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Central banks are about to print new money in huge quantities – the risk of hyperinflation is real

Cash money
The accelerations in broad money growth will cause significant increases in inflation

The stresses of the next few weeks and months will be easier to bear if people can be confident about a more buoyant prospect in 2021 and 2022

March 2020 has been an extraordinary month, as the world economy buckles under the strain from the Covid-19 pandemic. But so also has been the policy response.

In the United States of America, Congress and the President have agreed on a “stimulatory” fiscal package, which will raise the Federal deficit in the next year by perhaps as much as $2,000bn.

In the Eurozone the constraints of the Stability and Growth Pact are being disregarded, with several governments – including Germany – announcing that they will incur budget deficits.

In the United Kingdom the Office of Budget Responsibility (OBR) has commended actions which will widen the budget deficit, saying this is not the time to be “squeamish” about a surge in public debt. Rishi Sunak, the Chancellor of the Exchequer, has responded with measures that are expected to have a cost in the 2020-21 financial year of £95bn, with this sum on top of the originally planned “public sector net borrowing” of £50bn.  

As the challenges to economic policy-making have been unprecedented, the deliberate lurch into deficits and debt is easy to understand. All the same, one has to wonder whether much thought has been given to the question of how the budget deficits will be financed.

National leaders compare their predicament to war, as if that justifies the enormous sums of money that have been promised. Perhaps they need to be reminded that the sequel to the big wars of the twentieth century was high inflation, even in the victor nations. For example, in the USA the consumer price index rose by just under 21pc in late 2018 and by almost 20pc in spring 1947.

Further, the origins of the inflation were well-known and widely discussed by contemporaries. In wartime conditions governments increased military expenditure far more than taxation, leading to larger budget deficits. The enlarged deficits were then financed to a significant extent from banking systems and hence resulted in the creation of new money balances. Money growth accelerated and, after an assortment of shocks and lags, so did inflation. 

In the four years to the fourth quarter of 1919 US broadly defined M2 money increased at a compound annual rate of 15.3pc, while in the same period the average annual rate of increase in the consumer price index was 14.5pc. By comparison, in the four years to the fourth quarter of 1947 US broadly-defined M2 money increased at a compound annual rate of 11.7pc.

Although in the same period the average annual rate of increase in the consumer price index was quite a bit less, at 6.7pc, the relatively low inflation number was possible only because of price controls and rapid growth of real output. The removal of controls coincided with the almost 20pc inflation of spring 1947. 

The US Federal deficit was originally expected to be $1,020bn in 2020. We are in a presidential election year, in which neither of the two main candidates will want to appear as a skinflint. A plausible surmise is that the deficit is headed towards $2,500bn and could exceed 10pc of gross domestic product.

2019 saw an acceleration in annual US broad money growth (to 8.3pc at year-end), with significant monetary financing of the Federal deficit being a large part of the explanation. 2019 could be interpreted as a small-scale, low-key and accidental flirtation with Modern Monetary Theory, with its proposals that the central bank finance all of government expenditure; 2020 will be a major, if again mostly unintended, experiment with these dangerous ideas.

Given that the Federal deficit appears now to be more than doubling, what sort of money growth rate might be envisaged in 2020? As always, the numbers need to be watched month by month, but reasonable surmises are that:

  • US broad money growth will in 2020 at least match the 2019 figure of 8.3pc and may go a bit higher to, say, a band between 10pc and 12 .5pc.

  • Even higher numbers (of, say, 15pc) are not to be ruled out, since the Fed does not look at these data and most of its economists nowadays dismiss a monetary theory of inflation.

  • US consumer price inflation at some point in the next three years will exceed 5pc at an annual rate

The upturn in inflation – at factory gates and in the shops – will occur only after a marked rebound in the economy and asset prices, but those too seem very likely once coronavirus is under control. 

Historical experience is clear that – in the US as in other nations – the growth rates of money and nominal GDP are correlated over the medium term. The risks of an inflationary boom – in 2021 and 2022, with the precise timing a matter of conjecture – are clearest in the USA.

But in Europe also governments and central banks are tumbling over themselves to appear open-hearted and socially-minded in their economic measures. This is hardly surprising: in a democracy no one in the public eye wants to be blamed for avoidable deaths. Even the German government – long resistant to deficits – is suggesting that it may incur debt of €160bn or over 4pc of GDP.

The European Central Bank is embarking on a new programme of asset purchases, with a figure of €750bn targeted between now and the end of 2020. If it assumed – realistically – that about half of that will boost M3 broad money, the addition to M3 growth will be about 3pc in a nine-month period. 

Regulators are loosening banks’ capital/ asset ratio requirements, in sharp and welcome contrast to late 2008 when they tightened them. Moreover, central banks are telling banks to show forbearance towards liquidity-strained customers and that they will provide ample amounts of cash to banks if corporate customers draw down credit lines en-masse.

In the UK the Bank of England has started a commercial paper facility which was described – in the Financial Times, no less – as “unlimited QE for large company financing”. Monetary financing of an enlarged budget deficit and extensive usage of this facility could take UK broad money growth towards an annual rate of between 8pc and 10pc, much above the 3.8pc number recorded at end-2019.

The wider messages are that:

  • Policy-makers in the main advanced countries are taking ultra-supportive measures to ease the economic pain caused by coronavirus.
  • Over the medium term (say from 18 months or so forward), the resulting accelerations in broad money growth will cause significant or even major increases in inflation.

This is not particularly to criticise the frenzy of fiscal and monetary generosity now under way. The stresses of the next few weeks and months will be easier to bear if people can be confident about a more buoyant prospect in 2021 and 2022.

But governments and central banks are not omnipotent: they can create new money balances out of thin air, but they cannot conjure up real goods and services from the same source. 

At any rate, the leading nations will soon offer an interesting test of the relative merits and usefulness of different theories in macroeconomic forecasting. If money growth does rise towards double-digit annual rates (as the facts suggest is very likely), and if inflation rates of 5pc and above do resurface, this will provide confirmation of the continuing relevance and validity of the quantity theory of money.

 

Professor Tim Congdon CBE is chairman of the Institute of International Monetary Research at the University of Buckingham