Inflation Cannot Be Micromanaged, or "Greenback Whirlybird Down!"

Contrary to conventional wisdom, central bankers don't have have the tools required to maintain price stability. Neither do governments. This is not to say that their actions don't affect inflation. When we combine the tools the central bank has (mainly the target rate) with the tools government has (mainly its control over the budget deficit/surplus), we are able to create inflation or deflation, depending on which one we want.

The ability to create inflation doesn't translate to ability to maintain price stability. The problem is that even though we can create inflation at will, we have no idea how much of it we will get -- and even more importantly, what will be the rate of change in inflation (for geeks: this is the second derivative of the hypothetical, general price level) at any point in time. Two years after the start of a government intervention, inflation could be three percent or it could be 10 percent, and it could be accelerating or decelerating. The most technically-minded among us might try to convince you otherwise, but they ignore the importance of inflation expectations and the role psychology plays in forming these.

The appearance -- or even a threat thereof -- of large fiscal deficits would affect inflation expectations among the public (investors included) in a very unpredictable way. As a consequence, inflation itself would be unpredictable (to be clear, time-lags, too, would make inflation management very difficult). This is because inflation expectations -- which depend heavily on human psychology and the relative attractiveness of competing stories -- are what really drives current and future inflation. All this is related to reflexivity.*

The "natural" (this is, absent a large-scale government intervention) outcome of our current debt overhang would be debt deflation. As far as I know, this is what William White is alluding to when he says "They have created so much debt that they may have turned a good deflation into a bad deflation after all.".

As I suggest above, and as Milton Friedman among others has suggested before me, a deflationary spiral could be countered through very large fiscal deficits (~10-20 %, without pretence to accuracy). This deficit could be "sterilized" (I stretch this concept) through a) new issuance of government bonds (by Treasury), or b) sale of existing ones (by central bank), or it could be un-sterilized as in "helicopter money" (see, for instance, Simon Wren-Lewis here) or overt money financing (OMF). (Related to this, I'd like to hear from Wren-Lewis, or any other expert, what is the difference between financing the deficit, on one hand, through bond issuance, and via OMF on the other, in a world where 2-5-year bond yields are negative while cash yields zero?)

So, my mental framework (or, theory) suggests that through large fiscal deficits an impending, severe debt deflation can be turned into volatile and unpredictable inflation. This inflation, or expectations thereof, would initially bring us increased spending, increased output and employment. It would increase the real GDP. This is exactly what the most short-sighted of us are after when they call for substantial government spending financed by a large fiscal deficit (this is why the "austerity vs. stimulus" debate doesn't make much sense to me). But this boost to the economy would be, to a large extent, due to increased speculation. At the extreme, we would see a Black Friday-esque spending frenzy as perfectly rational agents rush to buy real assets with existing and newly-created IOUs (formerly known as "money"), as they expect the value of currency to greatly diminish in the future. All this should be clear to any attentive student of inflation. Almost as clear to me is that we have already seen this kind of speculation in 2009-2014, albeit on a very small scale relative to potential.

Eventually, after a period of accelerating inflation, we would need to do what Paul Volcker and the Fed did -- thanks to sufficient public, and thus political, backing -- in the early 1980s. We would need to bring inflation down through an instant, deep recession and mass unemployment. Of course, there's always another option: to let the inflation run its course. I think we widely agree that it's better to take the recession than go down this path. Still, we cannot fully count on this to remain the case if push comes to shove.

There's always a possibility that the fiscal deficit would not be large enough -- let's say, due to political resistance -- to get the inflation even at the target level. In my world, this deflation or "low-flation" would ultimately have its cause in authorities' inability to convince agents that they should spend before inflation arrives and starts eroding the purchasing power of the currency. Something like this has been going on in Japan for something like two decades. But as my critique is aimed mostly at the same people who insist that Japan has not yet tried hard enough, and that all would be better there had they just tried harder, I won't analyze this possibility in detail here. All I want to say is that if we try hard enough, at one point we will get the volatile inflation and the (new) problems that come with it.

I state my critique once more: Inflation is not micromanageable in the way Modern Monetary Theorists (MMTers) or the living advocates of The Chicago Plan (CPs) seem to suggest. And I'm willing to bet that many of our best investors agree with me. We should never underestimate the effect of speculation on economic outcomes. Neither should we underestimate the difficulties we face if we try to differentiate between speculative and non-speculative transactions.

The biggest reason why we ended up with this massive, global debt problem is our inability to understand how all "money" is just a promise to pay (an IOU), and, as it logically follows, that it is not possible to pay for anything with this "money" (see my post from yesterday). Once we accept this, we must accept that the Quantity Theory of Money (QTM) should be dismissed in its entirety. But this we haven't done. Even people who understand quite well how "money" is just an IOU (for instance, MMTers and CPs) still view inflation more like a technical issue, something that is micromanageable -- wait for it -- through well-calibrated injections and withdrawals of "money" by the government. Are they all monetarists now?

I'm puzzled. Sometimes I wonder if nearly all our economists are suffering from doublethink.

* I'm greatly indebted to George Soros who, with his book "The Alchemy of Finance" (1987), has shed much light on reflexivity both in financial markets and the economy in general. Robert Shiller has helped me better understand the role stories have in affecting outcomes (see, for instance, his article at Project Syndicate). I present Soros as the prime evidence for my claim that to understand the economy one needs to be a philosopher, while Shiller's work speaks for the importance of understanding psychology. The society consists of individuals who contemplate and participate (i.e. act); they both compete and co-operate. That's probably all there is to an economy.

Mumblings post scriptum

There are many ways out of our current mess. Some are much better than others. None of them is an easy one. We have only bad options left. On the normative side, once we get there, I have a lot of suggestions on how to ease the pain, how to take care of the society and build a better future for all of us. (I'm dismal only as a scientist, not as a human being.) But first, we need to agree on what is ailing us -- only then we can try to apply the right treatment.

What got us here is our mistaken belief in the existence, both on a microeconomic and a macroeconomic level, of "money". The truth is that our financial system consists only of debts and credits -- all kinds of liabilities and a mountain of IOUs. The current amount of these liabilities and the corresponding IOUs is just too big. This is what is ailing us. We need to get it back to a substantially lower level, and it seems to me that it will take a global recession ("It" will happen again) to achieve this. This is my diagnosis (it's based on a considerable amount of work I've done since 2008). As we analyze the treatment options and weigh them against each other, we should keep in mind the following goal: to get the world through this turmoil with the least possible damage.

This is only my 11th blog post. It won't take long to read all of them, in case you would like to get a better understanding of where I come from. If someone is interested, I could add a short bibliography. I find myself unable to add any specific references in my text, as I usually have no clue about the person who planted a certain thought in my head. My list of suspects is very long. A random sample ("name-dropping"): Adam Smith, Léon Walras, Charles Mackay, Silvio Gesell, Walter Bagehot, Knut Wicksell, Alexander del Mar, Eugen Böhm-Bawerk, Ludwig Mises, Alfred Mitchell-Innes, Joseph Schumpeter, Friedrich Hayek, John Maynard Keynes, Irving Fisher, Henry Simons, Karl Polanyi, James Tobin, Adam Fergusson, Charles Kindleberger, Milton Friedman, John Kenneth Galbraith, Hyman Minsky, Paul Volcker, William White, Adair Turner, Claudio Borio, Philip Coggan, Nassim Taleb, George Soros, Robert Shiller, Daniel Kahneman, Amos Tversky, Bill Gross, Howard Marks, Stanley Druckenmiller, Warren Buffett, Charlie Munger, George Cooper, Michael Lewis, Matt Taibbi, David Graeber, Steve Keen, Izabella Kaminska, Steve Roth, Noah Smith, Martin Wolf, Matt Stone, Trey Parker, Paul Krugman and "Tyler Durden".

Money Pays For Nothing

What most people still call "money" is just an IOU for me. It is not different in kind compared to any other IOU. IOUs are always created in the same way, and cash or deposits don't make an exception. They are not created "out of thin air", because they derive their value from the promise to pay and are thus backed by the credibility, or trustworthiness, of the debtor. This backing should not be confused with collateral, which is nearly always a Plan B -- an insurance. An IOU derives its ultimate value from the later payment in goods or services which is expected to take place.

"Money", or any other IOU, cannot pay for anything. To transfer an IOU to a seller is to transfer a promise to pay later. It can be the buyer's personal promise (that is, it is issued by the buyer) or someone else's promise (issued by a third party). In neither of these cases does it make any sense to talk about a payment in "money". Handing over an IOU constitutes a non-payment.

What makes picturing all the various debt/credit relations slightly complicated is that there's often at least one of two types of intermediaries* between the debtor and the ultimate creditor: a) a financial institution (for example, a commercial bank), or b) government. These two can be quite intertwined, so it is sometimes hard to keep track of private-private-private and, on the other hand, private-public-private -- remember, the government is us, the people, so the ultimate debtors and creditors can never be public institutions -- debt relations.

  

As I said, the value of "money", like of any other IOU, derives from a promise to pay later in goods or services. The value is not derived from people's beliefs -- for instance, from a baseless expectation of acceptance of "money" by others as a medium of exchange ("just because it has 'always' been accepted"). Whether people realize it or not, "money" ultimately serves as a medium-of-exchange and a store-of-value exactly because it's an IOU, and it has value just like any other (non-worthless) IOU has. Of course, both the actual and the perceived quality, or strength, of a promise to pay varies from one point in time to another, and it is issuer-dependant -- we are, after all, talking about credit. 

When the system is well governed these IOUs are widely trusted, and thus accepted, in the society. As a consequence of this wide acceptance, they work well as a liquid medium of exchange. Nevertheless, it is credit which enables this exchange, just like it enables nearly all trade. Eventually, "money" becomes so liquid and widely accepted that people forget that it is ultimately just an IOU and view it more like an article of faith.

We could think of this ultimate logic -- which goes unnoticed by most of us -- behind the value of "money" as a law of nature. We could compare it, say, to gravity. Thanks to the gravitational pull of Earth, people have been able to run fast for thousands of years without knowing that these gravitational forces existed. If we somehow managed to substantially lessen Earth's gravitational pull, we couldn't possibly expect people to run, and all kinds of machines to work, just as before. This much we know now, but we have not always known it. Way back in time, when we understood much less, we could have well imagined life to proceed as before even if the mass of Earth was greatly reduced.

To me, the Chicago Plan is about breaking the supporting law, or logic, behind "money". It's about removing its link to debt -- a link which ultimately gives it its value -- and hoping that people's mistaken beliefs about "money" remain intact. It doesn't make any sense to me. And I'm actually someone who mostly agrees with Michael Kumhof when it comes to the details of our monetary system and the grave problems we currently face due to the massive, global debt stock.

One could say I'm a dismal scientist. If, through theoretical reasoning, I cannot find any easy way out of our current mess, and I'm left with only bad options, I'm able to live with it. All I can do is hope I've got it all wrong and search even more intensively (this I have done), but I won't let myself be fooled to think that there must be an easy way out. Nothing tells me that there has to be one. Looking at all the easy answers our economists are trying to offer us -- "A depression reckons, unless you listen to me and follow these simple steps..." --, I must conclude that the dismal science is dead. But the ghosts of Adam Smith, David Ricardo and Thomas Malthus still live in me.

Epilogue, and a Prologue

Above I have explained how "money" works. George Friedrich Knapp (State Theory of Money, or Chartalism) and Alfred Mitchell-Innes (Credit Theory of Money) got the logic mostly right. But as far as I know, they didn't go on to develop a more comprehensive credit theory. They seemed quite happy to stay with monetary theory; to mainly explain how money is actually an IOU. I believe I have taken a leap forward by painfully unlearning "money". Forgetting "money" has allowed me to study a pure credit economy in a way Knut Wicksell could only have dreamt of. Our contemporary economy is of course in many ways different from the economy in Knapp's, Wicksell's and Mitchell-Innes's time. Without the unnecessary confusion that arised from the gold standard we can see much more clearly how we actually do live in a pure credit economy. In addition, the types of debt, and especially their respective shares of the total debt, are different today.

Here I have only scratched the surface of a General Theory of Credit, still concentrating on "money". Once we manage to forget "money", we can focus on how credit really works in the economy. We need to descend to the microeconomic level and study human psychology. Perhaps the most important concept there is what I call maturity transmutation.

* An "intermediary" refers here to an entity in-between the debtor and the ultimate creditor -- not someone who borrows or lends "money".