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.