Why Inflation is not Inherent to “Printing Money”
By: Anthony Kim
Inflation. The buzzword that is moving financial markets and inciting shockwaves of hysteria amongst investors and citizens. In recent times, the case for the potential return of nineteen-seventies inflation is receiving significant media attention due to the extensive growth in the money supply administered by the Federal Reserve amidst this pandemic. Politicians and notable investors such as Charlie Munger and Micheal Burry warn of an impending hyperinflation crisis and use Germany and Venezuela as examples. There appears to be an accepted consensus amongst the general public that money growth leads to devaluation of purchasing power and rising prices. This assumption is severely misleading and is fundamentally flawed.
Adherents to the conventional view typically use the Quantity Theory of Money and occurrences of nations that have endured hyperinflation throughout histories such as Venezuela, Zimbabwe, and the Weimar Republic as evidence that inflation is inherently a monetary phenomenon. Many concur with this conclusion due to prevailing misconceptions regarding the nature of inflation favored by politicians and other economic schools of thought.
Let’s begin by defining inflation first.
By definition, inflation is the continuous upward movement in consumer prices. There are two main types of inflation: demand-pull and cost-push. Demand-pull inflation occurs when there is a surge in demand that supply cannot meet. To combat shortages and rises in demand, producers inflate prices. Cost-push inflation transpires due to supply-side shocks like droughts, rapid increases in the price of raw materials, trade, and resource insufficiency. Most of the inflation we encounter at the time of this writing are cases of cost-push inflation highlighted in the CPI data.
Now that we have ascertained that prices are set by supply and demand forces, not the quantity of money, let’s discover how the Federal Reserve “prints money.”
The Federal Reserve expands the money supply by conducting open market operations during rough patches in the business cycle and utilize quantitative easing during severe downturns. Open market operations involve the buying and selling of securities on the open market. Quantitative easing is the buying of various securities, generally from private non-banking enterprises to increase the quantity of deposits firms hold. These firms purchase higher yielding assets as a result. This pushes asset prices higher, stimulating the economy. From these realities, it must seem obvious that the Federal Reserve does not possess the inherent ability to inject a fixed quantity of money into circulation. In modern times, the Fed specifically targets interest rates, not the money supply as Central Bank’s around the world recognize that they simply cannot directly control the money supply whatsoever.
Since the Federal Reserve does not have full control over the money supply, who does?
That would be the financial sector. Banks do not function as mere deposit-taking intermediaries. They manufacture money out of thin air when they grant loans to customers. Banks are not reliant on external entities or deposited money to expand the money supply. For there to be an expansion of the money supply, there must be a demand for it. The supply of money is not determined by the Central Bank, it is determined by distinct economic variables.
Traditional macroeconomic textbooks often depict commercial banks as deposit-taking middlemen described by a theory termed Fractional reserve banking. The essence of this theory is this: deposits create loans. Fractional reserve banking is only relevant to a fixed exchange rate system that was deserted in 1934. In reality, banks are not intermediaries like the traditional theory insinuates, but rather, they are the creator of money. Loans create deposits and reserves, not the other way around. To fully apprehend this concept, let’s conceive a scenario where I am selling you an apartment for one million dollars. To buy my apartment, the bank grants you a loan for one million. The one million dollars lent to you are not pre-existing deposits. This loan is brand-new money created out of nothing. That money is deposited into my account, and a parallel deposit is created in your account. The Federal Reserve did not have anything to do with this, and they are completely oblivious that the transaction took place.
In the modern banking system, there is no such thing as deposits. As described by Prof. Richard Werner, banks are in the business of purchasing securities. When you deposit money, you are loaning money to the bank. Banks do not need your “deposit” to lend and increase the money supply. When banks grant loans, they are purchasing securities from borrowers. Commercial banks can create new money at will by lending. However, there is a constraint. Interest rates and monetary policy can influence financial markets, so banks are constrained to remain profitable. Moreover, firms and individuals may wish to pay off existing debt, exterminating money from existence.
The fact of the matter is, the Federal Reserve cannot autonomously manage the money supply, they can only conduct monetary policy to influence it. The private sector is in control as they can create and destroy money at will. According to the Bank of England, the majority of money in circulation is created by commercial banks, not the printing press at the Central Bank.
The Quantity Theory of Money/Equation of Exchange
The conclusion of “money = inflation” is rooted in the equation of exchange:
M*V = P*y
- M: Money supply
- V: Velocity of money
- P: Prices
- y: Real output
Assumptions
- V = constant
- y is not influenced by M
Reasonings for these assumptions:
M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision.
V: The velocity of money is related to people’s habits and the structure of the financial system. It is, therefore, relatively constant.
P: The economy is so competitive that neither firms nor workers are free to change what they charge for their goods and services without there having been a change in the underlying forces driving supply and demand in their market.
y: The economy automatically tends towards full employment and thus y (the existing volume of goods and services) is as large as it can be at any given moment (although it grows over time).
Since this equation is dependant on assumptions and not fact, let’s explore the mechanics of this equation with an example.
If the assumed variables held constant:
100 (M) x 2 (V)= 4 (P) x 50 (Y)
y and V cannot change as they are assumed constant. Lets see what happens if we double M.
200 x 2 > 4 x 50
Since 2(V) and 50(y) cannot change, we must change the price level to achieve equality. Let’s see what happens when we double the price level at the same rate as the money supply.
200 x 2 = 8 x 50
As you can see, this seems simplistic. If the assumed variables were constant, this equation would be accurate. Money growth would lead to inflation. Before accepting this conclusion, we must uncover the truth about these assumptions.
M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision.
This theory implies that the money supply is exogenous. As we have covered in the fourth paragraph, this assertion is false. According to this assumption, lending would be dependant on the number of reserves issued by the central bank. The exogenous money theory is inexact as we discovered that commercial banks create money endogenously. The central bank can solely influence “M” through monetary policy. This assumption may be relevant under a fixed exchange rates system but is not applicable in the real world. This theory poorly oversimplifies the modern banking system.
V: The velocity of money is related to people’s habits and the structure of the financial system. It is, therefore, relatively constant.
The velocity of money is related to people’s habits and the structure of the financial system. This does not infer that it is constant.
Empirical data suggests “V” is highly variable. The truth is, the velocity of money has never been constant presented in the graph above. The declining velocity that arose after 2008 is somewhat responsible for the lower inflation rate in the US despite the increases in the money supply before the pandemic.
From 1997 to 2021, the velocity of money was diminished by nearly 50% and declined by 1.07 from 2.192 to 1.122. The hypothetical equation below exhibits the outcome of “P” if velocity were decreased by 50%.
Before: 100 (M) x 2 (V)= 4 (P) x 50 (Y)
After: 200 x 1 = 4 x 50
The velocity of money collapsed to its lowest level since 1960. Plausible explanations for this decline in velocity may be attributed to expansionary monetary policy, wealth, and changing demographics.
P: The economy is so competitive that neither firms nor workers are free to change what they charge for their goods and services without there having been a change in the underlying forces driving supply and demand in their market.
As a result of endogenous money creation and distinguished variables determining the expansion and contraction of money, prices in specific markets react differently to changes in the money supply.
y: The economy automatically tends towards full employment and thus y (the existing volume of goods and services) is as large as it can be at any given moment (although it grows over time).
This assumption asserts that output is constant and is perpetually operating at maximum capacity. Although it may be true that economies typically operate slightly below full capacity, output is not constant at all times. It assumes that there will never be a rise in output. This contention is untrue as “y” may develop based on expectations, demand, and resources. For instance, if we double the money supply and the goods and services in the economy remain unchanged, prices will double. However, if the goods and services double, there will not be any changes in prices. To prove that “y” vacillates over time, in 1960, GDP was at 535.30 billion USD. In 2019, GDP reached 21433.20 billion USD. From 1960 to 2019, GDP increased by 39 times. If the money supply expands by 39x and GDP rises by 39x simultaneously, prices will remain unchanged.
The equation below exhibits the outcome of “P” if GDP increases by 39x
Before: 100 (M) x 2 (V)= 4 (P) x 50 (Y)
After: 3900 x 2 = 4 x 1950
Despite each of these assumptions being critically fallacious, history proves this theory wrong. From 2008 to 2014, the money supply more than quadrupled. Inflation temporarily rose to 5.9% due to velocity picking up and the economy recovering and expanding. As GDP rose and as velocity diminished, inflation went to negative 2%. From there, prices stabilized just below the 2% inflation rate target set by the Federal Reserve. If the Quantity Theory of Money was correct, inflation should have quadrupled at the equivalent rate as the money supply.
In 2019, Japan was managing a budget deficit of 240%. They administered an aggressive bond-buying program to lower interest rates and as a result, printed approximately 650 trillion yen out of thin air. Japan experienced an inflation rate of 0.48% in 2019 and -0.02% in 2020. Hyperinflation did not occur as they even experienced deflation.
The Weimar Republic
The Weimar Republic may be the most famous instance of hyperinflation in history. Prices spiraled out of control until $1 was equivalent to 4,200,000,000,000 Mark in November of 1923. Many point to this economic nightmare as concrete evidence that deficits and money growth inherently inflate prices beyond control. The German Mark was monetarily sovereign; what went wrong?
The Treaty of Versailles forced the Weimar Republic to pay hefty war reparations. The provisions involved the confiscation of merchant ships which restricted trade. German colonies in Africa and China impounded by Britain and France also led to additional reductions in resources. Furthermore, Britain and France seized and gained authority over German industries and limited what they could produce. Insufficient output, trade, and resources played a vital role in the hyperinflation that Weimer experienced.
Article 231 recognized as the War Guilt Clause compelled Germany to pay 5 billion in reparations. The amount was unattainable and economically improbable for Germany to pay. The Allies demanded Germany to pay reparations in foreign currency which gave rise to a convertibility issue. Since these reparations are a form of foreign debt, this caused the debt to be managed by the foreign exchange rate. Germany could either pay for the debt through taxation or exporting more goods/services. The amount was fiscally impossible to pay through the means of taxation without political and economic turmoil. They could have lowered wages and hiked taxes to boost exports, yet they failed to do so. Federal taxation was set too low and caused an irregularity between domestic and foreign goods. Since the low tax rate could not diminish domestic consumption, there was an insufficient amount of goods available to export to the Allies. If taxation fails to reduce domestic consumption, the exchange rate for the German Mark will collapse due to insufficient export revenue as they were unable to purchase the required foreign exchange. Moreover, market speculation significantly influenced the exchange rate as investors refrained from purchasing goods/services. The insufficient export revenues caused the price of foreign goods to rise perpetually. As they were unable to deliver sufficient exports, the German government resorted to deficit spending.
Between 1922 and 1923, prices accelerated rapidly. Britain, France, and Russia proceeded to occupy the Ruhr Valley (a crucial German industrial center). Workers responded by going on a general strike. The strike was catastrophic for the German economy as a significant proportion of output vanished. The German government reacted by quite literally printing money to pay for wages to support demand. The printed money that substituted wages progressed aggregate demand as output disintegrated. Remember, if production cannot meet demand, prices must adjust accordingly. As the German government refused to raise taxes, deficits skyrocketed, output declined, export revenue vanished, and created the perfect storm for hyperinflation. Additionally, Germany proceeded to deficit spend on workers and business despite output being practically non-existent. The cause of hyperinflation in domestic prices is the rise in prices of foreign goods, collapse of the exchange rate, inadequate trade, reductions in production capacity, and political instability.
Zimbabwe
Zimbabwe is typically accepted as another example to promote the “money growth = inflation” view. Unlike the Weimer Republic, they did not have to pay off extensive war debts. What happened?
Unlike the Weimar Republic, this particular case of hyperinflation was self-imposed. People of European descent composed one percent of the entire population despite owning 70% of all productive land. In 2000, the revolutionary Zimbabwean government-organized land reformations forcefully took over white-owned commercial farms. They did this to undo European colonialism which was reasonable. However, in terms of economic policy, this was suicidal. The soldiers that replaced white farmers were less productive and inefficient at producing sufficient supply, which caused a massive contraction in economic output. As a result, food production collapsed by 45% and consequently disallowed aggregate demand to adjust accordingly. GDP continued to decline by 7/8% annually followed by diminishing investment and potential output. As a result of the collapse of production, unemployment skyrocketed to 80%. In 2002, Zimbabwe experienced massive floods and the worst drought in two decades. This induced massive deficiencies in raw materials. The land reformation followed by poor weather conditions all constructively contributed to the 45% reduction in food production. The manufacturing industry disintegrated amidst the food shortages, falling exchange rates, burdens of foreign debt, floods and droughts, political turmoil, and widespread panic and speculation. In 2005, manufacturing output declined by 29% and 18% in 2006. In 2007, barely 18.9% of the entire industrial capacity was utilized.
The government responded to the food shortages by importing from foreign countries to avoid nationwide starvation. The government spent massive amounts of money on food imports and eventually turned to deficit spending. Since they owed money to foreign nations, this is considered foreign debt. Furthermore, the Federal Government set taxation at too low of a rate to compensate for the accelerations in spending. Because the amount spent on political favors was not for productive purposes, any spending would be inflationary if output did not adjust.
The burdens of foreign debt, and the reduction in output, employment, and taxation that did not adjust for spending consequently led to inevitable hyperinflation.
Venezuela
Adherents to the traditional view use the hyperinflation crisis that Venezuela endured as further historical evidence. Again, Venezuela and all other cases of hyperinflation typically occur under the circumstances of social instability and political turmoil.
On February 6, 2003, former president Hugo Chavez pegged the Venezualan bolivar to the US dollar. The currency peg enabled Venezuela to adhere to a fixed exchange rate system rather than a floating exchange rate system as the United States possesses. The fixed exchange rate policy was an effort to mitigate economic turmoil followed by a general strike that attempted to evict him. The general strike was disastrous for economic output as GDP contracted by 27%. The majority of the Venezuelan economy relied on exporting oil and importing food from foreign nations. In 2014, Venezuela possessed the most abundant oil reserves globally, and these exports accounted for 96% of total exports and comprised 50% of revenue. This made Venezuela vulnerable to immediate losses in revenue if the price of oil were to collapse. President Hugo Chavez announced price controls on dominant consumer goods such as raw materials and medicine. These price control policies intended to enhance the accessibility of these goods to the impoverished. The dependence on oil exports and imports, price controls, and a fixed exchange rate system was the perfect components for a hyperinflation crisis.
On June 20, 2014, the price of crude oil collapsed as its scarcity subsided. From 2014 to 2017, the price of oil declined by 70%. This was disastrous for the economy as oil accounted for 96% of export revenue and 50% of government revenue. The International Monetary Fund reports the Venezuelan economy disintegrated by approximately 30% within four years. Due to the extensive price controls on prevailing consumer goods imposed by the Chavez government, production continued to decline yearly. Social programs such as welfare were reliant on taxation on oil exports. As revenues vanished, these social programs diminished and were increasingly futile. Before the collapse of oil, these social programs alleviated poverty by 20%, and as a result of the reduction in funding, sparked lower employment and a contraction in aggregate demand. Reliance on imports urged Venezuela to take on debt to feed its people due to the destruction of export income. Because the Chavez government pegged the bolivar, they owed debt in US-denominated dollars. This qualifies as classified foreign debt. The Venezuelan government attempted to purchase imports by literally printing money into continuation, but because of the reduction in output, the loss in revenue, US-denominated debt, and the fixed exchange rate system, this money creation was consequently inflationary. In May 2018, the Trump administration announced sanctions and restricted Venezuela from selling US debt. Because of these devastating sanctions, Venezuela has nearly exhausted foreign reserves and inaccessible to the foreign debt market.
Conclusion
From these examples, there must appear to be three habitual causes of hyperinflation:
- Foreign debt
- Reduction in output
- Political Instability
Numerous nations have encountered hyperinflation throughout history, but every case is associated with social/political turmoil and the three causes listed above. Hyperinflation is not and has never been inherent to money creation. Nowhere in history has a nation endured such extreme rises in inflation solely from money creation. There are invariably underlying determinants in every inflation crisis. This is a harsh fact for people who love using developing nations that have endured absolute chaos in governance and geopolitics to support the conventional conclusion.
Nonetheless, such an extreme case of hyperinflation is impossible in the United States. As I covered in the fifth paragraph, our Central Bank cannot inject a fixed amount of currency into circulation as we operate under a free-float exchange rate system, unlike Venezuela. The money supply is determined by the demand for money, not the Federal Reserve. So this is how the relationship between the money supply and inflation really works. Until the day we start losing world wars, that is.
References
AP & AFP. 2003. “Venezuela announces currency, price controls.” The Sydney Morning Herald, 02 07, 2003. https://www.smh.com.au/world/venezuela-announces-currency-price-controls-20030207-gdg8co.html
Mcleay, Michael, et al. “Money creation in the modern economy.” Bank of England, 2014, https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy. Accessed 6 July 2021.
Mitchell, Bill. “Zimbabwe for hyperventilators 101.” Bill Mitchell — Modern Monetary Theory, 6 July 2021, http://bilbo.economicoutlook.net/blog/. Accessed 6 July 2021.
Mosler, Warren, and Phil Armstrong. “Weimar Republic Hyperinflation through a Modern Monetary Theory Lens.” Weimar Republic Hyperinflation through a Modern Monetary Theory Lens, 2020, http://moslereconomics.com/wp-content/uploads/2020/11/Weimar-Republic-Hyperinflation-through-a-Modern-Monetary-Theory-Lens.pdf. Accessed 6 July 2021.
The Guardian. 2003. “Venezuela pegs bolivar to dollar.” The Guardian, 02 07, 2003. https://www.theguardian.com/business/2003/feb/06/venezuela.internationalnews
