You’ve seen the gold commercials. You’ve heard the commenters and prognosticators. They’ve told you (correctly) that the U.S. central banking system has increased the monetary base of the United States at a pace previously unheard of in our history. They’ve told you over and over again to brace for an imminent wave of high, even hyper, inflation. But it hasn’t come.
People with sound economic principles and good minds have been pushing the imminent inflation line more aggressively. I keep telling them that they’re right, but early. Some listen; some don’t. But to give them credit; they’ve had a good point: the Fed has created an enormous pool of ‘money’ since the credit crisis. In fact, they have more than tripled their monetary reserves. Doesn’t that mean that we should have a more than tripling of prices?
If Milton Friedman is right (and I think he is) that ‘inflation is always and everywhere a monetary phenomenon,” then it stands to reason that if the Fed triples it’s monetary reserves, we should inflate our way up to a tripling of our price level. Even allowing for the time delays and the slower circulation of money in a more slowly moving economy, it seems as though monetary shenanigans which started in 2007 should have been felt by the summer of 2012.
Between the Fed hose and the consumer getting hosed with higher prices, there stand at least three points of interruption. First, Monetary Base does not have to turn directly into newly created money. Second, newly created money does not always circulate domestically. Third, economic growth lessens the impact of excess money creation.
Let’s start with the Fed and money. There is a kind of short-hand in which we say the Fed prints money. But that’s not exactly true. Money creation is a joint exercise between the central bank and the banking system. What the fed creates are entries in an accounting system which give the banks permission to act as if there is extra money on their balance sheets. The banks, therefore, have permission to lend more. The reserves they lend end up in someone else’s account in a bank, and that bank then has permission to lend more, and on and on the system goes. It’s called ‘fractional reserve banking’ because the banks only need to keep a fraction of their total lending in their reserves. Historically that fraction has been about ten percent. This means that one dollar added to the reserves of a bank, leads to ten dollars in new money or money equivalents. That ratio, in this case 1 to 10, is called the money multiplier. It is often confused with monetary velocity, which is something quite different.
I like to think of monetary base as money syrup, like the syrup that’s used to make soda. You add the carbonated water to the syrup and you get soda (or pop, or soda pop, depending on where you live.) The ratio of syrup to soda is the soda multiplier. How fast we buy and drink the soda is the velocity.
When I was in college, I worked in the cafeteria and one of my jobs was exchanging and maintaining the syrup canisters and making sure that they were properly connected to the tubes which mixed them with carbonated water. From time to time, I would swing by the beverage counter and see a puddle of clear water on the floor and importantly declare, “Looks like we’ve got a beverage leak.” It wasn’t a great job, but it is where I first saw, or actually was seen by, my future wife, so in retrospect I see that all of the sticky hands and mopping up was well worth it.
As I swing by the monetary canisters in my daily inspection of America’s econometric statistics, I have to declare once again, that we have a leak, or more aptly, a clog in the tubing. Syrup is turning into soda, but at only half the normal ratio. Monetary base is not turning into money at the normal rate. Why not? Because the machinery of our credit system is clogged with, among other things, too many regulations. If you don’t like that fact, you can thank Messieurs Frank and Dodd, who both have left or are about to leave the Congress, but not soon enough.
That’s how a 210% increase in monetary base leads only to a comparatively meager increase in domestic holding of cash and cash equivalents of 70%.
Will the hose stay kinked? Not likely. First, the Fed is like Coca-Cola
., and Snapple all in one, with an almost unlimited capacity to produce syrup and pump it at high pressure into the system. And they want to do so. They want more money in circulation, because their Keynesian models tell them that easy money is the answer to our economic stagnation. In addition, our long-run fiscal problems may require the Fed to create even greater excesses than they already want to, because financial realities have gotten quite near to the point after which governments almost always print their way out of trouble. In short, countries which get as deep in debt as we are, the central bank typically becomes the principle lender to the central government.
That’s why a tripling of monetary base has given us less than a doubling of M1, which is basically cash and cash equivalents.
But this still leaves us with a 70% increase in M1, and nothing like a 70% in prices over the past five years. Maybe it has something to do with the fact that we’ve had only a 37% increase in M2, which is slightly more than half of the M1 growth rate. Is there another clog?
No, it’s more like a leak. One of the differences between M1, a narrow definition of money, and M2 a broader one, is the amount of US money which is not actually IN the US. Not all dollars live here, some go for extended stays overseas in what is called the ‘euro-dollars’ market. They don’t have to actually go to Europe to be called ‘euro-dollars’, but when the phenomenon started in the 1960s, most of the ex-pat dollars went to Europe and the name sort of stuck. I guess that’s not a problem, because most of them are going to Europe nowadays, too. We don’t know exactly how many euro-dollars there are, because the government doesn’t track that data set any longer (cue conspiracy theorists), but we know there are quite a few, and that the number has been growing rapidly during the euro crisis. I’ve tried to make some estimates myself, and would put the figure at between 3 and 5 trillion. Those are big numbers and are big enough to impede, or at least delay, domestic inflation.
It’s important to understand that the only dollars which directly affect domestic prices are domestically circulating dollars. It is only money which is available to spend at a cash auction which drives the prices at a cash auction.
So, does this make us safe from inflation? Not likely. Yes, the world is hoarding dollars until the euro-situation comes to its point of resolution. But currencies are only hoarded so that they can be spent at some point in the future. US dollars are legal tender here (and in a very few tiny dollarized enclaves) and they are being hoarded elsewhere so that, eventually, they can be spent here. That’s what reason requires and it is what history demonstrates. So we’ve got a mountain of money out there in the world, and they (not we) decide when it is going to come home. When it does come home, it will be inflationary. The euro crisis cannot protect us from our monetary sins forever.
What about growth? There isn’t much. But when there is a lot of growth, it has a strong suppression effect on the fires of inflation. That’s because inflation is too much money chasing too few goods. But if money increases at the same pace as the increase of goods and services, prices remain relatively stable. Hayek points out in Prices and Production that you can even have monetary inflation and price level reduction when the supply of goods and services exceeds the supply of money.
But we haven’t had much growth. Just looking at a quick and dirty sketch of the data: during the past five years M2 has increased by about 7 ½ per year. Is our economy growing at 7 ½ per year? Are even the dizziest members of the Optimist Club forecasting that? Yes, growth can squelch inflation, look at the relationship between money supply and inflation you see in the mid 80s and 90s when the economy was booming? Money grew, but inflation stayed low and stable. But in this policy environment, another boom is unlikely, and therefore in time, inflation is likely.
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com.