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The financial system is open, minds not so much

28 Jul 2021 1 month(s) ago

Modern Monetary Theory is basically printing money, yet there is not a great deal of inflation. Why?

Modern Monetary Theory (MMT) is a much discussed economic theory which basically says that if the central bank buys back government and, even private, debt and put it on their balance sheets, which is a procedure called Quantitative Easing, then growth can be stimulated. As Stephen Moore says, it is basically printing money to stimulate growth. He adds that if that strategy worked then Zimbabwe would be the richest country on earth. (Note: Zimbabwe is not the richest country on earth).

Like most economic theories and debates, this is centred around circular arguments. ‘Economic growth’ is a measure of transactions, the amount of money changing hands. So if you increase the amount of money in the system, you will get economic growth: more transactions. QED. But of course that is not the point. The point is what is real, not what money represents as being real. Most economic measures, with a few exceptions, are not designed to detect that of course (purchasing power parity is an effort in that direction, but it has similar problems).

MMT, quantitative easing, may be defensible in very bad times, such as the global lockdowns during the ‘pandemic’. It can smooth out the downturn in the business cycles, or, in this case, the global panic about a virus that caused massive damage to the economic fabric.

But printing money is obviously ridiculous over the long term. Just look at the Weimar Republic in the 1930s when they had wheelbarrows full of cash, or Argentina in the 1970s, when the kept changing the price of coffee as people were drinking them.

Most of the world – including China, where domestic money supply is over two times its economy – is printing money like it is going out of style. It is Weimar Republics as far as the eye can see. The US is spending twice what it is taking in as tax revenue, then selling most of the government bonds to the US Federal Reserve where it is parking it on its balance sheet.

So here is the question? With so much money printing going on, why isn’t inflation going berserk as it did in Argentina or Zimbabwe? That is certainly what a lot of economists trained in their circular thinking would expect.

There are two reasons. The first is that most of the money being printed is going into assets, which are not into the kind of transactions that are measured in inflation statistics. Inflation measures essentially look at short term transactions like buying food, or paying rent. Consumption, in other words.

Assets are not consumed, and for the most part they are not short term transactions. If you are buying an excessively priced house you will probably hold on to it for decades, so there will be no transaction to measure. There has been massive asset inflation in developed economies – in Australia it is most seen in house prices – but that is hard to measure and central banks pretty much ignore it anyway.

The second reason is that the system is not closed. If you have a closed system, an ‘economy’ of people buying and selling, then printing money will inevitably make the price of what is being sold higher – there will be inflation. But developed economies – even to some extent China, whose financial system is closed on the capital account – are actually very open. About $US6 trillion sloshes around the world each day in cross border capital flows.

The US annual economy is only about three days worth, and the global economy is only about 15 days worth. That means that when money is printed it just spins around the globe in this giant casino called the derivatives market (essentially bets on conventional financial assets like currencies, interest rates, shares and so on).

It means that for most of this century, when derivatives started to grow like topsy eventually triggering the global financial crisis, national financial systems are not open. That is why inflation has not been out of control. But in a situation so unpredictable, anything could happen.

And there is only one way for interest rates to go (Australia’s base rate is 0.1%).



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