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January 13th 2013 print

Peter Smith

What happened to inflation?

All this stimulatory government spending should be eroding currency's value, at least according to the economics 101. Truth is, that all depends on what banks do with the money their anxious customers are socking away


I was talking to a builder who was at my place overseeing some re-tiling. We got talking about economics, as you do, and he asked why inflation had not taken off in the United States. He had quantitative easing in his mind. Or QE as the in-crowd say.


When I was spruiking my book a number of people asked me the same question about inflation. Economics has become like the weather; a lingua franca among people of different backgrounds. Adam Smith probably had a relatively small group of people interested in his doings. That was then; this is now. Welcome to an age when economics hogs centre stage. Well, really, I’d rather not. Sorry; it’s all part of a compulsory package with (un)reality TV. Housewives of Beverly Hills par exemple.

The classic definition of inflation is too much money chasing too few goods. Economics has a device for explaining why an excessive increase in the money supply does not necessarily lead to inflation. It is called the velocity of circulation. Simply put, if people don’t spend their money too often it will remain relatively dormant and won’t do too much chasing. Its turnover, or velocity, will be low.

Keynes was not impressed with this explanation unadorned. He thought it explained very little. He was right. You can’t be wrong about everything.

It is a truism, and therefore trivial to say, that the relatively low inflation in the United States is partly a product of low velocity of circulation of money. But there is a reason why velocity is low which makes economic sense. And, more importantly, in this case, low velocity is only the smaller part of the explanation.

A good start in addressing the issue is to ask what money we are talking about.

Money used to be pieces of gold and silver. Now it is coin of base metal and government promissory notes (dollar bills), and at-call bank deposits and, broader still, all bank deposits and, broader still, deposits at non-bank deposit-taking institutions (in Australia building societies and credit unions). This is all called money because, though it has no intrinsic worth, it can be exchanged, with little ado, for valuable and useful goods and services and assets.

Most of this money is created by banks when they extend credit or make loans. When a bank loan is drawn down it creates a deposit either for the borrower initially or the person who the borrower pays for goods or services. Bankers are therefore mighty powerful in the scheme of economic things. Remember that the next time you think they’re a bunch of wallies in pin-stripe suits. But I am off the point.

There is another set of assets which is a close cousin of money. These are highly liquid and secure assets held by banks. They principally comprise cash on deposit at the central bank and treasury bills issued by government. In a sense they are the “banks’ money”. What you see since the middle of 2008 in the US is strong growth in this “money”; much stronger than the growth in bank lending, bank deposits and conventional money.

Effectively, this means that a lot of the quantitative easing – the purchase of securities by the Federal Reserve – has found its way back into treasury bills and other highly liquid assets via the banks. It’s a sort of merry-go-round. Or, to carry the use of metaphors still further; Bernanke has been pushing on a piece of string. Confused? Well, talk to my builder.

Banks have built a store of highly liquid assets, not a store of illiquid loan assets that would have increased the money supply. As a result, M2 (the Fed’s broadest definition of the money supply) grew by a fairly modest 7% over the year to November, 2012. This has been the most important factor in explaining why inflation remains subdued.

Yes, there has been a fall in velocity, which tends to move in sync with the economic cycle as people’s preference to remain cashed-up grows in depressed times. But, the key to the lid being kept on inflation has been a relative lack of bank lending.

OK then, so what happens next? Banks are in position in a big way to switch proportionately out of liquid assets into loan assets. There is a lot of slack in that piece of string I mentioned above. Only confidence among the banks themselves and their customers is required. If this were to emerge, the money supply would start growing rapidly, spending and imports would rise, the US dollar would fall further, and the falling dollar plus growing demand for resources would cause an upsurge in inflation. Too much money would be chasing too few goods.

Is this likely to happen? President Obama is helpful because his policies tend to put a dampener on business. However, the US economy is resilient and quite capable of overcoming Obama, red tape and green zealots.

In all probability inflation awaits. When you think about it, how else is the US government ever to pay off its debts? There is, of course, the banana-republic possibility of minting trillion-dollar platinum coins, which apparently US law allows the Treasury to do without congressional approval.

This has been floated in the ether recently (presumably by the loony left) to circumvent the next fiscal cliff, which is the need to increase the current $16.4 trillion government debt ceiling. It would allow the US government to deposit the coins in its account with the Fed; and to go on spending willy-nilly without congressional approval.

Let’s take it seriously for a delusionary moment. Would it be inflationary? The answer is that it is no more inflationary than Congress approving more trillion dollars in unfunded expenditure. What matters is what happens when banks get the proceeds through their doors. Only if they lend madly will it likely lead to inflation.


Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics



Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics