The prospects for inflation have not been smaller since 1930

By L. Randall Wray

This post first appeared at “Great Leap Forward”, my EconoMonitor blog.

In the first part of this series on hyperinflation I addressed the critic’s view that if Modern Monetary Theory were adopted, this would inevitably lead to hyperinflation. I argued that this is obviously false—MMT describes how any sovereign government that issues its own currency spends. They’ve all done it for the past “4000 years at least” as Keynes put it. All modern sovereign governments spend by “keystrokes”—making electronic entries onto balance sheets—what most critics somewhat misleadingly call “printing money”. There is no other way to spend a sovereign currency into existence. Only the sovereign government can create it. If you try to create US currency in your basement, you go to jail.

In the second part, I argued that hyperinflation is a rare occurrence. Obviously, if “keystrokes” inevitably lead to hyperinflation, then hyperinflation ought to be a common feature of just about all economies for the past 4000 years. Instead, we find that experience with hyperinflation is quite limited, and seems to result from very specific circumstances such as unwillingness or inability to impose and collect taxes, with civil war, or with huge external debts denominated in a foreign currency. And while goldbugs and others think that tying a currency to gold (or to a foreign currency) is a sure-fire way to avoid inflation, what we actually observe in the real world is that such systems are inherently unstable and rarely last long before they crash—often with an exchange rate crisis and high or hyper-inflation.

In this final part of the series I will address the belief that the US (and other countries with large budget deficits in their own floating rate currency) faces hyperinflation. Many fear that “Helicopter Ben” (Chairman Bernanke) has pumped so much “money” into the economy that high inflation, if not hyperinflation, will be the inevitable result. This is one of the reasons for the run into gold—supposedly an inflation hedge.

In reality, there is no surer bet than the wager that the US will not experience significant inflation for many years to come.

Let us first deal with the helicopter story. In the aftermath of the financial collapse of 2008, the US government (Fed plus Treasury) spent, lent, or guaranteed to the sum of $29 trillion to save Wall Street. (That, in itself, is the story of the century; but it will have to wait for another day.) What concerns our hyperinflationary hyperventilators is the record increase of bank reserves—created as the Fed lent reserves, purchased toxic waste assets, and bought Treasuries from banks. The Fed makes purchases and lends by crediting banks with reserves (the Fed’s liability) in exchange for an asset (either the bank’s IOU, or the asset sold by the bank to the Fed).

Most of this occurred during QE1 and QE2, undertaken in the Fed’s misguided belief that it could pursue a “quantity target” (increasing reserves) rather than simply a “price target” (low interest rate) to stimulate the economy. (That too is an amazing story of self-deception, to be told another day.) It didn’t work. Now QE3 seems inevitable, and it will not work, either. But in any case, the banks have got a couple of trillion dollars of reserves that they do not need.

The hyperventilators scream hyperinflation! As soon as banks start to lend out those reserves, borrowers will pump up the economy beyond full employment, causing inflation. Worse, banks can lend a multiple of the reserves (the so-called deposit multiplier)—so rather than lending a measly $2 trillion, they might lend $20 trillion or more. That would add trillions to our GDP of about $14 trillion, obviously way beyond the capacity to actually produce goods and services. And all that comes on top of the Federal government’s record budget deficits—and its borrowing. So a debt-fueled spending bubble will make us the next Zimbabwe or Weimar.

Here’s what is wrong with the analysis. First, it misunderstands the relation between bank reserves and lending. Second, it misunderstands the economic situation.

Banks do not lend reserves. Indeed, they cannot—there is no balance sheet operation that allows banks to lend reserves to anyone except to another bank that has an account at the Fed. The reason is quite simple: reserves are an entry on the balance sheet of the Fed. When a bank lends reserves, the Fed debits that bank’s account and credits another bank’s account. You and I do not have accounts at the Fed. No bank can lend reserves to us. Period.

What do banks actually lend? Their own IOUs. Let us say that you are credit worthy (maybe a stretch, given the state of the economy—perhaps like many Americans you’ve lost your job and are delinquent in your house payments). You go to your bank and ask for a loan—for a car, a boat, a house, a TV. You provide your IOU to the bank (promising to make payments) and the bank provides you with a check (its IOU) that you hand over to the seller. The seller deposits the check and gets a credit to a demand deposit. (If it is a different bank, there is a clearing of accounts using reserves—we’ll get back to that.) In other words, banks make loans by crediting demand deposits—which are the IOUs of banks. As we MMTers say “loans make deposits”.

(When you repay a loan, the deposits are debited, or “destroyed”. You write a check, the bank debits your demand deposit and your IOU to the bank is simultaneously debited. The process is the reverse of bank lending.)

So to be clear: banks create demand deposits when they make loans; they do not lend reserves.

Now, what about check clearing? When a bank gets a check from another bank, it credits a demand deposit and sends the check to the Fed for clearing; the Fed credits that bank’s reserves and debits the reserves of the bank on which the check was written. The reserves “move” from one bank to another. Again, no reserves have escaped into the economy—they are all safely locked up at the Fed. They cannot get out except through ATM machines, in the form of cash. When you make a withdrawal of cash from your demand deposit, your bank debits your account and the Fed debits the bank’s reserves. Of course, you could just have well spent using a demand deposit—you took out the cash for convenience (perhaps to finance illegal purchases?).

The only other way that reserves disappear is when the banks buy Treasuries from the Fed or from the Treasury—they essentially “pay for” Treasuries using reserves. That is the end of the story of reserves. Except for cash withdrawals or purchases of Treasuries, they stay locked up at the Fed.

What about Helicopter Ben? When the Fed bought all that junk as well as Treasuries from banks, Ben had the Fed credit their reserves. The Fed also changed its practice and began to pay interest on reserves—25 basis points. So effectively reserves became indistinguishable from Treasuries—they are government IOUs that pay interest. Banks can choose to hold a Treasury that pays interest, or reserves that pay interest—it is a portfolio choice. One has a maturity (maybe as short as 30 days), so it is like a time deposit, and the other has zero maturity so it is like a checkable deposit. But since the market for Treasuries is highly developed and liquid, banks have no problem moving from their “time deposits” (Treasuries) to their “demand deposits” (reserves). (No substantial penalty for early “withdrawal”!)

The main case for hyperinflation rests on the misguided belief that banks are for some reason more willing to pump up lending when they hold “demand deposits” rather than “time deposits”. Clearly they do not lend either one. They use reserves (“demand deposits”) for clearing with other banks, and for ATM withdrawals. But Treasuries (“time deposits”) serve just as well—banks can always borrow reserves from other banks or from the Fed, using Treasuries as collateral (and they’ve got other assets that also serve as collateral except in a run to liquidity).

Indeed, banks do not need either reserves or Treasuries in order to lend. Recall they lend their own IOUs. If they then find they need reserves for clearing (or, later, to meet required reserve ratios), they borrow them from other banks (fed funds market) or from the Fed (discount window), or they sell assets to obtain them.

Turning to the state of the economy, except for the final stages of the speculative boom in commodities (that will surely end soon) there are no significant inflation pressures. Fourteen million people are looking for jobs. Even the most rosy projections see high unemployment for years. As Eric Tymoigne has demonstrated, at the current pace of “recovery” we will not get back to the employment levels of January 2008 before 2017—and meanwhile the potential labor force will have added millions of high school and college graduates as well as immigrants.

And the US is in relatively good shape—compared with Euroland and Japan. Further, all the recent evidence for the US shows a “double-dip” is underway. I expect resumption of the financial crisis any day (the lawsuits against the biggest banksters will help hasten that). Even the Chinese economy is slowing—which could increase their efforts to produce competitive exports.

Just where are all those borrowers who are willing and able to borrow the $2 trillion or $20 trillion that hyperventilators believe banks want to lend? The US private sector (firms and households) have instead ramped up their net savings—they are not borrowing, they are not even spending their diminished income. They are scared. They are (rationally) tightening belts, paying down debt, and accumulating claims on government and banks.

In short, the prospects for inflation have not been smaller since 1930.

  1. Edward Harrison says

    Note, Wray means a sustained increase in the consumer price level when he refers to inflation. The prospects for this are swamped by the deflationary forces of excess private sector debt.

  2. David Lazarus says

    He is right that the public do not want to borrow. The problem is that they realise assets look vulnerable. Even if they hope that they can make money on real estate. They are more concerned with wealth retention rather than gains right now. So in reality while the public understand the problem the central bankers do not. They are wondering why all their magic bullets have not got the confidence fairy buying houses with more debt.

    Like L. Randall Wray I also fully expect a massive financial crisis. It might be triggered by a Greek sovereign default but it will be credit default swaps that will lay waste to the US banking sector. The inability to pay those bets might wipe out other banks. The sums involved will be too great for governments to getaway with imposing on the tax payers again, after all this was supposed to have been fixed at the last bailout. Then eventually some bank reform will be possible. Though I suspect that the corrupt nature of US politics will mean that they do bail out the banks again.

  3. fresno dan says

    “In reality, there is no surer bet than the wager that the US will not experience significant inflation for many years to come.”


    I like the caveat “significant”
    Being a “Federale” with no wage increase for the next couple of years, what the heck, my purchasing power being reduced by 6, 8, or 10% – hey, it will all get lost in the aggregate.
    Of course, I consider myself very, very lucky, because many of my friends have no only not gotten any inflation adjustments for years, they have been downsized and their replacement jobs have cut their incomes by 50%.
    But go on thinking like an economist – GDP is increasing and never question why GDP is never reported on a per capita basis…

    1. David Lazarus says

      The whole policy of the UK and the US is to become competitive through fiscal drag. Years of lowering living standards this way is less apparent than an equivalent tax hike. The debt burden also is reduced with higher inflation, which is good for nominal asset prices in that they stabilise, but real prices are falling. I doubt that this will change in the US whoever the president is.

    2. Edward Harrison says

      Right, the caveat significant is the one that bears marking. Also remember that Randy isn’t talking about asset prices as that is the only way inflation is passing through to consumer goods right now i.e. via commodity prices. I think the right way to look at it is to realise that the Fed can QE all it wants, unless people are making more money, the huge household sector debt burden is going to keep them from spending – and that’s going to keep a lid on consumer price inflation. Likely, we will see deflation before we see high levels of consumer price inflation.

  4. David Lazarus says

    Longer term I totally support the deflationary scenario. Assets of all classes are spectacularly overvalued. Only today I ready one comment re a collapse of the Dow to 7000,

    I am even more pessimistic and think 6000 is possible. Much of that will be take up by a collapse in PE ratios. Single digit PE will become the norm.

    Yes but asset inflation is the Feds target, because otherwise banks will go underwater. All the banks are still over leveraged and undercapitalised if house prices collapsed. The fact that a lot of the QE has impacted commodity prices and is now feeding through to consumer prices is unintended. While it does boost inflation it also sows the seeds for the next collapse. As consumers incomes are squeezed even further it will make family budgets even less sustainable. Eventually household bills plus mortgage trigger another wave of defaults.

  5. steve says

    From listening to my grandfather talk about the depression, my expectation is that all the little luxuries people don’t really need will be cheap, while everything absolutely necessary to sustain life will be expensive. But at least in the aggregate, there will be no inflation.

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