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Money Printing Isn’t Always Inflationary

Thursday, May 9, 2013

Republicans are wrongly giving fear of money printing a higher priority than the growth debate. Robust growth is as close as we can get to a panacea for our monetary and fiscal problems.

Economic growth has been a persistent theme here, and a new book from the AEI Press provides yet another explanation of why broadly shared economic growth deserves top priority in policy debates, as does removing barriers to that goal. One of those barriers is a too-narrow focus on tax cuts at the exclusion of investment spending, as AEI’s James Pethokoukis has explained. Another barrier is the tendency to confuse causes with effects in fiscal policy debates, the theme of my previous article. A similar confusion occurs in the debate over monetary policy.

Money Printing: A Cause or Effect?

Regarding monetary policy, a theme of many on the right has been disdain for so-called “money printing” by the Federal Reserve. (“Money printing” is a crude catchphrase, because the Fed doesn’t drop free cash onto the banks; instead, it exchanges an increase in the banks’ balances at the Fed for bonds already owned by the banks — it’s an asset swap.) A popular objection by some on the right is that money printing causes higher inflation. A more nuanced objection is that when the time comes for tightening, the Fed will have difficulty getting the timing right; that is, even though the Fed in theory can prevent inflation by “unprinting” money (by selling bonds back to the banks and thus reversing the asset swap described above), it will in practice have trouble doing so at the rate necessary for price stability.

However, as is the case for fiscal policy, the causes and effects in monetary policy can be confusing. For example, below are two mutually exclusive possibilities regarding current monetary policy; note the stark difference in conclusions, depending on which is the true cause-effect relationship:

1. Money printing, in theory, causes inflation — sooner or later.

2. Sluggish money-spending by the public is contractionary, which in turn causes the Fed to print more money in response, which, in theory, encourages more lending, spending, and growth.

The first theory is the simple one: when the Fed buys bonds ("prints money"), inflation is sure to follow. The second theory is less simple: when the economy is sluggish or shrinking, bond-buying by the Fed might give a much-needed non-inflationary boost to economic activity. As usual, examining the track record can help sort out causes and effects. Has recent Fed money-printing caused higher inflation? No, not yet, according to the most widely watched inflation measures, one of which (PCE) is shown in Figure 1.

This begs the question, what has prevented the Fed’s money-printing from causing inflation? Figure 2 suggests one reason: a decrease in money velocity (the pace of money spending by the public) appears to have offset whatever inflationary effects the Fed’s policy may have had. In fact, Figure 2 suggests that sluggish money-spending may be what caused the Fed to implement its money-printing policy in the first place.

The false but popular view of Fed money-printing is that the creation of new money does nothing but dilute the public’s existing money supply. In fact, the Fed creates new money (a financial asset) and uses it to purchase bonds (financial assets) from the public. Money printing by the Fed is not a dilution of the public’s financial assets. Instead, it’s a zero-sum asset swap: although new money comes from the Fed, existing bonds of the same value are bought by the Fed, and the net change in the public’s financial assets is zero.

What the new base money does change is banks’ ability to make new loans — but if banks’ increased ability to lend to entrepreneurs and businesses is not accompanied by an increased desire to lend to them, then public borrowing, spending, and investing won’t increase. In that case (which has been our situation for several years), Fed money-printing ends up generating little if any boost to economic activity or inflation pressure.

Figures 1 and 2 show that money printing has failed to induce money lending and spending, which in turn is why it has also failed to induce inflation. True to the old adage, the Fed’s money-printing policy, so far, has been like “pushing on a string.”

Once Again, It All Comes Back to Growth

If banks’ increased ability to lend to entrepreneurs and businesses is not accompanied by an increased desire to lend to them, then public borrowing, spending, and investing won’t increase.

Lack of sufficient economic growth is behind most if not all of our fiscal and monetary problems. For example, unemployment is a sign of an output gap — that is, an economy operating at less than its capacity, as shown in a previous article; sufficient growth would (by definition) close that gap. Also, inflation is a sign of insufficient growth relative to the pace of bank credit creation (i.e., lending to businesses and entrepreneurs). In both cases, growth is an underlying solution. Robust growth is as close as we can get to a panacea for our monetary and fiscal problems. Too much bank credit is inflationary; insufficient bank credit is contractionary. When the Fed senses the former, it effectively “unprints” money; when it senses the latter, it prints more. But even if the Fed gets the timing right, there’s no guarantee that its policy will work. As Figures 1 and 2 confirm, money printing hasn’t yet reversed the decline in the pace of money spending, nor has it been inflationary.

On one side, the Democrats have the priority somewhat correct (qualified real growth, that is, a noninflationary return to full employment for the middle class), but are advocating an inferior prescription: government-driven, intelligent-design economics, supervised from the top down by regulators and fairness referees. Conversely, the Republicans have a better growth prescription (bottom-up, organic growth driven by entrepreneurs competing for consumers within an evolving, adaptive legal framework), but for some strange reason are wrongly giving fear of money printing a higher priority than the growth debate.

In short, the Democrats are advocating growth through intervention and the Republicans could be countering that with a message of growth through enterprise. Inexplicably, however, the GOP is choosing to ignore their best argument. In any case, boosting growth is the best solution to our fiscal and monetary problems — it always is. If the GOP continues to stifle its best argument, we should expect the Democrats’ inferior formula for growth to carry the day.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy.

FURTHER READING: Conover also writes “Confusing Cause and Effect in the Fiscal Policy Debate,” “Two Budgets, One Point of Agreement, and a Third Way,” and “The Budget Debate Simplified.” Vincent R. Reinhart examines “Auditing the Fed” and Alex J. Pollock asks “Does Interest Rate Risk Matter if You're the Fed?



 Image by Murat Baysan / Shutterstock


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