Mises Daily Articles
In an article that I first saw on June 28th, Martin Feldstein asserts that quantitative easing is NOT money printing, and suggests that is the main reason we have not seen any price inflation.
The link between Fed bond purchases and the subsequent growth of the money stock changed after 2008, because the Fed began to pay interest on excess reserves [which] induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008. As a result, the volume of excess reserves held at the Fed increased from less than $2 billion in 2008 to $1.8 trillion now, effectively severing the link between Fed bond purchases and the resulting stock of money. The size of the broad money stock (M2) grew at an average rate of just 6.4 percent a year from the end of 2008 to the end of 2012.
Yet, this is all wrong: every bit of it, except for the fact about paying interest on and the increased quantity of excess reserves after 2008. That may have diluted the significance of the Fed Funds rate as a policy tool, but it has absolutely not severed the link between open market purchases of securities and the resulting stock of money. Feldstein’s analysis starts out with making an incorrect observation, and then proceeds toward a rationalization.
But in fact, I have shown in graphs like the one below that money growth has been growing at a record pace as compared to previous inflationary episodes. If my observation is correct, however, then why have we not seen a major breakout in price inflation, as many gold bugs predicted?
First, let’s nail down the observation.
Just the Facts Ma’am
the size of the broad money stock (known as M2) grew at an average rate of just 6.4 percent a year from the end of 2008 to the end of 2012.
From the end of 2008 to the end of 2012 my money supply metric grew from $5.7 trillion to $9.4 trillion (+$3.7 trillion), or an average annual rate of about 13.3 percent per annum.
That is more than double what M2 says.
I’ve shown that this is the greatest money supply increase ever in many ways.
Another student of the Austrian School here confirms my analysis:
The basic difference between M2 and our Austrian metric comes down to money market funds (MMF’s) and time deposits.
The reason that we omit these items is that they are not money, and counting them effectively causes a double-counting error.
The reason is that securities held in the MMF are not cash. They have to be liquidated for cash. Where you can write a check on your MMF, the MMF either sells securities in order to raise the cash to meet your redemption request or it debits an account that it has at one of the banks it deals with. Either way, that sum of cash has already been counted in the money supply.
It is similar with term deposits. These too are not demand deposits. There is a clear and definite transfer of title to a certain amount of cash from the investor to the issuer, and the term deposit has to be liquidated in order to return the cash from issuer to investor. In other words, the cash comes from deposits that have already been counted in money supply. You cannot buy stuff with an MMF or a term deposit.
The difference between the Fed’s and the Austrian method here is that the Fed does not have an a priori definition for what constitutes money. It picks data that best correlates to GDP growth and to other credit aggregates. The Austrians approach the data with a definition of money already in mind, which in their eyes is the common medium of exchange or any substitute that can be used as final payment of goods, services, and debts. This is not a matter of preference, but of science. Isn’t it about time that we all stopped looking at the data that is being spoon-fed to us by the criminals?
Naturally, then, an analysis of why money supply growth was low must be wrong if money supply growth hasn’t really been low. So why is price inflation really so low? Well, I have my own ideas.
Feldstein’s definition of prices is too narrow
In the above article, like most analysts, Feldstein is pointing to the CPI. But not only is CPI the most manipulated statistic of all of them, but the “core” especially is the narrowest measure of the ultimate effects of any expansion in money. It is the last of the effects: the tail wind. And, it only reflects what government wants to confess. What about soaring stock and house prices? What about bond values? Remember, they have to buy bonds to push rates down, so there is inflation there. What about art? What about energy, which has tripled from the 2008 low? Many of the soft commodities made record highs after the 2008 reflation.
Indeed, as I argued recently, you cannot forget that the CPI would have been 25 percent lower if it weren’t for the expansion of the money supply post-2008. If that is true, the fact that the CPI has increased still only barely obscures a 25-30 percent decline in the value of money.
Austrian economist Mark Thornton has argued similarly in his January 2013 article “Where is the Inflation”:
This doesn’t even consider what prices would be like if the Fed and world central banks had not acted as they did. Housing prices would be lower, commodity prices would be lower, CPI and PPI would be running negative. Low-income families would have seen a surge in their standard of living. Savers would get a decent return on their savings. Of course, the stock market and the bond market would also see significantly lower prices. Bank stocks would collapse and the bad banks would close. Finance, hedge funds, and investment banks would have collapsed. Manhattan real estate would be in the tank. The market for fund managers, hedge fund operators, and bankers would evaporate.
In any other country where the capital structure is less developed, the transition to price inflation would be more intense and instantaneous. That is why less monetary inflation in Europe has produced higher price inflation.
This is what makes the US dollar so different as well. The US economy can absorb inflation better. This has to do with the productivity of capital and the ability of the US to expand production, thereby offsetting the inflationary impetus to prices. This process works through the other side of the demand/supply coin: the “demand” for money, which is where Feldstein should look.
Feldstein omits any discussion of the historically higher than average “demand for money”
The productivity of the capitalist system is not the only factor exercising its influence on the demand for money and thereby offsetting the effects of a historic increase in money supply.
In his Mystery of Banking, Murray Rothbard identified a total of six ways that this demand for money manifests and affects prices:
(1) Simple demand function (when prices fall, the demand for money holdings falls; and when prices rise, the demand for cash holdings rises — these movements occur along the demand function);
(2) Productivity of capital (when production expands it causes an increase in the demand for money);
(3) Frequency of the payment of salaries and wages (if people got paid daily they would probably need to hold less cash balances than if they got paid every quarter);
(4) Innovations in the clearing system (innovations by Visa and other methods of money transfer has changed how much money we need to keep on hand. Obviously if you live in the bush away from these technologies you are going to require holding more cash);
(5) General confidence in the money; and
(6) Inflation or deflation expectations.
This last one is most important.
Not all of these factors have to exist at any one time. But we know that deflation expectations have been high. People have been hoarding cash. So have the banks, and so have businesses. People have been widely expecting prices to fall after 2008, not just consumer prices, but a general deflation. Is this not true?
This is an important question for me, because of how hard I’ve had to argue that we are not going to get deflation: at least not the type that the deflation camp is predicting. The basic theory about a progression of a typical inflationary cycle over time mainly involves numbers 1, 5, and 6 above. Citing Hazlitt and Rothbard, I wrote recently about how the cycle progresses from a relatively high confidence in the monetary standard toward an eventual destruction of confidence. Along the way there is an inevitable decline in the demand to hold on to cash (which is what the Fed wants), which is what we are seeing today, i.e., a liquidation of deflation expectations. The seeds of the bust have been sown, and the Fed will soon have to deal with the fallout.
The demand for money is only now beginning to fall, in other words.
We are only now going to head into the phase of the “boom” where the fallout impacts on consumer prices. As inflation fears return, the cycle becomes vicious, so even as money growth slows (as it did from 2004-07), prices inexplicably begin to accelerate upward.
Finally: the lag
There is always a lag.
The expansion of money could not instantly result in the uniform increase in prices even if you neutralized all the factors influencing the demand for money. The reason is that it takes time for new money to circulate throughout the economy. That’s the reason it has redistributive effects.
If prices rose all at once to the same degree no redistribution of wealth occurs, which means no one would have any incentive in implementing the policy.
Conclusion on return of price inflation
Most people are looking at M2 or MZM or whatever the Fed spoon-feeds them. They are bound to have the wrong analysis.
Using these numbers, they are inevitably going to conclude that QE did not translate into money printing, and that no matter how hard the Fed tries it just can’t inflate!
Uh, oh, we must be close to deflation!
But how on earth could they have gotten the stock market up so much if they are only expanding money and credit by a 6.4 percent per year!? HFT? Real growth? C’mon!
There is no doubt that sooner or later we are going to get an outbreak of price inflation. This has historically tended to happen when the Fed tries to withdraw its stimulus. And the Fed tends to do this when the demand for money starts to fall because that coincides with an improvement in the economic data.
At any rate, money growth in the US is faster than Feldstein calculates in his analysis, and the main reason we haven’t had much price inflation yet is because of the higher relative productivity of capital and the concomitantly higher than average level of demand for cash balances (or hoarding) this past few years.
Like I said, in any other country, prices would have been up more by now in response to this much QE. If the US continues this policy, it will continue to deplete its capital base, and in future make it even more sensitive to inflation. But for now, it will still surprise many in the next few years.
Temporary factors affecting the demand for money have lulled people into a false sense of security about the potential problem.