April 6, 2021 Reading Time: 12 minutes

Back in the 1960s, Everett Dirksen (1896-1969) served as the Republican Party minority leader in the U.S. Senate. One of his famous lines about federal government spending was, “A billion here, a billion there, and pretty soon you’re talking about real money.” Those days are long past. Now it’s: A trillion here, and a trillion there, and then you are finally talking about a real amount of money.

Joe Biden hasn’t even reached his first 100 days in the White House, and he has already signed into law a $1.9 trillion spending bill, and is proposing over $3 trillion more of federal government expenditures that will fill in the potholes on our roads, help end global warming by building electric car charger stations about the country, and heal the racial wounds of those who see “hurtful” white clouds in the sky and just know they have been put there by those male white racists who are lurking under, seemingly, every bed.

Not one word was offered about where the money would come from for that $1.9 trillion of new spending, other than the presumption, obviously, that it simply would be more money borrowed by Uncle Sam and added to the national debt. And from whom would it be borrowed? U.S. Treasury securities are sold primarily to private bond holders at home and abroad, along with foreign governments investing in their “sovereign wealth funds.” But with the Federal Reserve chairman, Jerome Powell, assuring financial markets that key interest rates would stay near zero at least for another year or two, if the cost of borrowing is not to rise in the face of government demand for such sizable additional funds, the American central bank will basically create enough new money in the banking system to cover all or most of the Biden Administration’s deficit tab.  

Price Inflation and Money Creation

A number of economists have been reminding us that when a government or its appointed central bank prints enough paper money that ends up in circulation, at some point or another, we should not be too surprised if price inflation soon appears as a causal necessity. But other economists have been asserting that the presumptions of the simple and traditional quantity theory of money are no longer valid. After all, the Federal Reserve has massively expanded the monetary base; that is, cash held by the public plus reserves in the banking system, since the financial and housing crisis of 2008-2009, on the basis of which financial institutions may extend loans to private sector and government borrowers. And price inflation has remained relatively tame for more than a decade. 

In the middle of 2008, the monetary base was about $900 billion. By April 2015, it had grown to over $4 trillion. It had been declining slightly over the next five years, but in January of 2020, it still was at nearly $3.5 trillion. During the 12 months between February 2020 and February 2021, the monetary base grew to almost $5.5 trillion, or a 57 percent increase in one year. The monetary base grew by more than six-fold over the entire period between 2008 and early 2021.

The money supply as measured by M-2 (cash in circulation plus checking accounts, plus ordinary savings accounts and some time deposits) came to $7.8 trillion in mid-2008. It had increased to $12 trillion by mid-2015 and was $15.4 trillion in January 2020. Over the last year, M-2 expanded to $19.7 trillion by February 2021. Thus, the M-2 money supply grew by 54 percent between 2008 and 2015, and by 28 percent between 2015 and 2020, with an additional 28 percent increase just between January 2020 and February 2021. Or for the entire period, 2008-early 2021, M-2 expanded by 253 percent.

Assumptions of the Simple Quantity Theory of Money

So where has been all the price inflation, if one of the oldest of economic truisms, that increases in the money supply bring about rising prices, is still true? Like all properly expressed scientific statements, the simple quantity theory has attached to it the ceteris paribus clause, that is, “all other things being equal” or “staying the same.” The simplest expression of the quantity theory of money is captured in the Equation of Exchange:

MV = PQ

The total quantity of money (M) times the velocity (or turnover) of money (V) equals the average price level (P) times the total quantity of goods trading at those prices (Q). The quantity theory assumptions are that over a given period of time the rate at which money turns over to facilitate exchanges remains fairly constant and that the total output of goods and services over that same given period is fairly stable. Thus, if “M” increases, and “V” and “Q” are relatively unchanged, then the increase in the money supply has to manifest itself through a rise in “P.”

Consumer Prices and Real GDP

The Consumer Price Index (CPI), as a common measure of change in the price level and the cost of living, stood at 219 in the middle of 2008 (with 1982-1984 = 100). In 2015, the CPI was 238, or about 8.7 percent higher than in 2008. In January 2020, it was 258.7, or again 8.7 percent higher than five years earlier. And in February 2021, the CPI had reached 263.1, or 1.7 percent above a year earlier. Looking over the last 12 to 13 years, prices in general as measured by the CPI have increased by 20.1 percent. That is, a hypothetical basket of goods that would have cost, say, $100 in 2008 to purchase cost a little more than $120 in early 2021.

What, then, has been at work in the U.S. economy? In the 10 years from 2009 to the end of 2019, real Gross Domestic Product (GDP) grew from $15.2 trillion to $19.25 trillion, for a 26.6 percent increase. Thus, part of the monetary increase was counteracted by a significant growth in the “Qs” of the economy. That is, greater money demands for goods and services were partly counterbalanced by real increases in supplies meeting that increased number of dollars offered for goods and services.

However, considering that the monetary base grew by more than 600 percent over the 2008-2021 time period, why did M-2 only increase by 253 percent over the same 12 or 13 years, when it would be expected that such a huge increase in lendable reserves in the banking system would have percolated out into the market via far greater bank lending? The reason this has not been the case is that something else has not been “equal” due to a particular twist to Federal Reserve interest rate policy.

The Fed Pays Banks Not to Lend Reserves

When the Federal Reserve introduced its policy of “quantitative easing” – a fancy phrase for unusually large and rapid increases of bank reserves through central bank purchase of government securities and government-guaranteed mortgage-backed securities – the Fed was interested in bolstering bank liquidity in the midst of a serious financial and housing crisis, and preventing all that newly created money from generating the price inflation that at some point would have been highly likely.

So, the Federal Reserve introduced an additional trick into its usual toolkit of monetary policy instruments. This was to offer banks an interest rate premium slightly above the rate of interest financial institutions could earn from lending all those available reserves to the private sector; that is, to you and me. As a consequence, bank excess reserves – the bank reserves above those Federal Reserve member banks are legally obligated to hold against outstanding depositor liabilities – ballooned.

Before the 2008-2009 financial crisis, excess bank reserves were barely hovering above zero. In other words, any available reserves that banks did not legally have to hold as “cash” to meet hypothetical depositor withdrawals were readily lent out to willing and presumed credit-worthy borrowers. After all, any excess reserve dollar being held by a bank was one less dollar earning interest income for the bank and its depositors.

Trillions of Dollars of Excess Reserves

But from September 2008 to now, bank excess reserves have been at historically unique levels. In early September 2008, excess bank reserves came to $2.3 billion. But with the Fed’s bond and other buying plus paying banks not to lend money, by October 2014, excess reserves totaled $2.7 trillion. Just before the coronavirus crisis emerged with the accompanying government lockdowns and shutdowns that brought the U.S. economy to a screeching halt, excess reserves were still $1.5 trillion. But with the government prohibiting people to produce, work, or shop, plus the Fed’s interest premium policy, by May 2020, excess reserves were at $3.2 trillion. In February 2021, excess reserves stood at $3.3 trillion, even with the partial economic recovery in the second half of the year.

Another way of saying this is that out of the $5.5 trillion monetary base in February 2021, $3.3 trillion is sitting in the banks as unlent, excess reserves collecting interest from the Federal Reserve. In other words, 60 percent of the monetary base is made up of excess reserves. That, in itself, explains a good deal of the reason why an exceptionally large expansionary monetary policy by the American central bank has not brought about any of the significant price inflation that the simple quantity theory otherwise would have predicted.

A Decline in the Velocity of Money

Some economists have theorized that the explanation for the relatively low rate of price inflation in spite of the large increase in the money supply in the banking system is due to a noticeable decline in the velocity of money. That is, money is turning over more slowly, or the other way to look at it is that the demand to hold average cash balances has increased relative to income earned.

Looking over the data, before the financial crisis began in 2008, aggregate M-2 velocity was 1.93 (down from 2.13 at the beginning of 2000) and has been declining from then to the present. In late 2019, “V” was 1.42. But with the near total government command and control restrictions on economic life in the first half of 2020, by June of last year velocity had declined to 1.1. When much of the economy has reduced or shut down production due to government decree, and millions are now unemployed or underemployed with less income earned, while at the same time everyone is ordered to stay at home and not buy anything except what those in political authority define as “essentials,” it should not be too surprising that the rate at which dollars in the economy are turning over in transactions has noticeably slowed down. While velocity decreased by a little less than 25 percent between 2008 and 2019, it declined by 22 percent just over the first six months of 2020. By the end of 2020, velocity had only picked up to 1.13, or a less than 3 percent increase in the rate of money turnover.

Now, it is true that if, in our Equation of Exchange, on the left side “M” increases and “V” decreases while at the same time on the right side of the equation, the “Qs” are increasing, then any increase in the “Ps” can be noticeably less than if, as usually assumed for purposes of exposition, the “V” and the “Qs” are constant. But this does not mean that the simple quantity theory of money is logically incorrect and therefore invalid. It simply means that in the real world little that is analytically taken as “given” or “constant” for purposes of drawing inferences from reasoning starting points stays the same as time passes and human actions change in various ways not included in the hypothetical case.

Budget Deficits and Money Creation Do Matter

It certainly does not validate the declared “modern monetary theory” claims that all of the old economics that criticized budget deficits and money creation are no longer relevant or true. That now government can run annual budget deficits of almost any size for as far as the fiscal years can be seen into the future, with nary a worry about price inflation on the horizon.  

Before the coronavirus crisis broke out in early 2020, and before the government destruction of so much of the economy due to its central planning prohibitions at the national but especially at the state levels, the U.S. economy had reached an unemployment low of about 3.5 percent, and economic growth had been healthy through 2019, and was promising for 2020.

It was clear that at some point the anticipated, at that time, trillion-dollar-a-year budget deficits would bring about significant “drag” on the real economy, and that pressures were mounting on rising prices looking ahead. In other words, large and continuing budget deficits financed by money creation in an economy basically operating at “full employment” was not going to be able to permanently avoid noticeable price inflation above the 1.5 to 2.5 annual rates of CPI rising prices, as had been experienced during the preceding decade.

This past year temporarily changed all that. Unemployment reached over 14 percent in April of last year and while going down as state governments have been loosening up since last summer, as of February 2021, nationwide unemployment still stood at 6 percent of the labor force. And while GDP growth picked up in the second half of 2020, it is not yet fully recovered from the decline in the first half of the year. (See my articles, “America’s Fiscal Follies are Dangerously in the Red” and “To End Budget Deficits, Restrict Political Pickpockets”.)

Fantasies of Taxing “the Rich” with No Consequences

Now with the promise of an additional $3 trillion of government spending on top of the $1.9 trillion already passed by Congress and signed by the president, it will be difficult to forestall the workings of the “laws of economics.” Among those laws is that people respond to incentives and change their conduct in the face of changing costs and benefits. President Biden has promised that a good portion of that new $3 trillion will be covered by increased taxes on “rich” individuals and corporations.

A delusion that so many on “the left” seem to suffer from is that “rich people” have locked away in safes and strongboxes millions of dollars, just sitting idle in cash to be touched and gloated over like some compulsive cash-driven miser. The tens of millions, indeed, hundreds of billions of dollars, the political paternalists and social engineers are salivating over to fund all their collectivist redistributive dreams, are, in fact, tied up in the business of doing business. It is partly in the “fixed capital” of industrial plants, machinery, tools, and equipment, in inventories of resources, raw materials, and component parts essential and used in ongoing and continuous production. It is part of the “working capital” that continuously pays wages to all those employed and for all the other renewed means of production without which business cannot go on each and every day, which is necessary to produce all the outputs that represent the standards of living of all in society.

Try to tax away significant portions of all this wealth as it is monetarily added up on ledger books of private enterprises and the income statements of various financially comfortable individuals, and you do two things. First, you “nudge” people to find “shelters” for some of their wealth in less taxable and therefore less productive ways that slows down future economic growth and human improvement. 

Second, you prevent the existing levels of production and standards of living from possibly being maintained by taxing away the financial resources necessary for being able and willing to continue the size and scope of enterprises as before. It may seem extreme, but there have been instances in which tax burdens have resulted in capital consumption. 

Make it less financially possible and less profitably attractive to work, save, and invest, to creatively innovate, and entrepreneurially take risks and bear uncertainties, and you undermine both the present and the future of any society. Upon whom do these resulting lost opportunities for employment, rising standards of living, and financially securer futures most threaten to fall?  Those the political paternalists say they are most concerned about – the poor, the less skilled and educated, those with fewer chances and opportunities to get ahead.

Welfare State Makes More “Disadvantaged” People

They “transfer” a growing number of those “disadvantaged” and “marginalized” peoples from potential paths of personal betterment and self-supporting responsibility through the opportunities of a growing and improving market-driven economy to being permanent, dependent wards of the state. Which, of course, is where the political paternalists and the social engineers want them as rationales for their own governmental power and control that enriches them at the expense of not only those who they tax to pay for much of it, but also of all those whom they tie down to a life of welfare “security” from which escape is difficult once entrapped in its redistributive snares.

The “progressives” and the “democratic socialists” and the Democrat Party leadership in the political halls of Washington power are giddy with power and their dreams of remaking America and everyone in it in record time.  Who needs old fashioned Soviet-style five-year plans, when the political and legislative transformation to fuller collectivism in America can all be done within an achievable five-month plan of getting it done through presidential executive orders and Congressional bills squeaked through by manipulating the Senate rules and by keeping in line everyone on their side of the aisle through political carrots and sticks?

Reality, however, has a persistent tendency to keep rising to the surface. Running huge budget deficits does siphon off real resources that are no longer available for private sector improvements to the conditions of humanity. Debts accumulated will require huge expenditures simply on the interest to be paid on the cumulative national debt. The Congressional Budget Office (CBO) estimated in its latest revision that between 2022 and 2031, the Federal government will have to pay more than $4.5 trillion in interest on that debt. That is more than total federal spending in fiscal year 2019 of $4.4 trillion.

It may be true that the ceteris paribus clause must never be forgotten, but it remains a fact that if the monetary authority persists in printing large amounts of “paper” money year after year, both to fund government deficits and to try to “stimulate” private sector borrowing, and people’s willingness to hold larger and larger cash balances reaches a satiation point (at the margin), then those who find themselves with excess cash balances in their hands will attempt to trade it away for goods and services on the market, and prices in general will start to rise more and more at significantly higher rates.

The story of how inflations impact an economy is more complex than simply prices in general going up. Monetary expansions influence relative prices and wages, profit margins and resource allocations in ragged and uneven ways that bring about a whole series of distortions and imbalances that create instabilities and mismatches between supplies and demands that set the stage for a future “corrective” downturn during which markets attempt to rebalance themselves for sustainable economy-wide coordination. (See my eBook, Monetary Central Planning and the State, and my articles, “Macro Aggregates Hide the Real Market Processes at Work” and “The Myth of Aggregate Demand and Supply”.)

But what is clear is that the types of monetary, fiscal and regulatory policies being implemented and projected by the Biden Administration, the Democrat-controlled Congress and the Federal Reserve are all leading America down a dangerous and destabilizing road, any recovery from which will not be easy or cheap.  

Richard M. Ebeling

Richard M. Ebeling

Richard M. Ebeling, an AIER Senior Fellow, is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel, in Charleston, South Carolina.

Ebeling lived on AIER’s campus from 2008 to 2009.

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