Why there might
not be a surge in inflation . . . or not.
Historically, the amount of money that has been created and
in circulation, relative to the amount of gross domestic product (GDP) has had a
fairly constant relationship. Today, the
United States real GDP is approximately $18 trillion annually. There is U.S. money in circulation of
approximately $1.4 trillion, which is a ratio of approximately 13 to U.S. real
GDP currently. Following the strong
economic growth of the post-World War II era, in 1975, the United States GDP
was approximately $1.5 trillion, according to the World Bank, while U.S. money
in circulation was approximately $75 billion, which was a ratio of 20. Additionally, in 1950, the United States GDP
was approximately $250 billion, while U.S. money in circulation was
approximately $25 billion, which was a ratio of approximately 10. Expansion in the ratio of
money-in-circulation to United States GDP suggests that the United States
became more efficient with putting new available money to work, while a decline
in the ratio would suggest that new money came into circulation, but was used
in a manner that was less productive than the existing uses of available money
for investment.
$
in billions
YEAR 1950 1975 2000 2015
GDP $250 $1,500 $10,000 $18,000
Money $25 $75 $600 $1,400
Ratio 10 20 18 13
Sources: U.S. Federal Reserve Bank of St. Louis.
The above table shows that from 1950 through 1975, the
increase in money in circulation resulted in a greater increase in real
(inflation-adjusted) GDP. The primary
driver of the increase in money in circulation is when banks create new money
in the system through loans when there is a proposed productive use for that money
in the form of business expansion, construction opportunities, equipment
replacement requirements for consumers and businesses and sometimes governments. During this time period, a tripling of the
money in circulation resulted in a six-fold increase in real GDP. This suggests that the new money created,
mainly through new credit creation in the form of bank lending, generated very
high productive and economic-expanding returns.
Similarly, the roughly flat trend in the ratio of real GDP to money from
1975 to 2000 also suggests highly productive money creation at or near 1975
levels. However, in the more brief
period of 2000 through 2015, the GDP-enhancing impact of new money created has
fallen; approximately $800 billion of new money in circulation more more than a
100% increase, and yet annual real GDP increased by approximately 80%. This suggests that the new money in
circulation, again largely generated through new lending from banks, was not as
stimulative to economic growth as such money supply increases in prior
periods. This suggests that more money
is chasing incrementally less productivity, which can be inflationary.
Going forward, the United States banking system currently is
flush with lending capacity, as there is more than $3 trillion of available
lending power that, due to the multiplier effect, represents approximately $15
trillion in potential new money creation capacity. In the absence of incremental real GDP growth
at a minimum ratio of 13 dollars of real GDP growth for each one dollar of
money creation through bank lending, such new money creation would be
inflationary. Therefore, in a scenario
that our money in circulation increases from approximately $1.4 trillion to
$16.4 trillion without U.S. annualized real GDP expansion from approximately
$18 trillion to $213 trillion, inflation will likely result.
While economic expansion from $18 trillion to $213 trillion
may seem unlikely, and therefore may stoke inflationary panic, there are some
checks that naturally reduce the potential for inflation. First, banks scrutinize loan requests and
have capitalistic profit-seeking motivations for limiting loans to
strong-return investment opportunities.
Second, if banks begin to see existing loans produce
less-than-productive returns through loan quality deterioration, the money
multiplier will fall from the maximum of the formula: money multiplier =
loanable funds * (1/required reserve ratio);
if the required reserve ratio is 20% for most banks, then the maximum
money multiplier would be 5, but in times when loans do not perform well, banks
will slow lending due to profit goals, and new money creation will slow until
higher productivity opportunities arise.
Third, if the pace of credit creation is methodical over many decades or
even a century, then the odds that the $15 trillion of potential incremental
new money created does in fact generate an incremental $195 trillion of real
GDP probably is greater.
In summary, it would be overly speculative, and probably
irresponsible, to stoke the flames of inflationary panic that some gold bugs
tend to rely on with regard to money creation as a definitive driver of coming
hyper-inflation. However, the decline in
productivity of new money creation from roughly 20 dollars of incremental real
GDP to 13 dollars of incremental GDP for each new dollar created does warrant
vigilance. In the context of a
highly-Keynesian global economic environment, where foreign central banks are
using the Great Recession-induced U.S. experiment with quantitative easing in
unprecedented levels, such vigilance seems even more warranted than otherwise.
