The destructive power of weak
money
The
rate at which money is being manufactured out of thin
air has accelerated in recent times, as shown by the
chart of the US Monetary base, which is shown below:
The
exponential rise in the monetary base from the post-war
years was enough on its own perhaps to eventually
guarantee a hyper-inflationary outcome for the dollar,
even before the credit bubble suddenly burst in 2007.
The Federal Reserve Board then responded to contracting
bank credit by increasing the quantity of money
threefold in less than four years. This raises the
question of inflationary implications for prices, given
the Quantity Theory of Money as understood by mainstream
economists.
Milton
Friedman, who is associated with monetarism, summed it
up by repeating Hazlitt’s earlier assertion: inflation
is always and everywhere a monetary phenomenon.
Indeed, it is generally forgotten that there cannot be
an increase in the general level of prices without an
increase in the quantity of money. This is too imprecise
for modern economists who theorise over what measure of
money to use. Today, the economists at the Fed lead us
to assume that the link between monetary inflation and
prices applies to the broadest measure, which includes
bank credit. This is suspiciously convenient, given the
deflationary implications of a contraction of bank
credit, which left unchecked would threaten the end of
the fractional-reserve banking system. Using the
broadest measure allows the Fed to argue that deflation
arising from contracting bank credit must be balanced by
the expansion of raw money, when their true concern is
the prevention of a banking collapse.
Indeed,
this unprecedented expansion in the monetary base has
not yet been reflected in a substantial rise in consumer
prices. Monetarists point out that the bulk of this
expansion is due to an accumulation of non-borrowed
reserves, or money left on deposit at the Fed owned by
commercial banks, and so not in general circulation.
This increase is shown in Chart 2. In the neat world of
the mathematical economist, price inflation will only
take place when the banks draw down on these reserves to
expand bank credit, presumably to lend to the private
sector when the economy recovers. But the point that our
neat mathematical economists miss is that the money is
already in circulation, having been lent by the Fed to
the Government through its purchases of Treasury bonds
and T-bills.
The
replacement of bank credit by expanding non-borrowed
reserves amounts to a gift given by the Fed to the
banks. Without it, the American banking system would
simply be insolvent. The hope was that the banks’ future
solvency would be guaranteed by the economic recovery,
eliminating the need for the Fed’s continuing support.
In the
last few weeks it has become apparent that the US
economy is not recovering as forecast, and the decision
has to be taken as to whether or not more monetary
expansion is appropriate. While more quantitative easing
may be required to keep the banks afloat, as a means of
stimulating the economy, monetary expansion has not
worked. The Fed will remain focused on keeping the Wall
Street banks solvent, which is after all its primary
function. It is therefore very likely that QE3 will
happen in one form or another. To allay fears of price
inflation, QE3 will probably be explained as necessary
to stop an ailing economy from sliding into deep
recession, so it will be introduced when this new trend
is confirmed in the coming weeks. And it is interesting
to note that Mr Bernanke in his speech at Atlanta this
week has prepared the ground: “The economy is still
producing at levels well below its potential;
consequently, accommodative monetary policies are still
needed.”
But
this represents the triumph of hope over experience.
There has been no net benefit to the economy from zero
interest rates and an unprecedented expansion of the
monetary base. In the face of a deteriorating economic
outlook, the banks will continue to deposit the bulk of
any new money at the Fed in the form of excess deposits,
as they have been doing for the last three years. This
might matter less if there is little practical
difference between the monetary base and bank credit,
but they are two very different things. To understand
the different effects of the expansion of one relative
to the other, we must differentiate between the drivers
for changes in the general price level of goods and
services, compared with those of assets typically used
as collateral at the banks.
An
increase in the quantity of money tends to be spent on
goods and services, pushing up prices, as we have
recently seen. The effect on capital goods is similar,
though bank finance can play a role in overall demand,
depending on the capital good. The effect of an
expansion of money quantity on bank collateral is more
complex: the lower interest rates that usually accompany
monetary expansion tend to underwrite collateral values;
however, in most cases buyers require bank credit to
facilitate actual market transactions, and if this
credit is not available prices will trend lower as
forced sellers find no buyers.
Put
more simply, narrow money tends to fuel purchases of
everyday items, while bank credit is required to sustain
asset prices. Consequently, a rapid expansion of the
monetary base results in a fall in the currency’s
purchasing power, or a rise in the general price level,
while contracting bank credit can, at the same time,
lead to lower asset prices. We see this in the US today
with price inflation rising and house prices continuing
to fall.
In the
absence of growing demand for goods and services, the
rise in prices is classic stagflation. Stagflation seems
to be poorly understood by mainstream economists, who
habitually associate price inflation with excess demand,
not understanding that over-supply of paper money
produces the same price effect.
The Fed
appears to have fallen into this same trap, but being
closer to the markets than theoretical economists it
almost certainly understands better what is happening to
prices. It is aware of the slide in the dollar against
other currencies, and against commodities and raw
materials generally. It also sees that despite expanding
the monetary base in dramatic fashion the value of
bank-held collateral is not improving. However, it
cannot admit to stagflation and it continues to conceal
its true motives of keeping the banking system solvent.
The moment the Fed tells the truth, the markets would
anticipate more inflation by devaluing the dollar and
the big banks would suffer a run on deposits: the spell
would be broken.
Instead
markets prefer not question the Fed’s strategy too
closely. Economists and market analysts, who rarely
concern themselves with purely financial matters,
discuss further quantitative easing only in an economic
context. They are confused that monetary stimulation and
the lower dollar have not led to a stronger economy.
However, the failure of monetary stimulation to spark
economic recovery was entirely predictable. It fails to
address the underlying problem of excessive levels of
debt; instead, monetary policy is intended to grow that
debt even further.
At some
stage, these inconsistences will be revealed for what
they are. The markets’ ability to ignore the gathering
clouds of stagflation, coupled with a banking system
moving back into crisis, will be tested. The financing
of a rising budget deficit at negative real interest
rates, as the economy slides and revenues collapse, is
unlikely to continue for long. The scene is set for both
a lower dollar and rising bond yields. The distortions
have been wound up so much that a return to normality
will be a violent, disorderly event.
This is
the eventual cost of expanding the monetary base so
dramatically. And the option of abandoning weak monetary
policies is not available, because a move towards sound
monetary policies would break the banks, the stock
market and the Government. The banking system, which is
central to it all, has to be kept going at all costs.
Gold
has only just started to anticipate this risk with its
rise from severely depressed levels. The Western
financial system, which has been in thrall to Keynes, is
short of gold, and this folly is about to become more
widely understood. Those central banks not sitting at
the Bank for International Settlement’s high table see
the danger, and are accumulating gold. Into this mix is
thrown the West’s cold-war enemies, who have broken its
monopoly of economic sophistication, replacing it with a
newer, better model. Both China and Russia now have
sounder monetary bases than America, Europe and Japan,
because their banks are less geared and they recognise
paper money for what it is. They have cleaned the market
out of physical gold, and are certain to hold
considerably more than they officially admit, while the
US is suspected of exaggerating her holdings. Here
again, the distortions are simply incredible, with over
$50,000 of bank liabilities and monetary base in the US
for every ounce of gold officially held by the US
Treasury.
Those
economists who think that any transition from today’s
problems into tomorrow’s can be managed as an orderly
event are simply naïve. But then they didn’t see the
financial crisis of 2007/08 coming either. Ever greater
manipulation of markets has developed distortions so
large that a return to reality will almost certainly be
sudden and violent. And then the Fed really will start
creating money in earnest, to save the world. That’s
when it all begins to fall apart.
