Alasdair Macleod – 9 March 2010
The most important issue facing savers today is the question of inflation, particularly in the context of the unrestrained issue of money and credit. Whither prices? All economists are guided to varying degrees by the quantity theory of money, differing only by the extent they incorporate the theory into their analyses. The theory is therefore universally accepted by those steering us to a hoped-for better future.
The quantity theory is however seriously flawed in its assumptions, applications and results. The basic assumption is fine, that the purchasing power of money is related to the amount in circulation. Indeed, to argue otherwise is plainly ridiculous; but any further theoretical development runs into difficulties. The mathematicians express it in an equation: the general price level depends on the quantity of money multiplied by its velocity of circulation. They then substitute the general price level with GDP, money with any one of several measures to include or exclude various categories of credit, and velocity of circulation becomes a residual number to make the equation balance.
Not one of these factors can be sufficiently defined for the purpose of proper analysis. GDP certainly reflects the general price level, but it reflects many other things as well. Money can be defined in one form or another, but the difference between pure cash and broad money merely allows economists to pursue a favoured number, rather than apply scientific rigour. And how do we know what the relevance of the velocity of circulation is? It is a number left over from dividing one approximation from another.
The application of this mish-mash is equally curious. Central banks stand ready to print all the money required by the markets, only varying the price (interest rates) on the basis of its assessment of the effect on a lagging CPI indicator. Furthermore, it stands ready to tear up even these loose rules when circumstances suggest. The results are never satisfactory, with central banks creating or permitting yet more and more money and credit with every economic cycle. The system, which has no meaningful restraint placed upon it, has ensured both money and credit have grown at an accelerating rate for at least the suspension of gold convertibility.
How much and when this excess money and credit is reflected in inflation is determined by human behaviour. There is evidence that markets and individual crowds have varying degrees of trust in the ways governments run monetary affairs: the price effect of money creation differs for example between Japan and the US. So, rather than pursue the quantity theory, there is more value in looking at the lessons of history to try to assess the prospects for price inflation in the coming years. The best documented inflation was that of the Weimar Republic, so it will suffice as an example.
There is a common assumption that there was a strong link between monetary inflation and prices in Germany in 1918-23, but this was not so. Inflation went through three distinct stages. In Stage One, prices did not increase nearly as much as the expansion of money and credit. This is because the man in the street was hardly aware that the money supply was being increased. He still had confidence in both money as an unquestioned medium of exchange, and in the pre-existing price level. He would even postpone some intended purchases because he thought it was the price of goods that had risen too high, not noticing that the mark had actually fallen against the dollar.
Germany then moved to Stage Two, when people become aware that the money stock had increased, and was still increasing. Prices started rising in line with the quantity of money, which is the result generally assumed by the quantity theory of money. But Stage Two only lasted for a short time. People quickly decided that the government would continue to print paper money indefinitely, so they lost all trust in it. The result was Stage Three, when prices begin to increase far faster than the government was able to increase the stock of money.
We cannot expect history to repeat itself exactly, but the current situation resembles Weimar’s Stage One. Not one person in a thousand is concerned with inflation: it is for cranks. Even the experts are unconcerned, taking the view that price inflation will only need to be tackled once economic recovery is established. If anything, the balance of economic opinion is that deflation is a greater and more immediate threat, and the premature withdrawal of monetary stimulation would be disastrous.
Also consistent with Stage One is a common assumption that there are policy options available to control inflation. The reality is that many countries, including the UK and US, are already beyond the point of no return, and in the absence of demonstrable price inflation central banks do not have a mandate to deal with monetary inflation. Rather, they have come to depend on it for budgetary purposes, so they have dressed up printing money as quantitative easing. While QE has been promoted in the name of price stability, the truth is that at a time of escalating government deficits, contracting global trade imbalances, and the private sector paying down its debts, savings are contracting and already insufficient to cover these deficits. There is no alternative to QE, or put another way monetary inflation. Indeed, there is every reason to believe that a return to sound money would trigger a slump, which as a deliberate policy option cannot be entertained in a modern democracy.
Without the power of prophecy, careful thought is required to anticipate when our Stage Two will start. If it is the time when common folk become aware of the debasement of money, then this will be when governments are clearly shown to be insolvent. Perhaps that moment will be when economic recovery has stalled, because of the effect on government finances. If this is true, the leading indicators that should be closely watched are the preliminary estimates for GDP growth for the first quarter, due to be released for the US and the UK at the end of April. This may be confirmed by a fall in shipping rates such as the Baltic Dry Index, indicating cancellation of shipping contracts by businesses earliest in the production chain.
Whatever the trigger point is for Stage Two, it would be wrong to believe that we will repeat the Weimar model mechanically. The character of monetary inflation today is very different, being more global in nature and with a far higher level of overall debt relative to cash. Stage Two, being a wider recognition of government insolvency, is likely to be experienced in the UK, some countries in Europe, and importantly, in the US. A Stage Two event on this scale is bound to bring down other economies that on their own may be judged to be solvent, because of the consequences for the global banking system.
While the investment banks have done much to improve their balance sheets since the credit-crunch, the position of the commercial banks has in many cases deteriorated. Importantly, confidence in them exists only because of implicit and explicit government guarantees. If it becomes obvious that the guarantor itself is insolvent the guarantee becomes worthless. The last few weeks have illustrated this point, with an estimated €8bn being withdrawn from the Greek banks by wealthy depositors, enough to make them insolvent without the covert assistance of the ECB. While the EU and the ECB can paper over the cracks for smaller members like Greece, this may not be the case for other member states.
So we can see that there is a nightmare in the making, involving a renewed slump in the private sector which triggers the insolvency of both commercial banks and governments. In this event, governments will undoubtedly accelerate the printing presses, because this is the only way a bankrupt government can meet its obligations. Stage One will be over, and Stage Two will have started. And given the dynamics of the problem, we can see that Stage Two is likely to be brief.
Stage Three in the Weimar example was the point when people began to anticipate monetary inflation, adjusting prices upwards faster than the increase in the supply of money. It was for this reason that on 25 October 1923 the Reichsbank was only able to supply 120 quadrillion marks to satisfy demand for a quintillion. Stage Three this time is likely to be characterised by the collapse of credit availability, because there will be a collapse of the commercial banking system. So it’s possible that the electronic supply of money might not actually work.
Besides the awful conclusion that it is already too late to escape severe inflation, with hyperinflation a strong and increasing probability, it will surprise many that deflation is not a risk. To understand why, deflation has to be defined: it is an increase in the purchasing power of money for goods and services resulting from the withdrawal of money from circulation. It is not to be confused with the contraction of bank credit, which is more closely associated with a tendency for asset prices to fall as people in the private sector attempt to pay down debt.
We are already too far ahead of ourselves in the prophecy business: the only justification being to entertain ourselves with a theoretical comparison with the demise of the Weimar Republic. That we have now done, and been thoroughly frightened in the process. But there is an interesting question: is this the nightmare seen by those masters of finance, who are buying huge amounts of gold? They include George Soros, John Paulson, David Einhorn, Paul Tudor-Jones and a few others who have made fortunes by understanding this crisis right from the beginning.