Does Debt Creation Cause Inflation?

Does Debt Creation Cause Inflation?

 

 

March 4, 2006

 

 

Contrary to popular belief, debt creation, by central governments, banks, corporations, individuals, or central banks, does not cause inflation.

 

But where did this popular belief come from?

 

In the past, it could indeed be said that “debt creation” led to inflation. When commercial banks themselves were issuers of currency, in the 19th century, they increased their supply of banknotes outstanding (“the money supply”) by making loans. If, for some reason, the legal obligation to redeem these possibly excess banknotes into gold (typical in the 19th century) could be avoided in some way, as was common in the Western and Southern states in the US for example, then the banknotes would lose value compared to their gold parity and the situation would become inflationary.

 

State governments were engaged in similar shenanigans back in the 18th century. To pay soldiers, many state governments issued IOUs that said something like: this note can be redeemed for silver in two years. The notes were, in essence, a zero-coupon bond, and by issuing them, the state governments were creating debts. The state governments soon found out that paying soldiers with paper rather than silver was quite a lot of fun, and they began to do it with enthusiasm, resulting in a collapse in the value of the supposedly silver-redeemable notes. (I doubt that anyone was actually able to redeem the notes for silver.) Quite a lot of similar stories could probably be found wherever paper money has been used, since its introduction in 11th century China.

 

Then, of course, there is the typical inflationary default, where a government that is in debt begins to pay off its debt with the printing press. In this case the issuance of debt was legitimate enough, and was fine for a while, but over the years the burden became so large that the inflationary option became irresistible.

 

Today, even if the government is in reasonably good shape, it may be the case that corporations or possibly individuals (like today) are so deeply burdened by their debt loads that the government may introduce some inflation to allow a “partial deflationary default” on that private debt, typically with the hopes that it would help the economy overall. This is certainly one reason for the round of devaluations/inflations worldwide beginning in 1931, and many suspect that the US government and Federal Reserve may ultimately choose to err on the side of inflation in the near future, to keep swathes of overindebted individuals from becoming bankruptcy cases. Thus, corporate and individual debt, in this case, may eventually lead to an inflationary outcome.

 

The Bank of England was the first so-called “central bank,” although it acted as a commercial bank. The Bank of England had an effective monopoly on banknote issuance in Britain, and, as noted above, like any commercial bank put those banknotes into circulation via the process of making loans. This is hardly different than any central bank today, which puts new base money into circulation via the purchase of government bonds. Purchasing a bond and making a loan are virtually identical activities, although it might be noted that a loan by the BoE in the 19th century actually resulted in new debt creation, while the purchase of government bonds today merely represents a change of ownership of government debt, as central banks almost never buy government debt directly from the government today.

 

Many people today claim that debt creation causes an increase in the “money supply,” although this is incorrect. Money, properly identified as base money, is not created in the lending process, but by the central bank. Central banks can create base money, but not debt (unless they use the discount window perhaps, which is extremely rare). Commercial banks (and all other lenders or issuers of bonds) can create debt, but not base money. As we noted two weeks ago, most measures of “money”, such as M2, M3, or MZM, are in fact measures of cash-like debt. So, to say that debt creation creates debt (M2, M3, MZM) is not very interesting.

 

There is quite a bit of confusion about what inflation is. Inflation is a fall in the value of money, indicating an excess of the supply of money (base money) compared to its demand. The result of this fall in money value is that prices may rise. If the value of the US dollar went from $1 to $0.50, then the price of a $4.00 mocha latte may rise to $8.00 as the market reflects this new monetary reality. Typically this price adjustment process takes place over ten or more years after the initial fall in money value.

 

Many confuse inflation with “rising prices,” so when they see some rising prices, they assume that they are witnessing monetary inflation. Often rising prices of assets are directly related to debt-creation, as we are seeing all to clearly in the recent worldwide real estate boom. If John Smith was unable to borrow $600,000, he would not be able to buy his dream home for $600,000. This rising prices effect can bleed into the Main Street economy as well, since if John Smith is bidding big bucks for his dream home, with his banker’s help, then that may also drive up incomes for local real estate agents, mortgage brokers, construction workers, etc. And finally, such debt creation (especially as it is used to purchase assets) may leak into the asset-management sphere as well, leading to the “excess of liquidity” type feeling that is so prevalent today — according to our hypothesis of two weeks ago.

 

However, it is also possible to have huge debt booms with no inflation whatsoever, if the value of the currency is stable. The US government’s own indebtedness during World War II, when it was running deficits on the order of 30% of GDP per year, was not inflationary, nor was the almost equally profuse spending and debt issuance of the Japanese government in the 1990s, which did nothing to dent the monetary deflation caused by the Bank of Japan.

 

Inflation is caused by a decline in currency value, measured in an absolute sense, which is done by comparing the value of currencies to gold. If there’s a decline, you’ve got some sort of inflation. No decline, no inflation.

 

Pretty simple, right?