Why the massive injection of money (QE) did not cause inflation
Since 2008, many people predicted that the economy would experience major inflationary episode due to the ‘rampant’ money printing by the Fed. They even predicted a great crash, only to be followed by a hyperinflation. Interestingly, none of those predictions has materialized. In this article, we will show why the crash that was predicted to happen in the economy never occurred, and why the prophesied inflation never comes about.
The monetization of debt by the Federal Reserve has grown its own balance sheet by trillions of dollars since 2009, on top of the hundreds of billions earlier on banking debts. This inflated the money supply several folds. Everyone was against the Fed, and the anger against the Fed has grown ‘exponentially’. It’s chairman Ben Bernanke, was labeled routinely as “Helicopter Ben” and was shown to drop newly printed money from a helicopter. Some even labeled the learned chairman as a Dracula, sucking the blood from the economy and especially from the poor. Some labeled him as a thief, who stole from the poor and helping the rich. All these labels are in fact really far from the reality.
The forceful injection of money into the economy by the Fed has collided with the massive force of deleveraging in the economy. Now, several years later, it appears that the Federal Reserve is once again, triumphant in its response, while the naysayers are proven wrong yet again, as they usually do. That massive injection of money has reduced the impacts of the deleveraging and allowed it to occur continuously without much pain to the general economy.
Without the unprecedented monetary response from the Fed, the economy would have fared much worse than it is now. The Depression of the 30s would have been repeated, causing grave damage to the general economy and the lives of millions of people.
Almost five years to the Financial Crisis of 2008, the Federal Reserve is still continuing with its Zero Interest Policy and its monetary easing (forceful injection of money). Is it still necessary to do so, even after five years? Check out the following graph, obtained from the Federal Reserve (St Louis).
The velocity of money, in general is continuing to decline, until to this very day. Commonly, the impact of a reduction of the velocity of money means that there are lesser activities, lesser trade occurring, in effect causing less money to circulate at any one time. In short, economic participants are hoarding money. With less money available for other trades, some needy trades may be hindered from occurring, causing unnecessary hardship. People with great ideas may not be able to see their ideas materialize and adopted by the economy. Lost opportunities could occur; other countries may act on these ideas, causing permanent loss of the economic potential.
During the Great Recession, the velocity of money simply crashed, and has not recovered since, and the worst part is, it continues to decline until today. Take a look at the following graphs, to gaze at the problem of money’s velocities at another angle.
The velocity of M1 and other types of money simply crashed; money is moving slower in the economy, with great impact. Credit was suddenly extremely tight. Nobody was willing to lend to anyone, even the banks were not lending to each other as they normally would. In order to counter this, significant monetary easing is required. The Fed responded by injecting the first few hundred billions into the economy in 2008. The monetary base then jumped from around 800 to 900 billion dollars, to 1.6 trillion dollars (refer to point 1 in the graph below). This injection was not nearly enough due to the large crash in the money multiplier. The Fed can expand the monetary base as much as it could, however it has very little control on the velocity of money. The speed of trade between economic participants is essentially set between themselves and outsiders have little control over it.
Thereafter, the Federal Reserve responded by the famous Quantitative Easing, or QE, increasing the money supply by hundreds of billions by buying the debt of the Federal Government (refer to point 2). Despite the headlines cover of “trying to reduce long term interest rates” the QE program was very successful in financing the debt of the federal government at a time of falling tax receipts and of course, in fighting the collapse of money’s velocity in the general economy. After the first QE, the money supply was again decreasing (refer to point 3) and a second QE was inevitable. The Fed again responded with another easing, dubbed QE2 (refer to point 4). Then the money supply stabilized, and towards the end, a large increase occurred due to further purchases, but this could also be the signal that the end of QE is near.
The following graph shows the debt of the federal government held by the Fed.
Despite the action of QE, the ‘monetization’ of the federal government debt is still manageable and is in check (but the room to maneuver has certainly diminished).
The main question that very few people are asking – What is happening to the velocity of money and why did it decline significantly?
The answer is simple, the economy is experiencing deleveraging, one that has not occurred for many decades. Previous recessions were hardly accompanied by any deleveraging by the economic participants. Deleveraging is where the economic participants make it a priority to pay down debt and they become much less incline to take on new debt. The impact of deleveraging is huge, one that is always under estimated. In Book 2 of the 259 Trillion Vs 5 Trillion series, we explained that when debt is taken out, it would unleash a new supply of money into the economy, expanding it by up to a factor of 10. However, can you imagine what would happen if debt is being repaid instead?
As you might have guessed, the money supply would shrink by 10 times faster than the debt repayment itself. Thus, the impact of any large scale deleveraging is typically magnified many folds in the general economy.
The M1 x Velocity level is actually quite steady over the last few years. If the Fed never intervenes to push up the money supply, the amount of money in the economy would have shrunk precipitously. Velocity of money is a measure of how fast each unit of money circulates within the general economy. One dollar circulating fast in the economy (say 20 times in a measured period) is said to have a velocity of 20 and this one dollar with a velocity of 20, is actually about equal to a 20 dollar bill that is hardly moving in the economy.
The function of money in the economy is to facilitate trade, facilitate transactions between economic participants. Money is after all, a “medium” for enabling exchanges between participants. Money’s effectiveness in enabling trades diminishes during this period of fear, and it is increasingly hoarded due to participants’ fear. If the velocity collapses by half, the amount of money in effective circulation would decline in the same ratio as well. This would be very bad for the general economy, thus it should be prevented. The Federal Reserve responded and did all it can to prevent this from happening, however its actions were frequently misunderstood by many.
The following graph showed what would happen if the Federal Reserve did not inject the trillions of dollars as it did since 2008.
The money supply would have collapsed, shrinking by almost 35%. Four thousand billion dollars would evaporate from the economy. It is highly likely the economy would crash instead, and the economic data will be worse than indicated. You cannot sell your house, and the buyer cannot buy your house, because there is no money in circulation to be used in order to trade (this was a problem with gold money before).
If the economy chug along just fine in 2008 and the bubble never burst and the Great Recession never occurs, yet the Fed injected the trillions in new money, the monetary base potential as in M1 x Velocity would be cataclysmically high. Take a look at the graph below – the money potential would be running to as high as 25 trillion dollars! Indeed, there would be rampant inflation everywhere and for once, those gloomy predictions made by the doom and gloom prophets would have been correct.
As we pointed out in Book 3 of the 259Tvs5T series (in the WHY ECONOMIC CYCLES CANNOT BE PREVENTED chapter), the economy would correct itself when irrationality occurs. The government must allow this correction to take place for good revival of the economic potential and not to prevent it at all costs (Japan is trying to do it for the past two decades). When every moms and pops out there starts to participate in greedy speculation, when every part of society is somehow involved, when the greed level has hit the maximum, then it is a sure sign of an impending correction because sooner rather than later, they would wake up realizing their ‘over expectation’ of future returns are just wishful thinking. Almost every time, everyone will accuse the government or the Fed, blaming them for everything that occurred. They always forgot about themselves, and these people have little chance of learning their own mistakes, and are bound to repeat them yet again. We explained in Book 3 what the government should do during such times.
Why did the velocity of circulating money go down? Typically, in once a generation economic correction such as this, not just the GDP would decline, there would be a deleveraging process occurring as well. Economic participants would suddenly be unwilling to hold debt, and they would pay existing ones in earnest. This is still going on even until today (almost five years since the recession), and as we have shown in Book 2 of the 259 Trillion Vs 5 Trillion series, when debt is being repaid, the money supply would have shrunk significantly. Remember the statement that banks can issue up to 10 times the amount of money deposited in them? Well when the situation is reversed, the amount of money would have shrink 10 times more than the amount of money paid in the form of debt settlement. The impact would have been catastrophic to the economy, if the Fed never intervenes. As we have shown above, the money supply would drop by 35%, a truly cataclysmic event greater than the Great Depression itself.
Let’s see the data on household consumers of the United States, who are continuously deleveraging since the Great Recession.
American households are actually a lot healthier than their peers in other countries due to the ongoing deleveraging.
The following graphs show how the consumers are changing their debt load, freeing significant amount of disposal income, for other worthy purposes. After all, we showed readers in Book 3 of the 259Tvs5T series that “houses” for example, are just luxury items in great disguise, which will divert the future incomes of the owners, leaving little for wealth generation.
Households debt service payments has shrunk significantly for the better, in fact the debt repayment of today is lower even when compared to the severe late 70s recession, during the Carter’s administration.
The financial burden of US households has touched the lowest level in 40 years. In fact, it still continues to go down further. Once again, Americans households are healthy and would be able to add debt (therefore wealth) should they are able to find jobs and work. The government must allow the market to correct itself and encourage the market to grow in new areas.
US households, who are one of the ultimate owner of all assets in the economy (as well as debt), have been deleveraging continuously since 2008. This process has not occurred for several generations. Note the small uptick near the end, showing the willingness of households to start adding debt once again. We hope the consumers would start adding useful debt, one that will add to their future wealth. No, buying a house on debt isn’t a good idea; we dissected, calculated and then explained this thoroughly in Book 3 of the series.
The following are lending data obtained from the Federal Deposit Insurance Corporation, the FDIC.
Total outstanding real estate loans in the banking system (national, domestic banks), decline continuously since the recession began. Almost 800 billion net worth of loans has been paid up (and by the same account, this will cause 8 trillion worth of money to be extinguished due to debt repayments). Without radical action from the Federal Reserve, the economy would have crashed as predicted.
Total overall outstanding loans in the banking system (national, domestic banks) also decline, almost continuously since the recession began. Almost 800 billion worth of loans has been paid up until the year 2011, where it started to go up once again. Almost all indicators that we checked showed that the consumer in general has started to accumulate debt once again in late 2012 (except for real estate debts). Very soon, the Fed may need to reverse course and reign on the money supply to ensure that there will be no occurrence of major monetary inflation.
We hope that you enjoy reading this month’s article and have a better idea why none of the gloomy predictions ever materializes. To conclude, hyperinflation did not occur as predicted by many doom and gloom prophets (and their love for gold has started to wane, realizing their mistakes) owing to deleveraging process. The Fed has continuously injected money into the economy to maintain the actual money supply, and the Fed was very successful in maintaining it. The federal government took advantage of the situation and issued unprecedented amount of new bonds to please the critics, but plenty of the borrowed money is actually wasted. The consumers on the other hand, are nearing the end of their deleveraging process and have started to add debt once again. We only hope that the economic participants would learn their lessons this time around and would add only useful debt, not speculative ones.
We will continue to dissect and explain all the difficult questions out there, and if you have any, you may post them to us and we will consider answering them for you!
From the Authors of 259 Trillion Vs 5 Trillion Book Series.