Which brings us to nothing less than the monetary system, in particular the role of money. This area, one might think, would be the first taxi rank in economics education, but it remains the least understood, even by experts.
It is so vilified by many central banks, including the US Fed, that they have stopped bothering to release data on it. Does anyone care how money is created? Who creates it? Who controls it? How much do we need?
The only thing clear is that we need it to buy things, but what happens next is a mystery.
How it works
In the modern monetary system, eloquently called the fractional banking system, most of the money is created by the private sector, and every time a loan is taken, money is created. The proceeds eventually end up in the banking system where the loan issuer can collect the money to pay off the loan.
That’s right, the banking system allows banks to lend first and then borrow, through the central bank. They don’t need to check the safe or their reserves. It is the growth of credit that increases the amount of raw money in the system.
You cannot recover money that you did not create first.
The federal government also creates money every time it spends. More importantly, since she owns the printing house, she does not need to recover this money.
It can create net money. However, he usually recovers it, in the form of taxes or a loan. It basically creates the money it spends and then destroys the money it collects, leaving the raw money unchanged.
It looks like she taxes and borrows to get the money she spends, but it’s actually the other way around. You cannot recover money that you did not create first.
Thus, the private sector largely determines broad money, or raw money; the public sector determines the net currency. However, the private sector overshadows the public even now when the government is running large deficits. There is over $ 2 trillion in broad money and less than $ 200 million in notes, coins and excess reserves in the RBA.
Why is all this important? It is not the government that prints money that usually causes inflation, despite what it might lead you to believe. It is the animal spirits in the private sector that drive high credit growth and hence broad money growth.
This drives up asset prices and eats away at any excess capacity available to the economy. The last time we had decent inflation in Australia was between 2003 and 2008, when the investment boom pushed credit growth up to double digits. The government, on the other hand, drained rather than printed money, via budget surpluses.
The main impact of the government, which is running large deficits, is to increase activity in the private sector, not to flood the economy with money. Money is oil, not the engine itself. How the government spends money is therefore vital.
In a weak economy like this, the money spent should go to those with a high propensity to consume. The cuts in JobSeeker and JobKeeper are therefore a major concern.
In the hands of the most disadvantaged, money becomes like vouchers, guarantors of renewed activity. Tax cuts on high incomes are often saved: money which then goes to the government, having done nothing to revive activity.
The only long-term concern for inflation is a relatively recent development of governments trying to intervene directly in private sector money creation.
The COVID-19 crisis has seen a massive increase in offshore governments guaranteeing bank loans to the private sector. These are loans that the banks themselves would not grant for credit reasons.
However, with government support for loans, banks are freed from credit and all kinds of marginal projects and businesses are financed. Initially, this looks good as activity increases, credit takes off and excess capacity is absorbed. As in the 1980s, however, the credit boom was built on sand.
Inflation will take off and eventually the boom turns into a collapse. Think about the State Bank of South Australia or the State Bank of Victoria and the problems they caused.
While this outcome seems likely for the US and UK, the Australian government has yet to take this route. The slow recovery may well see these programs promoted, although often under the guise of socially beneficial outcomes such as green projects or job creation programs.
For a bond manager, that’s not the problem this year, but when broad money takes off, as it does in the United States, make sure you have protection against it. ‘inflation. This is an overt financial crackdown, because with the increase in public debt there, they will not want to see nominal yields rise.
As a result, inflation will end up being well above artificially low interest rates, eating into all of our pockets. And the sleight of hand of economic theory will change again.
Vimal Gor is responsible for bond, income and defensive strategies at Pendal Group.