Frances Coppola, a CoinDesk columnist, is a freelance writer and speaker on banking, finance and economics. Her book, “The Case for People’s Quantitative Easing,” explains how modern money creation and quantitative easing work, and advocates “helicopter money” to help economies out of recession.
Fiat currency always fails. The Federal Reserve’s ever-increasing balance sheet is a sign we are in the end times for the U.S. dollar. Eventually, all that money printing will cause runaway inflation. The dollar will go up in flames, and with it, the U.S. economy.
I have heard this line of argument many times over the last decade. In the aftermath of the 2008 financial crisis, it was usually advanced by people who wanted the return of the gold standard – “goldbugs,” as they are often known. More recently, Bitcoin hardliners have joined the chorus. Now, in these extraordinary times, even some conventional money managers are predicting hyperinflation. “Money printer go brrr,” they say, and mutter about wheelbarrows and currency wars.
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Are they right? Is the Fed’s enormous money creation going to cause runaway inflation and the loss of the dollar’s reserve currency status?
When the monetary base mainly consists of physical currency, a massive expansion of it can indeed cause runaway inflation. Weimer’s wheelbarrows contained banknotes. And they went to ordinary citizens, not into the vaults of banks.
But the Fed’s QE doesn’t increase physical currency. It inflates bank reserves. Some argue that banks will eventually have to “lend out” these reserves, and that this will cause high inflation. But so far, the evidence is that banks don’t “lend out” the money thrown at them by the Fed. For 10 years now, the problem has been too little bank lending, not too much. Small businesses, particularly, have suffered a lending drought.
The idea that expanding bank reserves will cause high inflation comes from a mistaken understanding of how fractional reserve banking works. The conventional view of bank lending, as described in a thousand economic textbooks, is that when banks receive a deposit, they keep 10% of it “in reserve” and “lend out” the rest. But the reality, as described in this paper from the Bank of England, is that banks create both loans and deposits through the act of lending. They don’t “lend out” either deposits or reserves.
Until recently, U.S. banks were required to hold reserves equating to 10% of their eligible deposits – reserves, in this case, meaning money they keep on deposit at the Fed. This reserve requirement was intended to ensure they always had enough ready cash to meet customer demand for deposit withdrawals. Of course, banks could always hold more reserves than their statutory requirement. And since, collectively, banks must hold all bank reserves issued by the Fed, they have done so ever since the Fed started doing QE.
But since banks don’t “lend out” reserves, giving banks more reserves doesn’t force banks to lend. Indeed, since the Fed pays banks to hold reserves in excess of their reserve requirement, it could be argued that having too many reserves in the system actually discourages banks from lending. And since nearly all money circulating on Main Street is created by banks when they lend, if banks don’t want to lend, there is no possibility of inflation. If anything, inflation will fall – as indeed we have seen since 2008:
Those who thought the Fed’s expansion of the monetary base would cause runaway inflation because banks would lend out the money have been proved wrong. So now there’s a different argument doing the rounds. Instead of runaway bank lending and consumer price inflation, Fed intervention is manipulating markets and driving up asset prices in an unsustainable way. Asset price rises are the new hyperinflation.
Here, for example, is investment writer Preston Pysh explaining why expansion of the dollar monetary base from $0.8 trillion to $7.1 trillion since 2008 hasn’t caused price inflation:
Sadly, this is not true. Here’s the S&P 500 charted against bank reserves since 2008:
Stock prices did indeed rise while the Fed was doing QE. But they rose even faster from 2016 onwards, even though the Fed had stopped doing QE and (from 2018) was actually reducing the monetary base. Currently, of course, both the monetary base and stock prices are rising.
Is one causing the other? It’s hard to say. But there isn’t much evidence that the expansion of the monetary base since 2008 has inflated asset prices in the way that Pysh claims.
Pysh goes on to argue that because asset price inflation raises inequality, it distorts consumer prices:
He goes on to argue the absence of CPI inflation is because people are getting poorer, so can’t afford consumer goods. And he then alleges that the U.S. government is now giving money directly to people to stave off civil unrest.
I agree the U.S. has a huge inequality problem, and this is fueling recent episodes of civil unrest. But it’s a bit of a stretch to blame it all on Fed money creation. Do U.S. government policies that benefit the rich at the expense of ordinary people count for nothing?
For me, the most convincing explanation for the mysterious absence of inflation since 2008 lies not in U.S. inequality, but beyond U.S. shores. Here’s the U.S. dollar’s trade-weighted exchange rate since 2008:
Note that this measure started to rise even while the Fed was doing QE, and rose considerably more since the Fed stopped. Far from the world rejecting the dollar after the financial crisis, the dollar has actually become even more dominant. And the exchange rate spike in 2020 is caused by international flight to the dollar, just as in 2008. The dollar is still the world’s “safe haven” asset of choice.
The rising dollar exchange rate suggests the Fed’s monetary expansion has been insufficient to slake international thirst for dollars. The world wants more dollars. Lots more. The only obstacle to their creation is the fears of Americans who do not understand just how many dollars the world needs to keep trade flowing.
It is, of course, possible some stupid action by the U.S. government, such as returning to a strict gold standard, might force the world off its de facto dollar standard. But until that day dawns, fears of hyperinflation and the loss of dollar dominance are massively overblown.
So let the Fed continue pouring dollars into international financial markets. That’s how to ensure the dollar remains king, and the U.S. economy remains the richest in the world.
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