Since the Great Recession many economies have struggled to meet their inflation targets despite massive asset purchasing programmes by many central banks, why is that? This contradicts monetarist theory of monetary economics, are the last decade proof that Friedman and company were wrong, meaning that we need other models to explain inflation? In this week’s blog post I tackle the mystery of the missing inflation and ask if monetarist theory is really obsolete. Let’s start by briefly explaining monetarism and then explain why the experiences of the developed world doesn’t seem to match the predictions of monetarism. Then I’ll explain what I believe has caused this divergence between theory and reality and why I think that monetarism still holds.
Monetarism is a school of thought in monetary economics which argues for a constant growth rate in money supply so that the stakeholders in the economy can predict how the value of money will change and so that there is always a desirable rate of inflation to encourage consumption and to safeguard against deflation. Milton Friedman is the most famous monetarist and his ideas have been influential in central banks since the early 80’s. Friedman famously stated that “inflation is always and everywhere a monetary phenomenon”, a statement which doesn’t appear to hold. As part of its three QE’s (Quantitative Easing programmes) the Fed added about $3.7 trillion between 2008 and 2014 to its balance sheet, adding up to a total of about $4,5 trillion. To put that into perspective, the GDP (gross domestic product, a measure of the size of an economy) of the USA in 2014 was according to the World Bank $17,5 trillion. There is no conceivable way that the increase in the money supply was too small to produce increased inflation. Does this mean that monetarism is flawed or is there something else at play here?
If the money supply increases dramatically without there being an increase in inflation there are two possible reasons for this; monetarist theory is wrong, or there is inflation but it’s not being captured by the way inflation is usually measured. I personally strongly believe that the latter is true. Inflation is usually measured using a Consumer Price Index (CPI) which is essentially a basket of goods and services that are supposed to be representative of what a typical consumer consumes and therefore it is thought to be an accurate measure of how prices change. The problem with CPI is that it does not take into consideration the areas in which QE and similar policies are highly inflationary. No CPI’s include index funds, government bonds, or other financial assets which have appreciated greatly as a result of QE. As it turns out when the central bank buys massive amounts of financial assets that has an effect on the prices of financial assets, simple supply and demand really, and as the amount of financial assets have not increased at the same pace at which central banks have bought them prices have increased. This benefits those who have financial assets which tend to be the rich and financial firms. This tends to be a small fraction of the population which benefit which means that the prices of goods which regular people tends to buy don’t increase. This results in a large windfall for the rich and at the same time the CPI is relatively stable.
Here’s a comparison between the S&P 500 and the US economy from 2008, and as you can see the US economy has grown by about a third while the S&P 500 has increased by about a factor of 2,5. This clearly shows that those who hold financial assets have fared significantly better than the average person and that the increase in valuation of the S&P 500 is seemingly divorced from the performance of the real economy. It also syncs up perfectly with my theory that all the money created as part of QE has ended up in the financial system, and in the hands of those who own financial assets, instead of in the real economy. The problem with the missing inflation is really a problem of poor measurement methods rather than that our theories are irrelevant. While inflation, increases in prices, is low the increase in money supply is large and it’s bound to catch up with us sooner or later. Inflation isn’t gone, it’s hiding.
If you found this blog post interesting you can read my other pieces on QE here, and if you disagree with me you can reach me via Twitter. Check back next week for another blog post, and you can sign up for my email list where you get a summary of the month’s blog posts. Please tell a friend or co-worker who might be interested about the blog!
Written by Karl Johansson, Founder of Ipoleco
Cover Photo by Public Domain Pictures on Pexels
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