Once you understand this you can understand the 21st century economy and Federal Reserve policy. If you can’t, rich people will lead you to believe things against your interest, like government debt is your mortgage or a trade deficit is money we owe other countries.
What follows is a simplistic explanation. A longer one can be found here.
The amount of money in circulation should approximate what’s needed to sustain economic activity. In a normal time, you can see how much you need by its price and what’s happening to prices in the economy.
When there’s not enough money, as was true in the Great Depression, the Great Recession and under COVID, economic activity grinds to a halt. People don’t buy stuff thus people can’t sell stuff. In the first two events, there was too much stuff for the money available. In the latest case, there wasn’t enough money to buy the stuff.
When there’s too much money people start paying ridiculous prices for garbage “assets.” Cryptocurrency is a symptom of this. So are SPACs and stocks that either have no revenue (2000) or no profits (2022). Even real things cost more than they’re worth. Stock in companies doing well trade above their fundamental values. Real estate becomes unaffordable, hoarded by people with money.
There are two ways the bank can deal with this. It can raise the price of money, hiking interest rates. It can also reduce how much money is running around. It does this by selling loans, and right now the Federal Reserve has a shit-ton of loans to sell. Many were acquired to deal with COVID, and some of them are garbage now. But selling the loans turns money into money-making assets, and so reduces the amount of money available for junk “investment.”
The aim of the exercise is to reduce inflation and bring the supply of money into line with real economic activity. If you have money in garbage, you’re going to be zeroed out. Even if you have money in good stocks, their value will decline. Same with your house. There’s now less money to buy all that. Things take time to adjust.
One caveat. The dollar is not the only kind of money, the Federal Reserve is not the only bank. What we are doing right now is increasing the value of the dollar relative to other currencies. We’re exporting our inflation, importing deflation. This may prove the gating factor on current policy. If we bankrupt the Japanese, Europe, and China, we’ll have no one to trade with, and billions of people will be shooting at us. We need to proceed with caution, to coordinate policy among central banks, so the world economy doesn’t collapse.
