by Alasdair Macleod, GoldMoney:
Note: all references to inflation are of the quantity of money and not to the effect on prices unless otherwise indicated.
In last week’s article I showed why empirical evidence of fiat money collapses are relevant to monetary conditions today. In this article I explain why the purchasing power of the dollar is hostage to foreign sellers, and that if the Fed continues with current monetary policies the dollar will follow the same fate as John Law’s livre in 1720. As always in these situations, there is little public understanding of money and the realisation that monetary policy is designed to tax people for the benefit of their government will come as an unpleasant shock. The speed at which state money then collapses in its utility will be swift. This article concentrates on the US dollar, central to other fiat currencies, and where the monetary and financial imbalances are greatest.
In last week’s Goldmoney Insight, Lessons on inflation from the past, I described how there were certain characteristics of Germany’s 1914-23 inflation that collapsed the paper mark which are relevant to our current situation. I drew a parallel between John Law’s inflation and his Mississippi bubble in 1715-20 and the Federal Reserve’s policy of inflating the money supply to sustain a bubble in financial assets today. Law’s bubble popped and resulted in the destruction of his currency and the Fed is pursuing the same policies on the grandest of scales. The contemporary inflations of all the major state-issued currencies will similarly risk a collapse in their purchasing powers, and rapidly at that.
The purpose of monetary inflation is always stated by central banks as being to support the economy consistent with maximum employment and a price inflation target of two per cent. The real purpose is to fund government deficits, which are rising partly due to higher future welfare liabilities becoming current and partly due to the political class finding new reasons to spend money. Underlying this profligacy has been unsustainable tax burdens on underperforming economies. And finally, the coup de grace has been administered by the covid-19 shutdowns.
The effect of monetary inflation, even at two per cent increases, is to transfer wealth from savers, salary-earners, pensioners and welfare beneficiaries to the government. In no way, other than perhaps from temporary distortions, does this benefit the people as a whole. It also transfers wealth from savers to borrowers by diminishing the value of capital over time.
Inflation of the money supply is now going into hyperdrive, so those negative effects are going to get much worse. It is time to move from empirical evidence to the situation today, which is the unprecedented increase in the global rate of monetary inflation and specifically that of the world’s reserve currency, the US dollar.
The dollar’s inflation
No doubt, the reluctance to reduce, or at least contain budget deficits is ruled out by the presidential election in November. But whoever wins, it seems unlikely that government spending will be reined in or tax revenue increased. For the universal truth of unbacked state currencies is that so long as they can be issued to cover budget deficits they will be issued. And as an inflated currency ends up buying less, the pace of its issuance all else being equal will accelerate to compensate. It is one of the driving forces behind hyperinflation of the quantity of money.
Since the Lehman crisis in August 2008, the pace of monetary inflation has accelerated above its long-term average, and the effect is illustrated in Figure 1 below.
Figure 1 includes the latest calculation of the fiat money quantity, to 1 August 2020. FMQ is the sum of Austrian money supply and bank reserves held at the Fed — in other words fiat dollars both in circulation and not in public circulation. Because commercial banks are free to deploy their reserves within the regulatory framework, either as a basis for expanding bank credit or to be withdrawn from the Fed and put into direct circulation, whether in circulation or not bank reserves at the Fed should be regarded as part of the fiat money total.
It can be seen that the rate of FMQ’s growth was fairly constant over a long period of time — 5.86% annualised compounded monthly to be exact — until the Lehman crisis when the rate of growth then took off. Since Leman failed in 2008 FMQ’s total has grown nearly 300%.
Since last March growth in the FMQ has been unprecedented, becoming almost vertical on the chart, triggered by the Fed’s response to the coronavirus. And now a second wave of it has hit Europe and the early stages of a resurgence appears to be hitting the land of the dollar as well. With lingering hopes of a V-shaped recovery being banished, a further substantial increase in FMQ is all but certain.
Already, FMQ exceeds GDP. If we take the last time things were normal, say, in 2005 when the US economy had recovered from the dot-com crash and before bank credit expansion and mortgage lending become overblown, we see that in a functioning relationship FMQ should be between 35%—40% of GDP. But with the US economy now crashing and FMQ accelerating, FMQ is likely to be in excess of 125% of GDP in the coming months.
What is the source of all that extra money? It is raised through quantitative easing by the central bank in a system that bends rules that are intended to stop the Fed from just printing money and handing it to the government. Yet it achieves just that. The US Treasury issues bonds by auction in the normal fashion. The major banks through their prime brokers bid for them in the knowledge that the Fed sets the yield for different maturities through its market operations. The Fed buys Treasury bonds up to the previously announced monthly QE limit, only now there is no limit, giving the primary brokers a guaranteed turn and crediting the selling banks’ reserve accounts with the proceeds.
This arm’s length arrangement absolves the Fed of the sin of direct money-printing but evades the rules by indirect money-printing. The Treasury gets extra funding through this roundabout arrangement. Participating banks generally expand their bank credit to absorb the new issue, which they then sell to the Fed, which in turn credits the banks’ reserve accounts. The Treasury gets the proceeds of the bonds to cover the deficit in government spending, and the banks get expanded reserves. The Fed’s balance sheet sees an increase in its liabilities to commercial banks and an increase in its assets of Treasury bonds. The Fed also funds agency debt in this manner, mostly representing mortgage finance.
Under President Trump, the Treasury’s current deficit initially expanded as a planned supply-side stimulus to the US economy to the tune of just over a trillion dollars before covid-19 created additional financial chaos. Businesses experienced severe dislocation and have suffered a widespread collapse. Consequently, and together with the direct injection of money into each household, the Congressional Budget Office revised its trillion-dollar deficit for the financial year just ended as the following screenshot from its website indicates:
Note how half the government’s income arose from revenues and half is covered by sales of government debt to the public (i.e. the commercial banks), which at the end of fiscal 2020 (ended yesterday) is estimated to total $20.3 trillion. But given that the first half of that fiscal year was pre-lockdown and the annualised rate of the deficit at that time was about a trillion dollars, simplistically the annualised rate of the deficit’s increase since last March is in the region of $4.4 trillion. Incidentally, the CBO’s economic projections look too optimistic given recent events, in which case budget projections for this new calendar year will be adjusted for considerably lower revenue figures, and significantly greater outlays at the least. We shall address the price inflation estimates later in this article.
Why QE is inflationary
On 23 March the Federal Open Markets Committee (FOMC) announced unlimited QE for both US Treasury stock and agency debt as well as however much liquidity commercial banks need.[i] While judging the expansion of the budget deficit to be inflationary, it is only inflationary to the extent that it is not financed by savers, either increasing the proportion of their savings relative to immediate spending, or to the extent they divert their savings from other investment media. In the latter case, citizens have been committing their savings more to equity markets than bond markets. The returns for discretionary portfolios managed on the public’s behalf have also found better returns in equities than in government and corporate bonds, though when assessing increasing investment risk Treasury stock is seen to be a safe haven in bond portfolios. Pension funds and insurance companies also allocate cash flow to US Treasuries and to the extent that this is the case, the issuance of further government debt is non-inflationary.
Furthermore, if a bank does not increase its balance sheet by expanding bank credit, its participation in the Fed’s QE programme is not inflationary either. For this to be the case, it would have to sell existing stock, call in loans or subscribe on behalf of clients.
By seeing them through a Nelsonian blind eye these factors give some encouragement to the Fed in funding the Treasury through QE, particularly since the statistics reflect a jump in savings, as the following chart from the St Louis Fed illustrates.
More correctly, the chart reflects the fall in spending when people locked down, as well as the $1,200 stimulus checks distributed to households at end-April, which marked the peak in the chart. Since then, there has been some downward adjustment, partly because some spending has returned, and the backlog of essential spending, such as property maintenance, is being addressed.
The evidence is not yet strong enough to claim this statistical shift in savings habits is permanent. Furthermore, being calculated as the percentage of personal disposable income that is not spent and given the high levels of personal debt throughout the population, much of these so-called savings will have disappeared into credit card and debt repayments. It is more likely that with rising unemployment and roughly 80% of the American salaried population living paycheque to paycheque, that far from there being a higher savings rate, personal finances have deteriorated so much that money is being withdrawn from savings on a net basis, to acquire life’s essentials. In fact, the savings rate is one of those unmeasurable economic concepts, and the reality is that Joe Average is worse off in today’s contracting economy and is drawing down on savings in order to subsist.
The non-inflationary element of QE then boils down roughly to increases in insurance company and pension fund investments in Treasury stock and the increase in bank holdings and reserves at the Fed not funded through the expansion of bank credit. But this creates another factor: the extent to which existing bond investments are sold in order to subscribe for Treasury stock inevitably undermines corporate bond markets and their ability to satisfy their funding requirements. And it is for this reason the Fed has appointed BlackRock to spearhead its purchases of corporate debt to ensure liquidity is available for those markets and to put a cap on risk premiums. Therefore, where banks do not expand credit to buy new Treasury stock, the Fed steps in to compensate with additional monetary inflation.