Debt Does Not Cause Inflation Part III
May 28, 2006
This series has become a bit misnamed, since we have been talking more about the “money supply” than debt creation per se. However, since the “money supply” as popularly conceived (M2 or M3) consists mostly of lending to banks (deposits), which is a form of credit/debt creation, and roughly what people are referring to when they say the “Fed is creating credit,” we will let the title stay for now. Really, we have been looking into why it is hugely important to focus on currency value rather than measures of “money supply,” arbitrarily defined.
Last week, we took some examples of gold-standard periods (or periods of vaguely stable money, such as was the case during Greenspan’s tenure), showing that it is quite natural to find “money supply” increasing, as the economy itself grows. A larger economy tends to have more “money”. Big surprise. As an example, we find an 1,882% increase in the “money supply” (M2) between 1880 and 1930, which was a classic gold standard period with the dollar pegged at $20/oz. This works out to a 6.04% increase per year over fifty years, by the way.
Between January 1933 and January 1934, the dollar was gradually devalued from $20/oz. of gold to $35/oz. So, if the 1,882% total/6.04% average annual increase in the “money supply” 1880-1930 did not produce a decline in currency value, how much did the “money supply” have to increase to produce a near-halving of dollar value during 1933? Well, it turns out that in January 1933, Currency Held by the Public (roughly base money) was $4,979m and M2 was $44,994m. In January 1934, Currency Held by the Public was $4,491m and M2 was $41,701m. Both declined. And not by a small margin either. So much for “printing money”! But doesn’t it make sense? Why would you want to hold a currency (or a bank deposit denominated in a currency) that is being devalued by the government? You would dump them, if you could. Thus, both base money and M2 declined.
Now, let’s look at the 1970s. In January 1970, the dollar’s value had been returned to near $35/oz., as a result of the “tight” policies of Fed Chairman Bill Martin. In January 1970, M2 was $592.0B, and the monetary base (real money) was $76.398B. In February 1980, the dollar hit its nadir against gold of $850/oz. That’s a 24-fold decline in value! Did the “money supply” grow by twenty-four times during the 1970s? In February 1980, M2 was $1,486B, and the monetary base was $154B. That’s a 151% increase in M2, or 9.64% annualized, and a 103% in the monetary base, or a 7.31% average annual increase. On an annual basis it was a bit more than the figure from the 1880-1930 gold standard period, but not a whole lot more, and certainly nowhere near a 24-times increase over the period. Thus we see that “printing money” willy-nilly had nothing to do with the catastrophic collapse in dollar value during the 1970s. Rather, it was a collapse in dollar demand touched off by a relatively small lapse in judgment by the Fed.
Thus, we find that during the only two major declines in dollar value during the twentieth century, nothing very dramatic happened in terms of what one may call the “money supply.” What happened, of course, were dramatic changes in dollar value, which we can see expressed by changes in the dollar’s value versus gold.
This is really elementary stuff, and if it seems easy, that’s because it is. Nevertheless, given the popularity of “printing money” type explanations, and the persistence of such explanations for literally decades — I guess everyone would rather take their turn at the pulpit than spend fifteen minutes looking up the actual numbers like we have here — it is important to get this straight.
Even the silliest “Fed is running the printing presses white hot” type of hype is nevertheless quite a bit better than what you get on the other side of the aisle, where Ben Bernanke comes from. At least people have an idea that something is up with the currency. Academics are more prone to blame too much employment for inflation, which would be pretty funny if the conclusion wasn’t that the solution is to reduce employment by blowing up the economy.
When you begin to feel disgusted with the antics of these clowns, and can understand and explain why you are disgusted, then you are making good progress in the study of economics!