How Money Works: The US Case

It is sad and dangerous that before the global financial crisis most academics and policymakers had excluded money from their economic models for over two decades. But it is sadder and more dangerous still that the role of money, banks and the financial sector in the economy continues to be misunderstood to this day, despite the chilling lessons of the crisis.

When the Federal Reserve engaged in the second round of its quantitative easing programme, many misguidedly worried about the resurgence of inflation. Indeed, a group of well-known economists and market professionals warned the Fed in an open letter in November 2010: “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”

The reason they got it wrong was a lack of detailed monetary knowledge, which produced a knee-jerk, rudimentary application of Friedman’s assertion. “Printing” money would surely mean inflation. The danger is that without understanding the mechanisms at work, the disinflationary experience of the past few years could well make policymakers and investment professionals miss the turning point.

My view at that time was that QE would boost asset prices, but was unlikely to translate into a general and sustained increase in consumer price inflation. The US economy had to deal with excessive household debt, and that meant more money was being destroyed than was being “printed” by the Fed.

If an economy needs to deleverage, those who cannot afford to service their debts either default or pay them down, which extinguishes money. To pay down debt an asset must be sold. If there is a flurry of forced sales, a self-fulfilling downward asset price spiral can ensue, further undermining overall consumer and corporate animal spirits.

If money is being destroyed on a sufficiently large scale, the economy will slide into depression, as many healthy economic transactions that would have taken place are stillborn for want of confidence and money as a medium of exchange. Luckily, the Fed stepped in by injecting money directly into the economy when it focused on buying assets from the non-bank sector.

I say luckily, as the Fed acted for the wrong reasons. Officials talked of credit easing and compressing long-term interest rates, which made little sense given that the economy was suffering from too much debt. Policy rates at near-zero or very low long-term rates will do little to help when there is no demand for credit at the same time as banks have to shrink their risk assets.

No matter how misguided their reasoning was, Fed policymakers staved off an even bigger recession and, possibly, a depression. But broad money growth was not pushed beyond what the economy needed to grow at trend and did not create the immediate inflation problem that many feared.

It is also important to think about the demand for money rather than just the supply. If more money is injected into the economy beyond what it needs to grow at trend, the ultimate inflationary impact will also depend on the desire to hold money.

A corresponding rise in the demand for money, for whatever reason, could offset or outweigh the increase in the money supply, which in that case will not be inflationary. The demand for money is notoriously difficult to model, but analysing the dynamics at play is vital to understand consumer price and wage inflation and the direction of asset prices.

If you would like to read more about my current analysis of monetary trends in the US and in China, which faces its own deleveraging battle now, you can request a free trial at Enodo Economics.