A lot of economists predicted the coming of hyperinflation with successive rounds of quantitative easing by the Federal Reserve. Inflation in the 1970’s came from too-loose monetary policy. They argued that loose policy since 2008 would result in the same consequences. Why hasn’t that happened?
Because since 2008 monetary policy hasn’t been loose. Sure, the Fed has printed a lot more of what we call “base money”, but it hasn’t steered expectations of inflation higher, and expectations mean a lot more than money (or gold) sitting in a vault.
To answer why, let’s examine how a central bank works. Say the Fed prints $1 and gives it to banks to lend. It sets a reserve requirement of 10%, meaning banks can lend $10 off of the $1. If consumers borrow the $10 in full, then exchange it 2x in one year, our $1 has transformed into $20 in income. $1 x 10x (through lending) x 2x (through velocity) = $20.
Previous to 2008, banks began to create their own form of securities from mortgages. These were viewed as so safe, then banks held them as assets and could thus loan more money off their reserves. In our fictional world, the $1 became $2 through the manufacture of this “fake” money. The $2 transformed to $20 from loaning it out. And the $20 become $40 because of velocity. Inflation is a full 100% (not in reality, but in our hypothetical world).
Then just as the banks realized their folly (that mortgage backed securities weren’t really assets), the Fed worries about inflation and prints less money, say $0.75. Now our base is $0.75, banks are creating nothing, and we only have $15 in income. Our initial economy has shrunk by 25% (from $20 to $15).
Below is a table of events that somewhat mirror our own financial crisis. We start with $1 in minted money, ending with $20 in income (1). Bank greed causes inflation (2), Fed pullback and bank sanity causes a recession (3). Consumer fear turns the recession into a depression (4).
|Event#||Timeline||Fed prints||Banks create||Reserves||Banks lend||Velocity||Total income|
|2||Banks get greedy||$1.00||$1.00||10%||$20.00||2||$40.00|
|3||Fed cuts back||$0.75||$0.00||10%||$7.50||2||$15.00|
|4||Consumers get scared||$0.75||$0.00||10%||$7.50||1||$7.50|
|5||Fed prints money||$1.00||$0.00||10%||$10.00||1||$10.00|
|6||Consumers get more scared||$1.00||$0.00||10%||$10.00||0.75||$7.50|
|7||Fed prints more, banks hold back||$3.00||$0.00||15%||$20.00||0.75||$15.00|
|8||Fed prints more, consumers worse||$5.00||$0.00||15%||$33.33||0.5||$16.67|
|9||Fed prints a lot more||$10.00||$0.00||15%||$66.67||0.5||$33.33|
|10||Consumers & banks regain confidence||$10.00||$0.00||10%||$100.00||1||$100.00|
What happens after event #4 is that the Fed starts trying to right the ship by printing more money (QE). But even as the Fed is printing money, consumers are trying to pay off their debts (6) causing the depression to worsen. Now the Fed prints a lot more money ($3, or 3x the initial amount), but banks raise their reserves because they’re scared now too. We have some recover to $15, but we’re still not at our $20 starting point, and nowhere near the peak of $40 in income. Step 8 is the Fed getting close to where it wants to be in terms of national income, but with a full $5 on its balance sheet (rather than $1 at the start).
When we get to steps 9 & 10, the Fed keeps printing money to get the economy back to equilibrium, but as confidence is already returning, we finally get the hyperinflation that gold bugs worried about in the beginning.
But the big problem is…
Printing money doesn’t mean more income so long as banks and consumers are scared. If expectations of overall income don’t rise, the newly-printed money from the Fed sits in a vault and creates no inflation at all. The Federal Reserve has, in effect, convinced us all too well that 2% inflation is the absolute ceiling it is willing to tolerate. Therefore we all act in a way that we’ll never breach, but often undershoot, 2% inflation. That means less loans, less consumption: in other words, depression.
Only recently has the economy started picking up. The Fed has at last convinced us that there won’t be deflation (unlike the ECB). It took almost 6 years, but now we’re waking up to the fact that at least the depression won’t get worse.
The Fed uses the supply of money to influence the decisions of the whole economy. But in the scenario table above, we see faulty logic. Picture the Titanic with it’s massive rudder. But then picture a smaller rudder in the engine room (velocity). When you turn it, it slowly pushes the big rudder in the ocean. Then there’s another even smaller rudder higher up the deck (bank lending) that slowly pushes the other small rudder. And finally a tiny steering column at the very top of the ship (reserves) that the Fed actually pushes to control the economy.
Iceberg to the right at 1 mile, another to the left at 3 miles? The Fed gently nudges its wheel to steer left. But the other rudders are being blown off course by other factors. So the nudge doesn’t work. Now the Fed pushes its steering full-force to the left. Finally the system reacts and the massive rudder in the ocean begins to turn the ship. Right in time to hit the iceberg on the left at 3 miles.
Instead of compound steering, the ship, our economy, should be driven directly. The Fed must find a way to raise or lower expectations of nominal income directly, rather than through a series of intermediaries. Otherwise we’ll just keep crashing through the North Atlantic.