The "inflationistas" are back again (here), worrying about accelerating inflation and even comparing the present with hyperinflation periods in the past, when the whole world economy is decelerating and the U.S. faces a massive unemployment crisis. It is extremely curious why people focus on a non-existing problem when we have so many serious real problems, but only they can answer that question.
The perceived hyperinflation being just around the proverbial corner is simply nonsense, here is why.
This is the single statistic that the inflationistas point at. Yes, central banks have slashed interest rates to virtually zero and many of them have embarked on programs of buying up assets, so called "quantitative easing," (QE) which the inflationistas call "money printing."
Apart from the fact that this shows an utter lack of understanding how the financial system works (more on this below), here is the great Richard Koo, whom we have proposed for the next Nobel prize in economics:
If central banks bring interest rates down to almost zero and nothing happens then it is not an ordinary world. [FT]
And indeed it isn't. This is the world of a balance sheet recession, where after an asset price bubble burst, with the associated debt remaining, the private sector will do almost anything to pay off debt, even at zero interest rates. This means lower spending, spare capacity, unemployment. Exactly the conditions we're in, and conditions not quite conducive to any acceleration in inflation.
The inflationistas have a simple view of the economy one in which the increase in the money supply (all that "money printing") will lead to an increase in inflation. The fact that this hasn't happened, even after years of 'money printing,' hasn't led to any diminishing in their beliefs. It simply has to happen, in their view.
All kinds of gimmicks are thrown at this situation. Some argue that the price statistics are 'doctored,' but if one looks at MIT's Billion Prices Project, it turns that the CPI is pretty accurate:
They simply cannot comprehend this situation and we sometimes wonder whether they would recognize a liquidity trap even if they fell into one.
What QE does is boosting bank reserves. These indeed have ballooned:
Is that the same as "money printing?" No. In order to get those excess reserves into circulation as money, banks have to lend them out. By lending to firms and households, banks simply credit their accounts. Accounts with which firms and households can pay, that is, bank accounts (unlike bank reserves) are part of the money supply.
But in a balance sheet recession, credit demand is weak, even in the face of near zero interest rates. Households are deleveraging, that is, paying off debt rather than taking on new debt.
Hence, retail sales are weak, hence corporations, already sitting on excess capacity, have little incentive to invest in new production capacity, despite record corporate profits and sitting on some $5.1 trillion in cash.
We have already written about a paper by Sing and Stella, which shows that there is virtually no relation between bank reserves credit creation, and inflation:
Total credit market assets held by US financial institutions (excluding the monetary authorities) rose by $32.3 trillion from 1981 to 2006 (744%). Commercial bank reserves held as deposits at the Federal Reserve fell by $6.5 billion during the same period. In fact, total commercial bank reserves at the Federal Reserve amounted to only $18.7 billion in 2006, less than the corresponding amount, in nominal terms, held by banks in 1951. So from the first angle it is fairly clear that not only have financial institutions not relied on an increase in reserves held at the Fed to expand credit, they have expanded credit by 744% while reserves fell. [Sing and Stella]
So, credit expanded by 744% while reserves (the "money printing," according to inflationistas) were actually down. Apparently, one can have credit creation (that is, money creation) without increasing (or even by decreasing) bank reserves (the "money printing" according to the inflationistas).
Years of predicting inflation taking off have failed to materialize completely, and this is no surprise because there is an economy out there which has been suffering from the same kind of balance sheet recession like ours for two decades. It has unleashed the same policies (expansionary fiscal and monetary policy) that inflationistas claim would create accelerating inflation. For instance, here is Alan Meltzer:
Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation. [NYT]
Krugman simply responded with a graph:
Japan provides the best evidence of the impossibility of inflation to take off under the conditions of a balance sheet recession. The country's economy has been kept alive by enormous budget deficits (with public debt now over 200% of GDP). The only time the Japanese retrenched from this, in 1997 under Hashimoto, the economy quickly slumped, exactly what happened in the US in 1937 when Roosevelt erroneously embarked on austerity.
On top of that, the Japanese central bank, the BoJ, embarked on six years of QE between 2001 and 2006. And what is the result of all these efforts which inflationistas are sure will lead to accelerating inflation? Japan still experiences DEFLATION, rather than inflation.
When I put this argument under the nose of one of the inflationistas, the aptly named Economics Fanatic, his counterargument was that:
Japan in 20 years of deflation and Tokyo is still the second most expensive city to love in. As I mentioned in my article also, you can have inflation in some sectors and deflation in others. [Economics Fanatic]
Huh?! Completely disregarding the ten years of Japanese deflation, what counts is that Tokyo is still expensive? Well, perhaps, but if it is, could that have something to do with a steadily appreciating Japanese yen? Or could it be that Tokyo used to be even more expensive (after all, deflation means falling prices..)?
More importantly, if Japan hasn't been able to create accelerating inflation (indeed, they haven't even managed to escape deflation) after decades of extremely inflationary policies, why would it be different under the similar conditions in the U.S., or U.K. now? And indeed, it isn't.
Here are U.S. inflationary expectations (from the Cleveland Fed):
The record low yields simply suggest that market participants disregard any inflationary risk. The same is happening in the U.K., where the central bank, the Bank of England (BOE) has embarked on a large QE program of 375 billion pounds ($580B) in total, or some 24% of UK's GDP.
People like to point to Zimbabwe as our inflationary future. After all, haven't they been "printing money" just like we are doing? Well, they indeed printed quite a bit of money, but that was far from the only thing going on:
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]
And, of course, what doesn't help (even if we discard the erroneous equation of creating bank reserves with "money printing") is when comparing the money creation in Zimbabwe with ours, using logarithmic scales in the first and normal ones in the latter, for extra dramatic impact.
In case you think of the Weimar Republic as another historical example, think again:
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]
What would be necessary to come anywhere close to these conditions? Creditwritedowns has that covered as well:
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]
Quite. So how relevant are these examples? Well, we'll leave that up to you..
- There is no evidence even remotely suggesting that inflation is about to take off, despite years of predicting this by inflationistas
- Actually, all the evidence point to inflation being subdued
- There is a simple framework available to explain the absence of inflation (that of the balance sheet recession, or alternatively, a liquidity trap) that the inflationistas keep ignoring (at best).
- They keep, erroneously, equating increasing bank reserves with "money printing"
- The relation between bank reserves and credit creation (which is what could transform those bank reserves into actual money) is weak at best
And even in the case inflation would start to increase, why would the Fed not be able to undo most of the easing when that happens? After all, when bank lending picks up, it's a sign that the balance sheet recession is coming to an end and the economy will return to normal. Households and companies will borrow money for a reason, which will stimulate demand and lead to economic recovery, which allows the Fed to unwind its expansionary policies.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.