There’s an invisible hyperinflation monster lurking right around the corner, which lots of people are having trouble seeing. And no, this is not a sarcastic barb aimed at conservatives who were wrong about QE and inflation — it’s aimed at people who were right, but don’t fully understand why they were right.
Recently I’ve seen more and more people suggest that the US could simply monetize the debt, by printing money. They point to the fact that the Fed has done lots of QE, and yet inflation remains below 2 percent. So why not go all the way?
First, let’s be clear what it means to monetize the debt. Here’s what it does not mean:
1. It does not mean replacing interest-bearing Treasury bonds with bank deposits at the Fed, which pay an equivalent interest rate. That accomplishes nothing. You need to replace interest-bearing debt with non-interest-bearing money.
2. It also does not mean buying back the debt only so long as interest rates are zero, but immediately selling the debt off at the slightest sign of higher interest rates, to prevent hyperinflation. That also accomplishes nothing.
If you seriously want to monetize the debt, you’d have to buy back the debt held by the public, with newly issued base money. There are two data points that suggest this will lead to hyperinflation:
1. Currency in circulation is about 8% of GDP.
2. Treasury debt held by the public is about 80% of GDP.
My claim is that if the Fed suddenly monetized the entire debt, and indicated that this action was permanent, the following would occur:
1. In the very short run, the monetary base would balloon to 80% of GDP, mostly excess bank reserves.
2. Within days, the excess reserves would leave the banking system, and become part of the currency in circulation. The base would now be more than 95% currency.
3. Within a year NGDP would grow at least 10 fold, so that currency fell from 80% to no more than 8% of GDP. Indeed the increase would probably be even larger, and the currency stock would probably fall to well below 8% of GDP. That’s because during hyperinflation, velocity also tends to increase.
4. RGDP would show relatively little change; the price level would increase at least 10 fold.
If I am right, then why haven’t the relatively large increases in the base under QE led to large increases in the price level?
One answer is that the Fed is paying interest on reserves, so they aren’t actually monetizing the debt. That’s true, but it’s quite possible that the QE program would have created relatively little inflation even in the absence of IOR, as we saw in America in the 1930s, and more recently in Japan and Europe.
The better argument is that temporary currency injections are not very inflationary. By temporary, I mean for as long as interest rates stay near zero. But once rates rise above zero, banks don’t want to hold excess reserves, and all those reserves would flow out into currency in circulation. And that’s highly inflationary.
Why do I think this would happen so rapidly? Consider the case where the market thought there was only a 3 percent chance that my theory was correct. In that case, the expected price level in 2017 would not be 1,000 percent higher, but rather a mere 30 percent higher than this year’s price level. But even 30 percent expected inflation is really high! It’s so high that banks would not want to hold onto non-interest-bearing reserves that were rapidly losing purchasing power. As the banks got rid of this “hot potato,” the price level would begin soaring, just as I predicted. In other words, there’s no stable equilibrium between 1 percent inflation and more than 1,000 percent inflation. Anything in between would imply the public is willing to hold implausibly large cash balances (as a share of GDP), despite relatively high expected inflation.
Thus QE is only compatible with very low inflation if the public believes there is only an infinitesimal chance that the QE is permanent. Because the actual QE has not resulted in high inflation, we know that the public has a very high level of confidence that the QE is not permanent (or that if permanent, interest will be paid on the excess reserves.)
So there really is an invisible inflation monster, lurking around the corner. The reason we never see it is because the Fed is sensible enough to not walk around the corner. They have the good sense not to print zero interest money to pay off the debt and make the money supply increase permanent. You may not see the invisible hyperinflation monster, but trust me: the monster is there. If the Fed did what some people recommend we’d see his ugly face almost immediately. And it would not be a pretty sight.