Once again I am seeing a lot of articles reference the exploding monetary base as proof that inflation is here. As a consequence, here is an updated graph of the monetary base and the bank reserves. It is still the case that the part of the monetary base that contributes to the money circulating in the economy hasn’t deviated from its trend in the same explosive manner. I also wanted to discuss some things.

I first wanted to point out that FAS 166/167 did get enacted. They will cause banks to move their off-balance-sheet investments back to the balance sheet. They will start to impact banks’ balance sheets when they start announcing first quarter results, roughly three months from now. However, I wanted to make it clear that this isn’t the end of what should be fraudulent accounting by the banks. The FDIC made a pre-emptive move to help banks cover up their losses. The capital ratios that banks must maintain to be considered healthy have been altered because realizing the full brunt of the losses of their toxic assets would cause too many systemically important institutions to fail. The FDIC recognizes that we can have honest accounting, or the big banks, but not both. The funny part is that none of the big banks would be awarding big bonuses if they had to implement these accounting rules last quarter. Instead, all of the “profit” would be allocated to cover expected losses. Recall that these accounting rules are the consequence of the Enron fiasco. Regulators realized that these ridiculous loopholes were bad, just not bad enough to enact them until after the banks booked fictitious profits and awarded themselves obscene bonuses.

The second point I wanted to make is that prices are not strictly a monetary phenomenon. What we think of as price inflation is too many dollars chasing too few goods. In other words, if the Fed prints too many new dollars, the price of things will tend to rise. But that’s not always the case. If you look at M2, for example, you’ll notice that the graph has a very different shape during 1985-1995 than 1995-2009. During that latter period, prices were somewhat in check. What happened? Instead of too much money chasing too few goods, we had too much money chasing a very narrow group of goods. First the money chased tech stocks, then the money chased houses. If the money doesn’t go to buy things that you buy on a day-to-day basis, there isn’t much reason for the prices on those things to rise. So, instead of getting price inflation, you get bubbles. Unfortunately, the Fed has admitted (correctly) that they don’t know how to spot bubbles. They only claim (incorrectly) to be able to spot price inflation. The things that you do buy every day are likely to rise in the near future. Oil has been sustained above $75 a barrel and there have been global reports of various crop failures. The former may actually be related to perceived problems with the dollar, but the latter is not. Even the same amount of money chasing fewer goods is likely to result in increased prices.

This isn’t to say that we won’t experience big inflation. The dominant narrative against inflation (too much excess capacity) is garbage. Let’s suppose there was a bubble in newspapers. If the bubble lasted long enough, there would be a lot of investment in newspaper production. After the bubble burst, we’d have a lot of excess capacity. However, that excess capacity would be useless. We wouldn’t need more newspapers to be produced before inflation could kick in. Looking at excess capacity as an aggregate only gives us an indicator that we should look at what kind of excess capacity we have. If our excess capacity is for automobiles, for example, we probably shouldn’t expect it to be used any time soon. Unemployment isn’t a huge impediment to inflation either. Zimbabwe recently disproved that (or the US in the ’70s). The only important impediment is whether or not banks need to sit on their reserves. If the banks didn’t need their reserves to cover future losses, and there was any chance of lending for a profit, and borrowers were willing to borrow (the rates might be rather high for the second condition), banks would lend. Then all of the monetary aggregates would explode, and big inflation would result. An increase in the velocity of money could have a similar impact.

This is still potentially a coiled spring, but we don’t know how coiled it is until banks have to account for their losses on their toxic assets. It is even possible that the losses exceed the bank reserves, and we’re still battling deflation. Every time someone defaults on a debt, money disappears. But, until the banks account for those defaults, the money doesn’t disappear from the statistics. This is why some people prefer to count money + credit marked to market as the true money supply. Marking credit to market gives an estimate of the default rate on the credit. We will skip the discussion of the efficient market hypothesis (the quality of the estimate) for now.