Yesterday's coordinated central bank intervention is aimed at relieving dollar funding problems for European banks. Many are fearing that any new 'wall of money' from central banks will be stoking inflation.
We will set out below that we think these fears are a little overblown. We also think that the real wall of money has to come from the ECB. It's frustrating to realize that while the rest of the developed world has long engaged in quantitative easing, central banks buying up government bonds, the only area where that would make a real difference is the eurozone, and that's exactly the area where the central bank, the ECB, is very reluctant to engage in QE.
Now, there are reasons for that reluctance. They might not want to reduce the market pressure on those countries to continue with hard reforms and austerity. They might feel legal constraints, or the wrath of the Germans. Whatever it is, it shouldn't be a fear of inflation, let alone hyperinflation. A look at the evidence will dispel most of it.
The Money Supply
Those who invoke accelerating inflation as the outcome of any ECB (or other central bank) money printing have a rather mechanical view of economics in which increases in the money supply always directly translate one-for-one into increases in the price level.
Technically, there are a few things wrong with that already. It assumes stable velocity, the average amount of times money changes hands. History has shown that the velocity of money is anything but stable. It also assumes a clear concept of what money is, while that is a rather tricky proposition.
However, the most immediate retort of those who fear accelerating inflation as a consequence of any massive bond buying (or quantitative easing) program of the ECB should be greatly reassured when looking at actual figures of the money supply:
The broad M3 measure tracked closely by the European Central Bank as an early warning indicator shrank last month by €59 billion to €9.78 trillion, a sign that Europe's long-feared credit squeeze is underway as banks retrench to meet tougher capital requirements. [The Telegraph]
If M3 is not your thing, the same is happening to narrower monetary aggregates like M1 (essentially bank deposits plus currency in circulation):
While real M1 deposits are still holding up in the German bloc, the rate of fall over the last six months (annualized) has been 20.7pc in Greece, 16.3pc in Portugal, 11.8pc in Ireland, and 8.1pc in Spain, and 6.7pc in Italy. The pace of decline in Italy has been accelerating, partly due to capital flight. [The Telegraph]
You might also want to keep in mind that there has been a good deal of bond buying by the ECB going on already.
However, until now, this is almost completely sterilized; that is, the expansionary effects on monetary aggregates are neutralized by offsetting transactions (tendering one-week bank deposits). But the limits of that are in sight:
It has been a while since the ECB has failed to drain the full amount in their weekly term deposit facility. The intention was to absorb 203.5bn but instead the ECB only received bids totaling 194.2bn leaving a small shortfall but enough to raise doubts over the ability to continue to sterilize SMP. [FTAlphaville]
This only looks like a small hick-up so far, but nevertheless.
We do, in fact, have examples where central banks have embarked on large scale bond buying (QE) without sterilizing the expansionary effects on monetary aggregates. Both the Bank of England and the US Federal Reserve have done so. Dare we say, there have been few, if any noticeable effects on inflation, while there have been considerable effects on at least some monetary aggregates.
Consider what happened to bank reserves in the US, for instance:
These have ballooned (black line) while inflation is stable (blue line). But they're just sitting there (gathering 0.25% interest per year, as it happens). Banks do have the reserves to expand the supply of credit, but manifestly do not -- the main reason is that credit demand is low.
Households are still struggling with the debt overhang of the previous credit boom, they have seen wages falling, jobs lost, and their wealth has been impaired by a $9 trillion loss in the value of houses. A quarter of outstanding mortgages is under water (that is, the value of the mortgage is higher than that of the house used as collateral).
These are not circumstances in which they're likely to embark on credit fueled consumption, last Friday's spending spree notwithstanding. That means that firms are not experiencing robust demand. Since the economy is producing way below capacity, there isn't much reason to increase that either.
And even in industries where there is robust investment in additional production capacity, firms are sitting on record levels of cash ($2 trillion) and profits as a percentage of GDP are the highest since 1929.
In fact, one can argue, as Michael Hudson has done, that the financial system is producing deflation, rather than inflation:
Ask why the banks are using these giveaways to speculate abroad, pay their managers bonuses and high salaries or to pay dividends rather than to lend to small businesses or do other things to actually get the economy moving again. This phenomenon cannot be explained without seeing that debt service is siphoning off revenue into the financial sector, which is not recycling it back into the production-and-consumption economy.
Indeed. Where are the days that the main function of banks was to provide loans for productive activities.
Global Savings Glut
Another way of looking at this is to see that there is an oversupply of savings in the world, a world savings glut.
Apparently, savings are so high with respect to productive investment opportunities, that interest rates are bumping up the zero bound without being able to equate the two (a condition that could be described as a liquidity trap). It's interesting to speculate on the reasons why, but we'll leave that for another article.
Hyperinflation and the Weimar Republic
If the limited action of the ECB have an origin in German fears about a possible repeat of the events nearly a century ago that led to hyperinflation in Germany in 1923, then one should really consider what actually happened back then:
Turns out it was those pesky war reparations that caused government deficit spending to soar to something like 50% of GDP annually, with most of that whopping deficit spending used to sell the German currency and buy foreign currency to pay their war reparations. [Creditwritedowns]
You might also want to consider that other famous example put forward by the inflationistas, Zimbabwe:
Turns out they had a tad of civil unrest that dropped their productive capacity by about 80%, but government spending stayed high and too much spending power with too few goods and services for sale drove prices through the roof. Not to mention rumors of insiders using the local currency to buy foreign currencies for personal gain (sound[s] familiar). [Creditwritedowns]
In order to replicate these examples:
Applying this to the US to replicate the Weimar inflation Congress would have to increase the deficit to about $8 trillion a year and then sell those dollars continuously in the market place, using them to buy the likes of yen, euro, and pounds. And replicating Zimbabwe would mean some kind of disaster that wiped out 80% of our real productive capacity and then continuing to spend federal dollars as if that never happened. [Creditwritedowns]
They're talking about the US, but there is little (if any) reason to think it would be any different in Europe. We think we can safely rule this out, even under today's rather extreme circumstances.
Some Inflation Would be Beneficial
Yes, something like 5% inflation would actually help in defusing the crisis:
- It would reduce the real value of outstanding debt
- It would assist in that most intractable of problems, how to restore the competitiveness of peripheral eurozone countries without them having to slash wages and prices to such an extent as to deflate their economies into the ground (if you think this is an exaggeration, we suggest taking a holiday in Greece).
Even the OECD
Rather remarkably, now even the venerable OECD is spurring the ECB on to embark on massive bond buying:
The OECD club of rich states exhorted the ECB on Monday to take radical measures to contain the crisis. "The ECB should buy bonds and set a limit to yields, or a floor to bond value," said chief economist Pier Carlo Padoan. [The Telegraph]
Yes, that's the same OECD that urged spending cuts and interest rate hikes a year ago.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.