The Federal Reserve System has indirectly increased the money supply (the M1 version) by a whopping 75% over the past year (I’ll call this money inflation, harking back to the classic definition), and yet there has been no price inflation to speak of (the contemporary definition). Inflation hawks have been driven back to their aeries, leaving the field clear for the newest version of monetary sophistry, so-called Modern Monetary Theory (MMT), which says in essence that governments who control the currency in which they borrow should feel free create all the money they want until such time as inflation ramps up.
What’s going on here? Why was so much money created, where did it go, and why didn’t it ignite price inflation? If it’s such sophistry, why has MMT seemingly won the day?
The money was created for the primary purpose of buying up Treasury securities that were issued to finance the massive federal budget deficits of late (more than $3 trillion for fiscal year 2020; probably higher next year). The Fed soaked up about $2.3 trillion of the new debt, bringing its total portfolio of Treasuries to about $4.7 trillion. In addition, it added about three quarters of a trillion to its holdings of mortgage-backed securities, boosting those holdings to over $2 trillion. This was done to suppress longer-term interest rates that it does not directly control.
Is your head spinning yet? Who can grasp a trillion of anything? It may help if we divide these numbers by 128 million, the total number of U.S. households:
|2020 Federal deficit||$3 trillion||$23,437|
|Federal debt, net of inter-agency holdings||$21 trillion||$164,000|
|One-year M1 money supply increase||$2.8 trillion||$21,875|
|Fed holdings of Treasury securities,one-year increase||$2.3 trillion||$17,968|
|Fed holdings of mortgage-backed securities, one-year increase||$0.75 trillion||$5,859|
Refining these approximate numbers, for example by considering international flows and stocks, would not alter the basic message: we’re in trouble. The $164,000 per-household debt is the biggest warning. Does anyone seriously believe this sum can or will be paid off? Corporations can’t do it because their share is included in the figures for households, which own corporations. Foreign investors are unlikely to increase their holdings substantially. Where will this all end? Will it be inflation, default, or repudiation? And when?
Let’s take inflation first. MMT proponents point to the low levels of inflation that have persisted in the face of massive deficits. Have they won their fight with the inflation hawks?
To begin with, inflation figures are suspect. Let’s assume the Bureau of Economic Analysis bureaucrats who produce the numbers are smart, dedicated people with lots of computing power at their disposal. The basic problem remains, that inflation is a slippery concept. You have to pick a representative basket of goods and services and that choice—what items to include and how much weight to give each—is necessarily arbitrary. Furthermore, the BEA makes “hedonic adjustments” to account for rising quality and substitutions. That means the result is a blend of the effects of money printing with the effects of quality improvements, which is not good if what you care about is the effect of money inflation on price inflation. But you do want these adjustments if your concern is what things really cost. The ShadowStats website claims that without the hedonic adjustments that were introduced in 1980, price inflation would be running at around 8% per annum, not 2%. There is no sure way to say who is right.
Money printing has fueled the rise in asset prices: stocks, bonds, real estate. Those prices are not included in inflation figures, but they have a pernicious aspect nonetheless in the form of rising wealth inequality. I hasten to add that inequality is only pernicious to the extent that it is fueled by government actions and crony capitalism; Buffett, Gates, and Bezos, earned their billions fair and square as far as I can tell. Elon Musk not so much, as he makes money selling tax credits.
When will we again see the sort of price inflation that we older folk remember from the 1970’s, manifested at the grocery store, the drug store, the gas station? A burst of consumer spending is an obvious possibility. Personal saving rates had been hovering around 8% prior to Covid, then shot up to an unprecedented 25% in May as lockdowns cut off spending opportunities, settling to about 13% at year-end 2020. This is household dry tinder, money that will compete for goods and services as opportunities open up. Headline price increases will surely follow.
A more significant stash of dry tinder lurks in the Federal Reserve computers (hat tip: Cathie Wood). I refer to the reserves that commercial banks hold in their accounts at the Fed. At one time, they were required to hold balances equal to 10% of their demand deposit liabilities and were free to hold more—excess reserves. As banks chose to hold reserves far in excess of requirements, the Fed removed the nonbinding requirement. Bank reserves have risen above $3 trillion, nearly double the year-ago level.
Why are these levels so high? Because of the interest the Fed pays on these amounts? That rate was slashed from 1.6% per annum to just 0.1% during 2020. The best one can say for this rate is that it is a tad higher than the 0.07% paid by four-week Treasury bills. But the traditional function of banks is to make long-term loans at rates in excess of what they pay on deposits, not to buy Treasuries. So it must be that banks are not finding enough good loan opportunities to draw down their reserve balances.
That could change. The danger is that banks could start drawing down their reserves, running those funds through the multiplier that is inherent in fractional-reserve banking, flooding markets with money, and igniting price inflation: dry tinder. Fed economists are aware of this possibility and could raise the interest they pay so as to disincentivize reserve drawdowns, but that would tend to boost interest rates generally, countering the Fed’s ongoing attempts to keep interest rates low, and thereby risking economic downturn.
Remember, the MMT people promise that money printing will stop when inflation picks up. This promise fails in two ways. First, monetary policy acts on the economy with long and variable lags, as Milton Friedman put it. By the time the authorities are alerted to inflation it would likely be too late. Second, it would be politically impossible, with so many dependent on money printing, to pull the plug. Have we not seen enough promises from politicians about what their successors will do some fine day?
What might signal the beginning of the Great Unraveling? One possibility is a rise in Treasury yields above those of high-grade corporate bonds, a signal of eroding confidence. Or another currency might challenge the dollar’s role as the premier reserve currency and payment medium for international transactions. Prices of gold or Bitcoin might soar. But more likely, the trigger will be something unforeseen. That’s just how the world seems to work.
Inflation is not the remedy that debt-burdened governments have relied on for so long. Sophisticated traders now operate across borders and with lightning speed. Gold and Bitcoin are well known to average investors, not just hedge fund managers. Commercial banks have a great deal of leeway as to how much lending they want to do with new money, and thus how much new Fed money would get multiplied.
If not inflation, what might default or repudiation look like? Not likely anything so stark as a holiday weekend announcement that “you’re not getting the principal or interest we owe you, sorry about that.” More likely there would be a mandatory rollover of maturing securities. Or there could be mandatory loans of public or private pension fund or retirement fund assets. All stopgap measures, accompanied by strident appeals to patriotism and severe penalties for evaders.
Those who understand that the piper will be paid must protect themselves and their families first, then do what they can to understand and promote sound economics.