Paul Krugman tells us that resurgent inflation isn’t likely to be a problem. He might well be right too. But inherent in his analysis of why it won;t be is a good reason why it might be. Which is that if it does come back – even just a bit – there’s a significant positive feedback in the system.
As I explained elsewhere back a little while:
There is a case against the idea that this increase in base money is going to produce inflation. It’s the flip side of using the money equation in fact. If V, that velocity of circulation, doesn’t increase then the higher base money supply won’t feed through into a higher broad money supply. There are even reasons to think that for at least some of that larger money supply that will be true too. When banks were financing their lending by borrowing from each other we had a higher V than we do now when they’re largely doing so through the swapping of reserves at the Fed. That’s likely to continue, for at least as long as they gain interest on those reserves, so it’s at least partially true that the M1 won’t feed through into M3 and thus inflation.
However, betting that V won’t increase at all is a heck of a stretch and a one a lot longer than I’m willing to countenance. For inflation really is at times simply a monetary phenomenon. If the velocity of circulation of money increases then we are going to see substantial inflation. That’s my read of it.
We can even go to the same – well, one of them is nearly the same – charts that Krugman uses:
The money supply that we’re actually worried about concerning inflation is the combination of those two. MV=PQ. Money, times the velocity of its circulation, equals…….
OK, so, V has fallen dramatically as M has risen. We might even run this the other way around and say that we should have increased M because V had fallen.
But Krugman talks of monetary cockroaches:
Some years back I tried to make a distinction between zombie ideas — ideas that should have been killed by evidence, but just keep shambling along, eating people’s brains — and cockroach ideas, false beliefs that sometimes go away for a while but always come back.
And lately I’ve been noticing an infestation of monetary cockroaches. In particular, I’m hearing a lot of buzz around how the Fed’s wanton abuse of its power to create money will soon lead to runaway inflation — or maybe that we’re already experiencing high inflation, but it’s being hidden by dishonest government statistics.
That second isn’t true, that first might be. Something inherent in Krugman’s explanation of why it isn’t as yet. His argument is entirely true by the way:
The other fallacy of the modern inflationistas is that they don’t understand how the role of money changes in a world of very low interest rates, even though we’ve been living in that kind of world for a very long time.
Before 2007 it was expensive for people to hold money, because cash yielded no interest while bank deposits paid less than other assets like Treasury bills. So people held money only because of its liquidity — the fact that it could readily be spent. When the Fed increased the money supply, this left the public with more liquidity than it wanted, so that the money would be used to buy other assets, driving interest rates down and leading to higher overall spending.
But when interest rates are very low — which they have been for years, basically because there’s a glut of savings relative to perceived investment opportunities — money is, at the margin, just another asset. When the Fed increases the money supply, people don’t feel any urgent need to put that cash to more lucrative uses, they just sit on it. The money supply goes up, but G.D.P. doesn’t, so the “velocity” of money — the ratio of G.D.P. to the money supply — plunges
Well, yes. But the moment that the cost of holding money rises then the process goes into reverse, doesn’t it?
If inflation ticks up then leaving money in cash means losing at that inflation rate. As interest rates rise – if the Fed does so – then not redeploying money away from cash loses money as against doing so. That is, the velocity of money circulation rises as either both or either inflation or interest rates rise.
Sure, a 0.1% rise in inflation will only tempt a few people into action. But then all economics happens at the margin. And that’s a worry when there’s positive feedback like this. If rising inflation – or interest rates – in and of themselves increase V and it’s increasing V that increases inflation and or interest rates then it all takes off like a rocket, doesn’t it?
And this is inherent in Krugman’s argument, that falling interest rates and or inflation caused the fall in V.
Gonna be interesting folks, gonna be interesting.