So why the hell didn't quantitative easing produce HUGE inflation?

After all, a large number of people insisted it would...


Worstall @ the Weekend There's two simple answers to the question of why quantitative easing (QE) didn't set off some massive burst of inflation (to answer commentard Gordon 10's question posted here). The first being that it did, the second being that some people, fortunately this time the people running the central banks, got their economics right.

There's also a complicated answer which we'll walk through in a moment, but in a simple manner (my being a bear of simple brain means we'll have to do it simply, if that suits you?).

The prediction was that inflation is always and everywhere a monetary phenomenon (true, derived from American economist Milton Friedman and not true therefore, simply one of the things he did get right).

So, if we increase the money supply then we'll get lots more inflation. This didn't happen, or as I'll point out, did in fact, so obviously those who were crying wolf were wrong. This isn't, by the way, a mistake that St Milton would have made: far too bright a man too well grounded in the details of this specific subject to make that mistake.

We've also Paul Krugman making a start to explaining this point here. But as he starts out talking about the Hicksian liquidity trap perhaps we need one more iteration of simplicity.

We need to have two pieces of economics to start with. As ever purists will protest at the brutality with which I treat economic theories of delicacy and subtlety but then that's me. The first is the idea that there's actually several different sorts of money. There's base money (cash, electronic money created by the Bank of England) and there's credit, that's the money produced by the financial system as a whole.

There's those who insist that banks actually create money and, well, OK, as long as we still maintain this distinction between base money and wide money, central bank money and credit. In the technical jargon we've M0 (cash), M1 (cash plus central bank reserves) and we go on to M3 and M4 (that last being all the ones before plus all of the credit created by the banking system).

The monetary authorities, the Bank of England, control M0 absolutely, pretty much entirely M1, and really can only influence M4 through their manipulation of short term interest rates. And it is only influence: long term interest rates are market derived, not from whatever the central bank says short term ones are.

Which brings us to our second piece of economics: MV = PQ. Money, times the Velocity of its circulation, equals Prices times Quantity demanded. PQ is also equivalent to nominal GDP: the total output of the economy without adjusting for the inflation rate.

Those better at maths than I am (i.e., every reader here) will see that if we change the quantity of money in the economy then we're going to change PQ. Holding V static, either the amount of stuff produced (real production, Q) or the price of it all (inflation or deflation, P). And that's what the worry was: that we increase the amount of money floating around through QE and we'll get that inflation.

However, another manipulation of the same equation also tells us that if V changes then a static money supply will also be reflected in a change in PQ. And V is best thought of as the multiplier of that M0 (or M1) turning into that M4, which is the real money supply we want to be careful of when we're considering inflation rates. That is, if there's £100bn in base money, what's the credit multiplier to give us the real money supply? And what happens if that multiplier, that V, changes?

This is how traditional (at least since St. Milton and the monetarists, rightly, won this argument) policies about and against inflation work. We note, for example, that Q is pretty much at the economy's limit, what can actually be produced, and any further stimulation is going to lead to a rise in P, or inflation.

So, we raise the short term interest rate, which reduces V. Or the BoE sells a few more Gilts out into the economy, reducing that M1 or M0 and thus relieving that pressure on P either way. This is all called Open Market Operations by the way and is one of the major functions of a modern central bank.

Similarly, when we've a bit of a recession then we reverse this. We note that Q is below what could be produced, P seems a bit weak, so let's either increase M (buy some Gilts) or increase V (reduce the interest rate and thus up the multiplier).

Yes, I know, purists, I'm butchering this. While this won't make anyone a central banker (you'd have to unlearn it to become one) it's a good mental image to have.

And then we come to the recent unpleasantness. Banks won't lend, no one who could repay a loan wants to take out a loan and that V collapses. This normally happens in recessions to a point: but it's worse if it's a financial collapse which induces the recession.

So, V is falling, that means we're either going to have P falling (deflation) or Q falling (falling GDP) or, because through different mechanisms we think that they influence each other, both. We don't like deflation in a debt funded economy because those debts don't fall in value as the value of production does. Thus, in a truly deflationary environment everyone gets killed by their debt overhang. We also don't like falling GDP because that is us all getting poorer.


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