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Economics and Inflation: A puzzle
The monetary base is exploding, but so far Wall Street is betting against a resurgence of inflation. The consensus seems to be that banks are sitting on their new reserves instead of lending, and the Fed can remove that cash from circulation at the right time and avoid inflation.
One of our favorite sources on economic thinking is Greg Mankiw’s blog. Professor Mankiw (of Harvard) recently argued that when banks’ reserves earn risk-free interest, they’re virtually identical to Treasurys, and so the monetary base as a statistic loses its predictive value. The issue for Mankiw isn’t technical, but the time-honored political one: will the Fed have enough strength and independence to do the right thing and “take away the punch bowl” at the right time.
Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University and author of this article on inflation in Reason, responds to Mankiw here. She counters that it would indeed be a remarkable achievement if the Fed had discovered a new method to increase the money supply without creating inflation; instead it is more likely to have simply replaced one asset bubble (housing) with another (Treasurys).
An anonymous reader replied to de Rugy that an asset bubble is not the same thing as a rise in the general price level, and that the money supply – properly understood – has not, in fact, dramatically increased because the money multiplier remains low. In other words, feel free to worry about asset bubbles but not inflation.
We assumed that we weren’t the only ones fascinated by this puzzle, and turned to one of our personal favorite thinkers to help solve it: Will Harrell, founding partner of Capco Asset Management here in Tampa. Will’s email response, below, qualifies him as Navigating Venture’s first guest blogger. (We also link to Will’s thoughts on the topic of risk here.)
The M3 figures – which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance – began shrinking last summer. The pace has since quickened.
“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.
The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.
The US authorities have an entirely different explanation for the failure of stimulus measures to gain full traction. They are opting instead for yet further doses of Keynesian spending, despite warnings from the IMF that the gross public debt of the US will reach 97pc of GDP next year and 110pc by 2015.