# Category Archives: Inflation

## Two Theories of Prices

Last May, John T. Harvey wrote a wonderful post about the quantity theory of money (QTM). This post picks up where John stopped, presenting a different theory of the price level and inflation. It’s a bit technical (so bare with me), but many readers have asked us to elaborate on price theory.
First, a quick recap. The QTM starts with the identity MV ≡ PQ, where M = the money supply, V = the velocity of money, P = the price level, and Q = the quantity of output (Fisher’s version is broader and includes all transactions: T). The identity is a tautology, it just says that the amount of transactions on goods and services (PQ) is equal the to the amount of financial transactions needed to complete those transactions. To get a theory of price (the QTM), one must make some assumptions about each variable. The QTM assumes that:
·         M is constant (or grows at a constant rate) and is controlled by the central bank through a money multiplier
·         V is constant
·         Q is constant at its full employment level (Qfe) or grows at its natural rate (gn)
Given this set of assumptions, we get (note the equality sign to signal causality):
P = MV/Qfe
Or, in terms of the growth rate (V is constant so its growth rate is zero):
gp = gm – gn
This is the QTM, which holds that price changes (inflation and deflation) have monetary origins, i.e. if the money supply grows faster than the natural rate of economic growth, there is some inflation.  For example, if gm = 2% and gn = 1% then gp = 1%.  If the central bank increases the money supply, then inflation rises.

John’s post explains the problems with this theory. M is endogenous, V is not constant, and the economy is rarely at full employment. If you want to know more, you should read John’s post.

Let’s move to an alternative theory of the price level and inflation by starting with another identity based on macroeconomic accounting:
PQ ≡ W + U
This is the income approach to GDP used by the Bureau of Economic Analysis. It says that nominal GDP (PQ) is the sum of all incomes. For simplicity, there are only two incomes: wage bill (W) and gross profit (U). Both are measured before tax.
Let’s divide by Q on each side:
P ≡ W/Q + U/Q
We can go a bit further by noting that W is equal to the product of the average nominal wage rate and the number of hours of labor W = wL (for example, if the wage rate is \$5 per hour, and L is equal to 10 hours, then W is equal to \$50). Thus:
P ≡ wL/Q + U/Q
Q/L is the quantity of output per labor hour, also called the average productivity of labor (APl) therefore:
P ≡ w/APl + U/Q
w/APl is called the unit cost of labor and data can be found at the BLS. The term U/Q will be interpreted a bit later.
Ok let’s stop a bit here. For the moment all we have done is rearranged terms, we have not proposed a theory (i.e. a causal explanation that provides behavioral assumptions about the variables.)  Here they are:
·         The economy is not at full employment and Q (and economic growth) changes in function of expected aggregate demand (this is Keynes’s theory of effective demand).
·         w is set in a bargaining process that depends on the relative power of workers (the conflict claim theory of distribution underlies this hypothesis)
·         U, the nominal level of aggregate profit, depends on aggregate demand (Kalecki’s theory of profit underlies this hypothesis)
·         APl moves in function of the needs of the economy and the state of the economy.
Thus we have:
P = w/APl + U/Q
Thus the price level changes with changes in the unit cost of labor and the term U/Q. What is this last term? To understand it let’s express the previous equation in terms of growth rate. This is approximately:
gp = (gw – gAPl)sW + (gU – gQ)sU
With sW and sU the shares of wages and profit in national income (sW + sU = 1).
Thus, inflation will move in relation to the growth rate of the unit labor cost of labor, which itself depends on how fast nominal wages grow on average relative to the growth rate of the average productivity of labor. As shown in the following figure, in the United States, a major source of inflation in the late 1960s and 1970s was the rapid growth of the unit cost of labor, with the rate of change between 5 and 10 percent.

Major Sector Productivity and Costs Index (BLS)

 Series Id:  PRS85006112Duration:   % change quarter ago, at annual rateMeasure:    Unit Labor CostsSector:     Nonfarm Business Inflation will also move in relation to the difference between the growth rate of U and the growth rate of the economy (gQ). U follows Kalecki’s equation of profit, which broadly states that that the level of profit in the economy is a function of aggregate demand. Thus the term, (gU – gQ) represents the pressures of aggregate demand on the economy. If gU goes up and gQ is unchanged, then gP rises given everything else. However, to assume that gQ is constant is not acceptable unless the economy is at full employment, so a positive shock on aggregate demand will usually lead to a positive increase in gQ. Thus, overall, there are two sources of inflation in this approach, a cost-push source (here summarized by the unit labor cost) and a demand-pull source (here summarized by the aggregate demand gap). Note that the money supply is absent from this equation. Money does not directly affect prices. Assuming that a drop of money from the sky leads to inflation, first, does not understand how the money supply is created (it is at least partly created to produce goods and services), second, assumes that people will automatically spend rather than hoard the addition funds obtained (people do hoard for all sorts of reasons and do derive “utility” from hoarding money), third, assumes that the economic output cannot respond to additional demand. If more people suddenly go to the store, producers usually produce more rather than raise prices. Output is not a fixed pie that involves allocation to one group at the expense of another group. The size of the pie increases and decreases with the number of people demanding pie. A version of this theory has been used in many different models that have endogenous money, liquidity preference, demand-led theory of output and other non-mainstream characteristics. Godley’s and Lavoie’s Monetary Economics as well as Lavoie’s Foundation of Post Keynesian Economics are good books to get more modeling. Of course, modern mainstream monetary economics is rejected in those books; income effect dominates over substitution effect, production is emphasized over allocation, monetary profit affects economic decisions, etc. Be prepared for a change of perspective in which scarcity is not the starting point of economics.

## Scott Sumner Agrees that MMT Policy Proposals Are Not Inflationary

Scott Sumner sets out to debunk theories of the price level not based on a form of the quantity theory of money, and lumps MMT in with those approaches that “deny open market purchases are inflationary, because you are just exchanging one form of government debt for another.” While this is true, what’s interesting is that from within Sumner’s own paradigm, MMT-related proposals should not be inflationary. This is clear right off the bat when he lists his first “qualifier” or exception to the quantity theory:
1. If the new base money is interest-bearing reserves, I fully agree that OMOs may not be inflationary.  That’s exchanging one type of debt for another.
And that is about all we need to hear. As we’ve said probably gazillions of times, you can’t have discretionary open market operations beyond that which is consistent with the Fed achieving its federal funds rate target unless an interest-bearing alternative to reserve balances is offered. Traditionally, this has been Treasury securities issued by the Treasury or sold by the Fed. The only way to leave all the reserve balances circulating and achieve a positive interest rate target at the same time would be to pay interest on reserve balances.
For instance, later, when Sumner writes, “Now suppose that in 2007 the US monetized the entire net debt, exchanging \$6 trillion in non-interest bearing base money for T-securities,” hopefully he realizes that this is not operationally possible without paying interest at the target rate on the excess reserve balances created unless the Fed wanted to have a zero-rate target.

So, in the MMT proposals, whether for functional finance fiscal operations without bond sales or basic coin seigniorage, or in our critiques of QE, we’ve always recognized that these were not operationally possible with a positive interest rate target unless interest is paid on reserve balances at the Fed’s target rate. As such, we always propose that the rate paid on reserve balances and the target rate be equal.
And just to be clear, when Sumner says above that “OMOs may not be inflationary” due to what he later describes as expectation effects, again MMT agrees that there can be such indirect effects as when expectations of QE2’s ultimate effect were likely behind rising commodity and equity prices. Cullen Roche pointed this out literally dozens of times.

Now, obviously, the MMT understanding of the effects of interest on reserve balances—namely, to achieve an overnight target while adding reserve balances in a discretionary manner, and virtually nothing else—is completely at odds with Sumner’s view and the view of many other neoclassical economists, where interest on reserve balances is akin to tighter monetary policy. But differences in how the two paradigms understand the monetary system or how monetary policy is transmitted to the rest of the economy are not my point here. The point is, from within Sumner’s own paradigm, policies proposed by MMT’ers aren’t inflationary.
Finally, just as an aside, Sumner concludes with, “So here’s my question: Are there any non-quantity theoretic models of the price level?” Of course, the price level itself can be anything depending on which year uses as a base year and the value at which the base year is set, so what’s really of interest is understanding changes in the price level instead of the level itself. Interestingly, MMT is also a quantity-theoretic model of changes in the price level. The differences are (1) net financial assets of the non-government sector, rather than traditional monetary aggregates, are the MMT’ers preferred measure of “money,” and (2) desired leveraging of the non-government sector is akin to what one might call “velocity.” In MMT, the two of those together (net financial assets of the non-government sector relative to leveraging of existing income) set aggregate demand and ultimately changes in the price level, at least the changes that are demand-driven.

## “The Hyperinflation Hyperventalists”

By Rob Parenteau**

After a two day blogging slugfest on fiscal deficits, I find that the question of hyperinflation now demands an answer. And here it is: fiscal deficit spending may be a necessary condition of hyperinflation, but it is hardly a sufficient condition.

Think this is yet another rant against the “deficit errorists?” Think again. Paul Krugman treated this question in his March 18th New York Times column:

Hyperinflation is actually a quite well understood phenomenon, and its causes aren’t especially controversial among economists. It’s basically about revenue: when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage – revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.

Krugman locates the source of hyperinflation in what is termed the “monetization” of fiscal deficit spending. He then attributes its perpetuation to shifts in the liquidity preferences of people — that is, the share of their portfolio that households and firms wish to hold in cash or cash like investment instruments (think Treasury bills, or money market mutual funds, for example). Krugman’s logic means that even the liberal wing, or the saltwater contingent, of the economics world has a touch of deficit errorism. We would invite Paul to take a closer look at the UBS research on public debt to GDP ratios and inflation first released last summer, reprinted in a FT Alphaville note, and discussed on Naked Capitalism. The story of inflation and fiscal deficits is more ambiguous, or at least more complex than the deficit errorists would have you believe.

Coincidentally, an investment manager friend forwarded me a letter that Ebullio Capital Management* allegedly sent to its clients after February’s investment results, which took them down nearly 96% for the year – virtually wiping out their stellar gains of the prior two years. The letter reveals that Ebullio was so ebullient about the possibility (inevitability?) of hyperinflation emerging from recent policy excesses that they bet the ranch on hyperinflation plays in the commodity corner of the investing world (metals), and lost big time. While we still have questions as to whether this is a spoof or not, there are undoubtedly people sitting around in gold wondering whether the old yellow dog is going to get up and bark again anytime soon. Although hyperinflation hyperventilation has been catching on in recent months, especially amongst the deficit errorists, gold has been dead money since late November 2009.

What gives? As a piece I wrote in the July issue of The Richebacher Letter explains, hyperinflation requires extreme conditions not just on the demand side, but on the supply side as well. A month after the Richebacher piece, Bill Mitchell published a similar conclusion. To summarize our findings: on the demand side, in order for household spending power to keep up with rising prices, household nominal incomes or credit access must be ratcheted up in synch with price hikes. Otherwise, the price hikes will not stick. Households will have to pull back less-essential spending areas to afford the same quantity of goods in essential items. So your gas, home heating oil, health care, or food bill goes up, and you cut back on your restaurant and entertainment spending, unless your paycheck also increases, or you can tap more credit. That is why hyperinflation episodes need more than just deficit spending. It is true, as Marshall Auerback and I explained in a recent New Deal 2.0 post, that fiscal deficits increase the net cash flow for the household sector as a whole. But we also usually observe some sort of escalator clauses or cost of living adjustment mechanisms built into wage contracts that allow this ratcheting up of household income pari passu with the inflation hikes. Take that element away — and it is a recurring theme in historical episodes of hyperinflation — and households cannot keep up with hyperinflation. The higher prices cannot get validated by higher consumer spending. The hyperinflation flares out.

Beyond this demand side component, which is scarcely to be found in the US wage contracts these days (although we must mention it is built into some government benefit programs like social security), there is the supply side issue. Productive capacity must be closed or abandoned in order for the hyperinflation to really rip. There is a built-in dynamic that encourages this. As the hyperinflation gets recognized, entrepreneurs eventually figure out that they would be much better off speculating in commodities (like Ebullio), buying farmland, chasing gold and other precious metals, or more generally, repositioning their portfolios and reinvesting their profits in tangible assets with relatively fixed supplies. That is, goods that are fairly nonreproducible become stores of value, as it is their prices that tend to rise most swiftly, since higher prices cannot, by definition, elicit any new supplies. Hence, those of you who lived through the ‘70s (and still remember what you were doing) will recall high net worth households were busy hoarding ancient Chinese ceramics while the middle class was chasing residential real estate, and the stock market basically went sideways.

In the case of the Weimar Republic following WWI, and Zimbabwe most recently, remember that war (civil or international), has an impeccable way of destroying productive capacity in a nation, or rerouting it to the production of war material. In the Weimar episode, the final back-breaking run up in hyperinflation accompanied the occupation by the French of the Ruhr Valley, which held a fair concentration of German production facilities. In solidarity with the workers who struck those plants in response, the Weimar Republic continued to pay the workers through fiscal measures. Cut production, but continue income flows, and you have the recipe for the kind of unresolved distributional conflict that often lies at the heart of the inflation process. Mainstream economics and popular lore refuse to see this.

Suffice it to say that hyperinflation takes a very special set of conditions. It is not, contra Paul Krugman, all about fiscal deficits, nor is it only about fiscal deficits. That is why we do not see hyperinflation breaking out all over the place on any given day, despite the fact the governments have to first create the money that you and I use to pay taxes or buy Treasury bonds (because even though we “make” money, we cannot create it, without risking a spell in jail for counterfeiting). Know your history. Try not to pass out with the hyperventilating hyperinflationistas: they are a particularly virulent wing of the deficit errorists, and they may simply leave you in a state similar to the one alleged to have been experienced by Ebullio Capital Management’s clients.

P.S. I have a piece called “On Fiscal Correctness and Animal Sacrifices” appearing on several blogs that formed the basis for the March 2010 Richebacher Letter. It is crucial that this piece get into the hands of Paul Krugman. If anyone knows how to get to him, I would be much obliged. His July 15th, 2009 NY Times diagram, which I call the Krugman Curve, has planted a seed that he would benefit greatly from watering. I believe it would help him escape the trap of continually returning to the manipulation of real interests rates (now requiring that he advocate central banks push a credible plan to deliver higher inflation in perpetuity, since policy rates are near the zero nominal bound in many places) as the holy grail for all countries operating below potential output. Time for him to exit from the IS/LM straight jacket, which even Sir John Hicks, one of its fathers, had his sincere doubts about, as well as the intertemporal utility maximization straight jacket of his more orthodox contemporaries. He knows how to do it…he just does not know it yet, which is why this paper needs to get in his hands, and soon, before the deficit errorists claim him as one of their own.

* You can go to Ebullio’s website, but unfortunately, authorization is required to see their performance, their track record, and their client letters.

## Is It Time to Reduce the Ease to Prevent Inflation and Possible National Insolvency?

The growing consensus view is that the worst is behind us. The Fed’s massive intervention finally quelled the liquidity crisis. The fiscal stimulus package has done its work, saving jobs and boosting retail sales. The latest data show that net exports are booming. While residential real estate remains moribund, there are occasional reports that sales are picking up and that prices are firming. Recovery is just around the corner.

Hence, many have started to call on the Fed to think about reversing its “quantitative ease”—that is, to remove some of the reserves it has injected into the banking system. Further, most commentators reject any discussion of additional fiscal stimulus on the argument that it is no longer needed and would likely increase inflation pressures. Thus, the ARRA’s stimulus package should be allowed to expire and Congress ought to begin thinking about raising taxes to close the budget deficit.

Still, there remain three worries: unemployment is high and while job losses have slowed all plausible projections are for continued slack labor markets for months and even years to come; state and local government finances are a mess; and continued monetary and fiscal ease threaten to bring on inflation and perhaps even national insolvency.

Me thinks that reported sightings of economic recovery are premature. Still, let us suppose that policy has indeed produced a resurrection. What should we do about unemployment, state and local government shortfalls, and federal budget deficits? I will be brief on the first two topics but will provide a detailed rebuttal to the belief that continued monetary ease as well as federal government deficits might spark inflation and national insolvency.

1. Unemployment

Despite the slight improvement in the jobs picture (meaning only that things did not get worse), we need 12 million new jobs just to deal with workers who have lost their jobs since the crisis began, plus those who would have entered the labor force (such as graduating students) if conditions had been better. At least another 12 million more jobs would be needed on top of that to get to full employment—or, 24 million total. Even at a rapid pace of job creation equal to an average of 300,000 net jobs created monthly it would take more than six years to provide work to all who now want to work (and, of course, the labor force would continue to grow over that period). There is no chance that the private sector will sustain such a pace of job creation. As discussed many times on this blog, the only hope is a direct job creation program funded by the federal government. This goes by the name of the job guarantee, employer of last resort, or public service employment proposal. (see here, here, and here)

2. State and Local Government Finance

Revenues of state and local governments are collapsing, forcing them to cut services, lay-off employees, and raise fees and taxes. Problems will get worse in coming months. Most property taxes are infrequently adjusted, and many governments will be recognizing depressed property values for the first time since the crisis began. Lower assessed values will mean much lower property tax revenues next year, compounding fiscal distress. Ratings agencies have begun to downgrade state and local government bonds—triggering a vicious downward spiral because interest rates rise (and in some cases, downgrades trigger penalties that must be paid by governments—to those same financial institutions that caused the crisis). Note that contractual obligations, such as debt service, must be met first. Hence, state and local governments have to cut noncontractual spending like that for schools, fire departments, and law enforcement so that they can use scarce tax revenue to pay interest and fees to fat cat bankers. As government employees lose their jobs, local communities not only suffer from diminished services but also from reduced retail sales and higher mortgage delinquencies—again pushing a vicious cycle that collapses tax revenue.
The solution, again, must come from the federal government, which is the only entity that can spend countercyclically without regard to its tax revenue. As discussed on this blog in several posts (here and here), one of the best ways to provide funding would be in the form of federal block grants to states on a per capita basis—perhaps \$400 billion next year. A payroll tax holiday would also help—increasing take-home pay of employees and reducing employer costs on all employees covered by Social Security.

3. Federal Budget Deficit, Insolvency, and Inflation

Resolving the unemployment and state and local budget problems will require help from the federal government. Yet that conflicts with the claimed necessity of tightening fiscal and monetary policy in order to preempt inflation and solvency problems. Two former Fed Chairmen have weighed in on US fiscal and monetary policy ease and the dangers posed. On NBC’s Meet the Press, Alan Greenspan argued:
“I think the Fed has done an extraordinary job and it’s done a huge amount (to bolster employment). There’s just so much monetary policy and the central bank can do. And I think they’ve gone to their limits, at this particular stage. You cannot ask a central bank to do more than it is capable of without very dire consequences,”

He went on, claiming that the US faces inflation unless the Fed begins to pull back “all the stimulus it put into the economy.”

In an interview (with SPIEGEL ONLINE – News – International) former Chairman Paul Volcker said the deficit will need to be cut:

Volcker: You’ve got to deal with the deficit and you’ve got to deal with it in a timely way. Right now, with the unemployment rate still very high, excess capacity is still evident, and the economy is dependent on government money as we said. We are not going to successfully attack the deficit right now but we have got to prepare for attacking it.
SPIEGEL: Should Americans prepare themselves for a tax increase?
Volcker: Not at the moment, but I think we would have to think about it. The present tax system historically has transferred about 18 to 19 percent of the GNP to the government. And we are going to come out of all this with an expenditure relationship to GNP very substantially above that. We either have to cut expenditures and that means reducing entitlements and certainly defense expenditures by an amount that may not be possible. If you can do it, fine. If we can’t do it, then we have to think about taxes.
Both the Fed and the Treasury are said to be “pumping” too much money into the economy, sowing the seeds of future inflation. There are two kinds of cases made for the argument that monetary and fiscal policy are too lax. The first is based loosely on the old Monetarist view that too much money causes inflation., while the second is more Keynesian, pointing toward the money provided through the Treasury’s spending. The evidence can be found in the huge expansion of the Fed’s balance sheet to two trillion dollars of liabilities and in the Treasury’s budget deficit that has grown toward a trillion and a half dollars. Chairman Greenspan, a committed Monetarist, points to the first of these, recognizing that most of these Fed liabilities take the form of reserves held by banks—which will eventually start lending their excess reserves. Chairman Volcker points to the second—federal government spending that will create income that will be spent. Hence, those trillions of extra dollars provided by the Treasury and Fed surely will fuel more lending and spending, leading to inflation or even to a hyperinflation of Zimbabwean proportions.
Some have made a related argument: all those excess reserves in the banking system will be lent to speculators, fueling yet another asset price bubble. The consequence could be rising commodities prices (such as oil prices) feeding through to inflation of consumer and producer prices. Or, the speculative bubble would give way to yet another financial crisis. Worse, either inflation or a bursting bubble could generate a run out of the dollar, collapsing the currency—and off we go again toward Zimbabwean ruin.
Finally, over the past two decades the Fed—accompanied by New Consensus macroeconomists—has managed to create a widespread belief that inflation is caused by expected inflation. In other words, if everyone believes there will be inflation, then inflation will result because wages and prices will be hiked on the expectation that costs will rise. For this reason, monetary policy has long been directed toward managing inflation expectations, with the Fed convincing markets that it is diligently fighting inflation pressures even before they arise. Now, however, the Fed is in danger of losing the battle because all of those extra reserves in the banking system will create the expectation of inflation—which will itself cause inflation. For this reason, the Fed needs to begin raising interest rates and (or, by?) removing reserves from the banking system. That would prevent expected inflation from generating Zimbabwean hyperinflation.

Unfortunately, all these arguments misunderstand the situation. Here is why:

You cannot tell much of anything by looking at current bank reserve positions. As and when banks decide they do not need to hold so many reserves, they will begin to unwind them, repaying loans to the Fed (destroying reserves) and buying Treasuries (the Fed will accommodate by selling assets in order to keep the overnight fed funds rate on target—if it did not, excess reserves would drive the fed funds rate to zero).There are no direct inflationary pressures that result from such operations. Indeed, all else equal, the reserves will be reduced with no new bank lending or deposit creation.

Banks normally buy financial assets (including loan IOUs) by issuing liabilities (including deposits). As the economy recovers, banks will want to resume such activities. If there is a general demand to buy output or financial assets, coming from borrowers perceived to be creditworthy, banks normally accommodate by making loans. This does not require ex ante reserves (or even capital if regulators do not enforce capital requirements or if banks can move assets off balance sheet). Yes, such a process can generate rising asset prices and banks broadly defined might accommodate this as they seek profits through lending to speculators. In this respect you could argue that expected inflation of asset prices fuels actual inflation of asset prices since that can fuel a speculative run up. Yet, this can occur with or without any excess reserves–indeed even if banks were already short required reserves they could expand lending then go to Fed to get the reserves. In other words, banks do not lend reserves nor is their lending constrained by reserves. Thus, while it is true that banks can finance a speculative bubble in asset prices, they can do this no matter what their reserve position is.

Nor will bank lending for asset purchases necessarily generate inflation of output prices. Any implications of renewed bank lending for CPI or PPI inflation are contingent on pass through from commodities to output prices. If the speculative binge in, say, futures prices of commodities feeds through to commodities spot prices, and if this then pressures output price inflation (as measured by the CPI and PPI), there can be an effect on measured inflation. There are lots of caveats–due to the way these indexes are calculated, to the possibility of consumer and producer substitutions, and to offsetting price deflation pressures (Chinese production and all of that). In any case, if there is a real danger that the current commodities price boom could accelerate to the point that it might create a crash or output price inflation, the best course of action would be to constrain the speculation directly. This can be done through direct credit controls placed on lenders as well as regulation of speculators.

It is true that the Fed has operated on the belief that by controlling inflation expectations it prevents inflation. Low inflation, in turn, is supposed to generate robust economic growth and high employment. This has been exposed by the current crisis as an unwarranted belief. The Wizard of Oz behind the curtain was exposed as an impotent fraud—while Bernanke remained focused on controlling inflation expectations for far too long, the whole economy collapsed around him. It was only when he finally abandoned expectations management in favor of bold action—lending without limit to institutions that needed reserves—that he helped to quell the liquidity crisis. All of his subsequent actions have had no impact on the economy—“quantitative easing” is nothing but a slogan, meaning that the Fed accommodates the demand for reserves (which it has always done, and necessarily must do so long as it has an interest rate target and wants par clearing).

It is sheer folly to believe that inflation expectations lead to inflation and that by controlling the expectations one controls inflation. In the modern capitalist economy, prices of output are mostly administered, with the caveat that competitive pressures from low cost producers in China and India put downward pressure on prices that may force domestic sellers to cut prices. Hence, US inflation has remained low in recent years because there has been little cost pressure; and note that most countries around the world have also experienced low inflation over the same period even though they did not enjoy the supposed benefits of a Wizard in charge of monetary policy. In the current environment of a global financial and economic calamity, the real danger is price deflation. The bit of inflation we do experience is due almost entirely to energy price blips—which could be prevented if we would just prohibit pension funds from speculating in commodities.

Still, there remains one path to Zimbabwean hyperinflation: a collapse of the currency due to insolvency and default by our federal government on its debts. Yet, as many have discussed on this blog (see here, here, here, here, and here), the US government is the sovereign issuer of our dollar currency. It cannot be forced into bankruptcy because it services its dollar debt by crediting bank accounts. It can never run out of these credits, since they are merely electronic entries on balance sheets, created at the stroke of a computer key. It can, and will, make all payments as they come due. In short, federal government insolvency is not possible.

To be sure, as we have emphasized many times, too much government spending can be inflationary. But the measure of “too much” cannot be found by looking at the size of the deficit (or, equivalently, at the shortfall of tax revenue), or at the ratio of government spending to GDP, or at the outstanding debt stock. Rather, government spending will approach an inflation barrier as the economy approaches full employment of resources, including labor resources. Yet, we are no where near to full employment. Any fear that current levels of spending, or even much larger amounts of federal spending, might be inflationary are premature. With 12 to 25 million jobless workers remaining, inflation is not a legitimate worry.

You can be sure that no matter how misguided President Obama’s policies might be, he is not taking us down the path to a Zimbabwean hyperinflation. This is not the place for a detailed analysis of the probable course of the dollar. In coming months it might decline a bit, or rise a bit (I’d bet on the latter if I were a gambler)—but there will be no global run out of the dollar. For one thing, runners must run to something—and as recent reports suggest, Euroland’s prospects look dire. That leaves smallish nations (Japan, the UK—both with their own problems) or big nations (China, India) that are too risky for foreigners. The best place to park savings will remain the US dollar.

## Another Embarrassing Blunder by Chairman Bernanke

By Felipe Rezende

The Fed chairman Ben Bernanke in his recent op-ed piece argued that “given the current economic conditions, banks have generally held their reserves as balances at the Fed.” This is not surprising since, in uncertain times, banks’ liquidity preference rise sharply which reflects on their desire to increase their holdings of liquid assets, such as reserve balances, on their balance sheets.

However, Bernanke pointed out that “as the economy recovers, banks should find more opportunities to lend out their reserves.” The reasoning behind this argument is the so-called multiple deposit creation in which the simple deposit multiplier relates an increase in reserves to an increase in deposits (Bill Mitchell explains it in more details here and here). This is a misconception about banking lending. It presupposes that given an increase in reserve balances (RBs) and excess reserves, assuming that banks do not want hold any excess reserves (ERs), the multiple increase in deposits generated from an increase in the banking system’s reserves can be calculated by the so-called simple deposit multiplier m = 1/rrr, where rrr is the reserve requirement ratio (let’s say 10%). It tells us how much the money supply (M) changes for a given change in the monetary base (B) i.e. M=mB. In this case, the causality runs from the right-hand side of the equation to the left-hand side. The central bank, through open market operations, increases reserve balances leading to an increase in excess reserves in which banks can benefit by extending new loans: ↑RBs → ↑ER → ↑Loans and ↑Deposits.
However, in the real world, money is endogenously created. Banks do not passively await funds to issue loans. Banks extend loans to creditworthy borrowers to meet the needs of trade. In this process, loans create deposits and deposits create reserves. We can illustrate this using T-account as follows:

The bank makes a new loan (+1000) and at the same time the borrower’s account is credited with a deposit of an equivalent amount of the loan. Thus, “the increase in the money supply is a consequence of increased loan expenditure, not the cause of it.” (Kaldor and Trevithick, 1981: 5)
In order to meet reserve requirements, banks can obtain reserves in secondary markets or they can borrow from Fed via the discount window.

As noted by Kaldor (1985), Minsky (1975), Goodhart (1984), Moore (1988), Wray (1990), Lavoie (1984) to name a few, money is endogenously created. The supply of money responds to changes in the demand for money. Loans create deposits and deposits create reserves as explained here and here. It turns the deposit multiplier on its head. Goodhart (1994) observed that “[a]lmost all those who have worked in a [central bank] believe that [deposit multiplier] view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system….’ (Goodhart, 1994:1424).
As Fulwiller put it, “deposit outflows, if they exceed the bank’s RBs, result in overdrafts. Banks clear this via lowest cost available in money markets or from the Fed.” In this case, let us assume that the bank issues some other liability, such as CDs, in order to obtain the 1000 reserves needed for clearing its overdraft at the Fed.

It reverses the orthodox story of the deposit multiplier (M=mB). Banks are accepting the liability of the borrower and they are creating their own liability, which is the demand deposit. In this process, banks create money by issuing its own liability, which is counted as a component of the money supply. Banks do not wait for the appropriate amount of liquid resources to exist to provide new loans to the public. Instead, as Lavoie (1984) noted ‘money is created as a by-product of the loans provided by the banking system’. Wray (1990) puts it best:
“From the bank’s point of view, money demand is indicated by the willingness of the firm to issue an IOU, and money supply is determined by the willingness of the bank to hold an IOU and issue its own liabilities to finance the purchase of the firm’s IOU…the money supply increases only because two parties willingly enter into commitments.” (Wray 1990 P.74)

As showed above, when banks, overall, are in need of more high-powered money (HPM), they can increase their borrowings with the central bank at the discount rate. Reserve requirements (RRs) cannot be used to control the money supply. In fact, RRs increase the cost of the loans granted by banks. As Wray pointed out “in order to hit the overnight rate target, the central bank must accommodate the demand for reserves—draining the excess or supplying reserves when the system is short. Thus, the supply of reserves is best characterized as horizontal, at the central bank’s target rate.” The central bank cannot control even HPM!The latter is provided through government spending (or Fed lending). The central bank can only modify its discount rate or its rate of intervention on the open market.

Bernanke is concerned that the sharp increase in reserve balances “would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures.” He is considering the money-price relationship given by the old-fashioned basic quantity theory of money relating prices to the quantity of money based on the equation of exchange (The idea that money is related to price levels and inflation it is not a new idea at all, you can find that, for example, in Hume and other classical economists):

M*V = PQ, where M stands for the money supply (which in the neoclassical model is taken as given, i.e. exogenously determined by monetary policy changes in M), Q is the level of output predetermined at its full employment value by the production function and the operation of a competitive labor market; P is the overall price level and V is the average number of times each dollar is used in transactions during the period. Causality runs from the left-hand side to the right-hand side (nominal output)

According to the monetarist view, under given assumptions, changes in M cause changes in P, i.e. the rate of growth of the money supply (such as M1 and M2) determines the rate of change of the price level. Hence, to avoid high inflations monetary policy should pursue a stable low growth rate in the money supply. The Fed, under Paul Volcker, adopted money targets in October 1979. This resulted in extremely high interest rates, the fed-funds rate was above 20%, the US had double digit unemployment and suffered a deep recession. In addition, the Fed did not hit its money targets. The recession was extremely severe and in 1982 Volker announced that they were abandoning the monetarist experiment. The rate of money growth exploded to as high as 16% p.y, over 5 times what Friedman had recommended, and inflation actually fell (see figure below).

Source: Benjamin Friedman, 1988 :55

The Collapse of the Money-Income and Money-Price Relationships

A closer look at the 1980s and 1990s help us understand the relationship between monetary aggregates such as M1 and M2 and inflation. This is a relationship that did not hold up either in the 1980s nor in the 1990s. As Benjamin Friedman (1988) observed “[a]nyone who had relied on prior credit-based relationships to predict the behavior of income or prices during this period would have made forecasts just as incorrect as those derived from money-based relationships.” (Benjamin Friedman, 1988:63)

Despite the collapse of the relationship between monetary aggregates and inflation Bernanke still believes that “we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.” He noted that “we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road” However, is inflation always and everywhere a monetary phenomenon? The answer is no. The picture below plots the credit-to-GNP ratio. Note that even “the movement of credit during the post-1982 period bore no more relation to income or prices than did that of any of the monetary aggregates.” (Benjamin Friedman, 1988:63, emphasis added)

What about the other monetary aggregates? Benjamin Friedman (1988) pointed out that “[t]he breakdown of long-standing relationships to income and prices has not been confined to the M1 money measure. Neither M2 nor M3, nor the monetary base, nor the total debt of domestic nonfinancial borrowers has displayed a consistent relation- ship to nominal income growth or to inflation during this period.” (ibid, p.62)

Even Mankiw admitted that “[t]he standard deviation of M2 growth was not unusually low during the 1990s, and the standard deviation of M1 growth was the highest of the past four decades. In other words, while the nation was enjoying macroeconomic tranquility, the money supply was exhibiting high volatility. The data give no support for the monetarist view that stability in the monetary aggregates is a prerequisite for economic stability.” Mankiw, 2001: 33)

He concluded that “[i]n February 1993, Fed chairman Alan Greenspan announced that the Fed would pay less attention to the monetary aggregates than it had in the past. The aggregates, he said, ‘do not appear to be giving reliable indications of economic developments and price pressures’… [during the 1990s] increased stability in monetary aggregates played no role in the improved macroeconomic performance of this era.” (Mankiw 2001, 34)

A recent study conducted by the FRBSF also concluded that “there is no predictive power to monetary aggregates when forecasting inflation.” What about the Japanese experience? As the figure below shows, the monetary base exploded but prices actually fell!

Source: Krugman

What about the US in the 1930s? The same pattern happened, HPM rose sharply and prices were stable!

Source: Krugman

Chairman Bernanke should learn the basic lesson that money is endogenously created. Money comes into the economy endogenously to meet the needs of trade. Most of the money is privately created in private debt contracts. As production and economic activity expand, money expands. The privately created money is used to transfer purchasing power from the future to the present; buy now, pay latter. It allows people to spend beyond what they could spend out of their income or assets they already have. Money is destroyed when debts are repaid.
Consumer price inflation pressures can be caused by struggles over the distribution of income, increasing costs such as labor costs and raw material costs, increasing profit mark-ups, market power, price indexation, imported inflation and so on. As explained above, monetary aggregates are not useful guides for monetary policy.

## BIS Report Warns That Main Problems Have Not Been Solved

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

## Don’t Fear the Rise in the Fed’s Reserve Balances

Many in the financial press have noted the rise since September 2008 in the Fed’s reserve balances from about \$20 billion to more than \$800 billion today. A number of well-known economists have expressed concern that this will be inflationary.

However, fears that these are inflationary are misplaced, even inapplicable, as they apply only to a monetary system operating under a gold standard, currency board, or similar arrangement, not the flexible exchange rate system of the U. S.

Under a gold standard, for instance, banks must be careful when creating loans that they have sufficient gold or central bank reserves to meet depositor outflows or legal reserve requirements. This is the fractional banking, money multiplier system standard in the economics textbooks. If there is an inflow of gold, then bank deposit creation can increase and prices can rise. The same can occur if the central bank raises the quantity of reserves circulating relative to its own gold reserves.

But that’s not the case under modern monetary systems with flexible exchange rates.

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed’s stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank’s ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

In other words, there is no loan officer at any bank that checks with the bank’s liquidity officer to see if the bank has reserves before it makes a loan.

What constrains a bank in the creation of new loans and deposits, then? First, there is the fact that there must be a willing borrower . . . one whom the bank deems to be creditworthy. Second, the loan must be perceived as profitable . . . in this case, the bank’s ability to raise deposits does matter, since it probably expects the borrower to withdraw the deposit it will create, and finding new deposits is much cheaper for the bank than borrowing from other banks or from the Fed. Third, the loan must be on the regulator’s approved list of assets, and if the loan results in an expansion of the bank’s balance sheet, the bank must be aware of the impact on its capital requirements and other financial ratios with which the regulator is concerned.

But, how many reserve balances the bank is holding does NOT affect its operational ability to make the loan.

Most fears expressed by economists, policymakers, and the financial press regarding the rise in reserve balances since September presume—like the inapplicable money multiplier model—this will necessarily lead to excessive creation of loans and deposits by banks and thus rising inflation.

But this cannot possibly be true. Banks have the same ability to create loans with \$800 billion in reserve balances that they had with \$20 billion. The difference now is mostly that they do not see as many creditworthy borrowers coming through their doors, given the deep recession, which has led them to create fewer loans.

Admonishments of banks by members of Congress for “not lending out the TARP funds” make the same mistake. Banks don’t lend out TARP funds or any other funds. They create loans and deposits out of thin air, then use reserve balances to settle payments or meet reserve requirements.

For further evidence, consider two recent extreme cases:

In Canada, reserve balances have been effectively zero for over a decade now, and bank lending continues as it does anywhere else. Canada’s inflation also has been similar to that of the U. S.

In Japan, under the so-called quantitative easing regime of 2001-2005, reserve balances reached around 15% of GDP, and the monetary base (reserve balances plus currency in circulation . . . often termed “high powered money”) reached 23% of GDP. But Japan has, if anything, experienced deflation during and since this period, which is not surprising, since—again—the rising quantity of reserve balances did not enhance Japanese banks’ abilities to create loans.

In the U. S., by comparison, reserve balances have reached about 6% of GDP, with the monetary base rising from about 6% to about 12% of GDP since September 2008. Those fearing rising Fed reserve balances apparently haven’t noticed that an increase in reserve balances about three times the size in terms of GDP already happened in Japan, with none of the effects that have been predicted for the U. S.

In short, don’t fear the rise in the Fed’s reserve balances. It is not inflationary because the money multiplier view, found in the textbooks, doesn’t apply to the flexible exchange rate monetary system of the U. S. The U. S. may indeed experience rising inflation in the future (or it may not), but it won’t have anything to do with the quantity of reserve balances banks are holding.

## Will the Run-Up in Government Debt Doom Us All?

Arthur Laffer has taken aim at Chairman Bernanke and President Obama, warning that somewhere down the road their policies will exact a huge price on the American economy. With respect to the Chairman’s handling of monetary policy, Mr. Laffer predicts “rapidly rising prices and much, much higher interest rates.” I am not going to critique Laffer on this point, because Paul Krugman and Mark Thoma have already done so in fine form.

“Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. . . With U.S. GDP and federal tax receipts at about \$14 trillion and \$2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.”

I believe that he is wrong on each of the above points, and here is why:

1. Increases in the federal deficit tend to decrease, rather than increase, interest rates. This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves – in the U.S. the federal funds rate – is driven to zero (yes, zero!). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the fed funds rate falls within the Fed’s target band. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn’t just true of the Fed. Just look at the Japanese experience:

Thus, despite a debt-to-GDP ratio in excess of 200%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either. The chart below shows that rates on 10-yr government bonds trended sharply downward as Japan’s public sector debt exploded:

Laffer’s prediction about what will happen to U.S. interest rates as a consequence of the Obama stimulus package are based on a faulty understanding of the relationship between deficit spending, bank reserves and interest rates. The Japanese experience serves as prime example of his flawed logic. (My fellow bloggers, Scott Fullwiler, Randy Wray and I have all published numerous articles that lay out the technical details surrounding the coordination of Treasury Fed operations and the management of U.S. interest rates.)

2. Increases in the federal deficit (and the subsequent run-up in outstanding debt) do not mandate higher taxes in the future. Taxes do not “pay for” the deficits we ran in the past. Taxes drain reserves (an important function) and constrain aggregate demand. Tax revenue obviously moves endogenously, with the business cycle, but revenues can also change as a matter of policy. What Mr. Laffer is apparently arguing is that today’s deficits will require “tomorrow’s” leaders to raise marginal tax rates (or impose new taxes). But this isn’t the U.S. experience.

Corporate taxes, as well as taxes on the wealthiest Americans, have trended downward for decades, even as the U.S. debt quadrupled in size.

And, while payroll taxes have risen steadily over the past 40 years, tax revenues, as a percentage of GDP have hardly budged in more than 50 years.

Thus, Laffer’s assertion that the current run-up in government debt will require “massive tax increases” isn’t borne out by our experience. And, it wasn’t the case in Japan either:

Despite an explosive increase in the government debt in both the U.S. (throughout the 1980s and again under George W. Bush) and Japan (especially in the late 1990s and early 2000s), taxes in both countries are among the lowest in the developed world.

3. Laffer contends that a “partial default on government promises” is an inevitable consequence of the Obama administration’s “ill-conceived” fiscal policies. A statement like this is at best misleading and at worst intellectually dishonest.

As any serious macro economist knows, a government like the United States – i.e. one that controls its own currency – can meet any and all outstanding financial obligations, provided the debts are denominated in the national currency. This is a point that Alan Greenspan made several years ago, when he wrote that “the U.S. government, by virtue of its ability to create money, can never become insolvent with respect to obligations in its own currency.”