Economics,  General interest,  Investing,  Markets,  Markets and economy,  Wealth Management

MMT and (hyper)inflation

I was going to write a post about the role tax plays in an economy, but I got a number of questions around MMT and the risk of inflation, so I figured I’d deal with that today instead.

“If you make more of something, by definition you are diluting its value. If you print more dollars, you will debase the currency and cause inflation. We’ll end up like the Weimar republic or Zimbabwe.” While this may sound intuitively sensible, it’s not right.

To deal with the first part, producing more of something does not necessarily dilute its value; think of diamonds, or Ferraris, or medications – you won’t dilute the value unless you produce too many.

Fiat currencies are not backed by a specific ‘thing’. When the world operated under the gold standard, which ended 50 years ago, dollars were convertible to gold, and yes, a government was restricted in how much money it could create. It was a horribly constrained system that created a world of problems and was duly abandoned.

Nowadays, a sovereign currency is backed by all the resources of the economy: all the goods and services that can be bought and sold. The only way to cause inflation by creating new money is if you create so much that the resources are fully utilised, which is called ‘demand pull’ inflation. The other way to get inflation is ‘cost push’, which is far more common, and is where prices go up independently of demand. The best example of that is the OPEC oil price spike in the 1970s.

To illustrate how simply creating money does not necessarily cause inflation, figure 1 compares the growth of the US money supply since the start of 2000 to the increase in US inflation (as measured by the CPI). Evidently there is no correlation.

Figure 1: The growth of the US Money Supply (M3) compared to the growth of US Inflation (CPI): the simple act of creating money does not have to cause inflation

Source: US Federal Reserve

The questions I got centred around the theme of what is there to stop governments going mad and spending like the proverbial drunken sailor. The constraint MMT imposes is inflation. It really is the lynchpin of the whole framework.

Hyperinflation

Hyperinflation, such as occurred in Germany in the 1920s or Zimbabwe in the noughts, is caused by the destruction of an economy’s resource base.

After World War 1 Germany was forced to pay reparations, in foreign currencies, equivalent to three times its GDP. However, its manufacturing base had been devastated, a situation exacerbated when the French occupied the Ruhr Valley region in 1921. The Papiermark suffered catastrophic devaluations against other currencies forcing the Reichsbank to issue greater and greater amounts of currency.

In Zimbabwe’s case, Robert Mugabe promised he would redistribute white-owned farms among his freedom fighters. Unfortunately, the ex-soldiers knew nothing about farming and Zimbabwe went from being the breadbasket of Africa to a basket case. It’s economy shrank by 60% and it was unable to feed itself. Once again, however, the government continued to print ever increasing amounts of money to pay for its imported goods, as well as its involvement in neighbouring wars.

Conventional economics struggles badly to explain how inflation works, and remains enthralled to the monetarist version that asserts any increase in money supply will necessarily lead to inflation. In fact, in November 2010, 24 leading US economists published an open letter in the Wall Street Journal to the Chairman of the Federal Reserve, Ben Bernanke, imploring him not to proceed with QE because they were convinced it would cause inflation. They were, of course, wrong.

Critics of MMT attempt to dumb it down by summarising it as suggesting governments are able to spend money at will with no consequences. That is utterly wrong. MMT simply points out that a government deficit, or surplus, is not, of itself, a good or bad thing. And most certainly, a government budget deficit is not a sign of overspending, rather, inflation is. Another way of thinking about it is rather than couching government spending as a narrative of scarcity, MMT promotes a narrative of opportunity.

This is a more detailed article about MMT and inflation.

As always, comments and questions welcomed at james.weir@stewardwealth.com.au



This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

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