There has been discussion over the weekend regarding an intriguing blog entry from friend Cassandra Inflation v. Deflation with regard to the Fed's monetization of debt. The principle assertion seems to be that if the Fed is merely replacing existing credit dollar for dollar as it is written off, then the result is not inflationary.
If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.
Implicit in this of course are two conditions. The first, that the level of wholesale borrowing and lending had not been and would have continued not to be inflationary, and secondly, that the expansion of the Fed's balance sheet is equivalent dollar for dollar with the debt it is said to be replacing.
These distinctions will be lost on most, but they are quite important, and we urge to reader not to gloss over them in preparing a rebuttal to support their bias du jour.
Let's consider an hypothesis someone put to us some time ago. They claimed that the appropriate rate of growth for any money supply is zero, which they considered 'neutral.'
To this we put the question, "If one holds the money supply static for a long period of time in a country whose population is growing at 10% per annum, and GDP is growing at 10% as well, is this a neutral money supply growth rate?
The answer of course is no. Money supply that remains static in a growth situation, whether one measures it in a ratio to economic growth or per capita, is obviously on a deflationary trend because supply is not growing at a rate equivalent to the increase in demand.
Seems obvious in this perspective right? We are not saying it is good or bad, appropriate or not. It is what it is, a growth in money supply that is lagging the growth in demand for money.
Conversely, if money supply is kept static in a country where the population is decreasing, and economic growth contracting, is it neutral? No it is inflationary, since the growth rate of money supply (zero) is greater than the growth rate of the demand for money, which is in decline presumably.
Now, one can imagine all sorts of possible scenarios as exceptions because there are lags in all economic cause and effect. To complicate matters there is no instantaneously correct rate of money supply growth without a context since reality is inherently in a state of flux.
However, though, it is clear that a static money supply is not necessarily neutral compared to the state of the growth of the money supply in a different economic context.
Secondly, we will postulate something we are not quite ready to prove yet, and that is that credit is not the same as money supply. We offer a piece instead that was blogged some time ago in which the various components of money supply are discussed.
Money Supply: a Primer
Its something to consider, and has received too little attention in our opinion.
If you have one thousand dollars in cash, in your pocket, is it completely equivalent to one thousand dollars worth of honey which you have at home in your pantry, in terms of its affect on inflation or deflation?
Forgiving the pun, the honey is decidedly less liquid than the cash.
What if you have one thousand dollars in cash, and another thousand is owed to you by an acquaintance in a distant city who promised to pay it back on demand the last time you spoke to them a year ago. Are those equivalent dollars?
Does it matter who is holding the money? What if the bulk of the money being added to to the economy is being given to gamblers in Las Vegas, rather than lets say farmers in Pennsylvania. Is there a difference in that money's effect on inflation or deflation? Yes there are few differences in the very long run, but sometimes the run becomes so long that it is irrelevant to the policy questions at hand.
This essay does not seek to provide answer to these questions at this time, since this is basis for a new perspective in economics. And unfortunately the discussion is premature. It is rather like a room full of well seasoned drunks, after a week long binge, gathering to attend a lecture on sober thought. We have so utterly lost the conception and relationship of value and risk that we must sober up a bit before we can even think about it once again.
Rather, the purpose of this essay is to cast doubt on the certainty that what we call money is always and everywhere equivalent in force and power and influence as an economic actor no matter where and how it is held.
Having said all that, it is obvious that the Money Supply as measured by the means at our disposal is growing at a rate more significant than economic growth, and that difference is now even greater as the economy slows and contracts. As an engineer and an operational business unit manager we always tend to fall back on what can be measured, what is real and knowable, when theory fails and the bosses are lost in flights of fancy.
The Fed is Monetizing Debt and Inflating the Money Supply
As water is added to the ecosphere, it flows and pools in many places. Money as water in the econosphere is evaporating through debt retirement, but perhaps not through debt destruction, or at least not in the same way. Someone must lose if a debt is written off right? What if that loss is booked at the Fed, and they realize that loss by simply 'making it go away' at least as far as the real economy is concerned? Is there a contraction in the money supply anywhere?
There are all questions worth considering, and we will have much more data as the results of Mr. Bernanke's experiments produce additional data.
But one thing is certain in our minds, and that is certainty in this situation is an illusion. We do not think that even the Fed knows exactly what they are doing. Rather, they are feeling their way through uncharted waters, projecting perhaps a confidence, but this is primarily for effect, not as a genuine state of mind.
And based on first principles, deflation, while possible, is never a certainty in a fiat regime where there is a central monetary authority that holds the power to monetize debt. The only boundary on their power is the acceptability, or value, of the money they produce, and that is also known as inflation.
Obviously the Fed may do a poor job or an outstanding job of managing the nation's money supply and economy. We will not really know until after the fact given the lags in these sorts of machinations.
But what is different, what is dangerous, is that the Fed has grasped the reins of a highly complex system, that is now more global than at any time before, and is trying to pull it in a certain direction, without immediate feedback on what it is that is happening. The last five or six times in which the Fed has done this something 'unexpected' has occurred.
Another factor most do not consider which is of some importance is the potential for systemic reform in the economy that is the context for the actions of the money supply. Without serious financial reform we most likely will take spin on the wheel of boom and bust again, with a greater disparity of wealth and a greater loss of democratic freedoms.
Either state is possible, make no mistake, but the probability is highest that the loss of control will be an inflation, with the key metric being 'how bad' and 'how difficult to subdue once it is unleashed.' Why? Because inflation is the default condition of a fiat currency that becomes uncontrolled. Deflation requires a sustained effort for whatever reasons, generally policy error or a conflict in desired outcomes.
A softer, much more judgemental reason, is that those who are now telling us that inflation is not an issue are the very ones who have been acutely wrong, for whatever reason, since this crisis began, if not years before that. They speak their book, and shamelessly. But that is no determinant, merely a confirmation of sorts.
What concerns us most is that the Fed is quite confident, in their own words, that they know how to deal with inflation after Volcker. That reminds us too much of hubris, and the classical myth of Phaëton who confidently took the reins of the chariot of the Sun from the golden Apollo, and very nearly burned down the world in the process.
