Monetary Expansion: An Update

In his illuminating The Triumph of Politics: Why the Reagan Revolution Failed, perennial fiscal truth teller David Stockman summarized hyperinflation as (p.65):

the deliberate debauching of the nation’s money in a futile effort by politicians to compensate for the shortfalls of capitalist growth that their own misbegotten bureaucratic enterprises had caused.

In plain English: politicians compensate for welfare-state overspending by printing money. I have pointed repeatedly to the signs of inflation pressure building in our economy, and how it is traceable back to the excessive money printing that has fueled recent government spending.

As I previously reported, money supply is now at such a level that the velocity of money in the second quarter fell below one. This means, plainly, that there is money idling in the economy that is not being used; wherever there is idle money, there will be inflation.

A review of third-quarter data on money supply shows that money velocity remains below one:

Figure 1

Sources: Federal Reserve (M1); Bureau of Economic Analysis (GDP)

The fact that money supply has continued to outpace GDP means that it has also outpaced the transactions demand for money. Some of it will be absorbed by equity markets and contribute to a speculative bubble, but part of it will also find its way back into the real sector of the economy.

That transmission mechanism is known as deficit monetization, or government spending money fresh off the Federal Reserve printer. This transmission mechanism between the monetary and the real sectors is a dangerous source of inflation. So far, in the American fiscal-policy debate, it has been widely under-appreciated.

We have only had a velocity this low at one point previously in recorded monetary history. That was in the early 1960s:

Figure 2

Sources: Federal Reserve (M1); Bureau of Economic Analysis (GDP)

Back then, the velocity was low because the Federal Reserve had just started implementing new policy instruments and was attempting to shift from classic to accommodating monetary policy. That policy, in turn, was incompatible with the gold standard, the formal remains of which evaporated during the 1960s.

Since then, monetary policy has been focused on providing liquidity for the U.S. economy. Up until the late 1970s there was little focus on monetizing budget deficits, but as the gaping hole in the federal finances grew bigger in the ’80s, monetization slowly became an accepted practice. In the 2000s that policy became systematic under the label of Quantitative Easing; in reality, QE was more of an excuse to turn an ad-hoc approach to deficit funding into a formal, open practice.

Today, as Figures 1 and 2 demonstrate, deficit monetization is as established as the budget deficit itself. This is deeply worrisome, and it does not get better if we break down the money printing on a monthly basis. As Figure 3 explains, not only is money supply vastly bigger than it was only a year ago, but the difference is still increasing:

Figure 3

Source: Federal Reserve

There is a bit of an oddity in the difference between M1 and M2 in 2020. It is not unheard of that the two expand at different rates, but it is unusual. We will examine that in greater detail in a later article; for now, the main point is that the money supply keeps expanding, our monetary velocity remains negative and that the transmission mechanisms that cause inflation remain active.