Debasing gold and silver coins and printing fiat notes has a long history of feeding the reckless spending ambitions of rulers and governments. It has never ended well. Governments today are again creating money out of thin air. Will it end badly or are these times different? We will need to wait and see. However, as I will posit, there are reasons to believe that the outcome, while cheerless, will be relatively benign.
Governments have spent big to provide succour to the citizens they threw out of work and the businesses they closed down in their overwrought response to the Wuhan virus. To be precise, this is not stimulus spending, though it is commonly so described. I am not sure what to call it; relief spending, perhaps. Stimulus spending is a modern-day Keynesian term used to describe government spending intended to boost economies which have fallen into recession. If economies, once reopened, struggle to regain lost ground, as seems inevitable, then further government spending, particularly of a capital nature, can be described as stimulus spending. And we are likely to see plenty of it.
This essay appears in the latest Quadrant.
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It is important to make a distinction between the two types of spending. Relief spending, absolutely essential in the unique circumstances of an economic lockdown, crowds out no private sector economic activity; there’s none to crowd out. Stimulus spending, on the other hand, can crowd out and distort private sector activity. But, that to one side, there is a common factor whether government spending is by way of relief or stimulus.
The common factor is that each dollar of spending without offsetting taxation (“deficit spending”) increases the money supply by one dollar. That dollar appears in the bank account of the recipient and also in the bank’s account with the central bank. In this latter iteration it is called base money, because banks, in a fractional reserve deposit system, of the kind we have, can use it to underpin lending of multiples of the dollar. And each dollar they lend becomes a bank deposit alongside the original dollar, and part of the money supply. The money supply primarily encompasses bank deposits plus the public’s holdings of cash (notes and coin). In normal course, bank lending contributes most to growth in the money supply.
Two questions arise. Will money creation or, to use literary licence, “money printing”, in the age of COVID-19, cause inflation? And also, as a related matter, will borrowing to finance deficit-spending produce burdensome government debt? While my reference point is Australia, a similar account applies pari passu across all countries with sophisticated banking systems.
A first point to make is that Australia, like other advanced countries, does not have a cash-based economy. Cash accounts for only a small proportion of the money supply. What this means, if hyperinflation were ever to occur, is that people would not be delivering wheelbarrows full of fiat notes to buy a loaf of bread, as they did in revolutionary France, the Weimar Republic and, more recently, Zimbabwe. And, precisely because cash is no longer king, hyperinflation, or anything close, is almost certainly a phenomenon of the past. Uncomfortably high and debilitating inflation is another matter and remains an extant risk.
A second point to make is that price inflation cannot occur unless it is driven or accommodated by increases in the money supply. Think of it this way. Inflation can be equivalently expressed as untoward rises in the prices of goods and services or, alternatively, as falls in the exchange value of a unit of money. Obeying the normal laws of economics, the more money there is, the lower is its exchange value and thus, conversely, the higher are prices. As Milton Friedman definingly put it in Counter-Revolution in Monetary Theory:
Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.
A third point to make is that the only effective constraint on governments engaging in deficit spending is inflation. Inflation signals that the demands of government cannot be met by the economy’s capacity to produce goods and services. This is not to say that any amount of government spending, sans inflation, is beneficial; simply that only inflation impedes spendthrift governments.
Government spending itself does not cause inflation. Inflation jumps, if it jumps at all, as a result of increases in the money supply contingent on the spending. When governments offset their spending with taxation, or by mopping up increases in the money supply by bond sales into the marketplace, inflation remains dormant. No increase in the money supply means no inflation. Can it be more complicated than that? Well, scenarios can be dreamt up in which each dollar turns over more rapidly than normal and hence produces inflation. But, in practical terms, the answer is no. Only increases in the money supply can produce, accommodate and sustain inflation. And only marked increases in the money supply can result in marked inflation.
In the age of COVID-19, bonds sold to finance deficit spending are being largely or wholly bought up by respective central banks. This is manifest in banks’ holdings of deposits with their central bank and of treasury notes or bills. Correspondingly, and equally, it is manifest in an increase in the money supply. The money supply is variously defined.
Money narrowly defined (“M1”) encompasses cash in the hands of the public and on-demand deposits with banks and other depositing-taking institutions (building societies and credit unions in Australia). There are broader definitions of money which include a range of term deposits. However, it is the narrower definition of money that I will focus on. It is the category of money spent.
In Australia, in the year to the end of April 2020, M1 money increased by a whopping 37 per cent (in the US it was 29 per cent) compared with just 3 per cent (4 per cent for the US) in the year to the end of April 2019. Bank lending did not account for this disparity. In each year, outstanding loans grew by only about 4 per cent. It is all down to deficit spending. And deficit spending will likely go on adding markedly to the money supply in the months and immediate years ahead. The government will struggle to get anywhere near to balancing the budget and the Reserve Bank will continue to buy bonds in quantity to prevent interest rates from rising.
Monetary growth of the magnitude of 37 per cent in just one year, and more of the same ahead, lays the groundwork for inflation. Unless, that is, each dollar turns over much less frequently than in the normal course. The turnover of each dollar on average is called the velocity of circulation of money. It is conventionally calculated as GDP divided by the money stock. An increase in velocity cannot of itself fuel inflation. At the same time, velocity does tend to increase during the upswing of an economic cycle and decline during a downturn. This is to be expected. Money more quickly leaves bank accounts when times are buoyant and tends to sit for longer when times are depressed.
The upshot, in these depressed times, is that we could expect velocity to fall and partially offset the increase in the money supply. But to fall by as much as it has? Absolutely not. GDP (the numerator in the calculation of velocity) is falling as a result of the lockdown and is unlikely to rebound into robustly growing territory very soon. At the same time, the money supply (the denominator) has been soaring. Throw away textbooks. Unsurprisingly, textbook theory never envisaged governments taking the extraordinary step of closing down their economies. We are in uncharted waters, which makes it difficult to predict the outcome. With that proviso I will go back to the two questions I posed above: Will inflation take off? Will government debt burden the future?
Inflation is unlikely to take off, at least over the next few years. The government has crippled the Australian economy, as other governments have crippled theirs. So, leaving the inscrutable case of China aside, not much mutual transnational help can be expected. Additionally, the need for banks to repair their impaired balance sheets will keep their lending contained. Moreover, inflation cannot sustain itself unless wages keep pace with prices. To elaborate, prices cannot go on rising unless wage increases underpin spending. The unemployment hangover from the lockdown and the longer-term malaise of the tourism industry and, no doubt, the government’s eagerness to ramp up immigration again, will keep wage rises in check—as, in the Western world more generally, will the inevitable resumption of immigration from the developing world.
We will see a rising money supply offset by low and falling velocity for some considerable time. Result: no inflation. Does this contradict Friedman’s dictum? Not really. The dictum says that inflation can only be caused by the money supply increasing faster than output. It is silent on whether a rapid expansion in the money supply must cause inflation. Mind you, as Friedman considered velocity to be “a relatively stable magnitude” (Monetary History of the United States) he would undoubtedly have thought that the current monetary expansion would be inflationary. But then, like textbooks, he did not envisage a scenario in which governments would create so much money while, at the same time, crippling their economies.
As to the debt burden, government debt as a result of this episode of “relief” deficit spending is unlikely to burden future generations, despite the popular wisdom to that effect. Much of the debt will be held by central banks; effectively, a government-sector in-house arrangement. Stephen Grenfell, a former deputy governor at the Reserve Bank, wrote in the Australian on May 11 that paying interest can’t be avoided because the “cash created when the central bank buys bonds finds its way directly to banks’ reserves at the central bank, which earn interest”. True enough. However, the current interest rate on the banks’ exchange settlement account balances at the Reserve Bank is just 0.1 per cent. Treasury Note yields are a few tenths of a per cent.
Similarly, interest rates on Australian government bonds are extremely low (the yield on ten-year bonds was around 1 per cent in early June) and will not burden the future, even if held in private hands, provided the economy starts growing again in nominal terms, even slowly. It will be a different matter if the government throws money around on ill-considered stimulus projects once the lockdown is over. Such projects might hold the economy back and in so doing add to the debt burden. Decreases in red and green tape and in business taxes are the best way to get the economy growing, and to more easily service the debt and progressively reduce its level in proportion to the size of the economy.
President Reagan’s economic policies provide a case study. Reducing government spending and a tight monetary policy to curb inflation were in his armoury but primarily his policies were to cut regulations and taxes to spur economic growth. Under the eight years of his presidency, from January 1981 to January 1989, real GDP grew at an average annual rate of 3.5 per cent. Government revenues grew strongly. Of course, predictably, he failed to control spending. Nevertheless, but for the high interest rates prevailing at the time, the ratio of debt to GDP would have fallen significantly. Then the average interest rate on outstanding US federal debt was about 8 per cent. Now it is less than 2 per cent and falling as new issues are made. Ten-year US government bond yields were around 0.75 per cent in early June.
To be clear, being sanguine about deficit financing in the age of COVID-19 does not in the least back up Modern Monetary Theory (MMT). MMT, embraced by a section of the modern Left, is an economic theory which postulates that permanent full employment can be achieved without undue inflation through the application of expansive fiscal and monetary policy settings allied with a buffer scheme to employ additional people on the public payroll during economic downturns and release them onto the private-sector job market during upturns. Cut down, MMT is a theory which sees no limit to applying government spending, borrowing and money creation to remedy unemployment. Does any of it have merit? No, not in normal times. But this time is far from normal.
In 2009 Carmen M. Reinhart and Kenneth S. Rogoff gave their well-known and impressive account of eight centuries of economic and financial cycles the ironic title of This Time is Different. In 2020 it is the plain truth. This time really is different.
Extremely low interest rates and deliberately damaged economies have combined to allow debt issuance and money creation much more scope before they come up against the economic roadblock of runaway inflation. Where it will end is another matter. Abnormally low interest rates will allow economies to grow; and grow enough, with any luck, to outgrow debt. Reagan’s policies of deregulation and lower business taxes would help if they were implemented in part or in whole. But, under any likely scenario, it’s hard to see a return to vibrant economic growth in the near future.
If history is any guide, continuing stimulus spending will fund value-sapping public-sector investments. Low interest rates will encourage low-value private-sector investments. Anaemic growth probably lies ahead for most countries. Though you can’t discount the lucky-country effect coming into play for Australia courtesy of China. Nor can you discount the marvellous-Trump effect coming into play for America—provided the American electorate is savvy enough to keep the forty-fifth president around beyond January 2021. However, best not to pin too many hopes on serendipitous developments. Somehow we need to get back to balanced budgets, to normal levels of interest rates and to accompanying vibrant growth. That seems a long way off.
Peter Smith wrote “Making Sense of Bottomless Interest Rates” in the December 2019 issue