Inflation has been chosen as the solution
Governments around the world have adopted a policy of financial repression and resorted to massive money printing in order to create inflation and avoid a deflationary bust.
Politicians and bankers like inflation because it decreases the value of money and debt, however they are fearful of deflation because it does the opposite. Deflation actually increases the value of money and debt, making the repayment and servicing of debt more difficult, and given the colossal debt burdens of many of the world’s developed economies, a prolonged period of deflation would be certain to send many of them into default.
As far as policymakers are concerned, inflation is the only politically palatable option for dealing with their unsustainable debts and deficits. This is why they continue to double-down on their efforts to avoid a deflationary bust and create inflation with policies such as QE Infinity and ZIRP (zero interest rate policy).
Why isn’t the price of everything rising?
As discussed in Part I, the inflation has not yet shown up to any great extent in consumer prices, rather it is showing up in asset prices. The reason for this is that the new money is being administered via banks and other financial firms.
The money is flowing from the Fed and other central banks, to the primary dealers, which are banks such as Barclays Capital, Goldman Sachs, HSBC and J.P. Morgan. However, because of the state of their balance sheets and the health of the overall economy, these firms are reluctant to lend out this new money. Instead, the majority of it is being hoarded or left on deposit at the central bank so as to earn interest.
However, although these banks aren’t keen to use the new money to finance home loans or loans to small businesses, they are happy to make the money available to their proprietary trading desk for use as margin. This has allowed some of the new money to flow in to the financial markets and bid up the price of government bonds, corporate bonds, junk bonds, stocks, real estate, etc. Not to mention the fact that these central banks are directly buying sovereign debt, stocks and, in the case of the Fed, mortgages.
It is because banks are reluctant to lend the new money into the economy that we have seen money velocity fall to the lowest level in more than 50 years, and that’s in spite of a huge rise in the money supply.
US M2 Money Stock 1980 to present (Click on the chart for a larger version)
Chart courtesy of the Federal Reserve Bank of St. Louis
M2 money supply is defined as the sum of currency held by the public and transaction deposits at depository institutions (commercial banks, savings and loan associations, savings banks, etc.), in addition to savings deposits, small-denomination time deposits (less than $100,000), and retail money market mutual fund shares.
Why prices will rise sooner or later
A sustained rise in the price of consumer goods and services requires that the new money building up in the banking system be lent and spent. Only when the money begins to change hands within the economy will we see a rise in consumer price inflation (CPI).
Such enormous quantities of fuel have already been added to the monetary fire that a spark (in the form of a pickup in money velocity) would almost certainly lead to very high rates of inflation, and there are a number of things that can cause this.
One scenario is simply that economic conditions begin to improve such that banks do start to make new loans and put the new money into the hands of consumers. It’s even possible that banks will be forced to make these loans, perhaps because they are penalized for holding money on deposit with the central bank (a policy that has already been muted).
Another scenario, and perhaps a more likely one, is that the Fed attempts an early exit from its asset purchase program which triggers both a slowdown in the US economy (and likely a recession) and a major correction in the financial markets. This would of course cause the Fed Chairman (likely Janet Yellen by this time) to restart QE on an much bigger scale, a side effect of which might be a loss of confidence in the Fed and a sharp decline in the US dollar.
Regardless of what the trigger ends up being, it’s important to realize that every inflation is a cycle, and although the early effects are often viewed as positive, the latter effects are anything but. As Jens O. Parsson explains in his book Dying of Money:
“Everyone loves an early inflation. The effects at the beginning of an inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the later effects, but the later effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
The stages of inflation are further clarified by Mises:
“This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.
These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”
Some will argue that the final crack-up boom is not yet inevitable, but there are an increasing number of signs that this is where we are headed, and inflation is a dangerous policy that cannot last. The expectation of a continual rise in the price of goods and services does not bring about increased production or an improvement in well-being. As Mises explains, it results in the “flight to real values,” and the “complete breakdown of the currency system”.