People with a free-market orientation believe that the economy has a strong tendency towards equilibrium. Over the long term money is “neutral”: a rise in the money supply merely raises the price level. In the short term, however, monetary policy may have a big impact on the economy. A big question, however, is over how to measure the impact of monetary policy in an environment such as the present one, when short-term interest rates are close to zero and the credit system is damaged.
The difficulty arises because of the huge divergence between what is happening to the monetary base (the monetary liabilities of the government, including the central bank) and what is happening to broader measures of money (principally the liabilities of the banking system). The former has exploded. But the growth rate of the latter is extremely low. (Look at the chart that accompanied my column, “Why it is right for central banks to keep printing”)
People worried that governments are “printing money” point to the balance sheets of central banks with horror and insist this is bound to be inflationary. Inside the eurozone, Germans are particularly concerned about the willingness of the European Central Bank to buy the debt of governments. Yet the growth of broad money (M3) in the eurozone over the past twelve months has been close to zero. That would suggest there is no inflationary pressure whatsoever.
So which measure is relevant? My responses would be as follows:
First, the monetary base does not itself have any impact on spending by the public. If governments borrow from their central banks to pay their bills, almost all of the money ends up as deposits of the commercial banks at the central bank (see, on this, this excellent paper by deputy governor Charles Bean of the Bank of England).
Second, such reserves have no direct impact on lending by commercial banks (their assets) or on the broad money supply (their liabilities). Many analysts of the Austrian persuasion refer to the evils of “fractional reserve banking”. Yet there is no direct link between the quantum of bank reserves and the quantum of bank liabilities. From the point of view of commercial banks, the question is only whether central banks will provide them with the liquidity they need. The central bank will normally do so through loans. The commercial banks do not need to own deposits at the central bank.
Third, should commercial banks be stimulated by the possession of reserves to expand their assets and liabilities, it is possible for the central bank to sell bonds to the non-bank private sector, to reduce those reserves. Alternatively, central banks can impose a liquidity ratio on commercial banks, thereby preventing them from expanding their liabilities beyond a certain point. Thus the size of the central bank’s balance sheet has no direct impact on the total stock of money held by the public (however the latter is defined).
Fourth, the policy of expanding the balance sheet of the central bank has an inflationary impact if and only if it succeeds in expanding the overall broad money supply beyond what the public wishes to hold, given the levels of economic activity, interest rates and expected inflation. If that starts to happen: people spend their excess money, generating both inflation and rising inflationary expectations. This leads to a further rise in spending, as people flee from money. At the extreme, we find ourselves in Zimbabwe.
Finally, such an inflationary impact of “money printing” can indeed only happen if the overall money supply starts to grow rapidly. This is not now happening. Only the monetary base is expanding rapidly. Should such a broader expansionary impact emerge, monetary policy will have been successful, the central bank can then raise rates, thereby preventing a rapid growth in credit and so constraining the growth of broad money.
My conclusion is that what is happening to the balance sheet of the central bank is unimportant, except to the extent that it has prevented a collapse of credit and money. What matters is the overall supply of credit and money in economies. This continues to be stagnant in the developed world. Concern about an imminent outbreak of inflation is consequently a grave mistake. To the extent that there is a danger of “monetisation” of debt, it will emerge only if we fail to return to growth, because that is the situation in which it is most likely that public sector deficits will fail to close. It follows that strong monetary tightening now may increase the long-term threat of inflation, rather than reduce it.
What do you think?
Martin Wolf responds to readers’ comments:
Martin Wolf gives his conclusion on the discussion:
