Monday, March 7, 2011


After writing my last post on nickels, I felt the need to explain what economists know about inflation and what will probably happen with inflation in our country. There is a lot of rubbish floating around the popular press, and I'd hate for any of my friends or family to be infected by it.

An important lesson from basic economics is that the money supply in the country depends on more than just how much the government prints. The amount that comes off the printing presses is called the money base. That is just a small fraction of the money supply. The rest of the money supply comes from bank lending. The banking system can generate $10 in loans for every $1 in cash in their vaults, and all of those loans end up counted as money. For example, when you take out a mortgage to buy a house, all of the money goes into the bank accounts of the construction workers right away, and then they can start spending it.

Inflation depends on the total money supply, including the money 'made' by banks as they make loans. In other words, banks can cause inflation by excessive lending, and they can cause deflation by lending less than usual. This action of banks is called the money multiplier, because it multiplies the base to produce the actual money supply.

When the economy is functioning normally, the money multiplier is constant. There will always be inflation if the government prints more money. But things are not normal now. The financial crisis caused the money multiplier to fall sharply. The resulting 'credit crunch' is exactly the same thing as 'deflation'. It was right and proper for the government to print lots of money to compensate. If anything, they did not print enough.

The best measure of the total money supply is called 'M3'. It is not perfect but it is the best number we have. It tries to take all the actions of the banking system into account. Inflation hawks rightly cried foul when the Fed stopped publishing M3 in 2006. Here is a graph of the best estimate of M3 over the last few years:

Note that this is not the inflation rate. Inflation is the growth rate of the money supply minus the growth rate in real output. If we make 5% more stuff, and M3 grows by 5%, then there will be no inflation at all, because the ratio of money to stuff stays the same. The country would be 5% richer and prices would be the same.

Still, this graph shows that there was a lot of inflation in 2006 and 2007, while the housing boom was still in progress. The reason that this inflation did not show up in the news was because it did not affect the things used to calculate the Consumer Price Index. It only showed up in housing and real estate costs. But if you wanted to buy a house, this inflation would have really hurt your purchasing power.

When the financial crisis hit, the growth rate of M3 started falling. By the middle of 2009 the growth rate went below zero and the level of M3 started falling. (The graph shows, at each date, the average growth rate for the previous year.) This means deflation. M3 is still falling. The economy has been experiencing deflation for the past couple of years, even though the government has printed a lot of money. That is one of the reasons the economic recovery has been sluggish.

A lot of people are afraid that there will be inflation in the future. It is true that the government has massively expanded the money base. But they have plenty of tools to take that money out of circulation again, shrinking the base back down to normal as the multiplier goes back up to normal. They have demonstrated a willingness to fight inflation, even at the cost of massive unemployment. If they did not inflate in the past two years, when things were bad, they will not start any time soon.

Of course, inflation is not impossible. It might happen. But I think the odds of American hyperinflation, or even of moderately high inflation, are very low. For any time frame you care to mention, the odds that intelligent computers will cause massive economic disruption are greater than the odds that inflation will cause massive economic disruption. There is no reason to be concerned about inflation, or to spend any time or money preparing for it, or to vote for politicians who make noise about it.

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