Fear of inflation scales new heights

The scaremongering about inflation and higher interest rates continues to flood out of the mainstream economics community. The conversation has become a little more sophisticated since the claims in the early stages of the crisis that the fiscal and monetary policy innovations introduced by governments would be inflationary. Now we are hearing stories about longer lags – channelling Milton Friedman who also fell foul of the evidence more often than not. So inflation is just around the corner rather than coming tomorrow. As in the past, the mainstream macroeconomics has a serious credibility problem. It is no wonder it keeps making erroneous predictions. It begins with an erroneous construction of reality. It is all downhill for them after that.

On the topic of sophistication, BuBa boss Jens Weidmann has now appealed to classic German literature to buttress his obsession with inflation. In a speech he gave to the 18th Colloquium of the Institute for Bank-Historical Research (IBF) in Frankfurt (September 18, 2012) – Money creation and responsibility – we learn that Johann Wolfgang von Goethe, the C18th German writer apparently “hit upon the core problem of monetary policy” – yes, “Paper money – Public finances – Inflation”.

Weidmann acknowledges that:

Central banks create money by granting commercial banks credit against collateral or by buying assets such as bonds.The financial power of a central bank is unlimited in principle; it does not have to acquire beforehand the money it lends or uses for payments, but can basically create it out of thin air.

So we should never hear anyone saying that a currency-issuing nation or the Eurozone for that matter has run out money or that the government is unable to provide first-class health care, pension systems and public education and – a job for all who are unable to find work elsewhere – because they do not have enough money.

Once we get beyond that point the discussion, inevitably, turns to inflation.

Weidmann appeals to the Goethe’s Faust, particularly the Second Part of the Tragedy where Mephistopheles is cast as a scheming lying fool. He tells the Emperor that he does not have enough money to do the things he desires and that there is a solution.

Mephistopheles connives to get the Emperor to sign some paper which creates fiat currency. The Chancellor reads out this announcement:

To all whom it concerns, let it be known:
Who hath this note, a thousand crowns doth own.
As certain pledge thereof shall stand
Vast buried treasure in the Emperor’s land.
Provision has been made that ample treasure,
Raised straightway, shall redeem the notes at pleasure.

The Emperor responds “I sense a crime, a monstrous, cheating lure! Who dared to forge the Emperor’s signature?”

The Treasurer tells him that last night while the Emperor was at a masquerade party (being Pan) that the Chancellor got him to sign some paper and the:

Conjurors multiplied what you did write;
And that straightway the good might come to all,
We stamped at once the series, large and small;
Tens, twenties, thirties, hundreds, all are there.
You can not think how glad the people were.
Behold your city, once half-dead, decaying,
Now full of life and joy, and swarming, playing!
Although your name has blessed the world of yore,
So gladly was it never seen before.

So there was a monetary stimulus. It is not clear how the notes entered the economy but there was an upsurge in commerce and happiness.

Mephistopheles urges them to appreciate the benefits:

Nor gold nor pearls are half as handy as
Such paper. Then a man knows what he has.
There is no need of higgling or exchanging;
In love and wine one can at will be ranging.

The Emperor and his supporters realise the advantages of fiat currency but not its dangers and start spending it without regard to the capacity of the economy to meet the nominal demand in real terms (that is, by expanding output). The result is inflation – which is unsurprising.

Goethe was making a satirical statement about the behaviour of the French government during the French Revolution.

However, Weidmann claims that Goethe knew of the evils of fiat currency as knew it was a “continuation of alchemy by other means … paper was made into money”. As it was, it remains.

The problem is that the dynamics in the Second Part of Faust are not intrinsic to fiat currency systems. Even in a gold standard, inflation could result easily if there were large gold discoveries and the government suddenly spent up without regard to the real capacity of the economy to meet the increased nominal demand.

Goethe’s example tells us that human folly leads to undesirable consequences. What else is new.

All this scaremongering however seems to be traumatising people. At least the Germans are more worried about inflation than most other things that normally might concern us.

The Frankfurter Allgemeine carried a story (September 24, 2012) – Die Angst vor der Inflation – (The Fear of Inflation) which documents a sort of national neuroses.

The article focuses on the recent decision by the ECB to buy unlimited government bonds for Eurozone nations that are introduce managed austerity programs and require relief from the private capital markets.

They pose the question:

Die große Frage vieler Menschen lautet: Wohin führt das alles? Ist der Weg in die Inflation unausweichlich? Und wenn ja: Wann kommt sie und in welcher Höhe?

That is, is inflation inevitable and when it comes what will be the rate?

The article then says that:

Die Angst vor der Inflation zumindest erreicht in Deutschland gerade außergewöhnliche Dimensionen. In Umfragen geben mehr Menschen an, sich vor Inflation zu fürchten als vor schlimmen Krankheiten, brutalen Verbrechen, der Trennung vom Partner, Einsamkeit im Alter oder sogar einem Krieg. Dem steht entgegen, dass die Inflation bislang zwar etwas gestiegen ist, aber noch keine dramatischen Ausmaße angenommen hat. 2,1 Prozent betrug sie im August in Deutschland – 2,6 Prozent im Euroraum. Beides ist zwar mehr als jene zwei Prozent, die als Grenze für Preisstabilität gelten. Trotzdem ist das kein Weltuntergang.

Which says that the fear of inflation in Germany has reached extraordinary dimensions. Surveys indicate that more people are afraid of inflation than they are of getting a serious illness, being victim of brutal crimes, the separation from their partner, loneliness in old age, or even a war.

They point out that at 2.6 per cent inflation is hardly at levels which would indicate the Germans were facing doom.

Then I read a Wall Street Journal Op Ed by John B. Taylor and Phil Gramm (September 11, 2012) – Gramm and Taylor: The Hidden Costs of Monetary Easing .

The former US Senator (Gramm) is notorious for denying that a crisis was upon the world in 2008. Remember this Washington Times Interview (July 9, 2008) – McCain adviser talks of ‘mental recession’?

He was characterised as “Republican presidential candidate John McCain’s top economic adviser” and was the vice chairman of UBS at the time of the interview.

He tried to dismiss the impending recession as a “mental” state:

You’ve heard of mental depression; this is a mental recession … We have sort of become a nation of whiners … You just hear this constant whining, complaining about a loss of competitiveness, America in decline …

And he claimed that the US had:

… never been more dominant; we’ve never had more natural advantages than we have today … Thank God the economy is not as bad as you read in the newspaper every day …

So he exhibited what we might refer to as an abysmal understanding of what was going on in mid-2008, as the US (and the World) was plunging into its worst economic downturn in 80 years.

Anyway, he combined with Taylor to argue that the US Federal Reserve’s purchases of “massive amounts of U.S. Treasurys and mortgage backed securities” is an inflation time bomb.

However, they realise that that sort of theme is now a worn-out record – the inflation has been predicted for some years now and hasn’t shown up as yet.

So their message is that it will when special circumstances change:

That kind of monetary expansion would normally be a harbinger of inflation. However, with banks holding excess reserves rather than lending them out-and with velocity (the rate at which money turns over generating national income) at a 50-year low and falling-the inflation rate has stayed close to the Fed’s 2% target.

At which point you conclude they either refuse to understand how the banking system actually works or more likely (in the case of Taylor at least) have chosen to deliberately misconstrue how it works.

Why would I say that? Simply because the characterisation that banks lend out the reserves they have in accounts at the central bank is false. Reserves are not loaned out. They are there to clear the payments system.

Banks do not need reserves to make loans.

I recommend they read the – Monthly Bulletin – for May 2012 from the European Central Bank – particularly Box 2 – The Relationship between Base Money, Broad Money and Risks to Price Stability – which begins on Page 20.

The ECB first consider whether “a large increase in central bank liquidity … necessarily implies rapid broad money and credit growth …” and conclude that:

The occurrence of significant excess central bank liquidity does not, in itself, necessarily imply an accelerated expansion of MFI credit to the private sector … The Eurosystem, however, as the monopoly supplier of central bank reserves in the euro area, always provides the banking system with the liquidity required to meet the aggregate reserve requirement … In the current situation of malfunctioning money markets, the Eurosystem supplies central bank reserves to each counterparty elastically against the provision of adequate collateral, through fixed rate tenders with full allotment. This ensures that each individual counterparty is able to meet its reserve requirements, as well as any additional liquidity needs. In the case of normally functioning interbank markets, the Eurosystem always provides the central bank reserves needed on aggregate, which are then traded among banks and therefore redistributed within the banking system as necessary. The Eurosystem thus effectively accommodates the aggregate demand for central bank reserves at all times and seeks to influence financing conditions in the economy by steering short-term interest rates.

In sum, holdings of central bank reserves are thus not a factor that limits the supply of credit for the banking system as a whole. Ultimately, the growth of bank credit depends on a set of factors that determine credit demand and on other factors linked to the supply of credit. The demand factors include borrowing costs and income prospects. Factors relating to the credit supply are the risk-adjusted return on lending, the bank’s capital position, its attitude towards risk, the cost of funding and the liquidity (including roll-over) risk. Liquidity risk refers to the risk that a credit institution does not have sufficient financial resources to meet its commitments when they fall due, or can secure them only at excessive cost. Loans to customers contribute to liquidity risk as, following their disbursement, they can generate obligations to make payments on behalf of customers.

This is contrary to what students are confronted with in mainstream macroeconomics courses. There they are told that banks need reserves in order to lend and an expansion of base money translates into a multiplied growth in broad money via the so-called money multiplier.

Nothing could be further from the truth. Banks do not lend out reserves (after soliciting deposits from their customers).

As the ECB acknowledges, bank loans create deposits and the banks can always get sufficient reserves to cover the payments obligations – with the ECB standing ready to supply them should there be insufficient reserves in the system (that is, the interbank market cannot generate sufficient reserves to ensure integrity of the payments system).

You also learn from the ECB quote that bank credit creation is constrained by its capital position and how many credit-worthy customers line up for loans.

The reason that the broad money has not grown is because the recession has blighted the taste for credit as households and firms try to reduce their overall debt exposure and return to more sedate spending patterns.

But one message is that banks do not need reserves to lend nor do they lend their reserves; there is no money multiplier operating; and the central bank cannot control the money supply (broad money).

The ECB also state that:

On aggregate, credit institutions cannot get rid of the excess central bank liquidity as banks cannot, as such, lend on deposits with the central bank to the money-holding sector. For the individual credit institutions, lending to the private sector will not mechanically reduce excess central bank liquidity. Although extending loans to the economy would, in principle, create deposits that are subject to reserve requirements, this approach to reducing excess central bank liquidity is extremely protracted. Importantly, excess central bank liquidity does not in itself alter the demand for loans or banks’ ability to bear credit risk. Moreover, for credit institutions with excess central bank liquidity, liquidity risk was not, in the first place, a constraining factor in their decisions to extend credit to the economy.

Which is another way of saying that the only way that excess reserves can leave the monetary system is via vertical transactions between the central bank and the non-government sector.

A bank with surplus reserves might lend them to a bank in need of reserves but that only shuffles the ownership of them and does not reduce the overall volume. If there is an overall excess of reserves only the central bank can reduce them (via transactions with the commercial banks – such as, selling government bonds).

That is a central insight of Modern Monetary Theory (MMT). Please read the following introductory suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – for basic Modern Monetary Theory (MMT) concepts.

Note also that there is a clear disjuncture between the volume of reserves in the system and matters relating to private bank lending. Which should reinforce in your mind that banks do not lend out reserves.

The ECB then considers whether the increase in base money “can create inflationary pressure without a corresponding increase in broad money and credit”.

They point to the experience of Japan:

The adoption of the monetary easing framework by the Bank of Japan in 2001 resulted in a sharp increase in excess central bank reserves … This increase was accompanied by a reduction in the Bank of Japan’s key interest rates to zero and stopped the slowdown in broad money growth. Despite the increase in excess central bank reserves in 2001, there was no strong acceleration of either broad money growth or inflation, both of which remained at very low levels … In 2006, within a span of a few months, the Bank of Japan was able to reabsorb the significant amount of excess central bank reserves and to re-establish balanced liquidity conditions by not rolling over short-term liquidity-providing operations

They generalise by saying that when banks try to ” offload undesired excess liquidity (which cannot, by nature, be successful on aggregate)” they reduce short-term interest rates (if the central bank doesn’t intervene to drain the excess liquidity themselves or pay a return on excess reserves) – which might stimulate the demand for credit from the non-government sector.

But:

… in an environment characterised by a stabilisation of economic activity at a low level, this is highly unlikely to translate into consumer price inflation. In any case, signs of a surge in inflationary pressure would be anticipated by a faster expansion in money and credit, which the ECB is well equipped to detect and address …

That is, to understand the inflation process you have to appreciate how the nominal growth in aggregate demand interacts with the real capacity of the economy to respond in quantity terms (increased real output). If there are vast quantities of idle resources (labour and productive capacity) then there is likely to be sufficient real space for any nominal stimulus to be absorbed without inflation.

In other words, worrying about the build up of central bank reserves in the context of inflation risk is a waste of time.

Mr Gramm and Professor Taylor, however, want to tell a story which is not consistent with the ECB story.

They think that apart from the impending inflation, monetary policy will place a brake on the economy once it is growing again.

There will be even greater costs when the economy begins to grow and the Fed, to prevent inflation, has to reverse course and sell bonds and securities to the public.

Apparently these costs will be the rise in federal government debt (because at present the US Federal Reserve has purchased “77% of all the additional debt issued by the Treasury”) “and the Treasury will then have to pay interest on that debt to the public”.

From a Modern Monetary Theory (MMT) perspective, the rising debt interest payments are an income to the non-government holders rather than a cost.

Gramm and Taylor claim that this will “drive up interest rates, crowd out private-sector borrowers and impede the recovery”.

First, the central bank might increase interest rates if the economy looks like over-heating. That is what counter-cyclical policy should do.

Second, bond yields might rise as growth occurs because the private sector diversifies its portfolio into more risky assets (which reduces the demand for US government bonds).

Third, borrowers do not compete for scarce funds as in the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.

The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.

So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.

Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.

According to this theory, if there is a rising budget deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.

So allegedly, when the government borrows to “finance” its budget deficit, it crowds out private borrowers who are trying to finance investment.

The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.

Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.

Additionally, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.

In terms of the monetary operations involved we note that national governments have cash operating accounts with their central bank. The specific arrangements vary by country but the principle remains the same. When the government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

Conclusion

There were several other errors in the Gramm-Taylor article which I have no further time today to analyse.

These characters have been making erroneous predictions since the onset of the crisis. I think the evidence will continue to render their story irrelevant.

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.