Alasdair Macleod – 09 June 2011
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.
 “The basic cause of inflation, always and everywhere, lies in the field of money and credit.” Hazlitt in Newsweek, December 22, 1947, p. 68