Morningstar Advisor - August/September 2012 - (Page 53)

types of money. The monetary base is money issued by the Federal Reserve, a bank owned and run by the federal government. Part of the monetary base exists in physical form (dollar bills and coins), or currency. The rest is electronic, or reserves, which are accounts that banks have at the Federal Reserve. People tend to hold a fraction of their wealth in the form of money, because we need money to purchase goods and services and we obtain money when we sell them. How much money we hold depends on money’s returns. If the returns to holding money are very low (compared with other investments), we try to hold less money. This low return occurs during inflation, when money is losing value quickly. Conversely, people are willing to hold a lot of money during a deflation. How much money we hold also depends on the overall level of economic activity—how much we’re buying and selling—and the costs of exchanging money for other assets. To hold very little money, you have to make a lot of trips to the ATM. Finally, people choose to hold a lot of money when the risks of holding other assets seem very high. We saw a massive increase in money demand during the financial crisis. We can also talk about money and inflation in the context of current economic events. Many countries, including the United States, have accumulated high levels of public debt, often with the purported reason of “stimulating” their economies. Does higher government spending actually stimulate economic growth? Will large public debts lead to inflation? How is money linked to government debt? In Europe, is it desirable for sovereign nations to share a common currency? Was the euro even a good idea to begin with? Cochrane and Uhlig help us tackle these questions and more. Our discussion has been edited for clarity and length. The Value of Money Gideon Magnus: I want to discuss the value of money and the idea that money is valued similarly to any other asset. Are there really assets backing money? If so, what are they? John, please explain. John Cochrane: Money is just very short-term government debt. Really. Reserves at the Fed now pay interest, so they are overnight, floating-rate government debt that happens to be very liquid and used by banks to settle transactions. Cash is just government debt that people are willing to hold despite the fact it doesn’t pay interest, because it’s convenient for other purposes. So let’s ask the bigger question. Why do you buy government debt? Well, because you think you’re going to get paid back. The government is borrowing in order to spend now, and promising to raise the taxes to pay you back later. So government debt is an asset that’s valuable because it’s a claim on future taxes. If the government doesn’t or can’t raise future taxes relative to spending in order to pay off the debt—like, for example, the government of Greece—then the government debt becomes worth less, just as stocks must become worth less if the company makes lower profits. If the government doesn’t default on its debt, then inflation must break out until all the debt— including money—declines in value. Now, let’s try to understand the mechanics of how this inflation comes about. Imagine a moment comes that the bond markets look at the U.S. and say, “You know what? These jokers aren’t going to solve their structural deficit problems. They won’t be able to pay back those debts, so we’re not lending them any more money.” You might think this isn’t so bad. All the U.S. has to do is cut out deficit spending for a while. But that won’t do. Every year, the U.S. government has to borrow money to pay off the old bondholders, even if it runs no deficit at all. We roll over short-term debt. Right now, our government spends about $3.5 trillion a year, borrows about $1.5 trillion to cover deficits, but must also borrow about $3 trillion to roll over maturing debt. If we can’t raise $3 trillion in new debt to pay off the $3 trillion that matures, we have a debt crisis. This is what happened to Greece. Of course, everything has its price: Rather than simply refuse to roll over, bond markets might just charge so high an interest rate that the debt is clearly unsustainable. That has the same effect. In a debt crisis, we have very few choices. One choice is we could default, simply tell the bondholders, “We’re not paying. Tough luck.” The other choice is we print up money to roll over the debt. That—you can all pretty clearly see—leads to inflation. It is to some extent a choice. You could imagine the Fed refusing to print up the money. But, as is happening right now in Europe, I think it’s a safe bet our Fed would not—or would not be allowed to—force a massive default on government bonds by refusing to step in and buy them. I hope this clarifies the link between debt, deficits, and inflation. If the government cannot convince bondholders that it will be able to raise tax revenues, which really means economic growth, or cut spending in the future, and if it does not explicitly default, then inflation must result. And it is future deficits that lead to current inflation. I told a pretty extreme story, so the mechanism would be vivid. But the same thing happens every day on a smaller scale. Every 1% of unexpected inflation is a 1% loss to government bondholders, and means the government pays back those bonds with 1% less tax revenues or spending reductions. We have this faith that [Federal Reserve chairman] Ben Bernanke’s got his hands on the lever and that the Federal Reserve can always MorningstarAdvisor.com 53 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2012

Morningstar Advisor - August/September 2012
Contents
Contributors
Letter From the Editor
How Much of the Behavior Gap Is Your Fault?
What’s Your View of the Muni-Bond Market?
A Balanced Life
How to Get to Know EMMA
A Strong, Robust Fund Business
Dividend Investing Abroad
Four Picks for the Present
Investment Briefs
Fund Expenses Through the Decades
Autos on Comeback Track
Lessons From the Muni-Bond Rebound
Municipal-Bond Landscape Shifts
Municipal Bonds 101
A Tale of Two Cities
Unraveling the Mysteries of Money
Small Companies Mean the World to Him
The Chinese Art Market and the Origin of Bubbles
The Myth of the Dumb Investor
Stocks That Can Stand the Heat
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The War on Savers

Morningstar Advisor - August/September 2012