Time was when investors feared inflation. Economics teachers told us that if a country ordered or allowed its central bank to print too much extra money it would be inflationary. It was true that the theory told you that if there was plenty of spare stock, excess capacity and surplus labour then extra money might bring those into play first, but it would not be long before excessive money creation led to price inflation as supply could not be quickly and greatly expanded.
There were plenty of warning examples of what happened if a country ignored these iron truths of economics. Weimar Germany was issuing small stamps overprinted with 100 million marks as their denomination before the hyperinflation was finished. More recently, Venezuela and Zimbabwe have shown how a country can lose complete control of its currency and create pricing mayhem.
When inflation leaps daily shelves empty, barter replaces cash transactions or people resort to a foreign currency as a store of value. The international value of the currency plunges making imports very expensive.
The equation that relates money to prices and output does of course modify the money variable by the velocity of circulation. Were a central bank to issue twice as much money but the recipients used the resulting money only half as often, the price level should stay the same. It is only if people or the government try to spend the extra money created on top of their normal spending will there be an inflationary explosion from issuing more cash.
Today, we need to ask how much longer the reputable central banks of the main economies can carry on creating extra money without it causing a general inflation. Can the Fed and the ECB continue to assume that they are following the Japanese model?
The Fed is still creating an extra $120bn a month, and the European Central Bank is working its way through the manufacture of another €1,850 billion. For many years now the Bank of Japan has been able to create many extra yen, to buy up government bonds and to facilitate the Japanese government borrowing huge sums at around zero interest to spend on public works and services. It has not so far proved inflationary. In contrast modern Venezuela has created a run on its currency and a major upsurge in prices from printing and spending too much in the old way.
In practice, creating more money is always to some extent inflationary. In the case of Japan, it has inflated the prices of Japanese bonds and shares, as the money has been applied to buying up those for the central bank collection. In the US, it looks as if some of the extra money has led to other price rises as too much money hits too few goods in certain markets. Property as an alternative asset to bonds probably rests at higher levels in markets with central banks printing more cash than if they were not.
So far, the latest massive round of money creation by all the main central banks has not been too much of an influence on the general price level. The velocity of circulation of the money has fallen away as more has been created. The cash has come to rest in the accounts of financial institutions and savers who have not been spending it on goods or services sufficiently to force up the price level, or it has been used to unleash a substantial inflation in financial assets.
During the big dive of economies forced into lockdown to combat the pandemic in 2020 there was much involuntary or prudent saving by people who could not spend all their income, and there was a fall in investment and borrowing to expand as businesses sought to conserve cash. These contractionary forces offset the extra public money and public subsidy programmes.
As economies come out of lockdown there has been a bit more general inflation around, particularly in areas of scarcity or in sectors where they think they can price up a bit after a period of closure. This will only become a more general and long-lived problem if the extra liquidity in the system is used more actively.
Were velocity to return to anything like pre-Covid-19 levels there will be a substantial inflation. The central banks have remained very liquid. Were they to use that extra money to increase the credit they extend to individuals and companies, that too could prove inflationary.
Japan a nation of savers
So why hasn’t inflation in Japan reappeared or taken off? After all its central bank has allowed government borrowing to expand to around 250% of GDP and have bought up bonds to a value in excess of annual GDP. It seems to be the case that an ageing and declining population has not wanted to take advantage of the expanded cash balances and the opportunities to borrow more at very low interest rates to expand their purchases to create shortages. Japan has all but abolished inflation since its banking crash of the late 1980s, with many people favouring savings over borrowing more.
The US cannot expect that its younger and growing population will necessarily behave in this Japanese way. As the economy improves, they should expect people and companies to want to spend and borrow more. The authorities will need to rein in excess money printing in good time, and ensure they supervise the expansion of credit by the commercial banks in a timely and sensible way.
The Bank of England has already signalled that it thinks its £875bn of government bond buying over the period of Covid-19 closures is enough, has slowed the programme and is now proposing a more conventional strategy to keep prices down from January next year.
The European Central Bank remains wedded to printing more at least until the end of the first quarter of 2022 and maybe beyond. They may be right in hoping that their economy, also with an ageing and falling population in many countries, has more of the characteristics of Japan to avoid inflationary problems as it has done so far.
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