Despite a zero interest rate the threat of falling prices is imminent, which hurts the economy rather badly. In a famous 2002 speech, former Fed chair Ben Bernanke proposed a conceptual solution to this very situation: as the printing press is a monopoly of the state, newly printed money should be injected into the economy, which will prevent deflation. He quoted Milton Friedman’s maxim that price deflation could be fought by dropping money out of a helicopter. Since then, his critics have often referred to him as ‘Helicopter Ben’.
Later on he also had the opportunity to do the stunt in practice. He happened to be chair of the central bank when the credit crisis began. The economy froze up, consumption was on the decline, causing prices to fall. Bernanke didn’t hesitate to print money. Obviously, he didn’t drop it out of a helicopter but instructed the central bank to purchase loads of government bonds and other securities, injecting fresh liquidity into the economy. This costs nothing to the central bank, which has free access to money and issues as much of it as it considers decent.
Money supply and inflation
According to the quantity theory of money, when extra liquidity is injected into an economy, it will lead to inflation. This is because in itself, more money will not create more goods (assuming that there wasn’t a chronic shortage of money previously). If the increased quantity of money is divided into the same quantity of goods, then there will be more money for a single unit of goods, i.e. prices will increase. Bernanke based the success of printing money on this theory. It’s a logical and elegant theory, and is also taught for economics majors. However, people tend to forget about a minor flaw: today it no longer holds true.
Is the Fed printing money for no good? Probably not entirely, but experience shows that over the past two decades, the relationship between money supply and inflation has become increasingly unstable. Previously, central banks strictly monitored the quantity of money circulating in the economy (monetary aggregates), and some tried to meet their inflation targets by regulating this quantity as well. Indeed, following the German tradition, the European Central Bank originally adopted a two-pillar strategy: in addition to the 2% inflation target, they specified a 4.5% reference rate for the growth of M3 money supply. (M1: narrow money, cash and sight deposits; M2: time deposits + M1; M3: M1 + M2 + savings deposits – ed.)
A breaking down relationship
However, something happened in the 1990s. The relationship between money supply and inflation has become looser, causing the world’s central banks to abandon the system of monetary targeting, just as in the case of the ECB, the M3 target lost its weight completely. The sentiment of the era is aptly characterised by a dictum of former Canadian central bank governor Gerald Bouey: “We didn’t abandon monetary aggregates, they abandoned us.”
Velocity of circulation
What could be the reason for the breakdown of the relationship? The phenomenon is better understood if we take a look at a chart of the velocity of money circulation in the US over the past half century. To use James Tobin’s simile, money is like a game of hot potatoes: even if it’s spent, it’ll be deposited with someone. Velocity of circulation is the average number of times the amount of money circulating in the economy is spent in the course of a year. The term is somewhat misleading, as the measure accounts for transactions relating to the real economy, i.e. when we pay for goods and services. When money changes hands during the purchase of shares, bonds and other securities, the transaction will have no effect on the velocity of circulation.
The chart shows the velocity of circulation for MZM (money with zero maturity, readily available/disposable money: practically M2 less the time deposits plus money market funds) in the US. Following the relatively stable figure of the 1960s, the 1970s were characterised by a steep hike. This was the period when financial innovations such as ATMs and bank cards became common, which all accelerated the velocity of money. Their effect was reinforced by rising inflation (if money is worth less each day, people will be in a hurry to spend it), and a higher interest rate (savers are better motivated to deposit their money for longer terms, which will be removed from the MZM stock). Not surprisingly, velocity of circulation peaked in the early 1980s together with inflation and the central rate, followed by a slight decline and stabilisation at a relatively high level.
Then, in the mid-1990s, an odd thing happened: the process reversed. In the world of electronic payments and credit cards, where daily transactions require hardly any uncommitted money, which then should circulate very fast – the velocity of circulation started to slow down. Indeed, today its rate is far lower than in 1959. This also means that both in real terms and as a percentage of the GDP, the US is sitting on a readily disposable stock of cash that is larger than ever before.
Heaps of money
What are they doing with this huge amount of money, what are they using it for? Is it simply sitting on their bank accounts without being committed or used? It is, partly. With zero interest, they lose nothing by not committing it, but as there’s no inflation either, there’s no hurry to spend it either – this is called the liquidity trap. On the other hand, this stock of money does circulate really fast. However, rather than being spent on consumer goods, it is increasingly used for the intermediation of the trade in securities as savings are building up and capital markets are becoming liberalised. That is to say, money increasingly fuels trade in exchanges rather than in the real economy. This gradually slows down the velocity of circulation, which accounts only for transactions of the real economy. Consequently, the supply of money has a diminishing impact on inflation.
There’s another problem with Helicopter Ben’s printing press due to the fact that wealth is distributed in the world in an astoundingly unequal manner. For example, the poorer half of the US population possess 2% of the total wealth. The more affluent half possess 98%. But there are also huge differences among the rich: the upper 1% possess more than one-third of the total wealth. Injecting money into the economy through the central bank’s bond purchases will also not have any impact on consumer prices because the additional money will be channelled to those selling the bonds, i.e. the truly rich. However, they won’t spend it on surplus consumption as they consume as much as they want anyway, but reinvest it over and over again. The extra dough flows through capital markets. No wonder this fails to boost inflation as virtually none of it finds its way down to the real economy. By contrast, exchanges are rallying, hitting new highs all the time, which is not surprising either as the additional funds are also channelled to the system through capital markets.
Our summary conclusion is that as the money circulating in the economy increasingly fuels exchanges rather than the real economy, what’s more, the additional funds are dumped on the world through the channels of capital markets, those funds will more likely increase exchange prices, causing inflation there, as it were, rather than in consumer prices. We may suspect that the rise in prices will sooner or later spill over to the real economy (it has probably had some effect already, e.g. in helping to avoid a major deflation). However, with growing impatience, we’ve been waiting for that to happen for years. It would indeed be beneficial, causing some of the debt to be inflated, that is, deleveraged. Because debt, no matter the credit crisis, has not decreased over the world. We should be careful not to swing to the other extreme, though.
Original date of Hungarian publication: 15 July 2014