Debt does not cause inflation part II
May 21, 2006
We are, actually, in an inflationary situation at present, and everyone can feel it at least a little bit. Like the time/space continuum is being warped. Actually, money itself is being warped, more than a little bit, and since money is the “time/space continuum” of finance and economies in general, the metaphor is fairly accurate.
This sort of environment gets people excited, and they tend to say silly things. I lapse into mini-rants about hyperinflation myself from time to time, like a number of other normally cool-headed characters like Marc Faber, although none of us have much evidence to point to that such a thing will happen. I wonder if it is a premonition.
Anyway, one of the notions getting kicked around rather too much today is that this inflation stems from “debt creation,” that this debt creation is performed by the Fed, and that Alan Greenspan and now Ben Bernanke are largely responsible.
People, please. Greenspan began his tenure in 1987 with long-term bond yields near 10%, and they went down to under 4% just a little while ago. Does this sound like an inflationary period? During that time, the dollar’s value, in terms of gold, went from about $440/oz. in August 1987 to under $260/oz. a few years ago, before climbing back above $400 just over the past couple years. There were a lot of ups and downs over Greenspan’s time at the Fed, with attendant economic consequences, but the record shows that Greenspan maintained the dollar’s value point-to-point during his tenure, much as a gold standard policy would have done.
What happened to debt creation during that period? Straight up, of course. In January 1987, M1 (mostly bank deposits, i.e. loans to banks) were $737.1B, and M2 (all sorts of bank deposits) were $2,757B. The monetary base (real money) was $225B. At the end of Greenspan’s tenure, January 2006, M1 was $1,377B, M2 was $6,707B, and the monetary base was $792B. Per the Fed’s flow of funds report, total debt outstanding was $9,816B at the end of 1986, and at end-2005 it was $40,229B. Big increases. Inflationary? Not by any reasonable measure.
It should be no big surprise that an economy is capable of growing during a period of stable money. The advantage of stable money is that it makes economic growth easier. As the economy grows, let’s call that nominal GDP, debt would likely grow alongside, at a similar rate. Maybe faster, maybe slower. But similar.
That’s the Greenspan period. Now let’s look at the Bretton Woods period, 1945-1970, before the dollar’s link to gold was severed in 1971, leading to the Great Inflation of the 1970s. This was a genuine gold standard, with the dollar pegged to gold at $35/oz. throughout the period. There were some bobbles, and at times the dollar’s value fell as far as $40/oz., but it was basically a time of stable money. We see that in 1945, there was $355B of outstanding debt, with $251B of that owed by the Federal Government as the result of its financing of World War II. In 1970, that amount had swelled to $1,600B. More than a quadrupling — and a natural phenomenon of 25 prosperous years on the gold standard. M2 was $150B in 1945 and $627B in 1970.
Now let’s go back to the period 1880-1930. The dollar floated during the Civil War, but was repegged in 1879, which gives us our 1880 start date. The dollar was devalued in 1933-34 to $35/oz. So, the 1880-1930 is a nice, fifty-year period in which the gold standard was in full force, the dollar pegged at $20/oz., and gold coins circulated as money. Base money (currency held by the public, we will ignore Fed deposits after 1913 for now) was $624m in February 1880, and had expanded to $3,809m by the end of 1930. M2 (currency plus various types of bank deposits, a form of credit) was $2,706m in 1880 and $53,714m at the end of 1930. Thus we see, during that 50-year period, a 510% increase in base money and a 1,885% increase in M2. Nevertheless, despite these huge “increases in the money supply,” it was a period under the gold standard, when interest rates of less than 5% were typical. Certainly nobody living at the time noticed any sort of giant inflation, of the type that took place in the 1970s. These “increase in the money supply” were just a natural phenomenon of a growing economy with a gold standard, which maintained the dollar’s value at $20/oz.
This is really kindergarten stuff, so it is quite appalling that there are still serious economist types who claim that any increase in the “money supply” at all constitutes inflation. Look for yourself: was there “1,882% of inflation” during that period, or was the currency value stable, pegged to gold, indeed the currency was made of gold, interest rates low, commodity prices volatile but largely unchanged over long periods? (This is supposed to be an easy question.)
Where did this notion come from, that any increase in the “money supply” at all constitutes inflation? From the 1930s, the birthplace of most of the economic fallacies of the last century. Specifically, it appears to have been a hobby horse of Friedrich Hayek, who transmitted it to Murray Rothbard. They were scratching around for a way to explain the bust of the 1930s as the result of a monetary inflation in the 1920s. There was no monetary inflation in the 1920s, of course. The dollar was pegged to gold. One troy ounce $20 gold coins circulated as money.
A 1927 $20 Saint Gaudens gold coin, containing one troy ounce of gold.
You can’t get much more “pegged to gold” than that.
Commodity prices were dead flat. So Hayek and Rothbard landed on M2 (a measure of credit) as their “money supply,” and since M2 went up, as the natural result of economic expansion during the Roaring 20s, this was conveniently labeled a inflation of the most destructive sort! The 1930s were a time of great confusion, but it is shameful that this sort of thing persists seventy years afterwards.
We’ve been saying all along here that inflation is a decline in currency value, which is most easily perceived by a decline in a currency’s exchange value with gold. Notice that we do not have to reference any “money supply” measure here. We are value-centric. If it takes twice as many dollars to buy an ounce of gold, i.e., the dollar’s value has fallen in half versus the world’s best measure of stable monetary value, then it should come as no surprise that, over a period of time that may take as long as twenty years, it will tend to take twice as many dollars to buy all manner of things, as all prices adjust to the reality of the change in currency value.