Modern History Doesn't Prove Inflation Lags Monetary Expansion

Includes: GLD, SLV
by: Robert Wagner

In a recent article "Inflation Lags Monetary Expansion: Prepare To Be Swindled," the implication is made that there is a tight correlation and causal relationship between printing money and inflation. Modern history and monetary policy theory seem to contradict that theory. While there are times when that relationship may hold, there are others when just the opposite occurs. One only needs to look at Japan for a case study to demonstrate that fact. Japan has been battling deflation for over a decade with a highly expansionary monetary policy.

In a statement released on Wednesday in Tokyo, the Bank of Japan said it wanted to "drastically change the expectations of markets and economic entities", and "lead Japan's economy to overcome deflation that has lasted for nearly 15 years".

The US Federal Reserve - an enthusiastic supporter of so-called "unconventional" monetary policies such as QE - is spending $85bn a month, only just above the $70bn planned by the BoJ, in an economy almost three times the size of Japan's.

Using the Japan case study, this chart pretty much proves there can be an inverse correlation between printing money and inflation. There are infinitely more factors that work into inflation than just printing money. While many people would like to believe that it is that simple, especially the gold bugs and anti-Fed crowd, it just isn't.

We are experiencing a phenomenon similar to Japan right here in the US, having embarked on an aggressive QE campaign only to watch inflation expectations fall. The reason for this isn't simple, it is extremely complex, but investors should not ignore the Japan and US case studies when they make investment decisions. People invested in gold, silver, SPDR Gold Trust (NYSEARCA:GLD) and iShares Silver Trust (NYSEARCA:SLV) are losing fortunes because they cling to the misunderstanding that printing money automatically leads to inflation. It simply doesn't.

In the above linked "Swindle" article that triggered this response, the case study of the US in the 1970's is used as evidence. I had the good fortune of entering college and majoring in economics and finance just after that era, and all we did was study inflation and its causes. The 1970's didn't have inflation, it had "stagflation," a phenomenon that was forcing all the text books be be re-written because prior to that period high unemployment and high inflation was thought to be impossible. Prior to that era the Philip's Curve and Keynesian economics dominated economic thought and teachings, and everything came crashing down in the 1970s. It was a very exciting time to be studying economics because everything people thought they knew was turning out to be false.

To understand the 1970s, you have to understand inflation, and to understand inflation you have to understand its very basis. The best definition of inflation is "too many dollars chasing too few goods." The critical term of the definition is "chasing." Contrary to the gold bugs, Austrian School of Economics and yes, older versions of Webster's dictionary, inflation is not simply "printing money."

Justin Lahart with the Wall Street Journal wrestles with the definition of 'inflation' in his article "Using a Dictionary to Define Inflation Can Spell Trouble." Lahart writes that up until 2003, Webster's defined inflation as printing money. Since the 2003 edition, Webster's defines inflation as "a continuing rise in the general price level."

Mainstream economists say that only those out-of-step define inflation as increased money creation. "They were quite far behind the times," says Harvard economist Greg Mankiw. In his widely used economics textbook, he defines inflation simply as "an increase in the overall level of prices in the economy."

Too many dollars chasing too few goods can occur in multiple ways, not just through printing money. In the 1970s we had "too few goods" because of oil embargos. The 1970s was "supply shock" inflation, and had nothing to do with printing money, and everything to do with the fact that OPEC was no longer selling the US oil. There is absolutely nothing the Federal Reserve or monetary policy could to to force OPEC to sell the US more oil. To battle inflation the US and their labor unions implemented wage adjustments called Cost of Living Adjustments or COLAs, that dramatically drove up the cost of production and put more money in the hands of those that did have jobs, further increasing demand while shrinking supply. The US also had a relatively weak currency and was running trade surplusses during much of the 1970s, further complicating the supply and demand issue. Yes, the Federal Reserve did print money during that time, and yes the Federal reserve did contribute to the inflation, but their role was more a supporting role than a starring role. That above analysis didn't even include the spending on the Vietnam War, so a discussion about the 1970s that ignores all the other factors that can lead to inflation other than simply printing money simply doesn't paint a complete and accurate picture of the inflation of the 1970s.

Today people often complain about high food and energy prices, and believe that the CPI and inflation measures are "rigged" because they show no inflation. They aren't "rigged" because those price increases have nothing to do with monetary policy. The Federal Reserve can't stop the US Congress and President from waging a war on coal, interfering with the supply of conventional oil, unrest in the Middle-East or emerging demand for oil from the developing BRIC nations. There is a similar story for food. Ethanol policy has the US diverting 40% or more of its corn production to fuel production. We have also had crippling droughts recently as well. Those factors have extremely distorted the food markets, driving up food costs and shrinking supply. Whereas OPEC caused the supply shocks of the 1970s, the US Federal Government is doing so today. Those are simply supply and demand dynamics over which the Federal Reserve has no power. The Federal Reserve doesn't cause supply-shocks, but supply-shocks are the cause of most recent bouts of inflation.

Going back before the 1960s, the "Swindle" article mentions that:

Consumer prices tend to rise for a long time after the start of a monetary expansion, but get off to a slow start in the beginning. During the Great Depression, it took 15 years before the CPI rose above its 1929 peak, but then prices did not stop rising until the mid-1950s, more than 20 years after the start of the Fed's expansion.

The Great Depression is another great example of printing money not causing inflation. 15 years after 1929 is 1944, a year before the ending of WWII. The War had infinitely more impact on inflation than printing money could every have had. Once again, the supply and demand relationship was caused by something other than printing money. Printing money may have played a supporting role, but spending on WWII played the starring role. Once again, just like the 1970's external factors drove monetary policy. Monetary policy was reactionary, not causative. By the way, what was the alternative? Not funding spending on WWII? The cost of possibly losing the war dwarf the cost of the resulting inflation. Inflation is almost always a trade off, and it is almost always the lesser of the two evils.

The "Swindle" also mentions the falling and stable prices post WWII.

After remaining relatively stable in the 15 years following WWII, the Fed's monetary base began to expand at a higher rate beginning in 1960. By 1966, the 28% monetary expansion over the previous 6 years began to show up in a slightly higher annual increase in consumer prices.

Once again, when discussing inflation you have to be able to see the forest through the trees. Immediately post WWII, tremendous production capacity was returned to the US as the GIs came home to staff huge factories that were being re-tooled from making tanks, tents and guns to making cars, planes and homes for civilian use. The supply of consumer goods exploded, helping to keep prices down. In the early 1960s, Kennedy and Johnson were getting us into and then escalating the war in Vietnam. All those macro factors greatly altered the aggregate supply and demand relationship, and none of them were under the control of monetary policy.

Other classical examples used by the "printing money causes inflation" crowd are Nero's Rome and the Weimar Republic. Under both those cases the newly "debased" currency was used to chase too few goods. Nero debased his currency to take items off the shelves and build, supply and staff his palaces. Nero created shortages with his spending. During the Weimar Republic, the German Government would print money and use them to buy goods off the shelves, and hand them over to the French as war reparations. The German Government created shortages with its spending. In all cases of inflation there must be an altering of the aggregate supply and demand relationship, that is the very foundation of inflation, and it doesn't require printing money.

The current economic environment simply doesn't support inflation.

1) We are way below an economic growth rate that would be associated with inflation.

2) It is very difficult to have sustained inflation without sustained growing demand. That is why it is very unlikely the US will experience inflation with such high unemployment. Unemployment is well above the level that would be associated with inflation.

3) China pegs its currency to the US dollar, and they peg it as a discount. That allows the US to export a tremendous amount of inflation to China. It is unlikely the US will experience demand driven inflation until China faces a tight labor market and high industrial capacity utilization.

4) Global growth is slow and slowing, as is global demand. That is disinflationary, not inflationary.

5) The US and globe are deleveraging. Deleveraging acts as an antidote to any demand that might have otherwise developed. The newly printed dollars are going to recapitalizing banks and paying down debts, not buying new items.

6) Many nations are implementing "austerity" programs. Here in the US we have the "sequester." Dropping Government spending isn't a recipe for inflation, it is a recipe for disinflation and slower least in the short run.

In conclusion, inflation is "too many dollars chasing too few goods," resulting in a sustained imbalance where demand outpaces supply, resulting in a sustained increase in aggregate prices. Inflation can be caused by a shift in the demand curve called demand-driven inflation, or a shift in the supply curve called supply-shock inflation, or a combination of both. Increasing demand for a given supply, decreasing supply for a given demand or increasing demand and decreasing supply over a sustained period of time all can result in inflation, and all can and do occur regardless of whether or not there is printing money. Right now both Japan and the US have "too few dollars chasing too many goods," and that is why we are talking about deflation not inflation, even though both the Bank of Japan and the Federal Reserve have printed unprecedented levels of currency. Simply put, if the newly printed dollars aren't used to buy things, it isn't inflationary. People holding gold and silver would be well served to understand that concept and study the basics of supply, demand and inflation. There aren't any easy answers to successful investing, and bumper-sticker slogans like "printing money causes inflation" are the easiest of easy answers...and they are simply wrong.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.