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.
Money and lending, of course, are central to banking and all financial activities. They are also deliberate in the sense that governments and central banks have much, though not complete, control over the money supply while banks grant or refuse loans. Conversely, inflation apparently “just happens.” That is, inflation is the backward-looking measure of how general prices have changed over the past month, quarter, year, et cetera.
There are no clear and coordinated public announcements of price changes as they occur to items such as fresh produce, heating oil, college tuition, and urban subway fares.
In this way, inflation is analogous to the weather. We see easily what the weather is today where we stand, yet the underlying causes of that weather are numerous and clouded. When the local market or oil company or university or city raises prices, the common explanation is “our costs have gone up.” Such an answer provides no clarity on the cause of the inflation!
Mark Twain allegedly quipped that “everybody talks about the weather, but nobody does anything about it.” Well, everybody talks about inflation (or deflation), too. Here’s where the analogy fails. The world has plenty of people and institutions “doing something” about inflation. The governments, central banks, and banks drive the level of inflation (or deflation) through monetary policy and lending. This chapter explains and explores inflation’s connection to money and lending.
Increasing the Money Supply Produces Inflation
History has shown many times that “printing money” leads to higher average prices for a country’s goods and services. In chapter 8 we noted the hyper-inflation of Germany and Austria circa 1923.[1] Leland Crabbe provides a concise statement:[2]
“In January 1923, France and Belgium invaded the industrial Ruhr valley in Germany, offering the failure of Germany to meet reparation payments as justification. The Germans responded with passive resistance, and output in the Ruhr fell two-thirds. The German government printed money to support the unemployed in the Ruhr and thus launched the German mark on its famous hyperinflation.”
As another “data point,” Crabbe also writes:[3]
“In the early days of [World War I], Austria-Hungary, France, Germany, and Russia all went off the gold standard as they suspended specie payments and instituted legal or de facto embargoes on the export of gold by private citizens. Like the British Treasury, the governments of these warring countries exported gold and borrowed heavily to finance the war, but these tactics raised only a fraction of the large sums of money that the war required. Because new taxes did not and could not make up the difference, the continental belligerents financed a large share of the war by printing money, which caused prices to soar and complicated the return of these countries to the gold standard after the war.”
Finally, we quote a short excerpt of a study of Zimbabwe in 2010:[4]
“With a shrinking tax base and revenue that could not support expenditures and obligations, the government printed yet more money. Currency lost value at exponential rates amid an imbalance between economic output and the increasing money supply.”
Jumping from historical anecdotes to hypothetical scenarios, let’s consider a few simple examples. Imagine that the Fed, the U.S. central bank, creates a “millionaire project” to print and give $1 million to every U.S. citizen. By printing Federal Reserve Notes (paper money) or wiring funds to our bank accounts, the Fed sends $1 million to all 300 million citizens.[5] This example is certainly extreme. The median net worth of U.S. households is well below $100,000,[6] so the new $1 million per person increases median net worth by more than a factor of ten. The total “new money” would be $300 trillion (300 million people multiplied by $1 million per person). We noted in chapter 8 that the 2014 outstanding Fed liabilities are roughly $4 trillion,[7] hence the “new money” would swamp the Fed balance sheet.
Prices in this unrealistic scenario would skyrocket. Many if not most people would immediately spend much of the new money and bid higher the prices of expensive and limited items such as houses, cars, and jewelry. All prices would rise including the price of labor since most workers would not choose to continue to work for the previous salaries. It would not be possible to pinpoint the order in which various prices increase in order to determine cause and effect. Water flowing into a bathtub raises the level everywhere.
Next consider a non-monetary analogy. Consider company X with 1 million publicly traded shares of stock that the market currently values at $100 per share. The value of the company, also known as market capitalization or “market cap,” is then $100 million. Company X designates a 2-for-1 stock split for the next day. All shareholders surrender their existing shares of stock and receive 2 shares of new stock in X. The market traded value of the new stock jumps immediately down to $50 per (new) share. Neither the government nor regulators nor the stock exchanges “force” the price of new stock to follow the stock split ratio in this manner. Rather, the market investors and specialists adjust their indicated bid and ask prices according to their economic judgment that each new share is identical to half an old share.
In this stock-split example, company X has authority to increase and decrease its outstanding shares in this manner – just as a central bank and government may increase or decrease the money supply. The analogy is a simplification since there is only one price to watch with the stock of company X rather than a seeming infinity of prices across an economy. Further, the company X scenario has full disclosure. All market participants receive forewarning and a precise date of the stock split. Yet the principle is apt. Issuing more money depresses the value of the money (evident in the general price inflation) just as issuing more company X stock depresses the price of that stock.
There are, unfortunately, a few caveats. Likely the most important is that increasing money supply will not impact inflation if the new “printed money” does not circulate. Suppose the central bank prints the (ridiculously high) $300 trillion of the earlier example and gives these funds to a small number of entities that simply leave the new money untouched. New money that is not spent and not invested essentially does not exist. The new money will be inflationary only if and when these entities spend or invest the funds.
While this scenario may strike one as far-fetched, we see it today (2014-2016) with U.S. and European banks holding excess reserves with their central banks.[8] In the U.S., banks hold $2.6 trillion of excess reserves.[9] The Fed has increased the money supply by more than $3 trillion from 2007 to 2014,[10] but this growth of bank excess reserves – “dead money” – from essentially zero to $2.6 trillion over the same period has blunted the inflationary impact of the money creation.
As a final point regarding government and central bank “money printing,” let’s acknowledge that the activity is not as simple as distributing money to 300 million U.S. citizens of the earlier example. Our references to the German hyper-inflation, World War I inflation, and Zimbabwe noted that the governments in each case printed money to pay government expenses. Whether the manufactured money goes to citizens “for nothing” or whether the money pays for citizens’ labor (paving roads, for example) doesn’t matter. The new money in the economy devalues the existing money – which is to say that general prices rise to reflect devalued money.
This principle also applies to the OMO (“open market operations”) we discussed in chapter 8. In OMO, the central bank creates money to purchase government debt obligations.[11] One might posit that removing a financial asset (the debt obligation) from the economy could neutralize the injected money with respect to price inflation. But that’s not the case. All else equal, as long as the new money circulates, general price levels will rise. One meaningful difference of this OMO, though, is that the principal payment at maturity of the debt obligation will reverse the money creation. The new money effectively flows back to the central bank and is destroyed. Thus, the habit of central banks is to purchase new debt securities immediately with funds from principal repayments to maintain the level of balance sheet assets.
The next excerpt for Chapter 10 will discuss the impact of lending on the Money Supply and Prices and the Boom-Bust Cycle.
[1] A. Fergusson, When Money Dies: The Nightmare of the Weimar Collapse, Kimber, 1975.
[2] See page 430 of L. Crabbe, “The International Gold Standard and U.S. Monetary Policy form World War I to the New Deal,” Federal Reserve Bulletin, 423-40, June 1989.
[3] Id. at page 426
[4] “Hyperinflation in Zimbabwe,” Federal Reserve Bank of Dallas Global and Monetary Policy Institute 2011 Annual Report, 2-12. The statement that “currency lost value” is equivalent to rising general prices.
[5] The U.S. population of 2014 is almost 320 million (see http://www.census.gov/popclock/), so we’re rounding to 300 million.
[6] See data for 2011 (latest year) available at http://www.census.gov/people/wealth/ .
[7] See the Fed’s balance sheet of February 26, 2014 and discussion in “Quarterly Report on Federal Reserve Balance Sheet Developments,” Board of Governors of the Federal Reserve System, March 2014. This level remains roughly valid in 2016 also.
[8] See T. Keister and J. McAndrews, “Why Are Banks Holding So Many Excess Reserves?,” Federal Reserve Bank of New York Staff Reports, no. 380, July 2009, for a pre-2014 discussion of U.S. excess reserves. See http://www.ecb.europa.eu/mopo/implement/mr/html/index.en.html for numerical values of 2014 in the Eurozone.
[9] See http://research.stlouisfed.org/fred2/series/EXCSRESNS
[10] In C. L. Evans, “Are We There Yet?,” Federal Reserve Bank of Chicago speech to AgFirst Farm Credit Bank, September 2013, Mr. Evans notes that the Fed balance sheet stood at $0.8 trillion in August 2007. At the time of his speech, the balance sheet had soared to $3.5 trillion and it now exceeds $4.0 trillion as we discussed in chapter 8. For the definition of “money supply” in this statement, we use “monetary base” – the sum of currency in circulation and reserve balances at the Fed.
[11] The term “OMO” also includes the reverse process of a central bank selling government debt securities it already owns and “destroying” the money it receives.
