Too Many Dollars Chasing Too Few Goods & Services

It’s been going on for decades, the great debate between two groups of intellectuals in the field of economics about the causes of, and cures for, inflation and deflation. Of course, now the arguments have heated up about the former.

On one side are most members of the Federal Reserve Board led by Chairman Jerome Powell. They apply the principles of Modern Monetary Theory (MMT) and Keynesian economics:

o   the dollar won’t be affected by increases in the money supply, tax policy or government spending

o   there’s always a tradeoff between inflation and unemployment

o   focus is strictly on demand, rather than on both supply and demand

In February 2021, asked whether “M2 (currency + deposits + money market funds) going up by 25% in one year would diminish the dollar,” Mr. Powell replied, “there was a time when monetary policy aggregates were important determinants of inflation and that has not been the case for a long time…the correlation between…M2 and inflation is just very, very low.”

On the other side is the Chicago school of economics which rejects both MMT and Keynes in favor of:

o   Milton Friedman’s monetarism: price stability is directly impacted by role of government in its monitoring of the money supply, which in turn affects the GDP in the short-term and price levels in the long-term 

o   Adam Smith’s classical economics—emphasizing rational expectations, free markets, property rights, the rule of law, low government debt and limited role by the administrative state

Why should we care? The current surge in inflation is one of the factors causing investment portfolios to lose value this year. One question is: to what extent are the Fed and Congress responsible?

Friedman made his mark by exposing the greatest myth in US economic history—that the Great Depression was caused by a failure of capitalism (it was actually sparked by government policies). The Fed created our worst unnecessary disaster by allowing the banking system to collapse.

Historical evidence shows that growth doesn’t cause inflation. In the 1920s, for example, when the highest tax rate was cut from 73% to 25%, real GDP and the stock market roared while the price level fell. This also repeated in the ‘60s and ‘80s.

Customers panicked after the stock market crash in 1929, rushing to their bank to withdraw their deposits. In a fractional banking system, very little cash is kept in local vaults, but instead of increasing the money supply, the Fed stood by as seven thousand banks failed, and the price level fell—the classic example of deflation.

Pure-Friedman monetarist economists John Greenwood and Steve H. Hanke declare, “It’s all about money, not fiscal policy, supply chains or energy prices. Money dominates…in normal times most money is created by commercial banks. When a bank makes a loan, it credits the borrower’s deposit account. The loan does not come from the bank drawing down on its reserves at the Fed. Banks can also create money by purchasing securities, again crediting the deposit account of the issuer or seller of the securities. Provided they can meet all capital, liquidity and leverage requirements, banks create loans out of thin air. If the ability of banks to create money is impaired for any reason, the Fed can step in and engage in quantitative easing, purchasing assets on a large scale. This increases the money supply because asset purchases by the Fed from the nonbank public result in a payment passing from the Fed to the seller, which deposits the payment in a commercial bank. This is new money. In turn, the bank passes the payment back to the Fed, which credits the commercial bank’s reserve account. This is how QE increases both banks’ reserves and the money supply out of thin air. 

“During the global financial crisis—which we define as the period when the Fed was engaging in QE, 2009-14—commercial banks’ balance sheets were seriously impaired by bad loans to subprime borrowers and losses on securitized loans. Short on capital in an environment where capital and other requirements were being tightened, most banks stopped lending and creating money in 2008 and didn’t start lending again until 2012. Fortunately, the Fed stepped in to create money via QE.” 

Good thing Fed Chair Ben Bernanke had read his Milton Friedman and pumped huge amounts of liquidity into the system. Why didn’t the Fed pump money into the system before the Great Depression? “In 1928 and 1929, the Federal Reserve had raised interest rates in hopes of slowing the rapid rise in stock prices. These higher interest rates depressed interest-sensitive spending in areas such as construction and automobile purchases.”

The FDR Administration experimented, as the president himself decided what the price of gold should be instead of the market, and even made it illegal for a farmer to grow wheat to feed animals on his own farm (check out Wickard v Filburn (1942) in which government was trying to decrease supply by severely limiting wheat production, and Amity Shlaes’ superb The Forgotten Man.)

If the Fed had only done the opposite, by increasing the money supply, argued Friedman, then the deflation would have been reversed, reducing the Great Depression to a typical recession.

Friedman then became a national figure in the 1970s when Great Depression’s flipside occurred, runaway inflation. He criticized the Keynesian model being used, illustrated by the Phillips Curve, theorizing that there’s a tradeoff between inflation and unemployment. However, stagflation occurred—meaning both inflation and high unemployment were happening at once—  with the misery index (inflation rate + unemployment rate) over 21 in 1980. In 1979, new Fed Chair Paul Volcker took Friedman’s advice and inflation eventually subsided.

Lawrence Summers is usually on the side of the Keynesians, but after Congress passed the $1.9 trillion spending bill in March 2021, as if he too had been mentored by Milton, Mr. Summers correctly predicted that inflation was coming, pointing out that 3x too much money was being injected into the economy.

Yet now Mr. Summers is defending the Phillips Curve, recently telling Bloomberg: “We need five years of unemployment above 5% to contain inflation.” Art Laffer and Stephen Moore, both adherents of the Chicago school, were quick to pounce: “Mr. Summers echoed the advice of his uncle, the Nobel economics laureate Paul Samuelson, who famously wrote in 1980, a time of double-digit inflation, that “five to ten years of austerity, in which the unemployment rate rises to an eight or nine percent average and real output inches upward at barely one or two percent per year, might accomplish a gradual taming of U.S. inflation.” 

Five years following the 2007-9 financial catastrophe however some critics of the Fed like Mr. Laffer and Mr. Moore had incorrectly predicted that inflation would come back. Why?

o   Huge government deficits adding to a huge government debt: in 2008 the debt was $10 trillion and by the end of 2013 it had grown to $17 trillion

o   Astounding increases to the Fed’s balance sheet: in June 2008 it was $0.9 trillion; by end of 2013 it had increased to $4 trillion.But no inflation occurred. Supply and demand must meet, and demand was still incredibly weak after the economic shock. “During the global financial crisis…commercial banks’ balance sheets were seriously impaired by bad loans to subprime borrowers and losses on securitized loans,” explain Mr. Greenwood and Mr. Hanke. “Short on capital in an environment where capital and other requirements were being tightened, most banks stopped lending and creating money in 2008 and didn’t start lending again until 2012. Fortunately, the Fed stepped in to create money via QE.”

Despite the Fed’s assurances, now inflation is back. Why?

o   Not enough supply, shortages of goods and services (too little US gas energy investment, Covid supply-chain issues, tension with Russia and China)

o   Too much demand (as per Mr. Summers)

o   The usual government-causing suspects: excessive spending, printing too much money, currency devaluations

Another Fed critic from the Chicago school, John Cochrane, notes that the debt must be paid back, and it will cost a lot more to service it with higher interest rates. The Congressional Budget Office (CBO) recently projected that annual net interest costs would reach $399 billion in 2022 and nearly triple over the 2023–2032 period, from $442 billion to $1.2 trillion and totaling $8.1 trillion over that period. And that assumes the CBO’s inflation projections aren’t too low.

However, with the war in Ukraine (and to a lesser extent, Brexit) destabilizing Europe, investors have been moving to the US dollar as a relatively safer investment. So, it appears that while US finances are a mess, everyone else’s are considered to be worse.

One argument made after the war between Israel and Egypt in 1973 and the subsequent OPEC embargo was that the total supply of oil was disappearing. But reserves have more than doubled since 1980. Just predictions of future scarcity can apparently increase the price of a commodity like oil.

Many economists at this point are predicting that the US is heading into an imminent recession, if it isn’t already in one. But in every recession going back 50 years:

o   Hours worked shrink by at least 2%—but thi time the US worker is working 1% more hours

o   Employers continue to hire at a robust rate, and the while the unemployment rate is 3.6%—those recessions featured at least a 6.0% rate

Laffer and Moore argue for supply-side solutions to keep us out of recession while also cutting inflation. Tax cuts for businesses spur “pro-growth policies that create incentives for more goods, more employment, less government spending and sound money. As the economy produces more, prices go down.” They like to brag about the 1980s, as tax cuts for the wealthy did increase government revenues. But they leave out the part where government spending continued to increase even more than the increase in revenues.

In 2022, total public debt is $30 trillion while the Fed’s assets are at $8.9 trillion. If the Fed had not purchased any assets, then interest rates would have been higher all along. One formula for valuing stocks is Discounted Cash Flow (DCF) analysis, where ‘r’ equals the interest rate or discount rate, so the higher the interest rate, the lower the stock valuation. By keeping real interest rates below 0%, The Fed was artificially increasing stock market valuations rather than letting the free market of supply and demand determine them.

It's arguable then, that investor sentiment would be less negative today had the Fed left its balance sheet with fewer assets. Plus, there are always tradeoffs—what was good for stock portfolios was not good for bond portfolios, as historically-low interest rates have hurt retirees and insurers. Now both stocks and bonds are getting slammed.

So, the back-and-forth arguments will continue. I wish investors paid more attention to Milton Friedman (Free To Choose is on YouTube) and also hope to see some politicians willing to put their careers on the line and tackle the debt problem, starting with Social Security reform. That would be a good way to help reduce both inflation and deflation.