In his illuminating The Triumph of Politics: Why the Reagan Revolution Failed, perennial fiscal truth teller David Stockman summarized hyperinflation as (p.65):
the deliberate debauching of the nation’s money in a futile effort by politicians to compensate for the shortfalls of capitalist growth that their own misbegotten bureaucratic enterprises had caused.
In plain English: politicians compensate for welfare-state overspending by printing money. I have pointed repeatedly to the signs of inflation pressure building in our economy, and how it is traceable back to the excessive money printing that has fueled recent government spending.
As I previously reported, money supply is now at such a level that the velocity of money in the second quarter fell below one. This means, plainly, that there is money idling in the economy that is not being used; wherever there is idle money, there will be inflation.
A review of third-quarter data on money supply shows that money velocity remains below one:
The fact that money supply has continued to outpace GDP means that it has also outpaced the transactions demand for money. Some of it will be absorbed by equity markets and contribute to a speculative bubble, but part of it will also find its way back into the real sector of the economy.
That transmission mechanism is known as deficit monetization, or government spending money fresh off the Federal Reserve printer. This transmission mechanism between the monetary and the real sectors is a dangerous source of inflation. So far, in the American fiscal-policy debate, it has been widely under-appreciated.
We have only had a velocity this low at one point previously in recorded monetary history. That was in the early 1960s:
Back then, the velocity was low because the Federal Reserve had just started implementing new policy instruments and was attempting to shift from classic to accommodating monetary policy. That policy, in turn, was incompatible with the gold standard, the formal remains of which evaporated during the 1960s.
Since then, monetary policy has been focused on providing liquidity for the U.S. economy. Up until the late 1970s there was little focus on monetizing budget deficits, but as the gaping hole in the federal finances grew bigger in the ’80s, monetization slowly became an accepted practice. In the 2000s that policy became systematic under the label of Quantitative Easing; in reality, QE was more of an excuse to turn an ad-hoc approach to deficit funding into a formal, open practice.
Today, as Figures 1 and 2 demonstrate, deficit monetization is as established as the budget deficit itself. This is deeply worrisome, and it does not get better if we break down the money printing on a monthly basis. As Figure 3 explains, not only is money supply vastly bigger than it was only a year ago, but the difference is still increasing:
There is a bit of an oddity in the difference between M1 and M2 in 2020. It is not unheard of that the two expand at different rates, but it is unusual. We will examine that in greater detail in a later article; for now, the main point is that the money supply keeps expanding, our monetary velocity remains negative and that the transmission mechanisms that cause inflation remain active.
As I explained last week, President Trump was entirely correct back in the spring when he predicted a V-shaped recovery for the U.S. economy. I also noted that we now have more evidence that the stimulus checks and unemployment bonuses blew out far more cash in the economy than was necessary under the artificial economic shutdown.
Now, though, it is time to issue another inflation warning. There are two mechanisms at work fueling the inflation fire. Both are caused by Congressional overspending, therefore both can be turned off with swift, responsible action by Congress.
If Congress doesn’t act, we are in for a rough ride in 2021.
In my second article on the V-shaped recovery I explained that this cash blowout
reinforces my previously expressed inflation concerns. We could be looking at a food-based surge in prices, which in turn could spread throughout the economy. It has been suggested that the artificial economic shutdown, with its disruptive effects on some supply chains, can be the origin of inflation. This is true only in theory: if we were to have permanent supply disruptions, such as in a centrally planned economy, there would be upward pressure on prices. At the same time, a centrally planned economy does not allow for market prices in the first place, so there is de facto no inflation there. Furthermore, the disruptive effects of the artificial economic shutdown in Q2 were almost entirely gone in Q3, suggesting that the rise in farmers’ earnings could be a sign of monetarily driven food-price inflation (transmitted by the aforementioned sharp rise in entitlement spending). Again, I am not suggesting that we are witnessing monetarily driven inflation. However, I see enough hints that it could be underway to suggest that the next Congress will have to make de-monetization of the economy its highest domestic-policy priority.
A closer look at the national-accounts data for the third quarter add more fuel to the inflation worries. My previous review was of annualized, seasonally adjusted numbers, which are good for analyzing long-term trends in the economy. However, they are not good for closer examination of short-term swings, especially when it comes to such extreme economic episodes as this year’s artificial economic shutdown.
For that purpose, the Bureau of Economic Analysis offers NIPA Tables 8.1.5 and 8.1.6, with quarterly GDP numbers that are not seasonally adjusted. These figures are as raw as they come, giving us one of the best street-level pictures of what is happening out there in the American economy (only surpassed by employment numbers from the Bureau of Labor Statistics).
Using these tables, we can see in closer detail what the V-shaped recovery actually looks like. We also get a not-so-happy picture of inflation numbers, one that we will return to in a moment. First, the recovery itself.
In current prices, third-quarter GDP was $5,318.3 billion. This is total spending in the economy in the three months July, August and September. It was a solid rebound from the $4,901.8 billion in Q2, but even more noteworthy is that it exceeded Q1 GDP by almost $73 billion. That may not seem to be much of a number to write home about – and it could change when the adjusted numbers are released in a few weeks – but it does show that the recovery is strong and our economy is resilient.
As I noticed in my first article on the recovery, we saw a strong come-back for American businesses. Capital formation – investments – rose sharply. In current prices,
- Equipment purchases increased 12 percent from Q2 to Q3 and are only eight billion dollars away from where they were in Q3 of 2019;
- Residential investments – home construction – increased by 16 percent from Q2 to Q3 and were 11.6 percent over their level from Q3 of 2019.
It is also important to note that businesses were back to increasing their inventories. In Q2 they reduced their inventories by more than $88 billion, the largest quarterly inventory decline on record. In Q3, they were back to increasing them again.
Changes in inventories are important. An expansion in inventories during a surge in economic activity is a sign of economic optimism. By contrast, inventory depletion in economic downturns (as we saw in 2009 during the Great Recession) is a way for businesses to liquidate future sales and stem losses.
The artificial economic shutdown was to some degree different. Many businesses were forced by government to cease operations. Albeit temporarily, they nevertheless had limited ability to respond to the demand they had from buyers. Depleting inventories was a way to bridge the shutdown gap.
By doing this, they could essentially keep supply flowing. To again dispel the suggestion that supply disruptions have caused inflation, Table 1 shows that inventory depletion actually correlates with a decline in prices. In short: thanks to inventories there were no significant supply disruptions in the U.S. economy in Q2. Using the two aforementioned tables from the BEA, we can get an inflation estimate for the second and third quarters and see where the inflation pressure is emerging. The “Q to Q” columns report price changes from, respectively, Q1 to Q2 and Q2 to Q3. The “Y to Y” columns report the same numbers for a full year, i.e., from Q2 and Q3 2019 to Q2 and Q3 2020. The picture is quite telling:
Table 1: Inflation estimates
Starting with the quarter-to-quarter numbers, there was an almost universal decline in prices from Q1 to Q2. The decline in prices on consumer goods – which covers everything from groceries to automobiles – of almost a full percent contrasts sharply to the 1.28-percent increase during Q3. Since Q3 was the quarter when the economy opened up, we can conclude that this increase is related to the cash blowout in the economy – and to access to cheap credit.
The low cost of credit is noteworthy. It is a spin-off effect of the massive monetary printing that the Federal Reserve has engaged in for almost a year now. In other words, this money injects inflation into the economy through at least two venues: monetized deficit spending in the form of the stimulus cash blowout; and cheap consumer credit.
We see the price push even more clearly if we disaggregate consumer goods spending into so-called durables and perishables. The former are goods that last for more than one economic period, such as lawn mowers, computers and furniture. Here, prices increased by 2.31 percent in one quarter.
Looking at the year-to-year numbers, the rise in prices of consumer durables in Q3 was enough to wipe out the decline that took place in Q2.
There is another interesting source of inflation, one that will probably be even more important going forward. Prices on consumer services essentially stood still in Q2 and increased by less than one percent in Q3. However, the year-to-year numbers tell us that prices are rising by as much as 1.76 percent here.
Access to cheap consumer credit is less of a driving factor here. More than likely, what we are seeing here is instead a price effect from the labor market: thanks to the unemployment bonus that Congress created in the spring, when the economy opened back up again it was more profitable for people with low-to-moderate income to stay at home than to go back to work. In response, employers have had to significantly raise wages.
I predicted this a bit over a month ago. The numbers we see here are a reflection of how this cost-push inflation is now working its way into consumer prices.
This means, bluntly, that we have two different inflation forces at work: one monetary and one from cost increases. Interestingly, both originate with government. The monetary inflation originates with exorbitant Congressional overspending on stimulus bills; the cost-push inflation originates with exorbitant Congressional overspending on unemployment bonuses.
As of today, inflation is not an imminent threat to the U.S. economy. However, I maintain my warning of more inflation to come: with two sources of inflation at work we will very likely see higher rates in 2021. The only way to quell the drive in prices is for Congress to end its highly irresponsible spending spree.
The excessive borrowing by the federal government in response to the Covid-19 economic shutdown is beginning to show up in economic statistics. As I have explained already, there was no need for the stimulus checks, and the combination of those checks, the unemployment bonus and excessive monetary expansion to fund the Gargantuan deficit may create a perfect storm of inflation.
The monetary component in this inflation threat is particularly serious. Other forms of inflation can usually be dampened with fiscal policy and other real-sector measures that allow the economy to return to price stability. Monetary inflation, however, creates a pricing pattern in the economy that is immune to such measures. Non-monetary inflation forms, often referred to as demand-pull and cost-push, depend on pricing of goods and services in various parts of the economy. By contrast, monetary inflation injects purchasing power into the economy that has no ground in any real-sector activity whatsoever.
Before we look at some frightening numbers on our monetary expansion, a note is needed on why high inflation is so dangerous. We have not had an experience with it in America, which very likely has insulated our policy makers against the dangers that come with it.
Technically, higher inflation means that prices are marked up by bigger percentages than usual. The higher the inflation rate gets, the larger the price increases in any given year. Furthermore, when inflation rises past a “breaking point” – somewhere in the bracket of 10-50 percent inflation – price setters start making price changes more frequently than otherwise. This results in an acceleration of the inflation rate by virtue of the “compound interest” effect.
The pricing frequency shortens because price setters do not want to be wrong in their price expectations. For every pricing period there is an expectation of how much prices will rise in general; if the price setter learns that he has under-estimated inflation, he will mark up his prices more, and more frequently, in the future. The higher inflation climbs, the steeper the price for being wrong about it: high inflation feeds expectations of higher inflation, which in turn feeds a behavior that makes those expectations come true.
Plain and simple, high inflation becomes a self-fulfilling prophecy. Monetary inflation is the most dangerous type of inflation, driving the rate of price increases up faster than any other form. Therefore, it is also the inflation type that most rapidly gains a momentum of its own. This is why our history is full of hyper-inflation episodes driven by reckless monetary expansion.
We are far away from hyper-inflation, and chances are we will never get there. However, every path to runaway prices hikes begins with a first step – and we have now taken that step. Figure 1 has a frightful story to tell:
Figure 1: M1 Annual Monetary Expansion
Source of raw data: Federal Reserve
The liquidity that has now been pumped out in the U.S. economy has to go somewhere. Transmission mechanisms between the monetary and the real sectors have already gone to work, and will continue to work their way spreading this liquidity. Since this money is printed out of thin air, it does not constitute payment for any real-sector transactions, but it just dropped into the real sector in the form of a massive line of credit.
Bluntly, spending materializes out of thin air. The real sector of the economy is suddenly supposed to respond to spending that no intra-real-sector transmission mechanisms have accounted for. The result will be a spike in prices.
I am not going to speculate in how high our inflation rate will be as a result of this monetary expansion. What we can say with certainty, however, is that our path to high inflation will be determined in the near future. If this enormous increase in money supply is at least partly reversed in the second half of this year, we may have dodged the inflation bullet. If not, we are in trouble.
A few days ago the Congressional Budget Office released a long-term outlook on government debt. Their dire prediction: by 2050 the share of the federal debt that is held by the public will have risen to 195 percent of GDP.
This is a frightful outlook, but it is only the beginning of the story. First of all, it does not include the debt held by other government institutions – an omission that should give us all pause – and therefore does not tell us the full impact that the debt has on the economy. When creditors look at buying U.S. Treasuries, they assess the debt default risk based on the entire body of debt; to them, it does not matter if the debt is owned by the Social Security Trust Fund or by the general public. Therefore, to not include the entire debt in the CBO calculation is to cushion the story in front of Congress and the American people.
Secondly, the CBO outlook does not take into account the effect on debt costs from a deterioration of U.S. credit worthiness. On the contrary, when CBO Director Phillip Swagel commented on the report at a Senate hearing, he noted that the U.S. economy is the strongest in the world, that our currency is a world reserve currency and that this means we are not in any imminent danger of a debt crisis. This is a mistake, albeit from Swagel’s viewpoint an understandable one: if he would start talking about the United States losing its credit worthiness he would most likely repel a lot of the audience he now had.
There is a third component that was left out from the CBO report, namely a discussion of the policy alternatives that Congress now has. However, it is not that hard to put together a list of what options our legislators have: there are three bad ones and one good. The three bad ones are:
- Austerity. This means, plainly, spending cuts and tax increases in order to balance the budget. Contrary to libertarian conventional wisdom, it is not a good option. It means spending cuts without corresponding tax cuts, thus raising the price of government either in absolute terms – spending cuts are accompanied by tax hikes – or in relative terms. This last part is the one that libertarians tend to not grasp: even if taxes are not raised, a spending cut increases the price of government. If you pay $100 in property taxes for your children’s schools and the schools cut their budget from $100 to $90, you get a poorer-quality education for the same money. While it may seem desirable in itself, this change in the price-product relationship means that we get less for the same money, while we could have used the $10 for private-sector spending instead. By choosing austerity, Congress will depress the U.S. economy on a broad scale, with the same detrimental effects as I documented in Europe during the Great Recession and the austerity response there.
- Monetization. This is perhaps an even more dangerous path, where Congress relies on the Federal Reserve to purchase large chunks of its new debt by simply printing more money. There is a downward slope of increasingly bad effects from this policy strategy, a slope that the Europeans got on ten years ago but shifted away from when they took to austerity instead. Venezuela, on the other hand, continued printing money at breathtaking rates, eventually causing hyperinflation. As I explained in a recent EconTalk episode of my podcast, we are inching closer to that precipitous point. We are not on the doorstep of hyperinflation – not at all – but the fuse that makes hyperinflation explode is lit, and it is shorter than most people think.
- Debt default. Yes, this is now an option that is being floated around in Washington, DC. It is talked about quietly, but when it is mentioned it comes with an inconspicuous moniker known as “debt restructuring”. This means, simply, that the U.S. Treasury unilaterally decides to only pay back cents on every dollar creditors owe them. This is the Greek solution, one that would have epic repercussions on our economy and our ability to function as a country for decades to come.
The third option has been unthinkable in the U.S. debate – until now. The Greeks had the same experience; for those who do not believe that the Greek experience is relevant to the United States, I recommend my paper for the Center for Freedom and Prosperity on the Greek crisis (Part 1 and Part 2). To make matters worse, the debt crisis does not even have to become a real debt crisis to have serious ramifications: the mere suspicion that the federal government would consider “restructuring” its debt could spark a surge in interest rates. At that point the cost of debt rises accordingly, in turn aggravating the debt situation by accelerating current government costs.
When default concerns raise interest rates, Congress has only two options: to take rapid action to curb the worries among lenders, or accelerate monetization. If the latter measure is already being used – as is currently the case – it is already exacerbating default concerns. Therefore, once default concerns raise interest rates, panic-driven spending cuts will dictate the fiscal agenda for Congress.
A coming episode of EconTalk at the Liberty Bullhorn will discuss panic-driven spending cuts in contrast to the kind of structural spending reform that constitutes the only productive path away from our looming debt crisis.