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Lockdown measures due to coronavirus in 2020 will lead to unprecedented falls in national output across the main advanced countries and many developing countries. The reductions may be of the order of 10-15%, perhaps even more. They must mean that the average citizen is worse off. We cannot consume something if it has not already been made.
Governments are trying to limit or even to suppress the consequences of the economic decline by running enormous budget deficits and financing them by borrowing from banking systems, particularly at the moment from central banks.
When a government borrows from its central bank, it registers a new debt – which may take the form of a Treasury security such as a bond – with the central bank. In principle, the government is supposed to repay that debt at a future date. In return for the Treasury security, the central bank credits a sum to the government’s deposit account. The government can then spend the deposit on whatever it wishes.
Since all the transactions are in the form of electronically-recorded book entries, they have no apparent resource cost. The central bank appears to offer the government a virtual ‘magic money tree’. On the face of it, abracadabra has become the key formula of contemporary economic statecraft, so that – miraculously – the coronavirus epidemic has no adverse financial implications for the government and citizens.
Believers in the gold standard may express their outrage, but they need to understand that the government can confer legal tender status on the central bank’s liabilities, such as the notes that it issues. Further, if someone refuses to accept legal tender notes in payment, that is breaking the law.
The modern world is one of legal tender ‘fiat money’, where the word ‘fiat’ is Latin for ‘let it be done’. More brutally, it is commanded from on high without further ado. In this world, the printing of money enables the state to pay for anything. Indeed, this power is practically unlimited, since the printing presses can be multiplied and instructed to print ever-higher denominations of notes.
Unfortunately, there is a problem here. The printing of money sounds great, but it cannot break the laws of physics. To repeat, we cannot consume something if it has not already been made. If national output drops by 10-15%, people have 10-15% less of everything to consume or invest. That constraint must apply, regardless of the gimmickry of legal tender and the printing press.
What is wrong with the supposed ‘magic money tree’? The trouble is this. When new money is fabricated ‘out of thin air’ by money printing or the electronic addition of balance sheet entries, the value of that money is not necessarily given for all time. The laws of economics are just as unforgiving as the laws of physics. If too much money is created, the real value of a unit of money goes down.
Inflation reduces the purchasing power of a dollar, a euro or a pound, so that – in the end – if output drops by 10-15% in real terms, then so must consumption and investment in real terms.
Traditionally, the USA was a bastion of sound money and strong public finances. In Latin America, dictators bullied central banks into printing money to finance extravaganzas of various sorts, leading to the crazy hyperinflations seen in nations like Argentina, Chile and Peru, and today – tragically – in Venezuela. But a worrying recent development is that, even in the USA, the public policy response to the coronavirus is leading to rapid money growth.
President Trump declared a national emergency on Friday, 13 March. Over the following fortnight the Federal Reserve, the USA’s central bank, announced a number of dramatic policy changes to help the Federal Government in the financing of its deficit.
This might be termed technically ‘monetary financing of the deficit’ or something of the sort, but in truth it is just the same thing as letting it become a magic money tree. New fiat money would be added to the economy, in just the way described above.
The Fed would also resume so-called ‘quantitative easing’ (QE), with large-scale purchases of assets (including Treasury securities) from both banks and non-banks (QE was previously used from late 2008). When the asset purchases are from non-banks, the result is an immediate dollar-for-dollar increase in non-banks’ holdings of bank deposits, which are money. Moreover, the Fed would become involved in direct finance to companies where cash flows had been disrupted by the lockdown, just as if it were a local bank.
The impact of these developments is already evident in the balance sheets of the USA’s commercial banks, which are tracked every week in a Fed press release. In the week to 18 March, deposits increased by 2.2%, in the week to 25 March by 2.6% and in the week to 1 April by 1.0%. So bank deposits – the main kind of money in a modern economy – jumped by almost 6% in a mere three weeks.
If this were to continue for a year, compound interest would cause the quantity of money to jump by roughly 175%, a truly Latin American pace of monetary growth.
Plainly, the three weeks to 1 April were exceptional. Everyone was alarmed about the short-run harm to output and employment from the coronavirus lockdown. The Trump administration was reacting with drastic and unprecedented measures to maintain spending power and to protect jobs, as well as to spend the money needed to save lives. The Federal Reserve is the government’s banker. It would have been suicidal – in terms of public relations – to have refused financial help.
The Federal Reserve’s preparedness to finance the coronavirus-related spending may prove suicidal to its long-term reputation as an inflation fighter. Of course, the US Government will not repay its debts at the Federal Reserve while it is running an annual budget deficit of $3,000 billion to $4,000 billion. In the modern world, the state can create money out of thin air, but it cannot create new goods and services in the same way.
If too much money is manufactured on banks’ balance sheets, a big rise in inflation should be expected. The laws of economics apply without discrimination to both Latin American countries and the USA.