Inflation: This Time Is Different
Bank lending is contracting, and it is important to understand why. At this stage of the credit cycle, which began expanding following the aftermath of the Lehman crisis over a decade ago, a sharp contraction of bank credit to nonfinancials is normal. It is what drives periodic recessions, slumps, and depressions, and monetary stimulus by central banks is intended to help commercial bankers recover their mojo and resume lending.
The relevant history of central bankers’ attitudes to bank credit goes back to Irving Fisher’s description of how contracting bank credit intensified the 1930s depression via the liquidation of debt, forcing collateral values down and leading to bank runs and the bankruptcy of thousands of banks. Ever since, monetary policy is guided by the fear of a repeat performance. But the Keynesian stimulus at the start of the credit cycle only increases the destabilizing nature of bankers’ behavior, consisting of long periods of growing greed for profitable loan business interspersed with sudden reversions to fear of loan risk. It results in a cycle of credit expansion and contraction, which in recent cycles has been resolved temporarily by increasingly aggressive expansions of base money along with government actions to support ailing industries.
It is a sticking-plaster approach which allows the wound to fester out of sight.
Following Lehman’s failure, a similar pattern to the one unfolding today of a rapid increase in bank assets through the newly invented QE (quantitative easing) was followed by a contraction of bank credit which lasted about fifteen months. But that crisis was about financial assets in the mortgage market, which had knock-on effects in the nonfinancials. Difficult though it was, its resolution was relatively predictable.
This crisis started in the nonfinancials and is therefore more damaging to the economy; its severity is likely to lead to a banking crisis far larger than the Lehman failure and possibly greater than anything seen since the 1930s depression.
Commercial bankers are now waking up to this possibility. For them, the immediate danger is associated with this quarter end, when demand for credit to pay quarterly charges increases significantly, just passed. Already, businesses are in arrears as never before, with many shopping malls, office blocks, and factories unused and rents unpaid. It is this problem, shared by banks around the world, which due to the severity of current business conditions is likely to tip the banking system over the edge and into an immediate crisis. The extent of the problem is likely to be revealed any time in this month of July.
Excluding the subsequent effects, the Lehman crisis cost the US government and its agencies over $10 trillion in support and rescue operations. This time, being in the nonfinancial sector with knock-on effects for the financial economy, this crisis is much deeper than Lehman and will require a far larger bailout check for collapsing industries. Part of the problem are the broken supply chains needing bridging finance. And none of this can be done without the Fed funding it all directly or indirectly through quantitative easing. Despite the massive monetary inflation already underway there can be no doubt that aggregate consumer demand and the production of goods to satisfy it will take an enormous hit this year and beyond, and there is little doubt that the states will be on the hook for even more monetary financing.
Unemployment of previously productive labor is already rising dramatically, and as bankruptcies increase, the rise in the unemployment numbers will continue. Let us therefore assume that compared with last year the production of goods and services and consumer demand for them will decline by at least 25 percent. Note that we avoid using money totals, since they are meaningless; it is the exchange of labor being converted into physical products and services that matters.
Into this situation are injected enormous quantities of money, none of which defeats the constraints on true supply of goods, nor on overall demand in a high-unemployment economy. Put in a more familiar way, we will have too much money chasing not enough goods. There is only one outcome, other things being equal; the purchasing power of the dollar in terms of consumer goods will be driven significantly lower. But central bank analysis rules this out, associating too much money chasing too few goods with only an expanding, overstimulated economy.
This explains stagflation, the situation where an economy stagnating in overall demand is accompanied by rising prices. Nor are other things ever equal, the condition for the paragraph above. The early receivers of inflated money will spend it, driving up the prices of the goods and services they acquire before the prices of other goods and services are affected. These early receivers include the federal government, which in an election year is doubly unlikely to hold back. Distribution of state money will increasingly be in the form of welfare to the unemployed, skewing spending toward life’s essentials. Inevitably, in an economy with subdued activity not responding quickly enough to produce the volumes of products desired, prices, mainly of essential items, will increase sharply.
Almost certainly, a broad index of prices will not capture this secular effect until too late. The CPI (Consumer Price Index) includes a majority of items which are only occasionally bought by individuals. Poor demand for nonessentials where there is now an oversupply puts downward pressure on their prices even in an inflationary environment. It is therefore possible for the CPI to record little or no price inflation as an average when food and energy prices are rising strongly, particularly when statistical methods designed to show little or no increase in price inflation are additionally taken into account.
Consequently, central banks are already being badly misled by the CPI’s statistical method. And when prices for essentials are soaring, they will continue to increase the quantity of money in circulation, distracted by that 2 percent increase in the CPI target. By the time it creeps up above that rate it will be too late, much monetary water having already flowed under the bridge.
The politicians will likely dismiss rising prices for food and fuel as the result of profiteering—they always do and then contemplate introducing price controls, making this outcome even worse.