toolbox (when time is of the essence, at least). This research article from Northwestern concludes it would have been more “effective” (a higher multiplier) to send money based on “liquidity”—how much money people had in their checking accounts (cash available on demand).

“People with the highest amounts of cash on hand—$3,000 or more in their checking accounts—had no response to the appearance of their stimulus check. On the other hand, those who maintained accounts with $500 or less spent almost half of the deposits—44.5 cents per every dollar—within 10 days.”

So, instead of being “rewarded” for having a low income, it may be *better* to reward people who empty their checking accounts every month, because the opportunity cost of saving is much higher for them. Punish savers; reward spenders.

You know what’s even better at multiplying dollars than spending the money you have? Spending money you don’t have. Borrowing money, and spending that!

Defining the money supply gets tricky, so I’m going to rely on Sal Khan to explain some of the technical parts.

Here’s my short recap: when it comes to defining money, even the United States Dollar, there isn’t one single agreed upon method. Different countries have different philosophies, and our official government definition has changed as recently as 2006. The foundation of any money supply is the monetary base (MB), or M0. This is the money created by the central bank, and it ends up in active circulation (in your wallet right now), or in the vaults of private banks (specifically bank reserves). Going a little broader, M1 includes money in M0 plus in “on demand” accounts, such as checking accounts. Any amount of money in a checking account or equivalent can be withdrawn at any time, in full, whether it’s via check or debit card or ATM machines or account transfers. Finally, M2 includes “near money”, which is money in savings accounts and other “near money” accounts—easily convertible to cash or checking. [M3 is shadow money, which the Federal Reserve recently decided doesn’t exist, prompting more conspiracy theories. #audittheFed! Or, is the Fed a classic example of misunderstood genius?]

So, how does spending borrowed money increase the money supply? Through fractional reserve banking.

Banks primarily profit from collecting interest from loans. Bank customers win by feeling confident their money is safe and secure in a vault, and banks win by taking their customers money and loaning it to other people. One of the tools of Monetary Policy is the “Reserve Ratio“, i.e. the Fed decides what percentage of savings deposits banks are legally allowed to loan out. If the Reserve Ratio was 50%, and you deposited $1,200 into your savings account at your local bank, that bank is legally allowed to loan out up to half, $600. The person who received the loan is buying a virtual reality headset on Craiglist, and the seller takes the $600 and puts it in his savings account. Once again, the bank can loan out up to 50% of that, so another $300. This process continues. Deposit, loan, spend, deposit, until the original amount is too small to be deposited or loaned (or we run out of approved loan applications). Can you see how the same dollars are being counted multiple times? You’re counting it as part of your net worth, everyone else who put it into their savings along the way is also counting it as their own money, and the banks are including it in their loans and are collecting interest on it. The more loans the same money is involved in, the more the money supply increases. Literally. Sort of.

It gets crazier. The lower the Reserve Ratio, the higher the money multiplier possibility. A 10% Reserve Ratio is typical, so a $1,200 deposit only requires $120 to be kept in reserve. As of writing? The Reserve Ratio is 0%. There isn’t a reserve rate. Infinite money multiplier; there are no rules! Does anyone remember seeing this in the news? Once the money multiplier is set to infinity, the Fed’s next goal is to encourage people to take out loans by lowering interest rates. Loan, spend, deposit, repeat! Does anyone remember me saying The CARES Act wasn’t so much adding money as it was replacing money that disappeared? This is why. When people stop spending and borrowing, the money supply contracts.

[If you happen to be thinking, “wowow, Economics is fascinating, I like knowing how the world works,” I have a book recommendation for you! Freakonomics, by Steven D. Levitt and Stephen J. Dubner. I’ll give away a copy to the first five students, current or former, who reach out.]

“Experts depend on the fact that you don’t have the information they do. Or that you are so befuddled by the complexity of their operation that you wouldn’t know what to do with the information if you had it. Or that you are so in awe of their expertise that you wouldn’t dare challenge them.”

-Freakonomics

Once you learn about fractional reserve banking, your next question should be “what happens if the original depositor goes to the bank and withdraws all $1,200?” Even with a 10% Reserve Ratio, it’s not all there, only $120 is. The banking system includes so much money and so many accounts, banks calculate it is nearly impossible for enough people to show up and withdraw enough money at the same time to cause the house of cards to collapse. If everyone shows up and stood in line and the bank handed their total savings account to each person in turn, only 10% of the cash on the ledger would actually exist (if all the deposits were fully leveraged). If you thought there was a chance your money was going to disappear if your neighbor got in line before you, you wouldn’t meander to the local Leander bank, you would sprint. Bank runs were a major factor in the Great Depression, but they’re not really a thing anymore. For one, most accounts are now FDIC-insured, which means the Fed promises to print money for the people at the end of the line if necessary (up to $250,000), but also, most currency is digital and banks can move it anywhere instantaneously. There are also delays in place; above certain amounts, savings accounts aren’t fully accessible on demand.

Suppose a bank has a run of people cashing out deposits, or, more realistically, approves a flurry of massive loans toward the end of the day, and they are below their reserve requirement. It would be illegal to close in this position, so what do they do? They take out a loan from a different bank!

Overnight loans between banks are common in the industry, and the Federal Reserve has a monetary policy tool to properly incentivize these loans: the Federal Funds Rate. The Federal Funds Rate is the interest rate banks charge to each other for overnight loans, and though the Fed can’t just spin a dial and set it to a certain number, they can set a “target rate” and then manipulate the money supply towards the target. If the Federal Funds Rate is high, then banks will be more conservative with their loans, because they want to avoid borrowing from other banks (and it’s more valuable to keep excess in reserve!). When you think about it, the interest rate banks loan to each other doubles as the “floor” for the interest rate they would be willing to charge anyone else. If I’m a bank and I have to pay 5% to borrow from another bank, there’s no way I’m decreasing my reserves by loaning money to anyone else at any rate below 5%.

When you see news stories talking about the Fed raising or lowering interest rates, the rate they are referring to is the *target* Federal Funds Rate. Other loans, whether its car loans, personal loans, mortgages, whatever, move up and down in tandem (more or less) with whatever the Federal Funds Rate is. What happens when rates are lowered? It’s more affordable to take out a loan; therefore, more loans are taken out; therefore, the money supply expands. What is the current Federal Funds Rate? 0%. The Fed fired its full clip of ammunition back in the middle of March, and lowered rates to 0% for the first time since 2008. Or does it still have a round in the chamber? Just today, traders started betting that interest rates end up in negative territory by December 2020. Being paid to borrow money! It’s never happened before in the U.S., but its reality in Germany, France, Japan, among others, right now.

There are only two Monetary Policy tools left—one that is rarely used, and one I kind of already covered, so let’s knock them out.

The “Discount Window” is an emergency option for banks who need to borrow money to cover the Reserve Ratio and cannot locate another bank with sufficient excess reserves. It gives banks the option of borrowing directly from the Federal Reserve, but with reserve requirements at 0%, I doubt this is a problem right now.

“Open Market Operations” is the most direct monetary tool of the Federal Reserve. The Reserve Ratio and the Federal Funds Rate are indirect, but OMO involves the central bank buying and selling securities, (more or less) directly increasing or decreasing the money supply. Increasing the money supply, aka “expansionary” monetary policy, tends to result in lower interest rates, which is how the Fed guides rates toward the target. Expansionary policy also *tends* to result in higher rates of inflation. One of the weirder aspects of our recently deceased 10-year bull market was the sustained low rates of inflation, which I’ve never seen a good explanation for—it’s unprecedented, and that is unsettling. The next inflation update (Consumer Price Index) is May 12!

The Federal Reserve has used every tool they have to incentivize spending and borrowing, measures that exceed their actions at any other point in history. Macroeconomic tools are like adjusting the throttle and turning the wheel on the Titanic—there is going to be significant lag before your speed and course adjusts, and by that time you may be trying to steer in a different direction. If you’ve ever driven a boat, you understand. The U.S. economy is the biggest boat ever built.

This has been my best attempt to explain Monetary Policy; here is Khan Academy’s:

Last thing. I don’t actually think it’s selfish to save your stimulus check, the point is to highlight a dichotomy once again between individual self-interest and societal benefit. Saving may be better for you; spending may be better for the economy; debt is the worst for you and best for the economy. That’s the bed and we’re sleeping in it. This. Is. Capitalism.

So what am I going to do with my money? I’m either going to save it all, or take out a loan to buy a boat.