I always find it fascinating when fellow economists become dispensers of economic drama. Like the prophets of yore, who carried a sign saying “Earth Ends Tomorrow” on their shoulders, these economic drama merchants travel the online media circuit and predict doom, gloom, and disaster for either the U.S. economy or for the economy as a whole.
Were it not for the lack of educated reasoning among these disaster merchants, we could leave them and their deeds without response. Unfortunately, they have a fair amount of influence over the public discourse—especially among conservatives. This is not good for the conservative movement: economic disaster merchants distract our attention from where it needs to be focused, they dispense aphorisms that facilitate economic reasoning beyond what is tolerable, and they often give the impression that all we need in order to solve the world’s problems is to get rid of our central banks.
This is a nonsensical endpoint for the economic disaster merchants. Therefore, I would like to take the opportunity and explain just how shallow and poorly reasoned such a rant can be.
Dan Lacalle, professor of the global economy at a business school in Madrid, Spain, is a case in point. Writing for the Epoch Times on May 6th, Lacalle dispenses dramatic drum beats about how the Federal Reserve is deliberately bringing back inflation because the Federal Reserve, he says, chooses “to keep the sovereign debt bubble alive as a priority over reducing inflation.”
Disaster merchants love criticizing central banks. There is no object in the world of economic drama pundits more berated than central banks. Lacalle is no exception, and he follows the recipe yet one more step: he avoids spelling out what he thinks the Fed should do differently.
This is symptomatic for the disaster merchants: they are long on loud criticism against the Federal Reserve—or the central bank of their choice—but short on constructive policy advice.
Persistent inflation is not a coincidence. It’s a policy. The money supply (M2) has bounced to March 2023 levels and has been rising almost every month since October 2023.
This increase in M2, Lacalle tries to tell us, is the reason why inflation has not fallen further than it already has. On the face of it, his argument sounds credible; it is hardly a secret that monetary expansion causes inflation.
Upon closer look though, we find that Lacalle does not have the foggiest idea what he is talking about. Since October last year, the M2 money supply has increased by 0.7%, which according to Lacalle is enough to end a trend of declining inflation. He makes this claim without offering the slightest explanation of how monetary expansion causes inflation.
Behold the facts. In June last year, the inflation fell below 4% for the first time since April 2021. From its rate then at 2.97%, U.S. inflation has fluctuated modestly around an average of 3.3%. In other words, it is correct that inflation has stalled.
The problem for Professor Lacalle is that inflation reached its current, rather persistent level four months before the Federal Reserve started expanding its M2 money supply.
If anything, Lacalle proves how easy it is to get a lot of media space by sounding educated and well-informed with a reversed correlation between cause and effect. It only adds insult to injury that he also implies (rather explicitly) that the last six months’ worth of money printing already has had a tangible inflationary effect by ending the decline in inflation. This is not possible, though: an expansion of the money supply needs more time to cause inflation.
In technical terms, Lacalle ignores the significant transmission mechanisms that turn a monetary expansion into price hikes. These mechanisms need time to operate; the length of those mechanisms varies depending on which type of transmission is at work.
We can see them at work in the statistics on monetary expansion and inflation. Here is one example, a time period similar to the one Lacalle uses, namely October to April, but this one is five years old:
- From October 2018 to April 2019, the Federal Reserve expanded its M2 money supply by 2.9%, which is four times faster than the expansion that Lacalle looks at;
- During this very period of time, consumer prices in the U.S. economy increased by 1.1%.
Another example:
- From January 2020 to January 2021, U.S. money supply expanded by 25.7%;
- During the same period of time, inflation was 1.4%.
Based on these numbers, it is easy from a statistical viewpoint to draw the conclusion that monetary expansion does not cause inflation. However, it is well established that money printing does cause inflation, and the causality is crisp, clean, and indisputable. The problem is that in order to get the strongest possible inflationary effect from a monetary expansion, we have to let the newly printed cash pass through the government budget. This means, in plain English, that the central bank—in this case, the Federal Reserve—buys Treasury securities with newly printed money.
As mentioned, this is no longer happening in the U.S. economy. Lacalle hints that the Fed is on the verge of returning to its so-called ‘Quantitative Easing’ program, that somehow the $149 billion increase in M2 money supply over the past six months—a marginal increase at best—facilitates a new QE program.
His piece of evidence has two parts. First, he says that Congress increases its debt faster than the Federal Reserve sells off the U.S. debt it owns since its ‘Quantitative Easing’ days:
U.S. government deficit spending has more than offset the decline in the Federal Reserve balance sheet. While the Fed’s balance sheet has shrunk by $1.5 trillion from its peak, the U.S. government deficit remains above $1.5 trillion per year. So, the M2 in the United States has bounced above March 2023 levels, while deficit spending offsets any Fed balance sheet reduction.
Somehow, this is supposed to motivate the Fed’s increase in M2 money supply. In reality, that increase happened because the Fed wants to prevent an interest-rate shock in the market for U.S. government debt. Figure 1 has the numbers: it shows the different maturities of U.S. Treasury securities on its horizontal axis, and their yields on the vertical axis. The curve, known as the yield curve, shows how yield rates fell minimally from January to February (1), then rose through May 1st (2), with a slight recoil in the early days of this month (3):
Figure 1
This rise in interest rates is mirrored by losses in the value of the underlying securities, i.e., Treasury notes and bonds. These value losses are essential to understanding why Lacalle is wrong when he says that the Federal Reserve is trying to protect a “bond bubble.”
The U.S. banking system is heavily exposed to Treasury debt. From 2020 through 2022, they bought $747 billion worth of federal government debt. This represented an unprecedented 50% increase in their holdings of Treasury securities. They bought these securities when the Federal Reserve’s policy-setting funds rate was at or below 0.1%.
Today, it is 5.33%. This means that the banks paid top dollar for U.S. debt securities. It also means that if they try to sell them today, they lose enormous amounts of money. The recent decision by the Federal Reserve to slow down its sales of the U.S. debt it owns should be viewed in the context of what would happen if Lacalle got what he wants. If the Fed abandoned the market for U.S. debt in favor of stomping out the last remains of inflation from the U.S. economy, it would send a shockwave of insolvency through the U.S. banking system. There would be bank runs and demands for astronomical bailouts.
If the Federal Reserve failed to bail out the banks, it would essentially mean the death knell to the U.S. economy. There would be rapid contagion across the Atlantic.
How would the Fed finance a bank bailout program? By printing inflation-inducing money. The exact thing Professor Lacalle wanted to avoid at all cost.
