google blogger on Saturday, May 28, 2011
And because "Stimulus" spending does not involve the creation of new money, it is probably not inflationary. It may raise the demand for money because of its temporarily higher "velocity," but should have no real inflationary effect. It simply moves assets from very productive people to others who are probably much less efficient, who will produce something that no one really wants.
Fed spending (quantitative easing) is certainly inflationary, and creates misallocation of resources, but bank lending (also a method for creating new currency) is also probably not inflationary, even at reduced interest rates, because each loan effectively trades ownership of a real asset (like a home) for new assets called dollars.
Because the process of issuing a bank loan effectively shifts ownership of the house to the new dollars, and those new dollars can always be traded for the house that the bank used as collateral (by paying off the loan with dollars), the new dollars generated by new bank loans are unlikely to be inflationary. Bank loans create new money that matches real assets. QE on the other hand, is inflationary because it does not match assets up for sale in the real world. The Fed simply spends new money and holds what it buys on its balance sheet, away from the market, which is a completely different process than taking a house as collateral and issuing new currency to match its value. The bank loan process creates money that chases existing assets in tandem. Fed spending increases the money supply relative to existing assets.
A bank loan can always be paid off with inflated dollars to acquire real assets, but the assets that the Fed holds on its balance sheet cannot be accessed by anyone. Because of this, the dollars the Fed spends are chasing assets that are no longer available for purchase, and this is inflationary.
With this understanding, low interest rates on bank loans can be regarded as a genuine discount on the process of currency creation. Banks are offering a sale, which does not create misallocation of resources. When a bank issues a bank loan with new dollars, it is effectively taking the house in exchange for its new dollars printed from thin air, and loaning the house (that it owns via the collateral agreement) back to the "homeowner," at a certain rate, which we look at in the wrong way. We see it as the bank loaning dollars at interest. More accurate would be that it is loaning the use of its asset, the house, for a fee.
"Stimulus" spending does create misallocation, because it moves wealth from productive people (successful businesses who are taxed) to other, probably less productive people (government contractors), making things that people probably don't want. But stimulus spending is not inflationary either; it creates no new dollars. It may increase the "velocity of money," which will create a temporary amount of inflation and a subsequent deflation when all the spending stops (higher amounts of trade raise demand for a medium of exchange), but no long term change will occur in the value of the currency.
One caveat is that the Fed will not print and spend new dollars unless it feels that the dollar is deflating (rising in value). The only purpose of QE is to correct a movement in the value of dollars. Similarly, if inflation slips too high, it will liquidate some of its balance sheet, selling treasuries or MBS on the open market for dollars, and destroying the dollars it receives. We hear a lot of complaining about QE, but not so much as a peep when the Fed does the opposite. This is quite strange, and seems to indicate that either people are not thinking clearly about why the Fed does anything, or they believe The Bernanke when he babbles on TV. The Fed's business is the creation of currency. It happens to hold a government enforced monopoly on the business in the United States, but it still does its job fairly well. The only difference is that it makes more money than it would with other banks competing in the same business.
The Fed still has every incentive to avoid rampant inflation or deflation, for two reasons. If it allows high inflation to happen, it ruins the profit generated by its bank loans, many of which are 30 year contracts. If people are paying back loans with worthless dollars, member banks are not making much money. Ultimately, this is not an issue, because member banks all own part of the Fed's balance sheet. But the problem is still there on the face of it. Inflation lowers the profit generated by long term loans, because the loans were signed with a set amount of expected inflation.
Second, if it allows rampant deflation, the economy grinds to a halt because people have more of an incentive to hoard dollars and are now forced to pay back dollars that are worth more than expected. So the incentive to save is raised, trade is reduced because people are less willing to part with dollars and use them as a medium of exchange, and anyone with a long term bank loan is becoming poorer by being forced to repay dollars with more value than expected. Paying off loans early (deleveraging) exacerbates the problem and removes more dollars from circulation. And deflation ultimately hurts the Fed and its member banks by reducing the amount of wealth being generated by the citizens of the United States. If people are generating less wealth, banks have less business. For these reasons they desperately try to keep the dollar stable, and have been fairly good at keeping inflation between two and five percent since it was freed from its gold-standard shackles around 1970.
The Fed realizes that a small amount of predictable inflation is best for their business. They get no deflation, constant growth, and the losses from inflation are not ultimately damaging to them. The only losers with a small and consistent amount of inflation are people with no bank loans who hold cash. (This is one way that the Fed "steals" from the poor, who mostly hold no loans and most of their wealth in cash.) There is no reason to suspect that the Fed will fail to keep inflation in its "zone of reasonableness" at this point. It has the power to keep inflation where it wants.
The gold standard is a topic for another day. Its removal was a huge plus both for the Fed and the United States, because it gave the Fed much greater freedom to control the value of the dollar without worrying about both the supply of dollars relative to assets, but also the value of gold relative to assets. The dual standard, which allowed dollars to be converted to gold and the homes or cars held as collateral, created a nightmare for the Fed. Freeing it from the government imposed obligation to redeem in gold and its collateral assets at a fixed rate created huge headaches, and huge swings in the value of the dollar. If you take a look at the stability of the dollar post 1970, there is no deflation and after a few years the dollar stabilized at 2-5% inflation for the last 20 years or so.
Posted by google blogger at 3:29 AM