Is inflation a monetary problem?

It’s unavoidable now. Even the corporate press is beginning to admit that inflation is here. However, they add the caveat that it’s only “transitory”, on the assumption that a fast recovery will take place after the Wuhan virus pandemic subsides.

Regardless of how long inflation will last, the more important part of these discussions is what ultimately set off this process. Some explanations offered by mainstream commentators are simply not up to par.

Mike Maharrey of Schiff Gold did a great job in detailing how the “supply chain bottlenecks” argument put forward by most commentators is not sufficient to explain why prices have increased in the past few months .

Maharrey starts off by laying out some uncomfortable truths:

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One of the reasons often given for rising prices is “supply chain bottlenecks” caused by the sudden recovery in demand. But a dive into the data reveals that most commodity prices have risen in tandem in an environment of wide levels of spare capacity, and in some cases, even overcapacity. The supply chain isn’t the problem. The money is the problem.

The problem at hand is overcapacity which Maharrey provides ample evidence of:

Economist Daniel Lacalle analyzed the numbers for an article published by the Mises Wire and found the “supply chain” excuse doesn’t hold up under scrutiny.

Lacalle looked at the utilization ratio of industrial and manufacturing productive capacity. Russia is at 61%. India is at 66%. Lacalle called this “a clear level of structural overcapacity.” In China, capacity utilization is at 77%, still below pre-pandemic levels. In fact, no G-20 country’s capacity utilization is above 85%.

So, what is this telling us? As Lacalle put it, “There is ample available capacity all over the world.

One of the least talked about aspects of monetary policy is how easy money props up “zombie companies”, companies that cannot pay off their debts with its total earnings in a given period.

Maharrey goes into details on how these companies get perversely propped up by fiat money: 

Loose monetary policy exacerbates overcapacity by prolonging the survival of “zombie companies.” Empirical studies by the Bank for International Settlements (BIS) have documented this phenomenon. A zombie company is a firm that can’t service its debt with operating profits. The availability of low-interest debt refinancing along with government stimulus allows these companies to survive far longer than they otherwise would. This short-circuits the process of “creative destruction” in the economy and leads to the perpetuation of overcapacity.

Maharrey cited economist Daniel Lacalle as one of the primary skeptics of the claim that the disruption in supply chains has led to inflation.

Lacalle argued:

Low interest rates and high liquidity have perpetuated or increased global installed excess capacity in aluminum, iron ore, oil, natural gas, soybeans and many other commodities.

The Spanish economist made the case that the transportation chain has no real problems at the moment.

The excess capacity in the shipping and transport sector is more than documented and in 2020 new capacity was added in both freights and air transport. Ships delivered in 2020 added 1.2 million twenty-foot equivalent units (TEUs) of capacity, with 569,000 TEUs of capacity on ultra-large container vessels (ULCV), ships with capacity for more than 18,000 TEUs, according to Drewry, a shipping consulting firm. International Air Transport Association (IATA) chief economist Brian Pearce also warned that the problem of capacity was increasing in calendar year 2020.

While supply chain disruptions can create economic havoc, we cannot ignore monetary policy’s role in generating inflation.

Increasing the money supply invariably results in inflation. With increased dollars chasing the same amount of goods, inflation is sure to follow.

Lacalle illustrated this quite well,“More supply of money directed towards scarce assets, be it real estate or raw materials. The purchasing power of money goes down.”

We should be careful when talking about inflation. Rising prices are one of various symptoms of inflation. Maharrey is correct in observing that inflation “shows up in rising asset prices. We see it in stock market and real estate bubbles. That fact is we’ve gotten inflation in spades with or without rising CPI.”

As of late, the Fed has increased the money supply at an alarming rate under the pretext of battling the Wuhan virus pandemic. Though, again, we should be careful about overlooking broader trends. For example, money supply was on the rise prior to the Wuhan virus outbreak. Lacalle pointed to several differences between 2020 and years prior.

Previously, the Federal Reserve or the ECB increased money supply at or below the levels of demand for money (measured as demand for credit and use of currency). For example, the increase in the money supply of the United States was close to 6 percent with a global demand for dollars that grew between 7 and 9 percent. In fact, the world maintains a dollar shortage of about $ 17 trillion, according to Luke Gromen of Forest for the Trees. This keeps the dollar or euro relatively stable and a perception that inflation is low. However, there were red flags before covid-19. There were protests all over the world, including Europe, against the rising cost of living. The world’s reserve currencies export inflation to other countries.

Lacalle offered an overview of what took place in 2020 as far as monetary policy was concerned:

For the first time in decades, the Federal Reserve, and the main central banks increased money supply well above demand. The response to the forced shutdown of activity with massive money printing generated an unprecedented inflationary wave. The economy did not collapse due to lack of liquidity or a credit crunch, but due to the lockdowns.

The Spanish economist listed off three consequences of the “monetary tsunami” that the Fed has recently facilitated:

  1. Emerging market currencies plummeted against the dollar because their central banks “copied” the US policy without the global demand that the US dollar enjoys.
  2. A disproportionate amount of money flowing to risky assets joined by more flows to take overweight positions in scarce assets. That excess money made investors move from being underweight in commodities to overweight, generating a synchronized and abrupt rally.
  3. Extraordinary measures typical of a financial or demand crisis were taken to mitigate a supply shock, generating an unprecedented rise in money with no added credit demand. More money in scarce assets is not a price increase, but a decrease in the purchasing power of money.

Overall, we should remember that inflation is the product of loose monetary policies coming from central banks. Contributing factors like supply chain shocks cannot be viewed as the principal factor behind inflation. In fact, by focusing so much attention on non-monetary factors that supposedly cause inflation, economic pundits effectively give the Fed a free pass.

If we want any meaningful change in economic policy, we must start coming to grips with the fact that central banks are the main drivers of inflation, and because of this, they must be shut down if economic stability is our main goal.

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