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In an attempt to fight the international credit market
turmoil and its effects on economic activity and overall prices, the
US Federal Reserve (Fed) keeps increasing the supply of base money —
which is cash in circulation and commercial banks' money balances held with
the Fed.
From August 2008
to May 2009, the monetary base in the United States more than doubled. The
bulk of the expansion reflects an unprecedented rise in banks' excess reserves
— that is, banks' base money which is available for additional credit
and money creation.[1]
 
People are being
told by governments, central bankers, and leading mainstream economists that such a policy
wouldn't be inflationary — because the money would remain in the
portfolios of banks and would not spill over into the hands of firms and
private households.
This is, to put
it mildly, an uninformed view. To show that a rise in base money is inflationary —
that it either lowers the purchasing power of money or, what basically
amounts to the same, prevents money's exchange value from rising — let
us start right from the beginning.
How
Mainstream Economists Define Inflation
If you ask
mainstream economists what inflation is, they typically respond that
inflation is an ongoing rise in the consumer price index of more than 2 or 3
percent per annum; if the increase remains between zero and 2 to 3 per annum,
these economists would speak of price (or price-level) stability.
Currently, annual
changes in consumer price are running at around zero. So it comes as no
surprise that mainstream economists do not see inflation whatsoever; in fact,
they would warn against deflation
— which they characterize as an ongoing decline in consumer prices.
The prices of
assets such as stocks, bonds, real estate, and housing are typically
considered different from consumer prices. Asset prices are seen as prices sui generis,
especially as they are not included in the official definitions of price
indices.
So-called asset price inflation —
a term which mainstream economists use for characterizing the phenomena of
extraordinarily strong and ongoing increases in the prices of, for instance,
stocks and housing — is not seen for what it really is: a visible
symptom of the erosion of the purchasing power of money.
What is more,
mainstream economists wouldn't mind about the Fed increasing the monetary
base, or commercial banks increasing money supply, per se. This is because
they do not see a direct, let alone a logically necessary, link between
changes in the money stock and the purchasing power of money.
Austrians'
Definition of Inflation
In sharp
contrast, Austrians hold that inflation
is an increase in the money stock, and that the upward drift of
money prices is a consequence of a rise in the money stock; from the
Austrians' viewpoint, rising prices are a symptom
of an increase in the money stock.
Mainstream
economists may say that if a rise in the money stock is accompanied by a (sufficient)
rise in the supply of goods and services, an increase in the money stock
would not cause inflation, as it would not make prices go up.
From the Austrian
viewpoint, such an argument does not hold water, though: had the money
remained unchanged, money prices would have actually declined (other things
being equal), thereby having increasing the purchasing power of money.
In other words, a
rise in the money stock prevents
the money stock from gaining in purchasing power (other things being equal).
That said, there are two consequences that come with a rise in the money
stock that need to be highlighted in this context.
First, the
visible effect is a rise in money prices; it is the result of a rise in the
money stock while the supply of goods and services remains unchanged.
Second, the
invisible effect is brought about by a rise in the money stock, even if it is
accompanied by a rising supply of goods and services: the rise in the money
stock prevents money prices from declining.
Needless to say,
to most people the first effect goes unnoticed — as a result of a
misguided definition of inflation. That said, the only economically
meaningful definition of inflation is a rise in the money stock.
An
Invisible Effect of a Rising Monetary Base
As far as its impact
on prices goes, the rise in the monetary base sponsored by the Fed has so far
been restricted to an invisible effect.
First and
foremost, the base money increase prevents banks' troubled asset prices from
adjusting to lower levels. Buyers of these assets have to pay a higher price
when compared to the scenario in which the Fed hadn't increased the money
supply.
In addition,
prohibiting the prices of banks' assets from adjusting downwards keeps
markets from performing an essential function, namely, rewarding those
players who serve the needs of their clients and pushing those players out of
the market who do not.
Furthermore, as
prices of banks' troubled assets are kept from declining, the need for
revaluing other assets (such as book loans extended to firms, house builders,
and governments; bonds; stocks, etc.) tends to decline or is prevented
altogether.
If, however,
asset prices are kept from falling by monetary policy expanding the money
supply, the mechanism of
relative prices cannot do its job properly. It actually paves the
way for making other prices — such as wages, and producer and consumer
prices — go up.
A Visible
Effect of a Rise in the Money Stock
Let us take a
look at the visible effect caused by a rise of money on consumer prices
— an effect that is put into question by mainstream economists. The
graph below plots annual changes in the stock of M2 against those of the
consumer price index from 1960 to May 2009.
At first glance,
there isn't much of a correlation between the series under review. However,
if a closer look is taken at series' underlying
trends, which strip out short-term fluctuations and
"noise," two findings stand out.
First, trend
money growth of M2 and trend changes in consumer prices are pretty much on
the same wavelength, and they are positively and highly correlated. Second,
trend changes in the money stock seem to affect trend changes in prices with
a time lag, and trend money growth seems to lead trend changes in prices.
The (admittedly
arbitrary) trend lines suggest that consumer prices will go up and that the
latest drop in rising consumer prices should be interpreted as a temporary
downward blip (driven by lower commodity prices).
Will It or
Will It Not?
A key issue for
many market observers is this: will the massive increase in base money really
translate into a rise in the money stock in the hands of private households
and firms, which would then lead to visible effects of a rise in the money
stock?
The multipliers —
which show the relationships between credit and commercial-bank money stocks
relative to banks' holdings of base money — have collapsed since late
summer 2008. Banks' willingness and ability to churn out credit and money
have declined severely.
Commercial banks
are in a process of deleveraging
and derisking
their balance sheets. Private owners of the banks are no longer willing to
risk their capital in the credit business at currently prevailing return
levels.
That said, one can
say that markets have embarked on a process of correcting the effects of
misguided policies — caused by a relentless expansion of circulation
credit and money created out of thin air, encouraged by central banks'
artificial lowering of interest rates.
Markets are about
to cause a contraction of credit and money supply; if banks are no longer
willing to extend additional credit and call in maturing loans, credit and
money supply will decline, leading to recession and deflation.
Such a
development would be highly undesirable from the viewpoint of governments and
their beneficiaries in particular; in fact, it would threaten their very
existence. And it is from here that the real danger for even higher inflation
comes.
Why
Inflation Will Become Worse, Not Better
The policy of
expanding the money stock is the foremost tool of government aggrandizement.
It allows financing the state's income, public deficits, and elections, and
for expropriating and corrupting members of society in the most subtle way.
As Ludwig von Mises noted,
A government
always finds itself obliged to resort to inflationary measures when it cannot
negotiate loans and dare not levy taxes, because it has reason to fear that
it will forfeit approval of the policy it is following if it reveals too soon
the financial and general economic consequences of that policy. Thus
inflation becomes the most important psychological resource of any economic
policy whose consequences have to be concealed; and so in this sense it can
be called an instrument of unpopular, i.e. of anti-democratic, policy, since
by misleading public opinion it makes possible the continued existence of a
system of government that would have no hope of the consent of the people if
the circumstances were clearly laid before them. That is the political
function of inflation. It explains why inflation has always been an important
resource of policies of war and revolution and why we also find it in the
service of socialism. When governments do not think it necessary to
accommodate their expenditure to their revenue and arrogate to themselves the
right of making up the deficit by issuing notes, their ideology is merely a
disguised absolutism.
Those who hope
that inflation will now come to an end — given that market is close to
contracting circulation credit expansion and the money supply —
implicitly express optimism that the government leviathan is on the retreat.
Unfortunately, the latest developments — namely, increasing base money
and the running up even bigger public deficits — don't support such a
view.
Even though banks
scale back on their lending activity, one should not forget that, under
today's government-controlled fiat-money systems, the money stock can be
increased at any time, in any amount deemed politically desirable.
Tragically, deflation — the decline in the money stock, which is so
widely feared these days — can be prevented if this is politically
desired.
Inflation can be produced
by central banks or commercial banks, simply by lending or purchasing assets
from nonbanks, paying with newly issued money. As things stand, central
banks' monetizing government debt is presumably the way forward for producing
inflation — which is, and must be, defined as a rise in the money
stock.
Thorsten Polleit is Honorary Professor at the
Frankfurt School of Finance & Management. Send him mail. See his article archives. Comment on the blog.
An MP3 audio version of this article, read by Floy
Lilley, is available as a free download.
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Notes
[1] Under normal market circumstances, banks would keep excess
reserves close to zero, and they would just keep required, or minimum,
reserves. Holding base money does not yield any interest income. So if the
risk-reward profile of investment opportunities becomes attractive, banks can
be expected to put their excess reserves to use — that is, they will
either start lending or purchasing assets (stocks, bonds, etc.).
Thorstein Polliet
Thorsten
Polleit is Honorary Professor at the Frankfurt School of Finance &
Management.
Also
by Thorsen Polleit
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