André de Godoy, a Brazilian journalist from the Mackenzie University of São Paulo, interviews economics professor and Mises scholar Antony Mueller about the causes and consequences of credit expansion and the relations between credit, money, and price inflation.
André de Godoy: Please explain the relationship between the money supply, the price level, and economic activity.
Antony Mueller: The supply of money determines the price level in the long run. Whether prices will rise or fall depends on the relative variation of the money in circulation compared to the relative variation of the supply of goods. However, one must take into account that the process from the creation of money by the central bank, the so-called monetary base, and the impact on the economy in terms of demand is long and contains a series of variables. These transmitters of the monetary impulse can work in tandem and strengthen the original impulse or, say, may counteract each other. Let me give you an example: over the past fifteen years, the main central banks have practiced the policy of “quantitative easing,” which has expanded their balance sheet by a factor of over five. In the United States, the monetary base rose from $830 billion in January 2008 to over $4 trillion in September 2014 and stands as of now, in January 2020, at $3.4 trillion. Yet this drastic increase has not led to a price inflation and has stimulated economic activity only moderately. The reason for this is that the commercial banking sector did only transform a part of this base money into money in circulation and that the economic agents reduced the transaction velocity. For the monetary aggregate M1, the velocity halved from 10.6 in early 2008 to 5.5 in the fourth quarter of 2019.
Godoy: Authors like Ludwig von Mises and Milton Friedman hold that inflation is a monetary phenomenon. However, I have heard that it is possible to expand the amount of money in circulation without causing negative effects for the economy because inflationary effects could be controlled by the adjustment of the interest rate. Is this true or just a remedy?
Mueller: This is a very confused view. What sense does it make to expand the money supply and then try to control it by raising the interest rate? The result of such a policy is market turmoil and confusion. It is interventionism of the worst kind. Why should the money supply increase anyway? If the supply remains fixed, and productivity rises, prices will fall. That is beneficial deflation. Why should one complain when the goods become cheaper for the consumers? The point is whether price deflation happens slowly according to productivity increases in the economy or abruptly as a hefty liquidity contraction due to a financial market crisis.
Godoy: Why do central banks try to manipulate the money supply?
Mueller: Central bankers have a deep-seated fear of deflation. They presume that a price deflation will lead to an economic contraction. Yet if central banks had left the system alone, such a deflation would be very gradual and not only be not harmful but beneficial for the economy. If the central banks intervene and expand the money supply and implement, as it is the case today, a “zero interest rate policy“ (ZIRP), or even a “negative interest rate policy” (NIRP), a tension builds up between the natural tendency of the prices to fall because of productivity increases and the inflationary money supply. A deep discrepancy builds up between the human time preference and the monetary rate of interest which would converge in a free market without central bank interventions.
Godoy: Would a stable money supply not be too rigid for the economy?
Mueller: One must remember that a falling or rising price level is the result of the difference between the rate of variation of the supply of goods and the rate of variation of the money stock and the velocity of economic transactions. The monetary system has a natural elasticity. Even when the money supply is linked to a fixed supply of central bank money, expansions and contractions of nominal spending will take place. Money has loose joints, but when the monetary base is stable, the system has a definite anchor. There is elasticity of money under a gold standard even when the stock of gold is constant. Different from what we observe today, no long-term and extreme divergences were possible. We must change our present monetary system which is highly dysfunctional.
Godoy: Some prominent Brazilian economists mention the post-Keynesian theory as a counterpoint to the classical quantity theory of money and claim that the so-called modern monetary theory would provide a better model for the present.
Mueller: As I explained above, even when the money supply stays fixed the use of money is volatile, and thus even a gold standard has monetary elasticity. It is wrong to claim that only fiduciary money would provide financial flexibility. The point, rather, is that with an anchored monetary system, the degree of deviation is limited, while under the current fiat money regime there is no constraint. That is the problem with the modern monetary theory. Its adherents praise an anchorless system, because it would allow unlimited funding of government expenditure. Even these theorists, however, recognize the problem of price inflation when the money supply is excessive. In this case, they believe, the government could control price inflation through taxation and then siphon off the excess money. Yet while the adherents of this “new” monetary theory praise anchorless money as a boon because they live under the illusion that the economy is in permanent need of macroeconomic management, the truth is that it is not the free market that produces booms and busts but the intervention of the governments and their central bankers.
Godoy: Could you cite a few examples of how inflation comes about in our day because of the monetary policies that governments have recently pursued?
Mueller: Venezuela is currently a sad example along with the very tragic case of Zimbabwe. Let’s concentrate on Brazil’s neighbor country. Massive government spending, foolish interventionism, and the expansion of the money supply are behind the gigantic price inflation in Venezuela. These policies form part of the grander plan of implementing a “Socialism of the Twenty-First Century.” But what they got was not prosperity and equality but even sharper social divisions, a brutal hyperinflation, and mass misery. Venezuela is the empirical verification of what we have discussed: the process begins with the false promises of social justice and comprehensive welfare. Private property is no longer secure, government intervention is on the rise, and business investment falls. Yet instead of the deteriorating economy inducing the political leadership to change course, government expenditures, based on credit expansion, increase even more and with them rises the money supply. While more regulation and interventionism suffocate the supply side, inflationary demand is on the rise. The country enters a deadly spiral of economic, political, and social crises that reinforce each other. At the very beginning of this process, some illusionary benefits appear, yet after a short while the poorest people are those who suffer most until it also brings down the whole rest of the society in a cataclysmic collapse.
Godoy: From what I’ve gathered, monetary inflation itself is not the problem that causes a raise in the price levels. The problems are people’s expectations and the speed with which transactions happen, is that correct?
Mueller: Well, let us put it this way: the reason for obesity is not the food but how much one eats. The expansion of the money supply is the food. Whether the economic actors take the offer is another question. In this decision expectations play a major role. Here, however, we must consider that expectations do not come from nowhere. They have a point of reference in the economic reality and in the public discourse, including the media. The laissez-faire approach to money does not mean the absence of control. It is rather the present monetary system, with constant central bank intervention and the craving of governments for deficit spending, that is out of control. In contrast to a fiat money system, a gold standard or a similar system with a strong anchor would combine short-term flexibility with long-term stability.
Godoy: The mechanism that uses interest rates to control inflation is actually a way to try and contain price raises in a fiat money system, right?
Mueller: For the policymakers, interest rates are an instrument of intervention while for Austrian economics they should reflect time preference and as such would be the natural rate. Policymakers can only manipulate the monetary rate of interest. What matters is the money supply and the expectations. A higher interest rate makes borrowing more expensive and thus may stop the expansion of the circulation of money in the economy. Furthermore, higher interest rates may change expectations about future price inflation and thus reduce the velocity of circulation. The main point, however, about raising the interest rate is that the central bank has to reduce the monetary base in order to obtain higher interest rates. Central banks cannot just raise the interest rate and leave the monetary base as it was. When central banks target a certain level as their policy rate of interest, they must manage the monetary base accordingly.
André de Godoy: Ludwig von Mises mentions in his books that credit expansion is one of the causes of the inflation beyond the monetary expansion. What are the similarities and differences between those two phenomena?
Antony Mueller: Money comes into circulation through the channel of credit. Commercial banks get a loan from the central bank and provide loans to consumers, business, and government. Thus, there are two sources of credit creation and two basic types of money: central bank money and depository money. The modern monetary system is a pure credit system based on fiat money without a physical backing such as gold, for example. Governments left the gold standard with the beginning of World War I and they never returned to it. Nowadays, the government through its central bank can create as much money as it wants.
Godoy: What exactly is the relationship between credit and money?
Mueller: While fiat money is based on credit, not all money impacts on the economy. For example, commercial banks can borrow money from the central bank and not use it for loans but deposit it in their accounts at the central bank. Then more central bank money does not mean more commercial credit for the investors and consumers in the economy. Also, more money that comes into the economy does not necessarily mean more demand because the holders of money may slow down the frequency of transaction–the so-called velocity of money. When the economic agents spend less and hold their money assets for longer period of time, the velocity of circulation of money slows. Therefore, it is wrong to postulate that more money means more credit and that more money always means more spending. That was the false assumption of the monetarists.
Godoy: Concerning the exchange rate policy, how can the variations of the exchange rate lead to inflation?
Mueller: In the long run, the exchange rate reflects the purchasing power parity. In the short run, however, significant deviations happen because of policy intervention and because the central banks manipulate the interest rate. One intervention leads to the next, and finally everything gets messed up. For example, when the governments try to stimulate their economies through extra deficit spending, the interest rate should rise because of inflationary expectations, yet the central bank may counter this and keep the monetary interest artificially below its natural rate. In this case, smart money leaves the country and the currency devalues. When, as it is often the case with developing countries and emerging economies, the import elasticity is low, the quantity of the imports will not fall very much even when the price of the imports in domestic currency rises as a consequence of the exchange rate devaluation. This then may ignite price inflation at home and then, in turn, even more money tends to leave the country. In its desperation, government then typically feels forced to manipulate the exchange rate or to impose capital controls. In the end, the mess is so great that the stimulus experiment backfires and instead of the intended economic expansion, the country suffers a foreign exchange crisis along with an economic contraction or even a collapse.
Godoy: Inflation is a subject that often shows up in the news, but the causes of the inflation do not get as much attention as its consequences. What are the causes of inflation and how do the factors interact?
Mueller: Let us first make it clear that the term “inflation” suffers from a false use. The exact meaning of inflation is the expansion of the money supply. To say that “inflation rose” makes no sense because the term inflation refers to a volume, the monetary volume, which can expand (inflate) or contract (deflate). When I talk about the price level, I prefer the term “price inflation” to differentiate the fall and rise of the price level from the inflation that takes place with the expansion and contraction of the money supply. Additionally, Austrian economics stresses that the relationship between monetary expansion and the price level does not work in a mechanical way.
Godoy: Could you explain the process?
Mueller: To put the problem as simply as possible, one may say that price inflation happens when spending grows faster than the production. An excess of spending over production results when the money supply expands and when business, consumers, and government borrow to spend more. The discrepancy between the demand and the supply of goods and services leads to rising prices. Price inflation may also happen without the expansion of the money supply when a so-called supply shock happens and the supply of goods contracts. Then prices rise because the volume of goods has shrunk while the money supply has not changed. In order to understand inflation, one must keep various factors in mind: the process of how money enters the economy beginning with the central banks and the credit policy of the commercial banks, the rates of change of the money supply, of the credit volume, and of the velocity of transaction, as well as the nominal aggregate spending compared to the real supply of goods and services. The economics of inflation is not an easy topic.
Godoy: When the government expands the monetary base but the commercial banks do not put the excess money into circulation, money in the hands of the public does not increase. Does this mean that in this case there will be no increase of prices and reduction of the purchasing power?
Mueller: Yes, that is how it works. In the end, the outcome depends on human action. Human action takes place in time and therefore expectations matter. Inflationary expectations feed on themselves and likewise do deflationary expectations. That is why both processes, once they gain momentum, are so hard to control. If we had a sound monetary system, expectations would be relatively stable. Yet we have a state-run fiat monetary system with fractional reserve. Such a monetary system is not only very volatile but prone to prolonged phases of credit expansion and credit contraction. These big cycles can cover decades. We have been experiencing such an expansionary cycle in the industrialized countries since the end of the link of the US dollar to gold in the 1970s.
Godoy: Can this cycle end?
Mueller: This current cycle has been long overdue to turn into a contraction. Yet all major central banks have been fighting like mad against the trend. In Japan, the futile fight began already in the 1990s, in the United States it started at the beginning of the new millennium. Since the European debt crisis about ten years ago, the European Central Bank has also joined in. Thus, what we observe today is a desperate fight against deflation.
Godoy: How does the unitary decrease in the money value happen under a fiat system?
Mueller: Under the gold standard or a similar system with a strong anchor that moors the money supply, there will be fluctuation of the money supply in the short run. In the long run, prices will tend to fall as productivity increases. Expectations do not get out of whack, because inflation and deflation cannot deviate disproportionately. Yet under a fiat monetary system, inflation and deflation can take on excessive proportions. I fear that the ketchup parable of inflation holds up. You shake and hit the bottom of the ketchup bottle, but nothing comes out. Suddenly, the ketchup splashes onto your plate, on the table and on your shirt in a burst. It is the same with money inflation. The central banks push and shake, and no price inflation appears, until it suddenly comes as a massive burst of price increases and as hyperinflation. The analogy holds also for what comes after it. Whereas the ketchup sauce pours out of the bottle in a splash, it takes a lot of work and a long time to get the excess sauce back into the bottle. In fact, a full redoing will be impossible. Under a fiat monetary system, it is not only inflation that comes suddenly as a splash but also deflation. Under a fiat system, a monetary contraction is malicious, because it will typically show up out of the blue and play havoc with the business of the economic agents.
Godoy: As a final question, please let me ask you for your outlook for the US American economy compared to Brazil’s.
Mueller: The two economies are in very different stages of the business cycle. Brazil is still in a slump that began five years ago which brought with it an unemployment rate of over ten percent (and the rate still lingers above this mark), while the United States is officially at full employment. The question is when Brazil may recover and if the United States economy will tank. First to Brazil: Since January 1, 2019, Brazil has a new government which is different from its predecessors, as it has a strong pro-market profile. Confidence is on the rise, and in this respect, it is only a question of time when the Brazilian economy will recover. However, there are two risks: firstly, that inflation may come back to haunt Brazil when the recovery gets stronger and secondly, what will happen if the international economic environment continues to weaken and Brazil’s major trading partners, including China, enter into a recession.
Godoy: How about the United States?
Mueller: The policymakers have fabricated a gigantic balloon that has taken us atop a pyramid. We know that this situation is unsustainable, but we do not know to which side the balloon will fall. The American central bank has tried several times to deflate the balloon but blinked as soon as the stock market started to wobble. Like fiscal policy, monetary policy has painted itself into a corner: fiscal policy with too much public debt and monetary policy with too much private sector debt. Austrian economists have always warned that such policies of excessive credit creation will end in a disaster. I suspect that we have moved beyond the disaster stage and are approaching a catastrophe, which hopefully will serve as a wake-up call and alert the public and the policymakers about the need to reform the monetary system.
This interview appeared in two parts at the Mises Institute USA. Part I as “Why Deflation Can Be a Good Thing” on March 6, 2020, and Part II as “What Comes after Quantitative Easing?” on March 9, 2020