Monetary Inflation and the Welfare State

Back in September I pointed to three bad ways for Congress to deal with a debt crisis: austerity, monetization or debt default. On October 6 I warned that exorbitant money printing is destroying American capitalism. A couple of days later I pointed to equity-market inflation as the first sign that over-monetization was getting unhealthy for the economy.

A month later I noted how the velocity of money had fallen below one, indicating that we have money literally idling in the economy. Idle money means more speculation, because cheap money (and idle money is ultra-cheap) always finds its way to profit. All other things equal, this means more inflation in the stock market, in real estate and other assets.

In last week’s hyperinflation update, I tied the monetary expansion back to government and excessive spending. This is the essential ingredient in the debate about macroeconomic over-monetization. It is, namely, the missing transmission link from money printing to inflation, and it needs a lot more attention than it is getting.

I am not the only one warning about over-monetization and its inflationary consequences, but even the good analysts out there fail to see the transmission lines between money and real-sector economic activity. Over at Zerohedge, Tyler Durden’s quality publication, Harley Bassman explains:

The lack of (CPI) inflation should not distract anyone from recognizing that our financial economy is presently overwhelmed by too much debt, both public and private; and it is beneath the cloak of systemic risk management that the Federal Reserve (FED) flipped on their printing press to support an alphabet soup of asset purchase programs. And while I do not begrudge most of the FEDs actions to offer relief from both the Great Financial Crisis (GFC) and the COVID pandemic, what we all must recognize is that the financial remediation of these two crises have pulled forward the day of reckoning for how to fund the promise of Social Security and Medicare for the retiring Baby Boomer demographic. The political game of “kick the can” for managing the two largest strands of our social safety net has reached an end; about a decade sooner than hoped. We are at a crossroads where one path is well trodden by financial history, and the other newly paved by an economic Pied Piper. But her siren song has been too sweet, and we are turning to the perfidy of Modern Monetary Theory (MMT).

Bassman is right on the over-printed money, but it is not just Social Security and Medicare that are sinking the federal government. For sure, in 2019 Social Security spending exceeded $1 trillion for the first time in history, and as I explained two days ago, and Medicare rang in at $651 billion.* But Medicaid is en route to overtake Medicare, especially if its Expansion component reaches all 50 states. So-called income security programs, which includes the Earned Income Tax Credit, Food and Nutrition Assistance and Housing Assistance, add up to half-a-trillion dollars per year.

And so on. Which brings us to the transmission mechanism from money to inflation that Bassman and other analysts, despite good contributions, keep overlooking. He continues:

The Velocity of money declined because the dollars the FED created went into asset purchases instead of hourly wages where those funds would be recycled back into the economy. A recent FED study reported that nearly 40% of US households do not have cash on hand to cover a $400 emergency expense (car repair or broken appliance). Surely funds directed to these households would soon be spent (recycled). Velocity is a measure of recycled spending; financial asset purchases are static.

Here, Bassman comes very close to the transmission mechanism that triggers high inflation in consumer prices, but he doesn’t see it. He is correct that the newly printed cash must make its way into the pockets of America’s consumers, and he notes that it would happen if there was another government-administered “stimulus check” payout. However, this is just a discretionary transmission of printed cash into household bank accounts; it would come nowhere close to igniting the inflationary bonfire. For that to happen you need a permanent infusion of significant, monetized government spending.

You need the Federal Reserve to permanently fund significant entitlement programs under the welfare state.

It is understandable, though, that the monetary expansion has not yet been tied to the welfare state in the mainstream debate. Economists and members of the public punditry tend to live by conventional wisdom, which spans its wings between textbook macroeconomics and random tidbits from the supply side. In that intellectual domain, most of the reasoning around money and inflation revolves around the quantity theory of money, which says that the money stock times monetary velocity is equal to total economic activity times the general price level.

There is no room for transmission mechanisms in this type of reasoning, which explains why even a good analyst as Bassman from time to time makes an unfortunate misstep.

Another misunderstanding has to do with plain statistical reviews of Federal Reserve purchases of government debt. Historically, the current levels do not look very dramatic, but, as Figure 1 notes, one has to put historic peaks in Fed purchases of government debt in their proper context.

Figure 1

  1. This is the Vietnam War era. From 1960 to 1970, defense spending increased by 70 percent. However, since overall spending by the federal government went up by 112 percent, a budget deficit opened up. The Federal Reserve was more than willing to help.
  2. Then came the death of the Gold Standard. The Federal Reserve once again stepped in to save the day.
  3. This is the lastest stint of Quantitative Easing. It is worth noting the decline in the central bank’s share of federal debt since Trump took office; that was the work of Janet Yellen, who was actually a relatively conservative central banker.

It is a safe bet that the Fed share of government debt has risen sharply in 2020. However, it is not the only channel through which newly printed cash finds its way into the Treasury’s pockets. Commercial banks actually play a bigger role than is often recognized. Their holdings of government debt has varied over time, with a conspicuous peak in the early 1990s. That peak was likely driven by the combination of high interest rates and the anvil reliability of Treasury debt.

For about 15 years, commercial banks reduced their holdings of Treasurys, in good part because the interest rate declined.** However, in the past ten years they have returned to sovereign debt, begging the question why they would want something – anything – in their portfolio that comes with practically no yield. The reliability of U.S. government debt is still an argument, but after two credit downgrades and excessive borrowing in recent years, that has become a weaker point. A far more likely explanation is that the Federal Reserve has provided commercial banks with ultra-cheap money, on the explicit or implicit premise that they use the money to buy debt from the Treasury. The European Central Bank did this a decade or so ago, forcing commercial banks to take on volumes of government papers in their portfolios, with zero or even negative yield.

Figure 2

Source: Federal Reserve

Again, the welfare state is the transmission mechanism from newly minted cash to high inflation. As more and more entitlement spending is paid for with newly printed cash, we move closer and closer to the point where inflation takes off and becomes uncontrollable. This transmission mechanism has different components to it, depending on how the Federal Reserve goes about funneling the cash into Treasury pockets, but the exact method does not matter as much as the combined size of the monetization efforts.

*) This is the federal-budget expense. Program total, including all funding sources, adds up to more than $750 billion.

**) The spelling of “Treasurys” is deliberate, to indicate the distinction between “Treasuries” which refers to several government treasury departments, and the variety of sovereign debt.