When global central banks responded to the Global Financial Crisis (GFC) with Quantitative Easing (QE), many economists, not least Austrians, foresaw a wave of inflation. Central banks were embarking on a monetary experiment, purchasing astronomical amounts of government bonds for freshly printed money, thereby not only facilitating huge government deficits but expanding the money supply. With more money chasing the same amount of goods, many economists expected prices to rise. In the words of Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.”
But more than a decade later, consumer prices have risen only modestly. The dreaded end game of inflation forcing central banks to raise interest rates, thereby suffocating the recovery and crashing overvalued asset markets, has not played out. Why not?
Money supply is a fickle concept. It is not clear if focus should be on base money, cash plus on demand deposits (M1), or include time deposits (M2 or M3). But looking a bit further than the headline numbers reveals that growth in the stock of money has actually been far less than the astronomical QE figures and suggests that the absence of runaway inflation does not in fact invalidate the Austrian claim that inflation is a monetary phenomenon.
First, it is important to understand that the natural state of a growing economy is one of deflation. Economic progress means more being produced for less, which is reflected in falling consumer prices. This is what competition achieves in an entrepreneurial free market economy, where producers compete by offering consumers better value for less. Globalisation and accelerating technological advances are among such forces which have contributed to downwards pressure on consumer prices. However, in the era of fiat money, this dynamic competes with nominal price increases caused by the ever-expanding money supply.
But central banks are not in sole control of the money supply. Before the era of QE, the growth in the (M1) money supply was largely controlled by the commercial banking system through fractional reserve banking, where banks use deposits to make loans while only holding a small fraction in reserve. It is the size of the total balance sheets of the commercial banking system which is the main determinate of the money supply, as the liability side of these balance sheets are the total sum of deposits made by the private sector.
So when commercial banks retreated from risky lending in the immediate aftermath of the GFC, the effect was to contract the money supply at the same time as central banks engaged in the first of many rounds of QE.
However, after 2010, bank lending started to increase again. QE had allowed the government to borrow money to buy goods and services from the private sector for freshly printed cash and this in turn had increased the amount of deposits made by the private sector. Banks now took advantage of the larger deposits to make more loans, despite having to abide by more rigorous regulation limiting their ability to leverage their balance sheets like in the old days (essentially, the reserve in fractional reserve banking had to increase).
But domestic bank lending might only tell part of the story. Let’s concentrate on US Dollars, the reserve currency on the world. Apart from the Federal Reserve, there exists another large source of US Dollars, the so-called Eurodollar market, USD deposits held in banks outside the US and used to finance for example international trade (in parallel there exists markets for Euroeuro, Euroyen and Eurosterling). Whether the Eurodollar market should be included in the US monetary stock is a question of debate, but it is clear that to an extend this source of funding can act as a substitute for domestic deposits, by foreign branches lending money raised in the Eurodollar market to its US based parents. While the size of the Eurodollar market is difficult to estimate, it is at least comparable in size to US domestic bank credit. However, after peaking in 2008, the market has contracted dramatically, continuing long after US banks started expanding their domestic balance sheets again. Banks have ‘on-shored’ their lending, substituting Eurodollar funding from foreign branches with fresh QE money (this is reflected in a reversal of the debtor position of US banks towards their foreign branches, from net borrowers to net lenders).
The net effect on the amount of fiat money in the economy is not easy to assess, but the shrinking of ‘private’ money supply which has happened concurrent with the expansion of ‘public’ money supply goes a long way to explain the absence of runaway consumer price inflation. While QE has added at least USD 7tn of newly printed cash to the US economy, it is clear that this is not reflected in a comparable expansion of the US money supply. The absence of rapidly increasing consumer prices can therefore not be interpreted as a refutation of the Austrian claim that inflation is a monetary phenomenon, not least bearing in mind the downward pressure on prices which is ever-present in a capitalist economy.
The question is how long this shrinking of the ‘private’ money supply can act to offset the accelerating supply of banking reserves provided by QE. Of the USD 8tn in assets accumulating on the balance sheet of the Fed, around half has been added in the last 18 months, reflected in a comparable jump in domestic commercial bank deposits. So far though, bank lending has not followed suit, with businesses instead relying on relief funding from the Federal government and lockdown slowing the growth in mortgage lending. In other words, so far those commercial bank balance sheets which determine the money supply has failed to respond to the acceleration in QE. But as banks resume normal function after lockdown, they can take advantage of their increased deposits to expand lending, channelling the QE money into the economy. Inflation is poised to spike – in fact it is already happening, with consumer prices across the world showing the highest readings in years. The Fed and others assure us that this bout of inflation is ‘transitory’, a so-called ‘base effect’ likely to last 6-12 months as the economy recovers from Covid lockdowns. They will be proven wrong. Bank deleveraging will not last forever and the relentless and accelerating QE programmes will eventually feed into rising prices if central banks continue to be unwilling to pull the emergency stop and cut off the flow of new money. Inflation is a monetary phenomenon after all.