People often ask today: if the Fed has created so much new money, why hasn’t it produced more inflation?
When the Fed creates masses of new money, it initially flows to Wall Street, which profits from it in a variety of imaginative ways, but from there its path is unpredictable.
The Fed inserted into the TARP bill in 2008 the authority to pay interest on bank reserves. Of course this interest is paid by creating even more new money, but it provides an incentive for banks to leave reserves idle.
On the other hand, the reserves are not as idle as they look. For example, they support derivatives activity. The total amount of derivatives held by the top four US banks is estimated at the moment to be $217 trillion. And keep in mind that it was derivatives exposure that brought Lehman Brothers down in 2008.
To the degree that the new money does get out into the economy, it will flow in different directions and have different effects. If it reaches the average consumer, it will produce consumer price inflation. This does seem to be happening. Consumer price inflation calculated as it was in the past would be much higher than today’s reported 1%.
If the new money reaches rich people, it will drive up the prices of what rich people buy. We see this today when a single townhouse in Manhattan is listed for over $100 million. If it flows into the stock market, it will raise stock prices. If enough flows in this direction, it will create an asset bubble, which seems to be happening once again today. Asset bubbles are followed by crashes, which in turn bring recession and unemployment.
Wherever the new money flows, it may increase demand in the short run, only to reduce it in the long run. This is because the new money created by the Fed is not just given away. It is made available to banks to lend, which means that it enters the economy as debt. A little debt, especially if spent or invested wisely, may help an economy. But too much will strangle it.
As consumers, businesses, and governments become weighed down with more and more debt from the past, especially debt that was spent unwisely, the interest and principal payments become increasingly burdensome. Dollars that might have been spent on new investments with the potential to create new jobs and new income are instead siphoned off to pay for past mistakes. We end up with a zombie economy, still breathing, but just barely.
Historically we can measure how many dollars of economic growth we get from each new dollar of debt. At the moment, it seems to be negative. In other words, more new debt makes it worse, not better.
Despite this plain evidence, the Fed continues to try to persuade consumers and businesses to increase their borrowing and spending and also underwrites government borrowing and spending. It holds interest rates very low, which for now keeps the debt house of cards from tumbling down.
Will the Fed’s feckless money creation end in inflation or depression? It could go either way, which is potentially confusing. Insofar as it stokes demand, it could lead to inflation. Insofar as it increases an already too heavy debt burden, it could lead instead to recession, joblessness, and depression. Or it could lead first to the one and then to the other.
It could also lead to a third possibility: stagflation. In this scenario, consumer prices advance even while unemployment increases. We had this in the 1970’s. If we measured inflation as we did in the 1970’s, it would be apparent that this already exists today.
