Don’t Like “Money Printing”? Then Stop Borrowing. Whip Inflation Now!

April 12th, 2011

Cross-posted at Angry Bear.

There’s a widespread conception that “money printing” by the government causes inflation, and that “money printing” = government deficit spending.

But people don’t realize that:

1. Most money “printing” is done by banks, not government.

2. Government deficit spending is only one of four flows that affect inflation.

Here’s how borrowing prints money:

You borrow $10 from the bank. You give them nothing more than an IOU, and they credit your account for $10, created out of thin air. Voila! Money printing.

That’s the essence, but in practice it’s a bit more complicated. The bank is required (by their charter) to hold reserves (money) on deposit in their account at the Fed to “cover” that loan. But — ah, the beauty of fractional-reserve banking — they only need one extra dollar in their reserve account to cover the ten-dollar loan.

Where do they get the dollar? They sell $1 in treasury bonds (also, originally, created out of thin air) to the Fed. The Fed credits the bank’s reserve account with $1, and adds a $1 Treasury IOU to the Fed’s assets. (This is also more complicated in practice, but that’s the essence.)

Meanwhile you’ve got $10 to spend.

So yeah — there’s government debt involved, but of the ten dollars that were printed in this transaction, the Treasury/Fed printed one, and your private bank printed nine.

(For more on this, which I’ll call the Demand-Side Theory of Money Creation, see my key inspirations for this post here, here, and here.)

So if you don’t like money-printing, (sell your financial assets, and) pay off your loans. It’s the best way to destroy money.

Whip Inflation Now!

I hope my gentle readers will understand that this last is somewhat facetious. The relationship between inflation and the stock of money is tenuous at best. What drives inflation (pace some of my assertions here) is flows, not stocks. In particular, flows relative to production capacity.

This is actually remarkably simple and intuitive, even “obvious,” based on straightforward supply and demand.

If the national demand for goods is less than the real economy’s capacity to supply goods (think: 1930s), the value of the goods (in dollars) goes down, and the value of dollars goes up — deflation. If demand exceeds supply capacity (or gets close), it’s the reverse: dollars get less valuable (buy less goods) — inflation.

Now: where does that demand-flow come from? Four places*:

1. Income: personal income (not including capital gains) and real (non-financial) corporate profits. (Some of the corporate profits flow to personal income via dividends and interest payments — perhaps indirectly, because they’re paid to other corporations which book them as financial profits; they can then, perhaps after several such steps, flow to individuals.)

2. Increases (decreases) in prices of financial assets, a.k.a. financial capital gains (losses). Think: the “wealth effect.”

3. Credit issuance — new money available for spending (debt payoffs reduce demand).

4. Government deficit spending. (When the government runs a surplus, net demand is reduced.)

So yes: when you pay off debt you’re helping to control inflation — but not really because you’re reducing the stock of money (though you are doing that); rather, because you’re reducing the flow (you’re saving rather than spending), hence reducing the demand for real-economy goods and services.

Now of course you gotta question whether cutting inflation is what we want right now. I’m here to say that we’d all be a lot better off — even rich people, in the long run — if inflation were running at three or four percent.

More on that anon, and on those four flows and their relationship to inflation (etc.).

* This has a somewhat complicated relationship to Fed asset purchases. Especially when the Fed buys a lot of extra assets — paying banks by crediting their reserve accounts, resulting in excess bank reserve balances and nominally increased money supply (think: TARP, QE I and II), it at least momentarily drives up the prices of those assets by increasing demand (see #2, above). Those prices — and prices of financial securities in general — will presumably decline whenever it unloads those assets, both increasing supply and sucking money out of the financial system. That effect aside, these purchases only increase demand if the banks A. lend more based on their increased reserves (#3, above), B. use the money to buy other financial assets, driving up the prices of those assets (#2; again, zero-sum long-term), or C. spend money the wouldn’t otherwise have spent on real-economy goods and services (especially if the wouldn’t ever have spent it, even long-term). In fact, most of those excess reserves (about $1 trillion — circa 20x required reserves, up from almost zero pre-crisis) are just sitting in the banks’ accounts at the Fed, earning .25% interest. Big asset purchases by the Fed can also, of course, have an even-more-complicated short-term impact on #3, credit issuance, via interest-rate shifts. Based on this data suggesting low demand for credit and relative indifference of borrowers to small interest-rate moves, at least in the current climate that impact seems to by relatively small.

  1. April 12th, 2011 at 20:01 | #1

    “The bank is required (by their charter) to hold reserves (money) on deposit in their account at the Fed to “cover” that loan. ”

    Huh. I had been taught that banks were required to hold reserves to cover their demand deposits – that is, their liabilities. Not their loans (aka assets). So that when I walk up and demand the money in my checking account, they will have enough to cover it. And that the amount of reserves that the Fed required then affected the money supply (back in the day when the Fed worried about, and tried to influence, some measure of the money supply).

    Is all of that now old school? The reserves now are to cover the loans? What does that mean? If I borrow money from the bank, I owe them – not the other way around. What are the reserves covering?

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