Monetary policy is often surrounded by a lot of mysticism and superstition:
- On the one hand, we have the Mad Monetary Theorists whose doctrine says that you can print an unending amount of money to fund government spending, and when inflation starts rising you simply raise taxes and bring that money back into government coffers;
- On the other hand, gold-standard purists claim that if we just tied the U.S. dollar back to gold in a fixed $/ounce ratio, we would never have inflation or budget deficits again.
Both these positions are fancifully detached from reality. To start with the gold-standard advocates, they forget the slight problem that money today is a lot more than just cash; a return to the gold standard would wipe out practically all modern forms of liquidity used as payments for all sorts of transactions throughout the economy. They also ignore the minor problem that the amount of gold in the world does not grow with the growth of our economy.
To show the problem in this, let us go back to 1990 and tie our money supply to the supply of gold. Just as a strictly hypothetical example, suppose the world’s total known reserves of gold that year had been 244,000 metric tons (which happens to be the known reserves of gold around the world today). With the M2 money supply standing at $3,222.6 billion that year, this translates into a money-supply-per-ounce ratio of $374.42.*
In 1990 our current-price GDP stood at $5,963.1 billion, giving us a GDP-to-M2 ratio of 1.85: over the course of one year, we use 85 percent of the M2 money supply twice, in order to pay for all economic transactions in the economy.
Suppose, again for the sake of our experiment, that all the world’s gold reserves are under U.S. control. Suppose also that we do not discover any new reserves of gold anywhere.
In 1991 our actual GDP was $6,158.1 billion. This is an increase of 3.27 percent in current prices, but since inflation was 4.37 percent (measured by the GDP deflator) we had a real contraction of 1.1 percent. If we assume – as is often claimed under the gold-standard proposition – that inflation is a purely monetary phenomenon, the tie of money supply to gold means that the real contraction would also be the nominal change in GDP.
So far so good. But what happens in 1992, when real economic growth amounted to 3.5 percent, the situation is quite different. In other words, if there is no inflation, this is the actual percentage by which the economy would expand. Now we have an economy of $6,374.9 billion. We now need to use almost the entire M2 money supply twice in order to clear all transactions throughout the economy.
Here is where the problems begin. When the economy does not have enough cash (and other means of payments) circulating, people start withdrawing money from their savings accounts. They sell off Treasury securities and liquidate other near-cash assets in order to have the means of payments to clear their transactions. In doing so, they force up interest rates: banks raise interest rates to encourage people to keep their money in savings accounts; any increase the supply of Treasury securities at given demand automatically results in higher interest rates.
To give an idea of what this means, in 1990 the federal funds rate exceeded eight percent. In real life, where the supply of money outpaced GDP, by the end of 1992 the federal funds rate had fallen below three percent. Under the gold-standard scenario, the exact opposite would happen; when interest rates go up, businesses are more reluctant to invest. Households are more reluctant to buy a new home, finance a new car, etc. Both businesses and households postpone spending to an unspecified future date when they believe they might have more of a down payment to make, and since this future date is unspecified, this means a net loss of economic activity that could last for years.
When the loss of activity today is not followed by any reasons to expect a near-future return to higher levels, a loss of jobs begins that by multiplier effects proliferates throughout the economy. In other words, the gold standard traps us in a perennial recession.
By contrast, MMT, Mad Monetary Theory, suggests that monetary expansion has no limit, even as they recognize that inflation is a monetary phenomenon. In reality, inflation originates in the real sector of the economy; money printing fuels inflation if it is channeled through certain transmission mechanisms into a sustained, artificial rise in spending in the economy. However, even if MMT proponents would recognize these transmission mechanisms, they would still claim that inflation cannot become a hyper phenomenon as it has in Venezuela. The reason, they say, is that they will simply raise taxes and thereby pull the extra cash out of the economy again.
Any MMT proponent who cannot explain better than that the distance between Venezuela and his vision of an MMT-ridden America, should by logical necessity be disqualified from influencing any kind of economic policy, anywhere. The Venezuelan experience with 300,000 percent inflation – per month – is directly caused by the nation’s unending monetary expansion. I will explain this in more detail in a later article, though I do discuss Venezuela in my book Democracy or Socialism. For now, though, let us look at where monetary policy stands in the United States and what the risks are that we end up in hyperinflation.
In the following I take a brief look at recent American monetary-policy history. In just the past 40 years we have shifted from having a central bank that operated independently of the federal government to one that is highly accommodating. This transition is the main reason why we have reasons to believe that our country is not entirely safe from hyperinflation. Figure 1 and the following text outline the story:
The seven episodes are as follows:
- This is the Volcker-Greenspan purge of inflation from the U.S. economy. It was a successful endeavor, with inflation staying low for 40 years.
- This is an interesting period, albeit a short one. With the exception of the second quarter in 1981, the period Q3 1989 – Q2 1990 was unique in the sense that the Federal Reserve reduced its holdings of Treasury securities. Their portfolio was not cut by much, only approximately $14 billion or less than six percent, but the reduction was accompanied by an unusually tight monetary policy where M2 money supply increased by less than two percent on an annual basis.
- Greenspan kept monetary expansion in a tight leash all the way up to 1995, when the U.S. economy was reaching, even exceeding four percent growth per year. The monetary expansion came in response to rising interest rates. By increasing the supply of liquidity in the economy, the Federal Reserve reversed the trend: as just one example among many, the ten-year Treasury note fell from 7.96 percent in November 1994 to 6.2 percent two years later.
- In the midst of the brief, shallow Millennium recession, the 9/11 terror attacks brought about a disruptive change in U.S. monetary policy. Immediately after the attacks, in the fourth quarter of 2001, the federal funds rate, a key monetary-policy indicator, fell from 3+ percent in the two preceding quarters to 1.82 percent. It continued downward, dipping below one percent in Q4 of 2003. That was the first time it had been at sub-one percent since 1958.
- When the 9/11 driven monetary expansion began, the general belief among economists and other policy analysts was that it would be a temporary exception to the norms of the otherwise monetarily conservative Federal Reserve. That turned out not to be the case. While Greenspan led an unwinding of the monetary excesses post 2001, he was only able to bring the monetary expansion back to where it had been in the mid-’90s. When Bernanke takes over, the Federal Reserve sets its crosshairs on monetary expansion. The federal funds rate is again pushed downward, in a year and a half plunging from 5+ percent to less than 0.25 percent.
- It is interesting to note that while Bernanke champions a return to high monetary expansion rates, his Federal Reserve reduces its holdings of Treasury securities. Over the next year from Q4 2007, the Fed cuts its $790.5 billion portfolio of U.S. government debt by almost 40 percent. However, this divestment episode comes to an abrupt end in 2009 it re-enters the sovereign-debt market and buys almost as much Treasurys as it got rid of. Under his Quantitative Easing regime, Bernanke goes on a Treasury buying spree that more than quadruples the value of Treasury securities on the Federal Reserve’s balance sheets. When he hands over the helm of the central bank to Janet Yellen in 2014, he has more than quadrupled the U.S. debt to its portfolio: from $475 billion to almost $2.5 trillion.
- Yellen, a central banker in the tradition of Paul Volcker and Alan Greenspan, reverses Bernanke’s expansionism. However, due to the unending deficits in the federal budget she is only able to reduce the U.S. debt stock owned by the Fed by roughly $100 billion. Nevertheless, she does change course compared to Bernanke.
Then Jerome Powell takes over, the 2020 artificial economic shutdown happens and all Hell breaks loose…
In other words, the accommodating monetary policy that popped up as a temporary phenomenon under Greenspan was turned into the default setting for the Federal Reserve under Bernanke. Yellen and her relatively moderate policy actually stands out as the exception to the expansionary rule…
Figure 2 takes a different look at the same phenomenon. Measuring GDP per dollar of M2 money supply, we now get a money-velocity style view of how money supply has expanded over the past two decades. The seven episodes are the same as in Figure 1:
We currently have the largest money supply relative demand (i.e., current-price GDP) that we have had since the 1950s. Up until this year, it has not created any significant inflation pressure. That, however, has now happened, and the reason is excessive monetization of deficits; the Federal Reserve has entered a Faustian Pact with Congress.
More on that pact in Part 2.
*) I should note that under a gold standard, the M2 money supply might not even be possible. We could all be restricted to M1, or even cash. I will return to the intricacies of that issue in a later article.