Thursday, May 27, 2010

Printing Money and Deflation

Everyone who doesn't study economics can tell you that if you print money you will create inflation. Before you know it the conversation will have verged onto Weimar Germany, wheelbarrows and paper kites made out of money. (See: Hyperinflation)

But, this is a complicated time with economic analysts worrying over everything from imminent hyperinflation to a prolonged Japanese style period of deflation. Printing money can definitely cause inflation, but, in the present climate of a liquidity trap, this link is easily broken - Money Supply and Inflation

Since the US pursued the policy of quantitative easing last year, the Federal Reserve has increased the monetary base to buy a range of assets. From one economic model, we would expect this to create inflation. But, it hasn't happened. US inflation is creeping down towards less than 1%. Statistics on the Money Supply are more surprising. Unofficial figures for M3 show a decline in the broad money supply.
$14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of institutional money market funds fell at a 37pc rate, the sharpest drop ever. (Telegraph)
The Federal Reserve no longer actually publish M3 statistics because they claim they are unreliable and subject to fluctuations.

Statistics for M3 Money Supply

Chart of U.S. Money Supply Growth

The decline in M3 could be due to institutional changes. But, despite the difficulties of measuring money supply, it does correspond to the lowest inflation rate since 1966. Other core measures of inflation show similar periods of falling.

In the boom years before 2006, M3 was growing at double digit rates. Then it fell sharply in 2008,

Why is M3 Falling?
  • Banks trying to restrict lending to improve balance sheets
  • Evidence of slowdown in growth.
A double dip recession is what most economists fear most, especially if the recession is accompanied by a period of deflation.

What this experience shows is that in a liquidity trap, increasing the monetary base is not guaranteed to increase the money supply, it is not even guaranteed to create inflation. A lesson already learnt by Japan - Quantitative Easing and continued deflation in Japan.


No comments: