In response to the last column Janet Yellen’s excuses for not raising interest rates will keep coming a reader wrote in asking why all the money printing that has happened since September 2008 in the aftermath of the financial crisis, hasn’t led to inflation.
In this column I try and answer that question. Economist John Mauldin estimates that central banks have printed $7-8 trillion since the start of the financial crisis. In another estimate, author and financial derivatives expert Satyajit Das points out balance sheets of the major central banks have expanded from around $5 trillion prior to 2007–2008 to over $18 trillion.
The central banks printed this money (or rather created it digitally through a computer entry) and used it to buy government and private bonds and this has led to the expansion of their balance sheets. In fact, the amount of money pumped into the financial systems of the developing countries has been so huge that it would be suffice to purchase a large flat-screen TV for every single individual in the world, points out Das.
By buying bonds, central banks pumped the printed money into the financial system. This was done primarily to ensure that with so much money floating around, the interest rates would continue to remain low. At low interest rates people would borrow and spend. This would help businesses grow and in turn help the moribund economies of the developing countries.
But money printing should have led to inflation as a greater amount of money chased the same amount of goods and services. Milton Friedman, the most famous economist of the second half of the twentieth century, wrote in Money Mischief – Episodes in Monetary History: “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation…Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.”
Nevertheless that did not happen. Inflation remains very close to 0% in large parts of the developed world. Why is that the case? Japanese economist Richard Koo perhaps has an answer. Koo calls the current state of affairs in the United States as well as Europe a balance-sheet recession. Japan had seen a huge real estate as well as stock market bubble in the 1980s. In fact, such was the confidence in the high home prices continuing that by the end of the 1980s Japanese home buyers were even taking out 100-year home loans or mortgages.
As Stephen D. King writes in When the Money Runs Out: “By the end of 1980s, it was not unusual to find Japanese home buyers taking out 100-year mortgages, happy, it seems, to pass the burden on to their children and even their grandchildren. Creditors, meanwhile, naturally assumed the next generation would repay even if, in some cases, the offspring were not more than a twinkle in their parents’ eyes. Why worry? After all, land prices, it seemed, only went up.”
That did not turn out to be the case. The stock market bubble started bursting in December 1989, and the real estate bubble followed. Koo feels the current Western situation is very similar to that seen in Japan in 1990, when both the stock market bubble and the real estate bubble had burst.
What does this imply in the current scheme of things? People in the developed world had taken on huge loans to buy homes in the hope that prices would continue to go up in perpetuity. But that wasn’t to be. Once the bubble burst, housing prices crashed. This meant the asset (i.e., homes) people had bought by taking on loans had lost value, but the value of the loans continued to remain the same. Hence, people needed to repair their individual balance sheets by increasing savings and paying back debt. This act of deleveraging, or reducing debt, brought down aggregate demand and threw the economies in the developed countries into a balance-sheet recession.
A similar thing happened in Japan as well in the 1990s. In the aftermath of the bubbles bursting the Japanese carried out quantitative easing where they bought bonds in the hope of maintaining low interest rates, so that people would borrow and spend. Nevertheless, that did not happen because people were busy paying off their old loans.
A similar dynamic is at play in the developed countries at this point of time. Hence, people are not borrowing and spending at the same rate as they are expected to, because they are busy paying off old loans. As Tim Harford explains in The Undercover Economist Strikes Back: “Printing money creates inflation only if people want to spend the money right away. And perhaps they don’t.”
While, there has been no inflation in the conventional sense of the term, what the world is seeing instead is asset price inflation. A lot of the printed money has been borrowed at very low interest rates by institutional investors and has found its way into financial markets all over the world.
Other than this money briefly went into gold and then into other physical assets as well. As Gary Dugan of RBS told me in an interview sometime back: “Gold went up as much as it did in its last wave. If you look at Sotheby’s and Christie’s, in the art market, they are doing extremely well. The same is true about the property market. Places which are in the middle of a jungle in Africa, there prices have gone upto $100,000 an acre. Why? There is no communication. No power lines.”
This explains why there is no inflation but there is asset price inflation for sure. To conclude, it is important to understand something that Harford writes: “The Federal Reserve(and other central banks) spent decades … acquiring a reputation for waging a ruthless, unending war against inflation. That reputation is so powerful and so valuable that people naturally wonder whether the Federal Reserve really would encourage inflation once the slump ended. The trouble is that if people don’t believe that threat, they won’t start spending and the slump will continue.”
The column originally appeared on The Daily Reckoning on Mar 24, 2015