The prevailing wisdom in some economics circles, primarily those adherent to orthodox Austrian and monetarist theory, is that an expansion of the money supply automatically causes inflation. The last few years have proven the hardline monetarist view wrong, with massive money supply expansion in the United States and accelerating money printing in the euro zone. That does, however, not mean that there is no connection whatsoever between money supply and inflation. There is, but the money needs a transmission mechanism from the banks – literally – to the real sector where prices are set.
In South America government entitlements serve that role as a transmission mechanism. In Argentina, e.g., there is a job guarantee effectively making government everyone’s employer of last resort. Together with other entitlements this has caused government spending to rise to unsustainable levels while eroding (my means of sloth and indolence) the tax base supposed to pay for those entitlements. Instead of reforming away its entitlement state, the government led by socialist president Cristina Kirchner pumps newly printed money into the government budget.
With consumer demand kept up by entitlements and productive activity kept down by the same entitlements (among other business-stifling measures) imports have increased. The massive money printing weakens the currency, causing imported inflation to compound a problem caused by domestic excess demand. Tradingeconomics.com reports the Argentinian CPI-based inflation rate at just above ten percent, though at least one other source put it above 13 percent. It is worth, though, to take any number coming out of Argentina with a grain of salt, as president Kirchner has been accused of trying to tamper with the country’s national accounts data.
Regardless of the fine print of Argentina’s inflation numbers, their economy exemplifies how excessive money printing can indeed cause inflation. One person who should definitely keep the Argentinian lesson in mind is Mario Draghi, president of the European Central Bank. Despite the restrictions put in place on the ECB when the bank was created, Draghi is pushing hard for a very expansive monetary policy. His money printing ambitions take many different forms, big and small. On Thursday August 7, e.g., in an official ECB statement, Draghi explained the ECB Governing Council’s latest policy decision:
Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. The available information remains consistent with our assessment of a continued moderate and uneven recovery of the euro area economy, with low rates of inflation and subdued monetary and credit dynamics.
In a brief press release the same day, the ECB announced that:
the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.15%, 0.40% and -0.10% respectively.
The latest M1 money supply data from the ECB shows an annual growth rate of 5.4 percent. This is actually a reduction from a bit over a year ago when they were pumping massive amounts of euros into saving Spain and Greece from collapse. However, back then the M1 growth rate relative real GDP growth was approximately four to one, meaning money supply expanded four times faster than transactions money demand. The U.S. economy has seen similar excess growth rates for a while, though with GDP growth picking up and the Federal Reserve tapering off its Quantitative Easing policy, the U.S. rate is declining.
The exact opposite is happening in Europe. With GDP growth at best reaching one percent per year, the euro-zone excess growth rate in M1 is now at 5:1. Of every five new euros printed, one is absorbed by the economy to serve as liquidity for spending, investment, labor compensation and tax-payment purposes. The remaining four dollars go into the financial system as excess liquidity. With the ECB’s overnight lending rate for banks at -0.1 percent, that means a dangerous rise in excess liquidity in the banking system.
It could also lead to an Argentine-style monetary inflation rally. For now, though, the ECB hopes that consumers and businesses will absorb all the money slushing around in the financial system. Back to Draghi:
The targeted longer-term refinancing operations (TLTROs) that are to take place over the coming months will enhance our accommodative monetary policy stance. These operations will provide long-term funding at attractive terms and conditions over a period of up to four years for all banks that meet certain benchmarks applicable to their lending to the real economy. … Looking ahead, we will maintain a high degree of monetary accommodation. Concerning our forward guidance, the key ECB interest rates will remain at present levels for an extended period of time in view of the current outlook for inflation.
Where would the demand for these loans come from? Other than random blips on the national accounts radar, there is no real movement in either business investments or consumer spending in Europe. The only way Draghi and the European banks can push new loans on entrepreneurs and households is to lower credit qualification requirements. That, in turn, exposes banks to significantly higher default risks, without stimulating private-sector activity more than on the margin.
Thus, in order to put their relentlessly expanding liquidity supply to work, the ECB has to go for other measures. And this is where Argentina comes back into the picture. Draghi again:
[The ECB] Governing Council is unanimous in its commitment to also using unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation. We are strongly determined to safeguard the firm anchoring of inflation expectations over the medium to long term. … the annual rate of change of MFI loans to the private sector remained negative in June and the necessary balance sheet adjustments in the public and private sectors are likely to continue to dampen the pace of the economic recovery.
Let us translate this into plain English. The point about “unconventional instruments” means that the ECB will do whatever it takes to drive up inflation to two percent. This includes using U.S.-style QE measures to prop up deficit-struggling member states. Which opens the door to Argentina. Unlike the United States, the European economy does not have the resiliency to get out from underneath bad fiscal policy and onerous governments. Furthermore, despite our overly generous welfare systems we do not have Europe’s massive income security structure which flood households with work-free cash.
Compared to the U.S. situation, Europe is at significantly higher the risk of monetary inflation. I would not want to keep my investments in Europe when the ECB starts pumping money directly into government budgets.
The last part of Draghi’s speech reinforces my concerns:
To restore sound public finances, euro area countries should proceed in line with the Stability and Growth Pact and should not unravel the progress made with fiscal consolidation. Fiscal consolidation should be designed in a growth-friendly way. A full and consistent implementation of the euro area’s existing fiscal and macroeconomic surveillance framework is key to bringing down high public debt ratios, to raising potential growth and to increasing the euro area’s resilience to shocks.
It is precisely the pursuit of welfare-state saving austerity that has brought the European economy to its knees. So long as the short-term budget balance is more important than GDP growth, consumer spending or reduced unemployment, policy makers at the ECB as well as in the EU leadership and member-state governments will continue to keep the European economy in its increasingly perennial state of stagnation. If they push hard enough on fiscal consolidation, in other words if they add QE to their current policy mix, stagnation will become stagflation.