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Contrary to popular belief, debt creation, by
central governments, banks, corporations, individuals, or central banks, does
not cause inflation.
But where did this popular belief come from?
In the past, it could indeed be said that
"debt creation" led to inflation. When commercial banks themselves
were issuers of currency, in the 19th century, they increased
their supply of banknotes outstanding ("the money supply") by making
loans. If, for some reason, the legal obligation to redeem these possibly
excess banknotes into gold (typical in the 19th century) could be
avoided in some way, as was common in the Western and Southern states in the
US for example, then the banknotes would lose value compared to their gold
parity and the situation would become inflationary.
State governments were engaged in similar
shenanigans back in the 18th century. To pay soldiers, many state
governments issued IOUs that said something like: this note can be redeemed
for silver in two years. The notes were, in essence, a zero-coupon bond, and
by issuing them, the state governments were creating debts. The state
governments soon found out that paying soldiers with paper rather than silver
was quite a lot of fun, and they began to do it with enthusiasm, resulting in
a collapse in the value of the supposedly silver-redeemable notes. (I doubt
that anyone was actually able to redeem the notes for silver.) Quite a lot of
similar stories could probably be found wherever paper money has been used,
since its introduction in 11th century China.
Then, of course, there is the typical
inflationary default, where a government that is in debt begins to pay off
its debt with the printing press. In this case the issuance of debt was
legitimate enough, and was fine for a while, but over the years the burden
became so large that the inflationary option became irresistible.
Today, even if the government is in reasonably
good shape, it may be the case that corporations or possibly individuals
(like today) are so deeply burdened by their debt loads that the government
may introduce some inflation to allow a "partial deflationary
default" on that private debt, typically with the hopes that it would
help the economy overall. This is certainly one reason for the round of
devaluations/inflations worldwide beginning in 1931, and many suspect that
the US government and Federal Reserve may ultimately choose to err on the
side of inflation in the near future, to keep swathes of overindebted
individuals from becoming bankruptcy cases. Thus, corporate and individual
debt, in this case, may eventually lead to an inflationary outcome.
The Bank of England was the first so-called
"central bank," although it acted as a commercial bank. The Bank of
England had an effective monopoly on banknote issuance in Britain, and, as
noted above, like any commercial bank put those banknotes into circulation
via the process of making loans. This is hardly different than any central
bank today, which puts new base money into circulation via the purchase of
government bonds. Purchasing a bond and making a loan are virtually identical
activities, although it might be noted that a loan by the BoE in the 19th
century actually resulted in new debt creation, while the purchase of
government bonds today merely represents a change of ownership of government
debt, as central banks almost never buy government debt directly from the
government today.
Many people today claim that debt creation
causes an increase in the "money supply," although this is
incorrect. Money, properly identified as base money, is not created in the
lending process, but by the central bank. Central banks can create base
money, but not debt (unless they use the discount window perhaps, which is
extremely rare). Commercial banks (and all other lenders or issuers of bonds)
can create debt, but not base money. As we noted two weeks ago, most measures
of "money", such as M2, M3, or MZM, are in fact measures of
cash-like debt. So, to say that debt creation creates debt (M2, M3, MZM) is
not very interesting.
There is quite a bit of confusion about what
inflation is. Inflation is a fall in the value of money, indicating an excess
of the supply of money (base money) compared to its demand. The result
of this fall in money value is that prices may rise. If the value of the US
dollar went from $1 to $0.50, then the price of a $4.00 mocha latte may rise
to $8.00 as the market reflects this new monetary reality. Typically this
price adjustment process takes place over ten or more years after the initial
fall in money value.
Many confuse inflation with "rising
prices," so when they see some rising prices, they assume that they are
witnessing monetary inflation. Often rising prices of assets are directly
related to debt-creation, as we are seeing all to clearly in the recent
worldwide real estate boom. If John Smith was unable to borrow $600,000, he
would not be able to buy his dream home for $600,000. This rising prices
effect can bleed into the Main Street economy as well, since if John Smith is
bidding big bucks for his dream home, with his banker's help, then that may
also drive up incomes for local real estate agents, mortgage brokers, construction
workers, etc. And finally, such debt creation (especially as it is used to
purchase assets) may leak into the asset-management sphere as well, leading
to the "excess of liquidity" type feeling that is so prevalent
today -- according to our hypothesis of two weeks ago.
However, it is also possible to have huge debt
booms with no inflation whatsoever, if the value of the currency is stable.
The US government's own indebtedness during World War II, when it was running
deficits on the order of 30% of GDP per year, was not inflationary, nor was
the almost equally profuse spending and debt issuance of the Japanese
government in the 1990s, which did nothing to dent the monetary deflation
caused by the Bank of Japan.
Inflation is caused by a decline in currency
value, measured in an absolute sense, which is done by comparing the value of
currencies to gold. If there's a decline, you've got some sort of inflation. No decline, no inflation.
Pretty simple, right?
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United
States, Japan,
and the Middle East. About the Book: Gold:
The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is
available at bookstores nationwide, from all major online booksellers, and
direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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