Why Foreign Digital Currencies Do Not Expand the Domestic Money Supply
March 17, 2011
Say that you have an account of $100,000 in a branch bank in Chicago. You decide to buy a $100,000 German car. You will pick it up in Germany, drive it around Europe, and ship it home as a used car.
You have your bank wire the $100,000 to the car company in Germany. But the car company cannot use the dollars in Germany except to import American goods. (Joke!) It pays its workers in euros.
It finds a broker who sells euros for dollars. The broker has a bank account in the United States, where dollars buy things. The broker debits his German account of euros. The car company increases its account in euros. The German car company debits its account of dollars.
The currency broker now owns the dollars that you sent to the German car company.
Fact: you did not send the car company dollars. The word "send" is a euphemism for "transferred ownership to." There has been no increase in the money supply in either nation.
The dollars never left the United States. Ownership of legal IOUs changed. You used to own them. Now a currency broker owns them. He will soon sell them. That's how he makes his living.
Digital money is not paper currency. Paper currency does get shipped abroad. Dollars serve as alternative currencies in third world nations and second world nations such as Mexico.
Are we agreed so far?
Next, what if lots and lots of Americans try to buy euros? The money flows into Europe, right?
Wrong. No money flows into Europe. The money never leaves the United States. The price of euros in dollars rises: supply and demand. The currency brokers make their money on the spread: transaction costs.
The only way that the money supply in Europe can increase is if the European Central Bank buys dollar-denominated assets, such as U.S. Treasury bills or bonds, and pays for this with an entry in its account. This is called monetary inflation.
The newly created money -- euros -- does not flow into the United States. The Treasury cannot pay the U.S. government's expenses in euros. It can pay only in dollars. So, the European Central Bank buys dollars -- held in American banks by currency brokers -- and purchases the T-bills with dollars.
The T-bills count as the monetary base of the European Central Bank. But the ECB bought these assets by means of the expansion of its own currency.
If the ECB does not sell other assets to offset the purchase of T-bills, then this is inflationary.
The determination of whether to inflate or not to inflate lies with the ECB. The inflow of digital dollars has no effect on Europe's money supply. That is because -- stop the digital presses! -- there is no inflow of dollars. There is a change of ownership of dollars and euros.
Inflow and outflow are terms that derive from paper currency transactions. They are merely euphemisms for digital transactions comparable to real-world transactions with paper currencies. No digital money flows; ownership changes.
It's just like when you write a check on your bank. No money "flows." Ownership of digital entries changes -- account by account, bank by bank.
Keynesian textbooks never explain this. Most readers do not understand it.
Monetary capital does not flow. It changes hands. Wow! Another euphemism! It doesn't change hands. It is not paper money. No one touches digits. Ownership changes.
Dollars do not wind up in European banks. Legal claims on dollar-denominated assets do. But if the European Central Bank is not the purchaser, these digital entries have no effect on the prices of European goods and services.
To use borrowed language, central banks propose, but commercial banks dispose (the asset vs. excess reserves issue).
Commercial banks do not propose. They operate under the reserve requirements of the national central bank. If they buy a dollar-denominated asset, they must sell other assets. This does not change the domestic money supply . . . unless the bank reduces its excess (idle) reserves held at the central bank and buys the legal claim, called an IOU. But it could have done that at any time to purchase any IOU.
Unless a central bank buys an IOU from someone with newly created money (IOUs) issued by the central bank, changes in ownership of IOUs have no effect on domestic prices. If it buys an IOU denominated in dollars and sells IOUs denominated in yen, these future dollars will have no effect on the domestic price level of the the central bank's nation. The yen would also have had no effect.
What has an effect? The newly created IOUs issued by the central bank.
To understand why a central bank buys dollar-denominated IOUs rather than some other IOU, search this site for:
I post this in response to a question.