Why the ‘Great Inflation’ didn’t happen
Along with many others, I expected that the great money printing binge that the US Federal Reserve kicked off in November 2008 to create massive inflation. As the Fed does, they came up with a great term to make it seem as if they knew what they were doing (Quantitative Easing, or QE for short, of which there have now been three programs, QE1 through QE3) and a rationale for it, based firmly in Keynesian economics: that triggering inflation would stimulate demand.
Those of us who consider classical (i.e. pre-Keynesian) economics to be a better depiction of reality took one look at this and either shook our heads sadly or laughed hysterically. Many of the classical (or Austrian economics) writers claimed this would inevitably lead to inflation, and probably hyper-inflation given the massive scale of the printing.
Why then have we not seen the prices of everyday goods spiralling upwards in the US in response to this huge increase in the monetary base, which should have reduced the value of money?
The start of the answer goes back to the basic money supply equation that the monetarist school used to love – MV = PQ (I promise – that’s the last equation I will use) where the total stock of money multiplied by the average number of times it’s used in any given period must, by definition, equal the average price of all items multiplied by the number of items. The monetarists argued that the velocity (“V” the average number of times it’s used bit of the equation) will remain fixed, or change only slowly. As the number of items sold (the “Q”) will also change only slowly therefore the only way to change the price level (“P”) would be to change the amount of money (“M”).
Given the massive change to the money supply, why did we not see a huge change in the price level? Even the Keynesians expected some change, it was the whole point of the exercise. The failure of QE1 to achieve this lead to QE2 and QE3, each of which in turn failed to stimulate demand as forecast. For Austrians and their classical forebears this was not a surprise, but the failure to cause inflation was.
The simple answer is to look at velocity. In short, it dropped by about as much as the money supply increased. The money was not used for the purchase of goods and services, so the huge change in money above did not affect the price level. Apart from further falsifying the claims of the monetarists, what happened?
The answer is a simple one: all that money that was printed (or at least, that had computer records created) was not used for transactions. As I noted earlier, money only has a use in its ability to ease transactions. In chart after chart from the St. Louis Fed you see that it was deposited straight back with the Fed or in other US Government departments.
As with Japan’s experience of quantitative easing from March 2001 what happened was that banks sold their debt holdings (mostly US government Treasuries) to the monetary authority (the Bank of Japan and the US Fed respectively) and, in return, received newly printed cash, or at least the computer record of it.
Some of that cash was then used to increase cash reserves at the banks, depleted as a result of the loss of confidence in the banks and the rest was then deposited back with, in the US, the Federal Reserve, at an interest rate. Almost none of it was lent out to customers.
Even the customers who withdrew the money from the banks mostly just sat on the cash, perhaps by putting it in a tin under the bed. Others bought gold with it (as a chart of the gold price demonstrates) or bought riskier assets, such as shares and so forth. Very little of it found its way into consumer goods or services, so their prices were not affected. It short, it was a shell game, but a profitable one for the banks as the deposits with the Fed mostly had a higher interest rate than the US Treasuries they sold.
The Japanese experience of this particular shell game is illustrative, the Japanese economy has barely grown in the entire period since it started, over 16 years ago. The government has continued increasing debt, the Bank of Japan has continued to print money to cover it and the banks have made money out of buying the government debt using the money printed by the Bank. It has not worked to grow the Japanese economy.
What will happen next in the US is a good question. All that debt that was sold to the US Fed to allow for the money to be produced will still need to be repaid. The US Fed now has a massive balance sheet, with copious amounts of assets matched by vast amounts of money outstanding.
The Fed could do a direct swap back and hand the Treasuries and other assets back to the banks and then cancel the money. This would be a huge problem for the US Treasury though, as the large amount of its debt flooding back onto the market would likely drive their price down meaning that the interest rate would go back up and future debt issues by the US government would become more expensive. Given the huge amount of US government debt outstanding (nearly $20 trillion) this would be close to catastrophic for the US budget.
The US Fed could just stop paying interest on the deposits they hold – but this would then mean the banks would need to get a return on the money in some other way, meaning they would be likely to lend it out or buy other assets. This would then mean massive amounts of cash flowing into the real economy, triggering a Great Inflation. This would be good for the US Treasury, in a way, as the real value of the debt they owe would drop quickly and the dollar value of the tax receipts would increase, making the debt easier to repay.
The Great Inflation would, however, devastate the real economy. Perhaps this would not be on the scale of the hyperinflation of Germany in 1923 or Zimbabwe 2008, but it may well be a revisit of the experience of the 1970s stagflation.
Why has the Great Inflation not happened? The answer is: it hasn’t happened yet. The US Fed can keep delaying it by printing money and continuing the shell game at the cost of continued anaemic growth. It can avoid it at the price of forcing the US government to pay a proper price for its debt. Whatever it chooses, the longer-term outcome is not a pretty one.
My advice? Buy gold – or bitcoin. Neither of those can be printed.