By 4 November 2009, the US monetary base had increased by 142% over the previous two years to about 2 trillion dollars. These unprecedented and large open market operations conducted by the Fed stirred up the usual suspects, including a number of hapless Austrians and others, who were screaming that hyperinflation was on the way. A good example of such dire predictions can be found here:
Marc Faber with Peter Schiff – Hyperinflation in the United States a 100% Certainty, Glenn Beck, 28th May, 2009.
Other pro-free market bloggers boldly proclaimed that the UK or the US was the new Zimbabwe, with equally ridiculous and contemptibly stupid rhetoric.
Now we are in the first month of 2011, and there is no sign of any hyperinflation. In the UK and US, 2010 was a year of disinflation, not accelerating inflation.
Moreover, despite the initial QE in 2009, there was massive disinflation or outright deflation in the US or UK in that year. Various Austrian and other free marketeer predictions of hyperinflation were, and still are, wrong. Why?
The simple fact is that inflation of the base money supply by x% does not necessarily cause price inflation of x% (and to believe so relies on the flawed quantity theory of money which I have criticised elsewhere on this blog). Nor does a large increase in base money necessarily mean a large increase in the CPI, particularly in an economy with high unemployment and low growth. Predictions of hyperinflation in the current economic conditions are absurd. There is no reason why all the base money created by QE will be injected into the economy by banks when business confidence is low, credit demand is limited, and banks themselves are wary of lending.
The key to all this is the Post Keynesian insight that the broad money stock is essentially endogenous (for the classic study, see Moore 1988), a view which is also held by the monetary circuit theorists, was supported by Wicksell and Schumpeter (Howells 2006: 53), and can be traced back to the 19th-century Banking school (Wray 1998: 32–33).
Before we discuss endogenous money, however, we need to distinguish properly between (1) the base money supply and (2) broad money stock.
I have done this in the section below, and take the US as an example:
(1) High-powered money (= monetary base, base money, M0)Now we can review the facts above. If it is to cause inflation, QE-created money has to be injected into the economy by debt and then spent into an economy to inflate the prices of commodities. But private credit/debt is precisely what collapsed in the UK and US in late 2008 and 2009: we are in a debt deflationary environment with deleveraging, where the private-debt-derived part of aggregate demand has fallen or even gone negative, just as the Post Keynesian economist Steve Keen has shown in numerous posts on his Debtdeflation blog (Steve Keen, “What Bernanke doesn’t understand about deflation,” Debtdeflation.com, August 29, 2010).
Base money is currency in circulation and bank reserves (both required and excess reserves).
This means that the monetary base includes all cash and coins, even vault cash at banks, as well as deposits that banks hold at the Fed (which are reserves). Reserves come in two forms: (1) required reserves and (2) excess reserves. The latter are balances held at the Fed in excess of required (or minimum) reserves. It was excess reserves that soared after quantitative easing began in 2009, when in March the Federal Reserve announced it would purchase $300 billion of US government debt over 6 months. Banks sold bonds and then mortgage backed securities (MBOs) to the Fed.
Now no one denies that the central bank has the power to increase the base money supply by open market operations, and to control the interest rate.
But we need to look carefully at what is meant by the expression “printing money.” This expression has two meanings:
(1) expansion of the central bank’s balance sheet and the base money supply (M0), and
(2) central bank financing of government deficits (= monetizing deficits).
In sense (1), one can refer to the Fed’s QE as “printing money.” But the money created is reserves, and the process involved is actually better described as an asset swap: the banks swap their bonds for reserves. Furthermore, since required reserves and excess reserves are merely held at the Fed, they are not injected into the economy, nor are they used to buy goods or services. Money in the form of reserves merely held at the Fed is not inherently inflationary, despite the nonsense from many economic commentators over the last few years. Reserves must be turned into private debt and spent into the economy to enter the broad money stock before becoming inflationary.
(2) Broad money (M1, M2, M3)
Broad money is different from base money, and can be measured by M1, M2, or the now discontinued measure M3.
M1 is the most liquid form of money. M1 includes:
(1) currency in circulation outside bank vaults (and also excluding bank reserves),
(2) checking/transactions accounts (or demand deposits) and other checkable accounts, and
(3) travelers checks.
M1 excludes vault cash and bank reserves at the central bank. All M1 money can be spent quickly or relatively quickly, and is not locked up in time deposits. The key is that M1 does not include bank reserves. This is very important. Reserves, a major part of the monetary base, are not included in M1, or in any other measure of broad money. This is why, when base money supply soared in 2009, M1 did not increase by the same amount. Thus, when Austrians complain that QE caused massive inflation of the money supply, they refer to the monetary base, not to the broad money stock M1. But, as we have seen, inflation of M0 does not necessarily increase M1, unless the money is injected into it via private debt.
The two other measures of broad money are M2 and M3, and they include increasingly less liquid forms of money, such as time deposits, money market deposits, and savings deposits. Thus M2 is as follows:
M1 supply + money held in money market funds + savings accounts + small certificates of deposit (CDs).
M3 is simply M2 plus large CDs. The M3 measure was discontinued by the Federal Reserve in 2006, although Shadowstats.com maintains a useful estimate of M3.
One of the most important facts about M3 is that from 2009 to 2010, M3 actually contracted (see Ambrose Evans-Pritchard, “US money supply plunges at 1930s pace as Obama eyes fresh stimulus,” http://www.telegraph.co.uk, 26 May 2010), which can be seen on Shadowstats.com:
http://www.shadowstats.com/charts/monetary-base-money-supply
Although both M1 and M2 have increased since 2008, the percentage increase has been nothing like the 140% increase in base money.
In April 2008, M1 was about $1.4 trillion, and is now about $1.8 trillion. This is an increase of 28.57% since 2008. In November 2007, M2 was $7.41 trillion and has gone up to about $8.8 trillion in November 2010, which is an increase of 18.75%.
Moreover, if one looks at the historical growth rates of M1 and M2 over the past 50 years, one can easily observe that the percentage increases over the past few years are not unprecedented at all (see the longer term historical monetary charts at Shadowstats.com). Despite base money surging by 140%, M1 and M2 have not exploded. Nor has inflation.
What should be particularly damning for the hyperinflation hystericists is the recent contraction of M3, the broadest measure of money.
We must remember that, just as the creation of debt creates broad money, the repayment of debt destroys broad money (Wray 1990: 73). We therefore have an endogenous system that creates and destroys money, and expands and contracts the broad money stock.
In the current environment of private deleveraging, debt is being paid down, and there are powerful forces at play destroying broad money, which are probably reflected in the contraction of M3 (although higher capital asset ratios are also a reason). We can also note that, in the latter part of 2009 and early in 2010, M2 remained flat and even declined slightly at times, which may well have been caused by money destruction through private deleveraging.
When we say that the broad money stock is endogenous, it means that changes in M1 are essentially caused by internal factors like the amount of private debt issued by the banks and private demand for such debt (for the debate between accommodationists and structuralists on endogenous money, see Fontana 2003: 291–292 and Piegay 2003). Thus the broad money supply is determined by demand for bank credit, and the latter is itself caused by other economic variables, such as expectations, business confidence, the state of the economy, and other factors. This is in stark contrast to the neoclassical and monetarist view that the broad money supply is purely exogenous: that is to say, that the money supply is determined and controlled by central banks outside of the private sector. The myth that the broad money stock or its growth rate is under the direct control of the central bank was demonstrated as false during the disastrous experiment with monetarism in the early 1980s in the UK and US, particularly in Paul Volker’s failed monetarist experiment from 1979–1982. Volker tried to control the growth rate of M1, through targeting non-borrowed reserves, but this was a miserable failure, with the Fed badly missing its M1 targets (Wray 2003: 92). In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy, through the Federal funds rate (which had always been the main policy instrument before 1979). The Fed tried to target M2 growth rates for the rest of 1980s, but this was also a failure, and the monetarist fiction that the Fed controls broad money was officially abandoned in 1993.
In short, central banks do not directly control the broad money stock or its growth rate. Instead, the central bank controls the interest rate and supplies reserves, while broad money is created by the banks, which often obtain reserves afterwards (Howells 2006: 52).
Post Keynesian economists like Nicholas Kaldor, Basil J. Moore and Thomas I. Palley have defended and developed the endogenous money theory. In brief, the conventional textbook account of our monetary system relies on the money multiplier, a view that is false, as shown here by Bill Mitchell (Bill Mitchell, “Money multiplier and other myths,” April 21st, 2009).
With new private debt issued by banks constrained by falling demand, the idea that all the excess reserves created by quantitative easing would enter the economy and inflate M1 to a large extent, causing massive inflation, was ridiculous, even in 2009. With the net annual change in private debt falling in the US, internal deflationary forces are gripping the economy. Those deflationary forces have been reduced by deficit spending and Keynesian stimulus, which certainly prevented a global depression. But the stimulus packages in the UK and the US have been insufficient to stimulate the economy back into full employment. The US case is particularly dire: the most accurate government measure of unemployment in the US is U-6, and that stands at 17%. John Williams of Shadowstats.com thinks that even U-6 is not wholly reliable and produces his own estimate, which is now running at a shocking 22%. There is also a significant amount of excess capacity (idle capital) in the US and UK, so that if demand was to surge, what would happen is that capacity utilization rates would rise, rather than disastrous inflation.
Moreover, many Western economies have dysfunctional banks and excessive private debt. What is needed now is a thorough auditing of the financial institutions of the US, the UK and other Western countries. Non-performing loans and bad assets must be written off or restructured. Effective financial regulation needs to be re-introduced. Then radical Keynesian stimulus needs to be conducted to bring down unemployment.
In the absence of such policies, the most likely scenario for the West will be debt deflation and low growth for many years, possibly like Japan’s lost decade in the 1990s. Japan itself tried quantitative easing from 2001–2006, with the monetary base in Japan rising by 70%. The Bank of Japan increased the base money from about 65 trillion yen in 2001 to 110 trillion yen by 2006. But no hyperinflation ever resulted: in fact, deflation continued for some years after 2001 in Japan.
In fact, Japan offers the West some stark lessons. Japan suffered from a property bubble in the late 1980s and early 1990s (after ill-advised financial deregulation), and that bubble burst. Japan then endured the lost decade from 1992–2003. Though the causes of it are hotly debated, it seems clear that debt deflation, a zombie banking system infected by non-performing loans and bad assets, and an overvalued currency crippled the economy. The economy was on life support, and was saved by intermittent use of Keynesian stimulus, which, when done properly (as in the case of 1995 stimulus package), worked well (for the myth that Keynesianism did not work in Japan in the 1990s, see Posen 1998: 29–54 and R. Katz, “The Truth About Japanese Stimulus, Fiscal pump-priming can work to revive the economy,” January 16, 2009).
But the real lesson from Japan is that debt deflation and a zombie banking system must be fixed before an economy can function properly, and Japan did not really address the problem of bad bank assets until after 2002 with the Takenaka Plan.
One other important point should be stressed: Japan is an export-led growth economy. The yen was clearly overvalued for much of the 1990s (see Lok Sang Ho, “The Moral of Japan’s Lost Decade,” February 24, 2009). The low interest rate policy pursued by the Bank of Japan and its later turn to QE helped to cause depreciation of the yen through the carry trade, which allowed export competitiveness to be restored by the early 2000s. This was no doubt a factor in economic recovery that ended the lost decade. But QE in Japan did not stimulate domestic aggregate demand to a significant extent, nor did the broad money stock rise proportionally or significantly, just because the base money was inflated by QE. Instead, deflation continued until 2006.
It is possible that with austerity the US or UK might even slip into deflation again, although the demand for primary commodities from China and other developing nations which are factor inputs for the West will probably keep inflation mild to moderate.
Another factor ignored by those who predicted hyperinflation is that such a phenomenon generally requires a severe loss of confidence in a currency as a store of value, and this can be quite independent of the changes in the money supply (for an excellent account of hyperinflation and the Weimar episode, see Rob Parenteau, “The Hyperinflation Hyperventalists,” New Economic Perspectives Blog, March 22, 2010; and the Richebächer Letter, Number 417, June 2009, p. 4ff.). Often terrible crises are required to cause hyperinflation, such as ruinous wars, supply shocks, blockades or sanctions, civil war or internal collapse. In Weimar Germany, the classic instance of hyperinflation, there was
(1) a supply shock caused by WWI and the loss of productive capacity and output, made worse by the occupation of the Ruhr Valley in 1923;It is obvious that these factors do not apply to the US or the UK. There have been no savage supply shocks affecting production in America or Britain; instead, there is significant unused capacity in these countries. Although there has been significant depreciation of the pound sterling and the US dollar, that is simply not the same thing as a collapse of the currency. Nor are budget deficits in either country anything like Weimar Germany: in fiscal year 2010, the US budget deficit was 9.1% of GDP and is projected to fall to 7% of GDP in fiscal year 2011. In the UK, the budget deficit for 2010 was about 12% of GDP. Neither the US nor the UK is being invaded, and the wars in Iraq and Afghanistan are confined to those countries. In short, the factors that applied to Weimar Germany do not apply to the US or the UK.
(2) huge war reparations and budget deficits (in 1919, for example, the German budget deficit was perhaps as high as 50% of GDP); and
(3) exchange rate collapse.
In November 2010, the Fed announced a second round of quantitative easing (QE2), in which it would buy up to $900 billion of US Treasuries by quarter 3 of 2011. What are we to make of this? The first round of QE failed to stimulate aggregate demand and end high US involuntary unemployment, and I expect the second round will as well.
But the zero interest rate policy (ZIRP) in the US, of which QE is a part, will probably encourage more speculation in equities and commodities, and the US dollar carry trade. However, it is US dollars in the money markets which will be mainly used in these speculative and carry trade activities. Most of the new excess reserves created by QE2 will probably remain at the Fed, just as most of the base money created in QE1 has stayed at the Fed. We must remember that base money went from $800 billion in 2008 to about 2 trillion in early 2010, and has hovered around $2 trillion ever since. The $1.2 trillion created in QE1 has not entered the economy, but has been held by the banks as excess reserves.
A worst case scenario that is a possibility is that the US zero interest rate policy could fuel speculation in energy and commodities (particularly ones that are important factor inputs), which, combined with demand from emerging economies, might cause double digit inflation.
But, even with QE2, the idea that hyperinflation is on the way remains absurd: it is nonsense from people who are, moreover, clueless about how the modern monetary system actually functions.
FURTHER READING
Steve Keen, “The Roving Cavaliers of Credit,” Debtdeflation.com, January 31, 2009.
This is a classic essay from Steve Keen on endogenous money in the context of 2008 financial crisis.
Bill Mitchell, “Quantitative Easing 101,” March 13th, 2009.
Bill Mitchell analyses quantitative easing, refuting some myths about it and showing its limitations.
Bill Mitchell, “Zimbabwe for Hyperventilators 101,” July 29th, 2009.
Another excellent post from Bill Mitchell on hyperinflation in Zimbabwe.
Bill Mitchell, “Building bank reserves will not expand credit,” December 13th, 2009.
Without appropriate demand for debt from the private sector, increasing bank reserves does not cause equal, or even significant, expansion of credit.
NOTE: US DOLLAR COLLAPSE?
Another prediction that was widely heard last July (2010) was that the US dollar would collapse in 6 months. The date for this “prediction” is rapidly approaching, and I expect it will be as embarrassingly wrong as the prediction that hyperinflation was 100% certain. A look at the trade-weighted US dollar index shows that the dollar’s value is in fact higher than the nadir it reached in 2008. Some are now expecting a US dollar rally in 2011.
BIBLIOGRAPHY
Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.
Fontana, G. 2003. “Post Keynesian Approaches to Endogenous Money: A Time Framework Explanation,” Review of Political Economy 15.3: 291–314.
Howells, P. 2006. “The Endogeneity of Money: Empirical Evidence,” in P. Arestis and M. Sawyer (eds), A Handbook of Alternative Monetary Economics, Edward Elgar, Cheltenham, UK and Northampton, Mass. 52–68.
Kaldor, N. 1982. The Scourge of Monetarism, Oxford University Press, Oxford and New York.
Moore, B. J. 1988. Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge University Press, Cambridge and New York.
Palley, T. I., 2002, “Endogenous Money: What It is and Why It Matters,” Metroeconomica 53: 152–180.
Piegay, P. 2003. “Post Keynesian Controversies on Endogenous Money: An Alternative Interpretation,” in L.-P. Rochon and S. Rossi (eds), Modern Theories of Money: The Nature and Role of Money in Capitalist Economies, Edward Elgar Publishing, Cheltenham, UK and Northampton, Mass. 246–264.
Posen, A. S. 1998. Restoring Japan’s Economic Growth, Institute for International Economics, Washington, D.C.
Rochon, L.-P. 2003, “On Money and Endogenous Money: Post Keynesian and Circulation Theories,” in L.-P. Rochon and S. Rossi (eds), Modern Theories of Money: The Nature and Role of Money in Capitalist Economies, Edward Elgar Publishing. 155–172.
Targetti, F, and A.P. Thirlwall (eds), 1989. The Essential Kaldor, Duckworth, London.
Wray, L. R., 1990, Money and Credit in Capitalist Economies: The Endogenous Money Approach, E. Elgar, Aldershot, Hants, England and Brookfield, Vt., USA.
Wray, L. R., 1998, Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar, Cheltenham.
Wray, L. R. 2003, “Monetary Policy: An Institutionalist Analysis,” in Marc R. Tool and Paul Dale Bush (eds), Institutional Analysis and Economic Policy, Kluwer Academic Publishers, Norwell, Mass. 85–114.
