The Fed Doesn't Cause Inflation

A number of knowledgeable people have written recently on the exploding prices for a number of goods such as energy, food, gasoline, and vehicles. Ryan McMaken of the Mises Insitute and Brad Polombo of FEE, among many others, have laid the blame for this fiasco directly on the leadership of the Federal Reserve, the U.S. central bank. McMaken surmises that as U.S. ports are unloading more goods than in the past, the only explanation must be that prices are rising due to an excess of money circulating. Polombo simply repeats that money printing by the Fed causes inflation

Is the Federal Reserve to blame for surging prices?

There is an old identity known to economists: MV = PT.

M represents the total amount of money in the economy. V is the velocity of money or the speed with which it moves through the economy. V is best understood as cash balances in banks or in one's possession. Rising cash balances mean a decline in Velocity whereas falling cash balances mean a rise. On the other side of the identity, we have P or the price of goods, and T or total output or production. The stock of money or M multiplied by its Velocity or V equals P or the prices of goods multiplied by T or total production.

Most, when examining the identity, focus on M and P, money and prices, with only scant attention to the most important factor: T or output.  McMaken essentially argues that as M or the stock of money rises, P or prices must rise.

But is this the case? We know private banks are in the business of lending, that is creating and lending out money through the fractional reserve banking system. A bank is free to lend out a depositor's money under the proviso of holding a fraction of deposits in reserve. Assuming a 10% reserve, a $1 deposit may create $9 in loans as it passes through the banking system. Thus, private banks add large amounts to the stock of money or M by adding to the assets and liabilities of their balance sheets.

Yet, this process of money creation does not spur inflation because banks lend for a return or purpose. Money is a claim on scarce resources. By ensuring the soundness or profitability of a loan, a cautious banker ensures scarce resources are placed in capable hands. The creation and expenditure of such funds yield a return to the borrower or investor for the effort in turning scarce resources to good use, a return to the banker for loaning out needed funds, and a return to the depositor for maintaining his funds in the bank to permit the loan. The valued effort usually results in a rise in T or output, and by an amount greater than the increase in M or money, bringing lower prices. Some efforts fail, but most succeed.

The Fed is a bank like any other, possessed of a balance sheet comprising assets and liabilities. However, it operates with a difference. Among its many duties, the Fed serves as the reserve bank for the entire U.S. banking system. The accounts of member banks and the U.S. government constitute a good portion of Fed liabilities. When the Fed makes a loan to a member bank, that loan constitutes a Fed asset. The credit to the account of the borrowing bank counts as a Fed liability. Thus, M rises and V falls, depressing market interest rates. When the new reserves are put to use, V rises and actions shift to the other side of the identity, that is to P and T or prices and output.

If the Fed makes a loan to the federal government, the same actions occur. Fed assets and liabilities rise by the same amount, the asset being the loan and the liability being the credit to the government’s account. The increase in bank reserves depresses market interest rates. Again, it is a case of M rising and V falling. When the government spends the money, putting it into circulation, V falls and again action shifts to P and T, which may fall or rise depending on how wisely the funds or rather resources engaged are consumed.

Though the Federal Reserve, having added an unprecedented $8 trillion to bank reserves the last 15 years, certainly abetted borrowers by greatly depressing interest rates, it is not the culprit in actually spending or circulating the reserves or money created. The Fed clearly has manipulated bank reserves, distorting financial markets and calculations and depriving savers of just returns. Yet, the decision to lend remains with the banker and the decision to borrow remains with the individual, firm, and government.  

We know that firms and individuals certainly labour at ensuring returns exceed all costs. Not so with government. For years, government at all levels, whether funds are taxed or borrowed, has been assaulting the value of T or output. Stifling laws, regulations and government actions have sharply curbed U.S. production in a number of market spheres. The abhorrent and exorbitant costs of green energy, U.S. military excursions, suffocating and intrusive regulations for labour and commerce, tariffs, welfare programs, COVID measures, omnipresent taxes and high tax rates, etc. have been detrimental to U.S. innovation and production stretching back decades. The level of government participation and, thus, squandering, has certainly soared with despotic COVID regulations, lockdowns, and mandates. Total governments share of the economy rose to above 45% in 2020 with new spending and amid a receding private economy, an increase of almost 8 points in one year. It should remain above 40% in 2021.   

With government wasting above 80% of what it spends, U.S. productivity declines with every increase in government share of the economy, regardless of whether attained through borrowed or taxed funds. Government expenditure represents the great threat to T or output, not Federal Reserve manipulation or control of bank reserves. A Soviet future of shortages of necessities and a dearth of novel goods is what awaits the U.S. and many western nations if this surge in government expenditure and control of the economy doesn't recede.

Image: Federal Reserve System

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