Friday, January 28, 2011

In answering a reader's question about the relationship between quantitative easing (QE) and food price inflation (hat tip: Crito) I mentioned that QE may not, in fact, increase money supply.  This is because it is not known how much of the liquidity injected by the Fed is additive to the system, or if it is just filling the vacuum left by debt defaults.

Here are some data on total credit expansion from the Fed's latest Z1 report (click to enlarge).

  Zero Total Credit Expansion in 2009-10

Credit expansion in the private sector collapsed after 2008 with the financial sector leading the way  down by contracting over 15% in two years.   The federal government took over as its borrowing zoomed 76% after 2007.  Net-net, however, total credit outstanding has been flat in 2009 and 2010, at least until the end of the third quarter (latest data available).

It seems to me, therefore, that QE1 and QE2 have merely substituted for  some of the "money" that has been destroyed via debt defaults and should not in theory create overall inflationary pressures.  But markets are mostly psychological manifestations and not theoretical structures;  if punters believe new money is pouring out of the printing presses, then they bet accordingly and commodities - to name but one - rise in price.  That's what I call Quantum Finance or, Perception Creates Reality.

Looking at things from a longer-term perspective it is obvious that total debt (i.e. money) and prices should move together: if there is more money chasing goods and services prices will inevitably rise.  Commodity prices have tripled in the last ten years (see chart below - click to enlarge).

 Reuters-CRB Commodity Price Index

The US dollar is the world's primary reserve currency used to price and trade everything from crude oil and gold to wheat and pork bellies, so it makes sense to look at how much of that "stuff" is around.  Total debt in the U.S. has more than doubled in the last 10 years.


  1. Good stuff! It is incredible how paranoid everyone seems to be about inflation. If inflation is an increase in the amount of money in the economy and if we continue to maintain a debt based monetary system, then how much inflation will there be in an already over-leveraged economy?

    We have had in the past twenty years substantial inflation, if measured by money/credit expansion. I believe there is a very high probability of a continued deflationary period for the next several years.

    The only thing that would change that is if we have a change in our monetary system, i.e. we change from a debt based system to something else.

  2. I don't think China or India care if we have 9% unemployment or if homes in Riverside are under water. They still want indoor plumbing, a nice steak, and a car.

  3. If QE 1 and 2, and the other bailouts and stimulus programs were never instituted, the deflationary collapse would have been so severe, that the casino (Wall Street) would have had little left to gamble on commodities.

    I guess the inflation/deflation debate is a half full, half empty glass viewpoint.

  4. Are you saying the Fed has managed this quite precisely - replacing lost credit with its own version, only so much and no more?

  5. It's not only the Fed that is "easing" but the Treasury, as well. No to mention the Chinese and the Oil Arabs - yes, the Chinese are 100% complicit in what is happening even as they appear to be "mad" at the US. The Arabs are a slightly different case, but not too much. Let me explain.

    The enormous bump in federal budget deficits is a textbook Keynesian response to the burst bubble; it is financed by issuing Treasury bonds. And who buys them? Essentially, those with surpluses, i.e. the Chinese and the oil exporters. If they stopped buying the bonds the US economy would tank and their exports would come crashing down. Simple stuff.

    But they ARE getting antsy..

    So, the Federal Reserve is in this too, by buying some more Treasurys, artificially inflating its balance sheet ("printing" money, i.e. QE).


    The Anglo-American financial community is also hard at work bad-mouthing the euro in order to avoid "competition" for those Sino-Arab moneys.

    Let's get this straight: there is no Euro Crisis in FACT, other than the one that is being whipped up into a frenzy by the likes of FT, Bloomberg, Reuters, WSJ, Roubini, Rogers and The Economist. As a reader aptly said "Greece is a sideshow". It's smoke, pure and simple.

    And THAT'S why lately I've been focusing on debunking this so-called Euro-Crisis. Because once that's understood to be nonsense, the REAL debt crisis will become quite starkly clear:


    The ONLY thing hiding the fact is bond purchases by the Chinese and Arabs. When - not if - they stop buying, it's GAME OVER.

  6. You are missing an important point.

    The govi debt creation is used largely for consumption. The idea that the Fed can sell the QE paper is ridiculous at this point. Where is all the real money going to come from? GDP expansion? Unlikely. Debt used to fund an income producing asset is far different than debt used to fund consumption.

  7. True enough. But the Chinese ARE still buying US paper because they are the ones exporting to the US and they are using the money to build productive capacity in their own country.

    In the end it won't really matter if the Treasury paper they own is worthless, they still get to keep the factories and infrastructure.


    PIMCOs Gross on what it might be that finally spooks the Chinese and Oilers.