Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.

Inflation – Part two

Part One was published on the 23rd.

Paul responds

Sherry,

My first realisation is that I don’t really understand what “money growth” really means. In fact I am little uncertain about money, as a concept!

Are we talking ‘growth’ as in more and more money being lent to the US Treasury Department from the [ever increasing] sale of US Treasury Bonds?

If the sale of these Bonds is to banks or institutions outside the US then there is a flow of money coming into the US via the Treasury Department that then comes into the economy via various Government programmes. Is that correct?

But this is money lent to the US. That means that in order for the US to pay it back (plus interest) there has to be the expectation of taxation income in the future sufficient to meet these debts. As my Pension advisor said, “More credit also means more debt.”

I guess that what really hurts my brain is trying to understand the cause and effect in this. It seems to me that while the sale of Treasury Bonds creates more money in the system it is also creating more debt which has a dampening effect to the inflationary effect of the more money in the system.

Over to you!

Sherry replies:

Paul,

Ah! Yes, very good questions. This back and forth is very useful – it helps me to understand what you (and the reader) understand, and what needs to be laid out better.

The “M1” definition of the money supply is the number of bills (and coins) in circulation plus the deposits in

non-interest bearing checking accounts, essentially.

Money growth is the rate of change in this level. The money supply increases when the Fed purchases an asset and pays for it with “created” deposits. And I mean “created” in the true sense of the word: out of thin air. The deposit wasn’t there yesterday and, because the Fed says so (by “the stroke of a pen” or, in today’s terms, by a computer entry), it’s there tomorrow.

Most people assume that the assets the Fed purchases are only Treasury bonds, but that is not always the case. Most Treasury bonds are bought by entities other than the Fed, and thus they are not part of the money supply. And if the Fed pays for Treasury bonds with an asset, like foreign currency for example, it does not increase the money supply.

So there is no necessary relationship between the U.S. debt level and the U.S. money supply.

In fact, for a long time, the Treasury endeavored to have minimal impact on the money supply by using the local bank’s “tax and loan accounts” to deposit its tax revenues and to pay the government’s bills. With this economic crisis and this Treasury Department Secretary, I am not at all sure about this any more.

Sherry

Paul replies

OK, that makes it clear how money gets into being, as it were.

So we have two processes going on;

1. The Fed creates money, as in putting it out there, by purchasing cash-type paper assets from banks in return for printed money (as a concept primarily, in practice computer transactions) and then destroying those assets so just the money remains.
2. The US Treasury, in managing government revenues, borrows money from people and countries by selling US Treasuries to fund the government’s programmes, as well as raising it directly from taxation.

It is the first process that has the potential to cause inflation if the growth of that money creation is in excess of the growth in economic output of the nation.

The thing that I’m still having difficulty with is how the money gets ‘used’ and from that how more money being ‘used’ leads to inflation, that being the underlying topic of this debate.

We are, today, in a situation where demand for housing loans is dropping, industrial production is dropping, employment is dropping, retails sales really dropping and so on. There is no sign that any of these indicators is going to turn up soon and by soon I mean before the end of 2010, earliest.

Even outside the US the international scene is just as bleak although the news media do their best to hang on to snippets of less worse news. France is experiencing deflation (July YoY CPI down 0.8%), Germany likewise, the UK unemployment figures are dire and on and on.

Thus the banks don’t have real clients for their increased cash balances so all they can do is to drive stock markets and commodities higher as part of yet more speculation.

Capital Professional Services have a piece on inflation.

As you can see in the most recent 6 months the money supply has increased from a growth rate of a couple of percent up to about 10%. Interestingly it is not up to the peak levels of the 2000 run-up. But if history is any indicator we can expect one of two outcomes either significantly higher consumer price inflation or another asset bubble.
From How does M1 relate to inflation by Tim McMahon, Editor (The original article has access to a larger version of that chart, PH)

So there’s the essence of my problem in understanding why there is an inflation risk while the outlook remains so grim.

The relationship between M1 money supply and inflation also seems less than tightly correlated so, as and when, the economy starts to grow what sort of indicators would give a reliable warning that a move from fixed interest investments was sensible.

Paul

Part Three continues tomorrow. Comments most welcome.

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