The True Gold Standard (Second Edition)
Previous article: The Link Between Money Supply and People’s Demand for It
It would seem from all this that the money supply cannot predict inflation. This is true under a gold standard of the kind we have just described, because there is seldom much difference between the supply and demand for money. However, chronic inflation is caused, in Rueff’s words, by a “rupture of the link between the money supply and the cash requirements of the people” (The Age of Inflation, p. x). When this link is ruptured by in convertibility, “Purchasing power has been transformed from effect into cause, and henceforth it will determine the value of purchasable wealth instead of being determined by it” (idem, p. 76, emphasis in original).
What could “rupture the link” between the supply and demand for money? There are two main practical causes: first, monetizing a government operating deficit; and second, monetizing international payments deficits through central-bank purchases of a “reserve currency.”
All money is created by a monetary institution purchasing some asset – usually gold or some sort of financial claim. A key condition for price stability is that, when people’s demand for money falls short of actual money supply, the banking system must be able to remove all the unwanted money, which means demonetizing the assets by selling them for at least their original purchase price. Otherwise, some or all of the unwanted money (dM – dL) cannot be removed from the market. And if the excess money remains on the market, it can do only one thing: cause an excess of total demand over total supply, which drives up the general price level irreversibly.
Rueff points out that the balance of supply and demand for money, and therefore of total supply and demand for goods, is not necessarily altered by a government budget deficit, as long as that deficit is not monetized by the central bank:
“If I had left home this morning with 5,000 francs in my pocket, and wanted to return in the evening with the same amount of cash, I could only have bought as much as I sold, that is, I could demand no more than I could supply. When the same situation prevails for the persons and institution that make up a community, total demand at any given period will be identical with the value of total supply. This would also apply if a political entity such as the government, in order to be able to demand more than it supplied, contrived, through taxes or loans to force other entities to demand less than they supply” (The Age of Inflation,p. 70).
But this equality of supply and demand ceases when the central bank finances the government’s operating deficit by issuing money to purchase its debt. To do this, the central bank must purchase the bonds at a higher price than they would fetch in the bond market (thus at a lower interest rate). But as long as the government is in operating deficit, it keeps adding to the supply of its debt, without adding to its salable assets; so that the central bank cannot resell the government securities except at a lower price – usually a much lower price. So, not as much money can be retired by selling Treasury securities as was originally issued. And of course, as long as the central bank adds new money by purchasing the government’s debt, inflation persists.
Even money created by discounting commercial paper could be inflationary, if the central bank’s interest rate is set too low. (One main reason for the requirement of gold convertibility was to prevent or correct such policy mistakes.) But apart from this, discounting commercial paper need not be inflationary, since the central bank can usually resell it at its purchase price, and so mop up the same amount of money as was issued. The difference is that – unlike the government – private businesses are not legally permitted to operate in deficit with a negative net worth. Businesses which do so are forced into bankruptcy and cease operating. But governments enjoy this legal privilege. And the government’s operating deficits can be financed by money creation when it confers this same privilege on the central bank, by waiving the requirement that the central bank redeem it’s liabilities with an asset like gold which is beyond the government’s control. Money created in this way will be demanded at existing prices only by accident. Other things equal, it adds to the total demand for goods without adding to the total supply of goods, and so causes inflation.
And yet, monetizing U.S. Treasury securities is how most of the “monetary base” – currency and bank reserves – is created by the Federal Reserve.
Next Installment: Reserve-Currency Inflation
The Rueffian Synthesis