With all of the money the Fed is printing to shore up banks' balance sheets, there's been a lot of discussion centered around whether or not this new money is going to suddenly "dislodge" and cause a rapid shift to a highly inflationary, possibly hyperinflationary environment. Personally, I'm not sure, but I'd lean towards continued deflation for the moment. That notwithstanding though, I've noticed that a lot of the debate has failed to take account of two very basic, but very important distinctions: the difference between physical cash and credit money, and the difference between productive assets and paper wealth.
Generally, the Fed "prints" money by electronically debiting a non-existent checking account, and then buying assets - typically short-term T-Bills, though they've recently begun buying commercial paper, long-term Treasury bonds, and a panaplea of junk bonds - on the open market. The newly-created credit money then changes hands from the Fed to the sellers of Treasuries: either the government or private investors, which are typically banks or other financial institutions. The banks then take this money and loan it out at interest to businesses and consumers, while keeping a required portion in reserve, almost always as a deposit in the bank's reserve account at the Fed. The consumers or businesses then take the money and spend it, creating income for other businesses or consumers, who in turn deposit it in their bank accounts. That bank then proceeds to make loans from the deposits while keeping a portion in reserve, and so on, ad infinitum.
This effectively means that each new dollar created by the Fed has a "multiplier," equivalent to the inverse of the required reserve ratio, which is also set by the Fed. So if the required reserve ratio is 10%, it works out like this:
Balance Sheet |
|
| Assets | Monetary Base | Reserve Ratio |
Federal Reserve | $100 | $100 | 10% |
|
| Assets | Liabilities | Equity |
| (Loans) | (Customer Deposits) | (Reserve Bank Deposits) |
Bank 1 | $100.00 | $90.00 | $10.00 |
Bank 2 | $90.00 | $81.00 | $9.00 |
Bank 3 | $81.00 | $72.90 | $8.10 |
Bank 4 | $72.90 | $65.61 | $7.29 |
Bank 5 | $65.61 | $59.05 | $6.56 |
Bank 6 | $59.05 | $53.14 | $5.91 |
Bank 7 | $53.14 | $47.83 | $5.31 |
... | |
Bank n | $0.10 | $0.09 | $0.01 |
| |
Banking System Total | $1000 | $900 | $100 |
In this way, private banks are essentially allowed to create money out of nothing and then loan it out at interest, which is reprehensible in principle, but that's not really the point. The point is that the system requires people and businesses to keep taking on new debt and to keep spending. If people decide to instead pay off their debts, or if they can no longer afford to service their debt, the system collapses - which is where we are now. As expected, the system has simply ceased to function, and without a functional financial system, the real economy is ceasing to function as well.
There's also another effect to this, which almost always goes unnoticed: it results in an upwards transfer of income from debtor classes (consumers and productive businesses) to banks and investors. This has several deleterious effects; first off, productive businesses which actually have to make things or provide useful services to get more income become unattractive investments compared to banks and financial institutions, which are able to simply create money from nothing. It becomes a situation in which good "money" (productive capital) is being driven out by bad (unproductive money creation).
Just as in the case of criminal counterfeiting, legalized counterfeiting by banks makes productive market actors pay more for goods and services, while the counterfeiter lives off the products of their labor. Thus, if not corrected by regulation of the pertinent firms, investors are induced to allocate capital to financial firms in such a way that the productive sectors of the economy are consumed in order to fund ever-increasing payments to parasitic financial institutions and their wealthy investors. As you might expect, this also results in an upwards redistribution of wealth from workers to (generally) idle shareholders, causing a huge amount of economic inequality.
The system (central banking and pseudo-capitalism) can operate indefinitely provided that the government redistributes this wealth back to workers via progressive taxation. However, if progressive taxation is abolished (as it has been over the course of decades in the United States), the disparity in wealth and income becomes so extreme that the debtor classes eventually realize that it makes no sense to continue kicking an ever-increasing share of their income up to banks and the wealthy. This realization may be conscious or unconscious (i.e., soaring defaults on consumer debt), but it is inevitable without remedial action on the part of the government. A complex, opaque financial system can hide the underlying reality for a very long time, but not indefinitely.
So now, back to the deflation/hyperinflation debate. Since the system is not functioning, all of the new money the Fed is creating is not behaving as actual cash, even though it's considered as such by businesses and in the monetary aggregates. Rather, it's mere accounting entries on banks' balance sheets and in their reserve accounts at the Fed. It may not seem important, but when the system has collapsed, there is a very important distinction to be drawn between this electronic credit money and physical cash. If the Fed were actually printing all of this money and dropping it from a helicopter (Bernanke's infamous policy prescription for dealing with credit deflation), it could generate inflation, but not by simply distributing it through the financial system as it generally does - after all, it's not functioning. What Benny-Boy, Hank the Destroyer, and their fellow clowns are doing is the financial and economic equivalent of trying to jump-start a car with a seized engine. This is because consumers are already so deeply indebted that the banks will refuse to lend them any more even if they were inclined to continue taking on more debt.
And, if you're wondering why incomes for the working classes have stagnated for the past few decades, you've found your answer. The consensus explanation is that incomes have stagnated because the upper classes have seen all of the productivity gains go to them, but that's a woefully inadequate description. Rather, the productivity gains really didn't materially exist; they existed on paper, and the rich saw the paper gains go to them, but they weren't real. There wasn't anything of value being produced - only debt, more debt, instruments to securitize and collateralize that debt, more debt on top of the preexisting debt, credit default swaps to insure the debt, banks and hedge funds to shuffle the debt around, and then more debt on top of that. But nothing real. It was a massive ponzi scheme to redistribute wealth upwards, and everyone participating is just finding that out now. Maybe not everyone, but the vast majority.
So, to sum this up, we aren't going to have to worry about inflation while policymakers stick to "supply-side" interventions (monetary supply, that is; not the actual supply of goods and services) - more monetary easing, tax cuts and credits, etc. It's simply not possible. Inflation is generated when the volume of expenditure exceeds the capacity of the economy to supply it; this is usually brought about when the the medium of exchange is debased - when the money supply expands. Inflation isn't going to happen in the present environment, not because there's not enough money chasing too few goods and services, but because all of the money isn't being used to chase anything. It can't; it's just sitting in electronic accounts at the Fed - precisely the very entity from whence it came - and not enough folks are able to pass the credit check required to get at it.
The harsh reality is that all of the wealth that's been redistributed up to the already wealthy via the financial system is going to have to be zeroed out. The system has made loans to people who can't pay them back, and it matters not how much money the banks have on their books - their debtors are still not going to be able to pay it back, period. The one way to get out of this is with fiscal policy action: engaging in domestic investment projects that put money in the hands of the working people now, and at the same time allows them to earn a higher income in the future. In the mean time, all of that funny-money in the monetary aggregates will be destroyed as defaults continue their inexorable climb.
So, it's either redistributive spending, or the system, the Big System - banks, corporations, governments, all of it - will eventually fail. The rich people who've had it so good for so long are going to have to disgorge themselves of their entitlement mentality, realize that they've been living largely at the expense of the working classes, and that a good chunk of their paper wealth is actually non-existent. Not that it will actually make any subjective difference to them; the really rich won't have to take a haircut to their lifestyles at all, only to their egos. If governments continue trying to prop up this exploitative system to maintain the wealth of the already wealthy, economic activity will continue plummeting, prices will continue plummeting, unemployment will continue rising, and the inevitable result will be the overthrow of the existing system. In the words of one of the greats:
Let me tell you now
Ev'rybody's talking about
revolution, evolution, masturbation,
flagellation, regulation, integrations,
meditations, United Nations,
Congratulations.
-John Lennon
Congratulations indeed.
Cross-posted at my (semi-)new blog, The Daily Elitist.