Here’s Why QE Isn’t Causing Inflation

Here’s Why QE Isn’t Causing Inflation
November 22, 2013

Patrick Barron

Patrick Barron is president of PMG Consulting, LLC and has been a consultant to the banking... (read full bio)

Our monetary czars lecture us to be unconcerned about their unprecedented expansions in base money and the money supply, because there has been little sign of inflation in the economy. For the purposes of this essay, we will assume that there has been no inflation, although John Williams at www.shadowstats.com and anyone who tries to make ends meet on the same money income will tell you a different story. Our purpose is to explain the theory behind the price level and how theory can explain the so-called miracle/mystery of an increase in monetary aggregates with little or no inflation.

There is no miracle or mystery as to why prices have not gone significantly higher. Our monetary authorities have not found the magic formula that allows the government to engage in noninflationary spending sprees, funded neither by an increase in taxes nor an increase in interest rates. Our monetary masters remind me of the story of the man who jumps off the Empire State Building. As he is passing a floor on the way down, an office worker leans out a window and asks him how he's doing. He replies: So far, so good!

What Determines Price Level

On page 505 of his magnum opus, Capitalism: A Treatise on Economics, George Reisman defines the price level as a formula: P = Dc/Sc. P is the price level. The numerator Dc represents demand for goods as manifested in a definite total expenditure of money. The denominator Sc represents the supply of goods as manifested in a definite total quantity of goods produced and sold. Notice the importance not of the total supply of money but of that portion of the supply actually spent.

A Scrooge McDuck swimming in his supply of money in his basement does not affect the price level until he actually spends some of his money. Similarly, if the money supply increases but remains unspent, it will have no effect on the price level. In fact, if the demand to hold money exceeds the growth of the money supply, prices actually will fall. Likewise, notice the importance of the supply of goods as that portion of production actually sold. For example, inventory accumulation does not affect the price level. The goods must be both offered on the market and sold at some market clearing price for them to affect the price level.

Two Events at Play

Therefore, two events, or a combination thereof, can cause prices to rise -- an increase in sales expressed in money terms, independent of whether or not the supply of money has increased, or a decrease in supply sold on the market, even if increased production goes into inventory accumulation. The opposite of these two events, of course, will cause prices to fall.

We easily see from this simple yet powerful explanation that a falling price level need not be of concern, if it is the result of an increase in the supply of goods offered on the market. As John Stuart Mill explained more than two hundred years ago, the purpose of production is consumption. Goods are produced to satisfy human wants. The Keynesian view that digging holes and filling them up again adds to the general welfare of an economy is nonsense.

Jean-Baptiste Say explained that increased production becomes the means by which increased sales are realized. Again, man produces for the purpose of consumption, and his production becomes the means by which he consumes via market exchange expressed in money terms. Digging and refilling holes does not represent anything that would be valued on the market. Neither would printing money and giving it to welfare recipients to spend.

What would cause an increase in the demand to hold money that would suppress the price level? And is this increase in money demand something that we can rely upon to hold down the price level forever?

Three Phases of Inflation, Monetary Destruction

Ludwig von Mises explained there are three phases to monetary destruction. Murray N. Rothbard summarizes Mises' explanation in his Mystery of Banking, Chapter V  (“The Demand for Money”), pages 68 through 72.

In phase one the monetary authorities inflate the currency, but the public expects prices will not rise or may actually fall, so they withhold their spending, which is the same thing as saying they increase their demand to hold money. Prices may actually drop during this period of monetary inflation, which seems paradoxical but actually is explained by proper theory. The demand to hold money rises faster than the supply printed by the monetary authorities. The people believe that whatever crisis causes an increase in money will end and prices will fall to pre-crisis levels or even lower. They are long accustomed to lower prices or even a gently falling price level. Therefore, their firmly held belief in lower prices becomes self-fulfilling, at least for a while, because their increase in demand to hold money brings about this very situation.

Phase one may last a long time, but eventually the demand to hold money abates and prices start to rise, gently at first but more robustly as time progresses. In this second phase the people come to believe that prices are not going to fall and that they actually will continue to rise. Therefore, they begin spending more to purchase goods before the inevitable increase in prices. In this phase, even if the monetary authorities shrink the money supply, prices still can rise, because the people's demand to hold money is falling too fast. 

The belief that prices will continue to rise becomes self-fulfilling. Price increases in phase two come faster and faster, as more and more people accelerate their spending to thwart the falling purchasing power of their money.

Phase two morphs into phase three, when people lose all confidence in the future purchasing power of their money and demand to hold money goes to zero. In this final phase the monetary authorities are unsuccessful in stopping the loss of monetary confidence even if they take drastic action to curb monetary inflation. People wish to exchange their money for any vendible commodity. The panic feeds on itself. This is what Mises calls the "crackup boom", because there is a flurry of buying as everyone tries to exchange his money for whatever he can.

Cantillon Effect and Boom/Bust Cycle

Not only do our monetary masters fail to understand the real danger of monetary destruction they have unleashed with their zero-interest rate and quantitative easing policies, they do not understand the true nature of money as part and parcel of the market. For example, they fail to understand that money is not neutral. Its expansion does not fall upon the economy equally, perhaps raising the price level but not disturbing its underlying structure. In his Eighteenth Century book, An Essay on Economic Theory, Richard Cantillon first observed that money enters the economy in certain places, enriching the early receivers of new money at the expense of later receivers. Money expansion transfers wealth within society, benefiting the politically connected and harming the true engines of progress, the savers. This is the Cantillon Effect of the non-neutrality of money.

In his first great book, The Theory of Money and Credit, Ludwig von Mises went even farther and corrected a major deficiency of the classical economists by integrating money into general economic theory that governs all economic processes. For example, money is just as much subject to the law of diminishing marginal utility as all other goods and services. Our monetary masters admit as much when they muse that more recent quantitative easing measures have had less effect on their favored monetary metrics than earlier ones. What they do not understand is that the economy was not helped by increases in money. Quite the contrary.

At the conclusion of The Theory of Money and Credit, Mises introduced another great contribution to economic theory: that bank credit expansion is the source of the boom/bust business cycle. Money and GDP aggregates fail to identify the capital destruction set in motion by monetary interventions. GDP may indeed increase but only due only to the Keynesian fascination with monetary aggregates. The capital structure of production is set in disequilibrium, sending too much capital to the earlier, long-term stages of production which eventually cannot be completed due to the fact that there never were enough resources in the economy for their profitable completion.  Mises termed such misallocation "malinvestment".

No one can predict when people will begin to lose confidence in the purchasing power of the dollar. Each new dollar the Fed creates is like one more strand of straw laid on a mountain of straw. The real question is "Is this next strand of straw going to be the one that breaks the camel's back?"

Patrick Barron

Patrick Barron is president of PMG Consulting, LLC and has been a consultant to the banking... (read full bio)