There is a new blog about the Irish economy by a very impressive list of professional economists, which I’m sure that many of you have been following. It’s definitely a blog worth keeping an eye on.

One post that I noticed recently, “On German Concerns About US Monetary Policy“, contains too many interesting points for me to deal with in one post, but I would like to focus on one simple idea and see if my analysis can add to the conversation. The question is: are central bank asset purchases inflationary? And what about loans? I will write generally about my understanding of some important effects of money creation.

From the blog post:

…it is simply not accurate to refer to the recent expansion in the Fed’s balance sheet as “literally printing money”. Bernanke occasionally gets referred to as Helicopter Ben, as in the Milton Friedman’s famous analogy about dropping money from a helicopter. Basic intuition explains why a helicopter drop will increase prices: It represents an increase in private-sector nominal wealth and this higher level of wealth is chasing the same real amount of goods and services, which leads to an increase in the price level… “Most Federal Reserve money creation does not represent an increase in private-sector nominal wealth. The Fed expands the money supply by purchasing securities from the public and paying for them by crediting the reserve account of the seller’s bank. From the point of view of the private sector’s balance sheet, a security of a certain value has been swapped for cash of that value, with no corresponding change in private sector wealth.”

I want firstly to make clear the distinction between money and wealth. In general, once we have a functional medium of exchange, what wealth does society gain from an additional supply? In the case of fiat paper money, which has no (or negligible) non-monetary use value, the answer is none. Since paper money only serves as a medium of exchange, and since we have assumed that there was already enough money to serve this purpose, an additional supply can provide no extra value to society as a whole. This is in contrast to a real commodity money like gold, where an additional supply enriches us through its many applications. In a paper money (€) scenario, suppose that a counterfeiter prints €50k in his basement, and then goes out and buys a car. Considering the balance sheet of the counterfeiter versus the balance sheet of everybody else in society, would we say that there had merely been an exchange of an asset of a particular value for cash of that value, and that there had been no change in everybody else’s wealth? I don’t think so. The goods purchased by the counterfeiter have been replaced on the balance sheet of everybody else by debased paper money. The counterfeiter has received a car, while everybody else has only received useless paper money. The counterfeiter is better off, while “society” (i.e. everybody else, taken together) is worse off, in terms of useful goods and services, by exactly one car.

There are some subtleties as to how exactly the cost of the car is borne. It would be wrong to say that everybody else in society had been made worse off by the counterfeiter. Naturally, he who voluntarily sold his car for counterfeit paper can experience a benefit (presuming that the money is not rejected as counterfeit when goes to market with it). Depending on how much is paid for the car, the seller of the car can now better outbid others for the goods and services he desires. Those who supply him, by experiencing increased demand for their products, can do likewise in their own capacity as buyers. In this way the new money flows through the economy, enriching first of all the counterfeiter, and then secondarily those in his or her chain of supply, and impoverishing everyone else to the same extent.

If the counterfeiter had instead been a thief, and had simply stolen the car, the difference in the resulting distribution for everybody else would of course have simply been that the original car owner had been left without his car. It’s worth noting at this point that whereas those who bear the costs of monetary inflation may have little or no idea about what is happening to them, victims of theft tend not to suffer from that problem.

If we are talking not about a car, but about a security such as corporate or government debt, the principle still holds. The government via the central bank experiences the primary benefit, while the bondholders experience the secondary benefit from increased demand for their assets. For the same reasons as above, everybody in the chain of supply to these bondholders benefits in this way. Wealth has been redistributed to the government and to everybody else in their capacity as suppliers to government, while it is redistributed away from people in their other capacities.

To picture some of these dynamics in very simple terms, we might imagine a small village which uses shells as its medium of exchange. Suppose that one particularly clever or lucky inhabitant of the village, called Ben, discovers a cache in a nearby forest containing an unlimited supply of shells. Ben starts using these shells for his expenditures, outbidding his rivals for the goods he wishes to purchase.

Now imagine that Ben has a particular fondness for fish. By supply additional money to the fishermen than they would otherwise have received, Ben will thus stimulate the fishing trade. Fishermen will be able to use the money they receive to satisfy their own various desires, outbidding rivals from other trades in the marketplace. Thanks to Ben’s activities, fisherman will be able to live more comfortable lives than they otherwise could, and this will be at the expense of, for example, the farmers, whose customers, unlike Ben, have no new means to boost farming income. The result is that fewer people will farm, and more will want to fish. There is a rebalancing of the labour market as people seek the lucrative returns provided by Ben’s virtually limitless demand. This will help to satisfy Ben’s demand by increasing the supply of fish, and yet to the same extent it will impoverish those who consume other items, by reducing the supply to them. Thoughout all of this the economy’s total productive potential hasn’t changed, it has only been altered to take into accout Ben’s heightened buying power.

So we understand that the economy evolves to reflect Ben’s demands. How much it changes depends on how many shells Ben is releasing to the market at any particular time relative to the stock already in supply at that time. The extreme case is where everybody else is directing their efforts only to satisfy his demands, when nobody else can afford to outbid Ben for any good.

This system breaks down when people figure out what is happening and stop using shells as their medium of exchange. If shell-prices are no longer useful for economic calculations, and if shells no longer act as a reliable store of value, then people will start looking for other commodities to serve this purpose. Therefore, to maximise his discovery for the long-term, Ben would probably be better off not letting anybody else know about his cache, and supplying additional shells to market only infrequently so that the inflation will not be too severe and the integrity of the shell money can be maintained for as long as possible. Additionally, if Ben is powerful enough, he could try to secure the long-term usage of shells by simply outlawing the use of any other currency.

Note that hyperinflation in our village wouldn’t actually be so bad as a 21st century hyperinflation, since at least the villagers would be left with an unlimited supply of pretty shells in their possession.

The main point that I want to drive home here is that swapping newly created money for assets does not avoid the inflationary implications of a helicopter drop. What you can say about the helicopter drop is that at least it only raises the price level, but the printing of money for asset purchases also has the effect of removing assets from the productive sector of the economy. Instead of having more money and the same stock of assets, the productive sector is left with more money and fewer assets. “Nominal wealth” (money) has increased, while the stock of real wealth has decreased. What’s more, the cost of these assets is borne through the higher prices faced by everybody outside the chain of supply to the government, and in such a way that they are unlikely to understand what is happening (this is in contrast to the outcome if the assets had just been expropriated or stolen). It’s a particularly oblique form of wealth transfer.

It might be a little bit confusing in the case where the newly created money is used to buy debt instruments such as bonds or mortgages. In this case, can the inflationary effect of money creation be nullified by the deflationary effect of removing debt from society’s balance sheet? Not at all: the debt instruments are not part of the money supply. The money which was lent to create this debt is a part of the money supply, but the debt instruments themselves are not. They are merely claims to money, constituting part of the demand for money, not part of the supply. Thus, replacing them on society’s balance sheet with money is no less inflationary than would be replacing a car.

Next, we read:

“These types of permanent purchases are actually pretty rare: More common is that the Fed provides a temporary loan, securitized by some collateral. The Fed provides liquid funds (which is an asset for the private sector) but this is owed back to the Fed (which is a liability for the private sector). Again, no private-sector wealth has been created. ”

It is true that no wealth has been created, since, as we discussed, money and wealth are different categories of item, and the creation of a loan is merely the temporary creation of money. But using a similar analysis to the above, we can see that whoever voluntarily accepts money in exchange for their collateral has benefited from this transaction. Of course the Fed or other central bank has gained too, because they only had to will into existence the unbacked paper (or more likely, digital) money in order to receive a conditionl claim to the collateral for lending it. The losers are the people who are in competition with those who receive the new money and everybody who depends upon these people.

To take an example, a bridge loan to a car manufacturer will enable that manufacturer to outbid his rivals for factors of production (land, labour, capital). These can be rivals from the car or from any other industry, and this is why attempting to address the imbalance caused by aiding just one manufacturer won’t work: providing loans to every car manufacturer would merely divert productive resources into the car industry and away from everywhere else.

The only thing that can be said in favour of loans versus asset purchases is that the amount of wealth transferred to the government and its chain of supply in the case of a loan need not be nearly so great in comparison to the amount of wealth transferred in the case of an asset purchase of a similar amount (simply because the central bank may subsequently absorb the loan repayments and allow the money supply to revert to its orginal level).

Of course there is much more to be said about all of this, but I hope that what has been said is reasonably clear. Money creation is always “inflationary” in the modern sense of the word (which is why historically the terms money creation and inflation were synonymous), and the benefits of money creation, whether it is used for purchases or loans, and whether it is created by a central bank or an illegal counterfeiter, accrue first of all to the creator, and secondly to the creator’s supply chain. It thus redistributes wealth and changes the structure of the economy as a whole.