Scott Sumner  

The invisible hyperinflation monster (it's real)

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There's an invisible hyperinflation monster lurking right around the corner, which lots of people are having trouble seeing. (And no, this is not a sarcastic barb aimed at conservatives who were wrong about QE and inflation, it's aimed at people who were right, but don't fully understand why they were right.)

Recently I've seen more and more people suggest that the US could simply monetize the debt, by printing money. They point to the fact that the Fed has done lots of QE, and yet inflation remains below 2%. So why not go all the way?

First let's be clear what it means to monetize the debt. Here's what it does not mean:

1. It does not mean replacing interest-bearing Treasury bonds with bank deposits at the Fed, which pay an equivalent interest rate. That accomplishes nothing. You need to replace interest-bearing debt with non-interest-bearing money.

2. It also doesn't mean buying back the debt only so long as interest rates are zero, but immediately selling the debt off at the slightest sign of higher interest rates, to prevent hyperinflation. That accomplishes nothing.

If you seriously want to monetize the debt, you'd have to buy back the debt held by the public, with newly issued base money. There are two data points that suggest this will lead to hyperinflation:

1. Currency in circulation is about 8% of GDP
2. Treasury debt held by the public is about 80% of GDP

My claim is that if the Fed suddenly monetized the entire debt, and indicated that this action was permanent, the following would occur:

1. In the very short run, the monetary base would balloon to 80% of GDP, mostly excess bank reserves.

2. Within days, the excess reserves would leave the banking system, and become part of the currency in circulation. The base would now be more than 95% currency.

3. Within a year NGDP would grow at least 10 fold, so that currency fell from 80% to no more than 8% of GDP. Indeed the increase would probably be even larger, and the currency stock would probably fall to well below 8% of GDP. That's because during hyperinflation, velocity also tends to increase.

4. RGDP would show relatively little change; the price level would increase at least 10 fold.

If I am right, then why haven't the relatively large increases in the base under QE led to large increases in the price level?

One answer is that the Fed is paying interest on reserves, so they aren't actually monetizing the debt. That's true, but it's quite possible that the QE program would have created relatively little inflation even in the absence of IOR, as we saw in America in the 1930s, and more recently in Japan and Europe.

The better argument is that temporary currency injections are not very inflationary. By temporary, I mean for as long as interest rates stay near zero. But once rates rise above zero, banks don't want to hold excess reserves, and all those reserves would flow out into currency in circulation. And that's highly inflationary.

Why do I think this would happen so rapidly? Consider the case where the market thought there was only a 3% chance that my theory was correct. In that case the expected price level in 2017 would not be 1000% higher, but rather a mere 30% higher than this year's price level. But even 30% expected inflation is really high! It's so high that banks would not want to hold onto non-interest-bearing reserves that were rapidly losing purchasing power. As the banks got rid of this "hot potato" the price level would begin soaring, just as I predicted. In other words, there's no stable equilibrium between 1% inflation and more than 1000% inflation. Anything in between would imply the public is willing to hold implausibly large cash balances (as a share of GDP), despite relatively high expected inflation.

Thus QE is only compatible with very low inflation if the public believes there is only an infinitesimal chance that the QE is permanent. Because the actual QE has not resulted in high inflation, we know that the public has a very high level of confidence that the QE is not permanent (or that if permanent, interest will be paid on the excess reserves.)

So there really is an invisible inflation monster, lurking around the corner. The reason we never see it is because the Fed is sensible enough to not walk around the corner. They have the good sense not to print zero interest money to pay off the debt, and make the money supply increase permanent. You may not see the invisible hyperinflation monster but trust me; the monster is there. If the Fed did what some people recommend we'd see his ugly face almost immediately. And it would not be a pretty sight.

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COMMENTS (8 to date)
Ben Kennedy writes:

"But once rates rise above zero, banks don't want to hold excess reserves, and all those reserves would flow out into currency in circulation. And that's highly inflationary."

How does this happen? Through bank loans to consumers? Or, the banks directly buying stuff? I don't understand how banks would get rid of excess reserves

Britonomist writes:
My claim is that if the Fed suddenly monetized the entire debt, and indicated that this action was permanent, [hyperinflation] would occur:

Well obviously, but who on earth suggests monetizing the entire US debt?

Within days, the excess reserves would leave the banking system, and become part of the currency in circulation ... But once rates rise above zero, banks don't want to hold excess reserves, and all those reserves would flow out into currency in circulation. ... As the banks got rid of this "hot potato"

It makes sense that banks would want to hold less excess reserves as rates rise, but it doesn't follow that they'd just convert it to cash and it would go out into circulation. At least, you haven't explained the mechanism there. Banks can't just magically make more cash enter circulation. They can convert the reserves into cash, yes, but what are they going to do with it? If banks really want to get rid of excess reserves, they expand credit until they become required reserves. But there's no clear reason they would do this, banks make loans when they can reasonably expect a return from them, but banks can only lend so much - you get a classic stag hunt problem where there are no more profitable loans to be made at the margin because of weak demand. Only if the banking sector as a whole co-ordinated together to all simultaneously boost lending massively would more loans become profitable again, but this is not plausible for game theoretical reasons.

Your other argument is the expectations channel, the public's inflation expectations suddenly surging by 30% would certainly be dangerous. But I can't see that happening as a result of any measures realistically proposed by anyone (nobody proposes monetizing the entire US debt).

Paul writes:

this one is a head-scratcher.

how likely is it that most of the new deposits created from the debt purchase would be used to buy goods and services? isn't it reasonable to assume that folks who own treasuries don't want to hold money? if they are compelled to sell their treasuries, aren't they more likely to purchase another asset?

and why would banks convert their excess reserves into cash? they can use reserves to acquire other assets, no?

Marcus writes:

Ben,
Scott is talking about inflation expectations translating into increased aggregate demand - more demand for loans.

Paul,
they don't need to be "compelled" to sell their treasuries; at 30% inflation expectations, no one would want to hold the old bonds OR cash, so they'll be happy to swap their old bonds for cash in order to make other purchases (besides, the government can always purchase its bonds back at face value, so no reason for people not to sell). Yes, much of the new cash flow will likely take the form of inflating asset prices, but in doing so will have provided someone else with income: the hot potato. Increased income, more spending on goods and services.

Britonomist,
yes, banks do not decide the cash/demand-deposit ratio, the public does. I'm not entirely sure what Scott's reasoning is that rising inflation expectations would make the public's demand for cash increase immediately, but once actual prices did start to rise, the public's demand for cash would also rise mighty fast.

Benjamin Cole writes:

I dunno Scott. I think you are flogging a dead horse on this one.

Japan actually did money-financed fiscal programs in the 1930s, to good effect (see my comments over at Money Illusion). Even after the militarists took over and seized the money presses, to finance war efforts, inflation barely got into double digits.

David Beckworth says just the opposite of you, and that the Fed should make clear QE is permanent!

"Thus QE is only compatible with very low inflation if the public believes there is only an infinitesimal chance that the QE is permanent. Because the actual QE has not resulted in high inflation, we know that the public has a very high level of confidence that the QE is not permanent (or that if permanent, interest will be paid on the excess reserves.)"--Scott Sumner.

What minute fraction of the American public even knows what is QE?

If what you say it true, we should have runaway inflation now!

Certainly, many must surmise the Fed will never shrink its balance sheet. Certainly I do NOT think there is an "infinitesimal chance" QE is temporary. I think there is a fair chance the Fed's balance sheet will have to grow in the years ahead. The BoJ's balance sheet is growing continuously!

If I think Fed QE is permanent, does that cause rampant inflation? What if 100 people think this? One million? Given the mass ignorance of QE, this is a fascinating question.

The think Lord Adair Turner is on the right track. MFFP but using some sort of rules. Like Taylor Rules for MFFP.

Scott, something is not right here....


Laidler's Ghost writes:

The dramatic size of Scott's monster seems to hinge on the idea that the debt is bought back using pure currency (dollar bills), and that the whole monetary system and NGNP then expand in proportion (10x).

Surely the relevant point is that the buyback is done using checks, and so it expands the much larger broad money supply (M2) held by individuals by a correspondingly much smaller proportion (roughly 2x)? There is still a 'hot potato' effect as the individuals get rid of their 'excess' money, and so there is still a very big inflation beast, but it is not as big as Scott thinks.

johnny ventis writes:

Inflation is more of a never ending circle loop that never ends as money comes out of some assets and moves into others in an endless circular cycle. Inflation never goes down. Money flows from housing to gold, from gold into equities, and equities into housing. There also is bonds in the equation, but the main aspect to remember, is that inflation never ceases. This is why the price of your current car will be what your grandchildren will pay for groceries. This is also why your grandparents paid 10 cents a gallon for gas. Inflation never goes down, but what the FED and the government measures inside of their inflation model is not the entire spectrum. Also, the contents inside of the inflation model sometimes change, like rules or laws. It can go up rapidly, but it never goes down over long period of times. This is why the stock market never goes down over long period of times, because inflation never stops!

Marcus writes:

Laidler's Ghost,
it shouldn't matter whether or not the new money injected is kept as cash or in a deposit account - it's still adding to base money. If anything, one could conceptually imagine that keeping it in the deposit banking system as opposed to physical cash would be even more inflationary, as it can be theoretically multiplied through deposit banking in a way that physical cash (in the long run) cannot. Although I think that sort of misses the point.

Also, if I am not mistaken, checking accounts are initially aggregated as part of M1, not M2. So even if you want to use M2 as a useful metric for predicting inflation, you still have to consider that.

Benjamin Cole,
I think in our current (approximately) full-employment environment, the important factor is the banks, not the public. Bank lending strategies are currently constrained by the implicit understanding of the Fed's long-term policy. If any individual bank were to start lending at current rates, then if other banks were to follow, sparking even a small amount of excessive inflation (from the Fed's perspective), it is understood that the Fed will contract and pull interest rates up mighty fast, screwing anyone who chose to lend in the previous environment. So the broader public's understanding really isn't relevant, it's about the banks.

Besides that, if you've ever tried to talk to the average person about monetary policy, it's clear that they believe in the absolute neutrality of money - and typically in the short run, not just the long run. They believe it intuitively, and their intuition may be false or for the wrong reasons, but they still believe it. For better or for worse, people like Paul Krugman have been fighting that attitude for the last 8 years, with little success. It doesn't take much for people to come to the conclusion that government not paying its bills -> debasement of the currency, even if the mechanism in their mind through which that happens is inherently flawed.

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