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Has the pandemic shown inflation to be a fiscal phenomenon?

Economist Staff The Economist
Date Posted:
December 21, 2021
Is Database:
Database

Western Central Banks have bought more than $9T in assets; during the same period, American commercial banks deposits +~$4.5T from $13.5T in early 2020 to ~ $18T today.

Western Central Banks have bought more than $9T in assets; during the same period, American commercial banks deposits...
During the pandemic, central banks in America, Britain, the euro zone, and Japan purchased over $9tn in assets, leading to a significant increase in commercial bank deposits in the US from $13.5tn in early 2020 to approximately $18tn today. This surge in broad money supply, which includes bank deposits, has been linked to rising inflation, challenging the traditional view that inflation is solely a monetary phenomenon. The fiscal stimulus, amounting to $10.8tn globally, equivalent to 10% of global GDP, strengthened household and firm balance sheets, encouraging spending and contributing to inflationary pressures. This scenario suggests a potential shift towards recognizing the fiscal roots of inflation, as fiscal policies have played a crucial role in boosting aggregate household wealth and spending during the pandemic.

Economist Staff, "Has the pandemic shown inflation to be a fiscal phenomenon?"The Economist, December 18, 2021, https://www.economist.com/finance-and-economics/2021/12/18/has-the-pandemic-shown-inflation-to-be-a-fiscal-phenomenon

Has the pandemic shown inflation to be a fiscal phenomenon?

Here is a potted history of recent economic policy and inflation. In the 2010s central banks created vast amounts of money through their quantitative-easing (qe) schemes, while governments enacted fiscal austerity. Inflation in the rich world was mostly too low, undershooting central banks’ targets. Then the pandemic struck. There was plenty more qe. But the truly novel economic policy was the $10.8trn in fiscal stimulus implemented worldwide, equivalent to 10% of global gdp. The result was high inflation. The rich country that has splurged the most, America, has had the most inflation. With consumer prices rising at an annual pace of 6.8%, the Federal Reserve on December 15th was forced to acknowledge that inflation had become a big threat.

At first glance, this apparent supremacy of fiscal policy is awkward for fans of Milton Friedman’s view that inflation is “always and everywhere a monetary phenomenon”. Central banks, not governments, are charged with hitting inflation targets. But does the experience of the pandemic show that inflation is really fiscal?

One way in which fiscal stimulus boosts inflation is by strengthening households’ and firms’ balance-sheets, making them more likely to spend. Suppose the government raises cash from investors, who receive bonds in exchange. Then it hands out the money to households, returning it into circulation. Netting off, it is as if the government has just given out new bonds. Whether those bonds truly constitute new wealth for the private sector is the subject of an old theoretical debate. When the government runs up debts the public could also expect to pay higher taxes in the future—a liability that offsets their newly created assets. Yet in reality it is clear that fiscal stimulus leads to more spending.

Now introduce a new step into the thought experiment. The central bank, implementing qe, creates new money with which it buys the bonds that the government has given out. So when you net everything off, the government is not giving out bonds. It is giving out cash. This is not far off the policy mix during the pandemic. The tsunami of fiscal stimulus was accompanied by bond-buying of almost equal magnitude: central banks in America, Britain, the euro zone and Japan have together bought more than $9trn in assets. The result has been a surge in deposits at commercial banks. In America they have risen from around $13.5trn in early 2020 to around $18trn today. As early as the spring of 2020 some monetarist economists, such as Tim Congdon of the University of Buckingham, pointed to surging measures of broad money, which includes bank deposits, and warned of inflation to follow.

So far, so Friedmanite. But which leg of the policy matters more: the fiscal stimulus, which boosted aggregate household wealth, or qe, which ensured the infusion was of cash and not of bonds? There is probably something special about infusing households’ balance-sheets with cash, says Chris Marsh of Exante Data, a research firm. He has suggested that a “rediscovery” of monetarism could be in the offing after the pandemic.

Other economists, however, argue that qe is mostly ineffective, except in periods of acute financial stress, such as the “dash for cash” in spring 2020. Suppose that once that crisis had passed central banks had shrunk their balance-sheets quickly, but had still promised to keep interest rates at zero for a long time. It seems likely that America’s enormous fiscal stimulus would, by boosting household wealth, still have driven up spending and prices.

Yet believing in the impotence of qe compared with fiscal stimulus is in fact consistent with monetarism—if you expand the definition of money. Distinguishing the electronic money created by central banks from debt securities issued by governments is increasingly difficult. This is partly because when interest rates are close to zero, they are closer substitutes. It is also because most central banks now pay interest on the electronic money they create. Even if rates were to rise, so-called “interest on reserves” would still leave electronic money looking a bit like public debt.

The reverse is also true. Investors value government debt, especially America’s, for its liquidity, meaning they are willing to hold it at a lower interest rate than other investments—much like the public is willing to accept a low yield on bank deposits. As a result “it seems more accurate to view the national debt less as a form of debt and more as a form of money in circulation,” wrote David Andolfatto of the Federal Reserve Bank of St Louis in December 2020. He also warned Americans to “prepare themselves for a temporary burst of inflation” in light of the one-off increase in national debt during the pandemic. If money and debt are substitutes, just swapping one for another, as qe does, might provide little stimulus, consistent with the experience of the 2010s. But expanding their combined supply can be powerfully inflationary.

Right on the money

The logical extreme of this argument is known as the “fiscal theory of the price level”, created in the early 1990s (and in the process of being refreshed: John Cochrane of Stanford University has written a 637-page book on the subject). This says that the outstanding stock of government money and debt is a bit like the shares of a company. Its value—ie, how much it can buy—adjusts to reflect future fiscal policy. Should the government be insufficiently committed to running surpluses to repay its debts, the public will be like shareholders expecting a dilution. The result is inflation.

Explaining today’s high inflation does not require you to go that far, though. It is enough to look at recent deficits, rather than to peer into the future. Yet it is striking that economists like Mr Andolfatto who focused on the supply of government liabilities foresaw today’s predicament while most central bankers, whose eyes were fixed firmly on labour markets as a gauge of inflationary pressure, did not. The past decade has shown that when interest rates fall to zero, it takes more than just qe to escape a low-inflation world. Still, Friedmanism lives on.

"...But does the experience of the pandemic show that inflation is really fiscal? One way in which fiscal stimulus boosts inflation is by strengthening households’ and firms’ balance-sheets, making them more likely to spend. Suppose the government raises cash from investors, who receive bonds in exchange. Then it hands out the money to households, returning it into circulation. Netting off, it is as if the government has just given out new bonds. Whether those bonds truly constitute new wealth for the private sector is the subject of an old theoretical debate. When the government runs up debts the public could also expect to pay higher taxes in the future—a liability that offsets their newly created assets. Yet in reality it is clear that fiscal stimulus leads to more spending. Now introduce a new step into the thought experiment. The central bank, implementing qe, creates new money with which it buys the bonds that the government has given out. So when you net everything off, the government is not giving out bonds. It is giving out cash. This is not far off the policy mix during the pandemic. The tsunami of fiscal stimulus was accompanied by bond-buying of almost equal magnitude:central banks in America, Britain, the euro zone and Japan have together bought more than $9trn in assets. The result has been a surge in deposits at commercial banks. In America they have risen from around $13.5trn in early 2020 to around $18trn today.As early as the spring of 2020 some monetarist economists, such as Tim Congdon of the University of Buckingham, pointed to surging measures of broad money, which includes bank deposits, and warned of inflation to follow....But which leg of the policy matters more: the fiscal stimulus, which boosted aggregate household wealth, or qe, which ensured the infusion was of cash and not of bonds? There is probably something special about infusing households’ balance-sheets with cash, says Chris Marsh of Exante Data, a research firm. He has suggested that a “rediscovery” of monetarism could be in the offing after the pandemic...."

Ed Comment:But I think the entry misses an essential issue, lower consumption during the initial pandemic added substantially to savings beyond government borrowing (of which 50% was saved according to a prior entry). That can’t be overlooked or solely attributed to monetary policy.

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Previous articleDecember 21, 2021Why supply-chain snarls still entangle the worldValue of merchandise goods exported from China to the US was up 20% two years/year in fall 2021, driven by heightened demand from American consumers.Next articleDecember 21, 2021Edward GlaeserThe correlation btw prime-age male joblessness in 2010 and 1980 is over 80%, highlighting persistent local economic dysfunction.
Showing 7 database articles primarily about Banking

The Disparate Outcomes of Bank‑ and Nonbank‑Financed Private Credit Expansions

Nina Boyarchenko and Leonardo Elias Federal Reserve Bank of New York
Date Posted:
August 22, 2024
Is Database:
Database

A @NewYorkFed analysis of 33 countries over 1966-2020 finds 1 s.d. higher growth rate in bank credit increases the probability of real GDP growth below -2% in two years’ time by 2.5 percentage points, while nonbank credit has the opposite effect.

Credit extended by the banking and nonbanking sector[s] do not always move together. One type of lending is [often] expanding while the other is contracting, which suggests a substitution between bank and nonbank lending. Overall booms in private credit can be driven by either. We find that bank and nonbank credit expansions predict differentially the downside risk to growth—that is, the probability of extreme negative real GDP growth realizations. The blue line in the chart shows that the likelihood of an extreme negative real GDP growth realization —which we define as year-on-year real GDP growth below -2%— increases following expansions in bank credit for horizons of one to three years, while at the same horizon, growth in nonbank credit actually lowers the probability of a large drop in real GDP growth. In particular, a 1 s.d. Increase in bank credit increases the probability of real GDP growth below -2% in two years’ time by 2.5 ppts relative to a baseline 6% probability in our sample. In contrast, a 1 s.d. higher growth rate in nonbank credit lowers the probability of real GDP growth below -2% in two years’ time by 1.9 ppts.

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  • Credit Allocation and Macroeconomic Fluctuations — .@KarstenMueIIer and @EmilVerner find that credit growth to non-tradable industries like real estate is predictive of a boom-bust output pattern and financial…
  • Private Credit: Characteristics and Risks — Private credit has grown exponentially since 2000, reaching over $1.7T in June of 2023. @FederalReserve analysis suggests private credit raises overall…
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Deposit Insurance, Uninsured Depositors, and Liquidity Risk During Panics

Matthew Jaremski and Steven Sprick Schuster National Bureau of Economic Research
Date Posted:
April 9, 2024
Is Database:
Database

Jaremski and Schuster document that before the establishment of the FDIC, deposits fled to the safety of local insured postal banks, illustrating that lack of universal deposit coverage amplifies run risk. @ssprickschuster

Before the Federal Deposit Insurance Corporation (FDIC) became active in 1934, the only federally insured deposit accounts available to American households were through the U.S. Postal Savings System. To examine the role that postal savings played on bank closure, we collect the balance sheets of over 16,000 commercial banks just before the start of the Great Depression and match them with information on which post offices accepted deposits. We find banks that operated nearby a post office that accepted deposits were more likely to close between 1929 and 1935. The effect of postal savings is severely weakened after deposit insurance was installed across commercial banks in 1934. This lends evidence to the theory that we are capturing a competitive liquidity effect due to the lack of universal coverage.

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  • The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications — Deposits – especially uninsured deposits that create run risk – have risen sharply, while banks with the most rapid growth in deposits have shifted…
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  • In Today’s Banking Crisis, Echoes of the ’80s — Phil Gramm and @cwcalomiris draw a parallel btw the current instability in the banking system and the Savings and Loans crisis which also played out against a…
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The Secular Decline of Bank Balance Sheet Lending

Greg Buchak, Gregor Matvos, Tomasz Piskorski and Amit Seru National Bureau of Economic Research
Date Posted:
April 5, 2024
Is Database:
Database

Bank balance sheet lending has declined from 60% of total private lending in 1970 to 35% in 2023. Private credit is increasingly intermediated through arms-length transactions such as securitization. @NBERpubs

The role of traditional bank-led intermediation has declined sharply since the 1970s. Private credit is increasingly intermediated through arms-length transactions such as securitization. A structural model explores what can explain these shifts [and simulates] implications for macroprudential policies. Declines in securitization cost account for changes in aggregate lending quantities. Savers, rather than borrowers, are the main drivers of bank balance sheet size. Implicit banks’ costs and subsidies explain shifting bank balance sheet composition. Together, these forces explain the fall in the overall share of informationally sensitive bank lending in credit intermediation. Raising capital or liquidity requirements decreases lending in both early (1960s) and recent (2020’s) scenarios, but the effect is less pronounced in the latter. The substitution of bank balance sheet loans with debt securities in response to these policies explains why we observe only a fairly modest decline in aggregate lending despite a large contraction of bank balance sheet lending.

Related Articles:

  • The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications — Deposits – especially uninsured deposits that create run risk – have risen sharply, while banks with the most rapid growth in deposits have shifted…
  • Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements — .@cwcalomiris argues high American public debt levels and chronic deficits may lead toward an era of “fiscal dominance,” in which the government…
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The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications

Samuel Hanson, Victoria Ivanshina, Laura Nicolae, Jeremy Stein, Adi Sunderam and Daniel Tarullo Brookings Papers On Economic Activity
Date Posted:
April 4, 2024
Is Database:
Database
Is Important:
Important

Deposits – especially uninsured deposits that create run risk – have risen sharply, while banks with the most rapid growth in deposits have shifted assets away from lending towards longer-term MBS and Treasuries. @lauramnicolae

To inform the ongoing discussion of the appropriate regulatory response to [such events as] the failures of three regional banks 2023, we examine trends in the banking industry over the last twenty-five years. On the liability side of bank balance sheets, deposits—and especially uninsured deposits—have grown rapidly. On the asset side, there has been a notable shift away from the information-intensive lending traditionally associated with banks and towards longer-term securities such as MBS and long-term Treasuries. We assess the main regulatory options to reduce the risk of destabilizing bank runs—expanding deposit insurance and strengthening liquidity regulation— and argue that the industry trends we document favor the latter option. Regulators may be more comfortable tightening liquidity requirements on uninsured deposits, insofar as the substantial increase in those deposits in recent decades has not been correlated with an increase in information-intensive lending.

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Manufacturing Demand

Joseph Wang Fed Guy Blog
Date Posted:
March 13, 2024
Is Database:
Database

.@FedGuy12 endorses a proposed adjustment to the Basel III leverage calculations that would increase demand for Treasuries from US banks as future issuances surge.

Banks were huge investors in Treasuries during World War II, but steadily reduced their holdings even as Treasury issuance climbed. The share of bank assets in Treasuries remains historically low as banks have preferred to make loans or invest in higher yielding securities. While banks are required to hold high quality liquid assets, they have chosen to meet those requirements with reserves and Agency MBS rather than Treasuries. A revision to Basel in the form of a revamped leverage calculation would not only boost liquidity across markets, but also potentially make banks significant investors in Treasuries just in time to meet increased future issuance.

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Monetary Policy and Innovation

Yueran Ma and Kaspar Zimmermann Federal Reserve Bank of Kansas City
Date Posted:
August 29, 2023
Is Database:
Database

Historically monetary tightening has had an impact on risk capital: 100bps of tightening is associated with a 1-3pp decline in R&D spending and a 25% decline in VC investment over the following 1-3 year period.

We normalize the shock to tightening by 100bps. Investment in intellectual property products (IPP) in the national accounts (NIPA) declines by about 1%. The magnitude is comparable to the decline in traditional investment in physical assets. R&D spending in Compustat data for public firms declines by about 3%. VC investment is more volatile, and declines by as much as 25% at a horizon of 1 to 3 years after the monetary policy shock. Patenting in important technologies declines by up to 9% 2 to 4 years after the shock. An aggregate innovation index constructed using estimates of the economic value of patents also declines by up to 9%. Based on estimates of the output and total factor productivity (TFP) sensitivity to the aggregate innovation index, a 9% decline in the index can contribute to 1% lower real output and 0.5% lower TFP 5 years later.

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    • Business Cycle
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