By Brendan Brown*
Inflations have a built-in mechanism that works to burn them.
The government (including the central bank) can thwart the mechanism if it resorts to sufficiently powerful new monetary injections.
Thus, inflations can last for a long time and in a virulent form. This happens when money issuers see a clear benefit in making further monetary injections, even if they are likely to be less than the first one that took so many people by surprise.
Ultimately, at some point, the cost-benefit calculation tips in favor of the government not blocking the operation of the burnout mechanism.
Let’s try to figure out what pattern of burnout the inflation of the Great Pandemic in the United States will follow.
Our discovery process begins with Milton Friedman’s observation of the nature of the “inflation gap”. Paraphrasing this, we can say that monetary inflation occurs when the supply of money consistently exceeds the demand for money. Ideally, this comparison is to base money (rather than broad money).
This gap between supply and demand is always in the future. Like the mirage on a hot road, when we come to where we saw the gap, it’s gone. Prices have adjusted upward (and perhaps other economic variables have shifted) so as to bring the demand for money in nominal terms in line with the initial increase in supply.
In the meantime, however, the issuer has injected new money supply. And so the gap is still there when we look ahead (along the inflation highway).
We can think of the depletion mechanism as a rise in prices (and a possible oscillation of other variables) that keeps the demand for money (in nominal terms) rising as the supply increases. The essence of the burnout mechanism is the destruction of real wealth in the form of money (and government bonds) by rising prices. These losses of wealth and the need to rebuild monetary assets in real terms weigh to some extent on demand in the markets for goods and services.
The monetary history laboratory sheds some light here.
Let us first take the extreme case of German hyperinflation. The government in Berlin, desperate for funds, kept pumping in money even as the depletion mechanism worked. In real terms, the revenue gains for the government became smaller and smaller as individuals replaced mark money with dollars. Eventually the gains from the new injections were so small and the social and political costs so great that they ceased.
Fast forward to the monetary inflation of World War II. From 1946 to 1948, the Fed made no new monetary injections (constant monetary base) despite galloping prices due to the excess money created during the war. A very mild recession in 1948 and the vast decline in military spending that had occurred meant that the government/Fed had no incentive to make further injections as consumer prices plateaued after their sharp rise. Nominal yields on long-term Treasury bills remained close to 2% throughout the period.
It was quite different in America’s “greatest peacetime inflation” from the early/mid-1960s to the late 1970s. Then the Fed repeatedly responded to inflation exhaustion by new injections; think of 1967-1968; 1970–72; 1975–77; and yes, 1980.
Each injection during the greatest monetary inflation had its own distinct cost-benefit analysis. In 67/8, a priority was to contain the cost of government borrowing amid the Vietnam War; in 70/72 Chair Burns was a leading member of Richard Nixon’s re-election campaign; later in 75/7, its aim was to promote recovery in the context of a difficult election to come for the Republicans (1976); in 1980 there was an impending election and fear of recession.
Two overriding comments apply to these continued injections through the greatest peacetime inflation.
First, the injectors (the Fed and the Administration’s economic team more broadly) have consistently overestimated the severity of the economic slowdown that seemed to be looming. Given all the revisions to the data since analyst today would find it hard to use the term severe recession or even recession at all in some cases with respect to episodes of economic weakness in the 1970s, 1974- 1975 or 1980. Yet, at the time, injectors saw the current data as justification for interfering with the burn-out mechanism.
Second, a whole Keynesian/neo-Keynesian mythology has grown up about how high and rising inflation expectations were the challenge that kept the monetary authority from allowing “natural” exhaustion to occur. However, it is difficult to substantiate such an assertion. In the counterfactual of the Fed resolutely refusing to reinject, expectations would surely have fallen.
Moving forward to today, Spring 2020, is the Fed finally allowing the burnout mechanism to work, having consummated its “warmongering trick?”.
A key issue in answering this question is how to estimate in an unanchored monetary system what burnout occurs. How to measure the demand for money in a system that has become so distorted?
Examples of such distortions include bank reserves, an important component of base money, paying interest and above the market rate. The base currency has lost much of its special qualities in an environment where banks or individuals have confidence in providing liquidity, whether in the form of “too big to fail”, “lender of last jurisdiction” or “deposit insurance”.
Without any specifics, we can say that substantial monetary inflation has emerged during the pandemic, with the prices of goods and services surely rising more than could be explained by supply shortages and disruptions such as they are. would produce under sound monetary regimes. But by how much?
Whatever the unmeasurable inflation gap, the nearly 8% rise in consumer prices over the past year has certainly helped to narrow it as we get closer to where we had it. initially seen on the inflation highway.
Chief Powell is now telling us that he has no intention of adjusting to inflation. For this senior monetary bureaucrat and his colleagues, that means projecting a series of hikes for the federal funds rate that looks impressive, either in frequency or cumulative size. No one, of course, has any idea how interest rates would move in the counterfactual case of just letting exhaustion occur and no further monetary injection.
It is therefore far too early for a sober and rational commentator to announce that the mechanism of burnout is now working soundly and will achieve its goal. And yes, it is possible that the Fed will at some point (erroneously amidst the general fog) limit the money supply such that it lags behind the demand for money, which means a period of deflation monetary.
It is difficult to make a diagnosis of the monetary inflation gap based solely on contemporary CPI inflation readings or by taking the speculative temperature of asset markets.
Notably, distortions in price signals in the asset market caused by monetary inflation can persist well beyond the closing of the inflation gap – as was the case during the crash of 1929 and 2008.
This writer’s central storyline is that the theater of pandemic monetary inflation still has several acts before its finale.
One would feature the apparent onset of recession and asset deflation to which the Fed eventually responds with further inflationary injections of money. And even though there is an inflationary curse on all fiat currencies, an act titled Runaway Dollar will most likely enter the program before this monetary theater season is over.
*About the author: Brendan Brown is a founding partner of Macro Hedge Advisors (macrohedgeadvisors.com) and senior researcher at the Hudson Institute. As an international monetary and financial economist, consultant and author, he was notably responsible for economic research at Mitsubishi UFJ Financial Group. He is also a Senior Fellow of the Mises Institute. He is the author of Europe’s Century of Crises Under Dollar Hegemony: A Dialogue on the Global Tyranny of Bad Money with Philippe Simonnot. His other books include The Arguments Against 2% Inflation (Palgrave, 2018) and he is the editor of “Monetary Scenarios”, Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution.
Source: This article was published by the MISES Institute