re: Interesting Business, Econ and Finance Links

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A decline in velocity therefore reflects a crisis in the economy; it does not mean that money is tight but rather that people have stopped spending as much of their incomes as they used to. It also means that even very substantial increases in the money supply do not lead to price inflation, as central banks cannot force people to spend the new money, or to take out new bank loans. Only when people are again willing to increase their spending will increases in the money supply result in higher prices.

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That increases in the money supply during a crisis do not result in price inflation is thus easily explained by an increase in the demand to hold money, but this does not explain the general failure of central banks in generating inflation. The rate of growth in the money supply has almost always outpaced the rate of growth in consumer price inflation. Does this not mean that, whatever other evils we may claim follow from central bank interventions, the dangers of inflation are significantly overstated?

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No. The confusion arises from ignoring the entry point of the new money into the economy. The new money does not instantaneously spread throughout the economy and prices do not immediately adjust. Rather, the new money goes to a few recipients first, who then spend it on goods and services, bidding up prices, and the next recipients then spend it, again bidding up prices, and so on and so forth, until the money has been distributed and the whole price structure has been changed by the infusion. This is what is known as the Cantillon effect. Hayek in a famous image compared it to the pouring of honey on a surface: the honey does not immediately spread out across the surface but forms a mound at the point where it is poured out and only slowly spreads from there.

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Modern central banks, however, don’t pour money on consumers. Rather, they produce new money by injecting it into the financial system. The Federal Reserve buys US Treasurys and other financial assets from banks with new money, and the banks then spend the new money during their normal business operations. What we therefore have is a system of financial inflation: the prices of bonds and other financial instruments are bid up, leading to ever-lower rates of interest on loans, real estate prices are bid up, as it is now cheaper to finance mortgages, and only much later does the new money filter down to normal consumer goods. The rise in CPI is thus only a shadow of the distortive effects brought about by the increase in the money supply.

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This does not mean that central banks would be able to cause inflation even were they to give the new money directly to consumers, for they cannot force each individual to spend the money on consumption. We saw an example of this recently when the US government distributed the CARES Act stimulus checks, the so-called Trumpbucks. I previously suggested that this kind of inflationary spending might quickly result in high inflation. However, I was mistaken in assuming that the money would be spent on consumption; most Trumpbucks seem to have been used to either increase savings or reduce debt. Thus the inflationary impact has been redirected or absorbed into financial markets or higher cash balances. (It is even possible that it has been neutralized to the extent that individuals have reduced or paid off their bank loans—if the banks have neglected to offer new loans in order to solidify their own position.)

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