Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt.
The previous excerpts for Chapter 10 explored connections between Inflation, the Money Supply, Lending, Boom and Bust, and Fractional Reserve Banking
Tale of Two Countries
At some risk of complicating the discussion, we add a section here on money, lending, and inflation among two countries that share a common fiat currency. We have the Eurozone in mind. The added complexity aids our understanding of the simpler case somewhat and has the benefit of highlighting risk that the central bank bears.
To visualize the impact of central bank lending to countries with persistent trade deficits, we create simple pictures in the following sub-sections. Consider a world consisting of just two countries (A and B) which share the same currency (€). Let’s assume that A and B are similar “today” in many respects such as money supply, price levels, and population. But A imports more from B than it exports to B. The consequences of this trade deficit depend on government and market reactions. We consider four cases below which guide us to a potential real world situation such as the Eurozone. Case 4 is most relevant to a practical situation.
Case 1: Fixed Amount of Money
Figure 10-1
Let us stipulate that the total money supply € is fixed and that there is initially an equal money supply in both A and B. Other than trade (exchange of goods and services for €) between A and B, there is no other form of investment between the two countries.
The first impact is that the money supply in A must fall while the supply in B rises by an equal amount. With the scarcity of money, general prices in A will fall. Hence, A experiences deflation while price levels in B inflate. As prices fall in A, labor costs and the prices for goods and services produced in A will also fall. Conversely, B will experience increases in labor costs and the prices of goods and services. Both the deflation in A and the inflation in B will push the trade between the countries closer to balance since consumers in A (B) will find imports from B (A) to be more (less) expensive. In the steady-state, A and B will reach different overall price levels that result in zero trade deficit.
The price adjustments in the two countries are “natural” in the sense that they do not need to be calculated or imposed by government or any other entity. We see the example of price level adjustments everywhere. Consider different regions of the same country such as Washington, DC (“DC”) and Albuquerque, New Mexico (“ABQ”) in the United States. As the seat of the federal government for the US, DC is a tremendous exporter of “political services.” One would certainly expect a net flow of money to DC if all price levels were equal. Conversely, ABQ has much less economic activity and fewer highly paid professional opportunities. To put it simply, there’s more money (per person or in an absolute sense) in DC than in ABQ. Prices and wages respond to the imbalance such that average per capita income is twice as high in DC as in ABQ. Hotel rates, restaurant meals, and gasoline prices are all higher in DC. If a young chemical engineer has job offers in both DC and ABQ, the DC job will need to pay much more to compensate for higher living costs. But that’s not a problem – there’s more money in DC.
It may seem unnecessary to provide this DC-ABQ example. There’s no surprise or mystery of price level differences intra-country. We emphasize, though, that this is a monetary phenomenon.[1] That is, one could conceivably explain that DC prices are higher because population density is higher. More people want to live and work around DC. Housing, therefore, should be more expensive in DC than in ABQ because there is greater demand. There is some truth here, but it’s the money supply around DC that induces the higher population and it’s also the money supply that “chases” housing prices higher.
Note that this discussion involves just one currency in which there is no deliberate manipulation of money supply. As long as the money supply remains fixed, this currency could be US dollars or EUR or gold.
Case 2: Money Infusion through Gifts and Grants
Figure 10-2
Consider the situation of Case 1 in which a third party such as a government or non-governmental organization (NGO) injects money into Country A with no repayment obligation. If the rate of injected € equals the rate of net € transferred to B in the trade imbalance, then the money supply within A remains constant and we expect the price levels of A to hold constant as well.
For the impact on Country B, we must specify the source of the € injected into A. Since our simple examples stipulate that countries A and B define the entire world, the money injected into A either must come from B or it must be created from nothing (i.e., “money printing”). Choosing the latter, the total money supply increases over time at the rate of the money printing. Country B would therefore experience inflation while prices in A remain stable. This money-creation funding enables the trade deficit to persist with no immediate negative consequence for A.[2]
If, instead, Country B donates the € to inject into A, then the total money supply remains fixed and price levels in A and B should remain quiescent. An example of “donated money” is public works spending from DC, for example, to ABQ. (As it happens, the largest employer in ABQ is an Air Force base. Another large employer is a national research laboratory. DC – the Federal government – funds both of these ongoing activities. One might view the Air Force base and national laboratory as public works projects or as exports of services from ABQ.)
Case 3: Country B Lends to Country A
Figure 10-3
Case 2 showed that grants and gifts to Country A could offset the loss of money supply due to the trade imbalance between the two countries. Net lending from Country B to Country A also accomplishes this offset in the short term. It may be that exporters in B lend to customers in A to fund purchases. But we will speak in terms of the economically equivalent lending of banks in B to banks in A. Alternatively, we could say that the NCB (national central bank) of B lends to the NCB of A. In any form, the concept is the same. The net rate of € transfer from B to A due to lending will replenish the flow of € from A to B due to the trade deficit.
If these two rates are comparable, then price levels in countries A and B should remain stable. If the trade deficit persists year after year, though, then the net outstanding loans of banks in B to banks in A would need to grow every year to continue to offset the trade deficit. Clearly there is a natural limit to the total loan exposure that can accumulate. Individual banks in B would not lend more to a single bank in A than is prudent given the potential for the latter bank to default on loan repayment. Thus, lending cannot offset a trade imbalance indefinitely.
The borrowers, of course, must eventually repay their loans. Even if the € flow from lenders in B to borrowers in A offsets the trade imbalance for a period of time, the lending € flow must ultimately reverse when banks in A repay banks in B. Hence, the monetary impact of the trade imbalance is merely delayed. At some future point, prices in A will deflate as prices in B inflate if the trade imbalance persists. A realistic outcome is that banks in B will agree to refinance some of the maturing loans and maintain a constant outstanding loan balance to banks in A. Net new lending will cease due to the risk management concern so that this Case 3 reverts to Case 1 such that A will deflate and B will inflate to the level necessary to bring trade into balance.
Thus far, we’ve assumed that banks in A remain willing and able to repay loans to banks in B. To the extent that banks in B suffer any loan losses, the monetary impact is indirectly inflationary for A and deflationary for B in the sense that the € loss amount is effectively “donated” from B to A (Case 2).[3] Of course, repayment defaults of banks in A will also reduce the capital and earnings of creditor banks in B and possibly discourage future lending to A.
Case 4: Country B Lends to Country A through a “Central Bank”
Figure 10-4
Let’s imagine that countries A and B retain their own national central banks but jointly create a new Central Bank (“the CB”) to determine and oversee € monetary policy for the combined “AB region.” Shareholders of the CB are the NCBs of A and B. Our fourth and final Case stipulates that, like Case 3, banks in Country B lend to banks in Country A to offset the trade imbalance. But here, banks in B aggregate their lending through their home NCB to the CB. Thus, the CB is the borrower of € from banks in B. The CB then lends to the NCB of A which lends € to individual banks of Country A.
All our observations regarding Case 3 apply here as well since this Case 4 also features net lending of Country B to Country A. The presence of the CB “nets out” in this regard. But the intermediating role of the CB does add a few new properties. First and foremost is that lenders in B likely view the CB as being far more creditworthy than individual banks in A. In fact, many observers (journalists, politicians, regulators) may even consider the CB to be “risk-free.” Thus, banks in B will be comfortable with a larger outstanding par amount for their loans with the CB as borrower. Hence, trade imbalances will persist for a longer period before overt monetary consequences are evident. Lenders may not consider themselves to be enabling or perpetuating imbalances since they see themselves as simply lending to the CB.
A second distinction due to CB loan intermediation is the set of possible outcomes when banks in A fail to repay loans. The NCB of A may absorb the losses. If not, the CB will either write down its equity or print € (increase the money supply). With the former option, the losses are borne by the shareholders of the CB (i.e., the NCBs of A and B). In effect, these losses are distributed to the banks in B.[4] This outcome of bank failures in Country A, then, is similar to what we found in Case 3 (i.e., losses borne by lending banks in Country B).
But the CB may well choose the second option of printing currency to withstand losses of bank defaults in Country A so that the CB may repay its loan obligations to Country B. The CB’s increase of the money supply will ultimately be inflationary to Country B.
[1] Milton Friedman is often quoted for “Inflation is always and everywhere a monetary phenomenon.” See, for example, F. S. Mishkin, “The Causes of Inflation,” NBER Working Paper No. 1453, September 1984.
[2] As a real-world example, there are allegations that the U.S. Fed “exports inflation” in this manner. See, for example, “Fed Exports Inflation, Stokes Revolutions,” Forbes, March 8, 2011.
[3] As a more extreme hypothesis, the banks in B could forgive the loans to the borrowers in A. We would say this action is indirectly inflationary in A and deflationary in B since future loan repayment – which would have deflated A and inflated B – is eliminated.
[4] The NCB of Country A is likely unable to contribute more capital to the CB at this point. Thus, the brunt of any capital call should fall to the NCB of Country B. The shareholders of the NCB are the country’s banks.
