The purpose of this piece is to very briefly connect what is happening now to what has happened throughout history as covered more comprehensively in my book Principles for Dealing with the Changing World Order.
It seems to me that people who received a lot of money and credit and felt richer, central bankers and central government officials who created a lot of money and credit and said that it wouldn’t create a lot of inflation, and people who believed what these officials said would all do well to review the lessons from history.
More specifically, this time around (i.e., since early April 2020) central banks (most importantly the Fed) and central governments (most importantly the US government) gave people, organizations, and state and local governments a huge amount of money and credit, and now most everyone is surprised that there is a lot of inflation. What is wrong with these people’s thinking? Where is the understanding of history and the common sense about the quantity of money and credit and the amount of inflation?
History has repeatedly shown that people tend to have a strong bias to believe that the future will look like a modestly modified version of the past even when the evidence and common sense point toward big changes. I believe that’s what’s going on and that we are in the part of the cycle when most people’s psychology and actions are shifting from deeply imbued disinflationary ones to inflationary ones. For example, people are just beginning to transition from measuring how rich they are by how much “nominal” (i.e., not inflation-adjusted) money and wealth they have to realizing that how rich they are should be measured in “real” (i.e., inflation-adjusted) money and wealth. From studying history, and with a bit of common sense, we know that when people shift their perceptions in that way, they change their investment and non-investment behaviors in ways that produce more inflation and that make central banks’ difficulties in balancing inflation and growth harder.
For example, people realize that cash is a trashy investment rather than a safe one, that virtually all debt assets (i.e., bonds) are bad, that inventories and forward coverage should be built up to protect against inflation, and that cost-of-living adjustments should be built into contracts to protect against inflation—all of which make upward inflation pressure more intense. Think of bond investors. Prices rose for over 40 years and yields declined to lousy levels (in both nominal and real terms), and they accepted them. Now they still have those lousy yields (though slightly better than when they were at the absolute lows) plus they are now experiencing price losses. After that huge 40+ year bull market in bonds, imagine how many investors are complacently long and beginning to get stung, and imagine how their behaviors could change to become sellers of bonds, and imagine the effects that would have. The total amount of bonds that would then have to be sold would equal the new bonds offered plus those being sold—a gigantic amount. When the supply is greater than the demand, either a) the interest rate has to go up to the point that it curtails the demand for credit, which weakens the economy, or b) the central banks have to print money and buy enough of the debt to bridge the gap, which cheapens the value of money and raises inflation. Whether it’s tighter or looser, it won’t be good.
We know from studying history and a bit of common sense that these developments will make central bankers’ jobs in trying to balance growth and inflation much more difficult and these things (i.e., higher inflation, tighter money, and their impact on markets and the economy) will have disruptive political and social implications that will make managing the inflation-growth and debtor-creditor trade-offs much more difficult.
All of this has happened many times before for the same ol’ timeless and universal cause/effect relationships. If you want to see the linkages and the historical cases more clearly and more comprehensively, I suggest that you read Chapter 3 (“The Big Cycle of Money, Credit, Debt, and Economic Activity”) and Chapter 4 (“The Changing Value of Money”) in my bookPrinciples for Dealing with the Changing World Order.
Several excerpts from these chapters can be found below.
Excerpt 1:
“While money and credit are associated with wealth, they aren’t the same thing as wealth. Because money and credit can buy wealth (i.e., goods and services), the amount of money and credit you have and the amount of wealth you have look pretty much the same. But you cannot create more wealth simply by creating more money and credit. To create more wealth, you have to be more productive. The relationship between the creation of money and credit and the creation of wealth is often confused, yet it is the biggest driver of economic cycles. Let’s look at it more closely.
There is typically a mutually reinforcing relationship between the creation of money and credit and the creation of goods, services, and investment assets that are produced, which is why they’re often confused as being the same thing. Think of it this way: there is both a financial economy and a real economy. Though they are related, they are different. Each has its own supply-and-demand factors that drive it. In the real economy, supply and demand are driven by the amount of goods and services produced and the number of buyers who want them. When the level of goods and services demanded is strong and rising and there is not enough capacity to produce the things demanded, the real economy’s capacity to grow is limited. If demand keeps rising faster than the capacity to produce, prices go up and inflation rises. That’s where the financial economy comes in. Facing inflation, central banks normally tighten money and credit to slow demand in the real economy; when there is too little demand, they do the opposite by providing money and credit to stimulate demand. By raising and lowering supplies of money and credit, central banks are able to raise and lower the demand and production of financial assets, goods, and services. But they’re unable to do this perfectly, so we have the short-term debt cycle, which we experience as alternating periods of growth and recession.
Then of course there is the value of money and credit to consider, which is based on its own supply and demand. When a lot of a currency is created relative to the demand for it, it declines in value. Where the money and credit flow is important to determining what happens. For example, when they no longer go into lending that fuels increases in economic demand and instead go into other currencies and inflation-hedge assets, they fail to stimulate economic activity and instead cause the value of the currency to decline and the value of inflation-hedge assets to rise. At such times high inflation can occur because the supply of money and credit has increased relative to the demand for it, which we call “monetary inflation.” That can happen at the same time as there is weak demand for goods and services and the selling of asset so that the real economy is experiencing deflation. That is how inflationary depressions come about. For these reasons we have to watch movements in the supplies and demands of both the real economy and the financial economy to understand what is likely to happen financially and economically.
For example, how financial assets are produced by the government through fiscal and monetary policy has a huge effect on who gets the buying power that goes along with them, which also determines what the buying power is spent on. Normally money and credit are created by central banks and flow into financial assets, which the private credit system uses to finance people’s borrowing and spending. But in moments of crisis, governments can choose where to direct money, credit, and buying power rather than it being allocated by the marketplace, and capitalism as we know it is suspended. This is what happened worldwide in response to the COVID-19 pandemic.
Related to this confusion between the financial economy and the real economy is the relationship between the prices of things and the value of things. Because they tend to go together, they can be confused as being the same thing. They tend to go together because when people have more money and credit, they are more inclined to spend more and can spend more. To the extent that spending increases economic production and raises the prices of goods, services, and financial assets, it can be said to increase wealth because the people who already own those assets become “richer” when measured by the way we account for wealth. However, that increase in wealth is more an illusion than a reality for two reasons: 1) the increased credit that pushes prices and production up has to be paid back, which, all things being equal, will have the opposite effect when the bill comes due and 2) the intrinsic value of a thing doesn’t increase just because its price goes up.
Think about it this way: if you own a house and the government creates a lot of money and credit, there might be many eager buyers who would push the price of your house up. But it’s still the same house; your actual wealth hasn’t increased, just your calculated wealth. It’s the same with any other investment asset you own that goes up in price when the government creates money—stocks, bonds, etc. The amount of calculated wealth goes up but the amount of actual wealth hasn’t gone up because you own the exact same thing you did before it was considered to be worth more. In other words, using the market values of what one owns to measure one’s wealth gives an illusion of changes in wealth that don’t really exist. As far as understanding how the economic machine works, the important thing to understand is that money and credit are stimulative when they’re given out and depressing when they have to be paid back. That’s what normally makes money, credit, and economic growth so cyclical.”
Excerpt 2:
“History has shown that we shouldn’t rely on governments to protect us financially. On the contrary, we should expect most governments to abuse their privileged positions as the creators and users of money and credit for the same reasons that you might commit those abuses if you were in their shoes. That is because no one policy maker owns the whole cycle. Each comes in at one or another part of it and does what is in their interest to do given their circumstances at the time and what they believe is best (including breaking promises, even though the way they collectively handle the whole cycle is bad). Since early in the debt cycle governments are considered trustworthy and they need and want money as much as or more than anyone else does, they are typically the biggest borrowers. Later in the cycle, new government leaders and new central bankers have to face the challenge of paying back debts with less stimulant in the bottle. To make matters worse, governments also have to bail out debtors whose failures would hurt the system—the “too big to fail” syndrome. As a result, they tend to get themselves into cash flow jams that are much larger than those of individuals, companies, and most other entities. In virtually every case, the government contributes to the accumulation of debt with its actions and by becoming a large debtor itself. When the debt bubble bursts, the government bails itself and others out by buying assets and/or printing money and devaluing it. The larger the debt crisis, the more that is true. While undesirable, it is understandable why this happens. When one can manufacture money and credit and pass them out to everyone to make them happy, it is very hard to resist the temptation to do so. It is a classic financial move. Throughout history, rulers have run up debts that won’t come due until long after their own reigns are over, leaving it to their successors to pay the bill.
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