Get 40% Off
⚠ Earnings Alert! Which stocks are poised to surge?
See the stocks on our ProPicks radar. These strategies gained 19.7% year-to-date.
Unlock full list

Central Bank Money Printing Doesn't Necessarily Cause Inflation: Here's What Does

Published 02/26/2024, 12:54 AM
Updated 07/09/2023, 06:31 AM

People handle money every day.

But they barely understand how our monetary system really works.

Universities, economists and mainstream media keep perpetrating false myths:

''Central Banks print money and cause inflation''.

''The US must pay back its debt or it it will go broke''.

In the past 3 years I have produced several pieces to debunk these myths.

But I’ve never written a condensed primer on how money really works.

So, here is my best attempt at a short note that should provide you with the most important basics and framework to understand our monetary system.

Financial Money and Real-Economy Money

There are two main different tiers of money: financial money and real-economy money.

That's your easy way to think about what operations are potentially inflationary and which ones are asset-price-inflationary only.

Who prints financial and real-economy money?

Financial money is printed by Central Banks, for example via QE.

The Central Bank changes the composition of the asset side of the financial institutions' balance sheet: it takes away bonds, and swaps them for reserves.

Bank reserves are financial money.

Central Bank vs Commercial Bank - Before & After QE

Now, the trick is that reserves are NOT money for the private sector: they are money for banks.

Banks DON'T lend or multiply reserves.

Reserves (red) in Japan doubled (!) in the 90s as the BoJ went on with QE, and yet bank loans (blue) shrank by 25% in the same period.BoJ's Quantitative Easing

QE (Financial Money Printing) Does NOT Encourage Banks to Lend More (Real-Economy Money).

When lending, banks look at:

  1. The creditworthiness of the borrower

  2. The loan yield

  3. The required capital for the loan

If the trade-off amongst these features looks good, they lend. Otherwise, they don't.

A large amount of reserves has a virtual zero impact on the willingness and ability of commercial banks to make more loans.

Later, we will see how lending does not involve ‘‘multiplying’’ reserves either.

So Why Do Central Banks Print Financial Money (I.e. Reserves)?

Central Banks print new financial money (e.g. QE) to add interbank liquidity (reserves) to the system in periods of financial market stress.

This helps banks to have more liquid balance sheets, transact with each other better, and stabilize repo markets.

Think of it like ‘‘oiling’’ the monetary plumbing mechanism.

But remember this: financial money can NEVER enter the real economy.

So, who prints real-economy money instead?

Governments (via deficits) and banks (via lending).

As the Bank of England itself shows, when making new loans banks literally credit your account out of nowhere and hence create new deposits.

You are getting credit against your future ability to generate cash flow.

You can now spend a lot of money in the real economy.

Please notice how banks are not ‘‘multiplying’’ reserves when lending: the green box for reserves plays a completely passive role in the lending process.

The banking system in aggregate creates new credit (loans), which is real-economy money that after being spent (for example to buy a house) ends up on the account of the house seller as a new bank deposit (red).

Lending Expands Banks’ Balance Sheets and It Creates New Real-Economy Money.

Bank's Balance Sheet

Government Deficits Also Inject New Spendable Money for the Private Sector.

If the government spends more than it collects taxes for, new money has been created.

Deficit spending increases the net worth of the private sector without adding a liability to it.Before and After Government Deficit Spending

What happens when the government goes for the so-demonized deficit spending?

The government blows a hole in its balance sheet, effectively creating negative equity through deficit spending – public opinion would say it spent money it didn’t have, and hence it must borrow (issue bonds).

But have a look at what the government really did.

The government spent $100 by sending cheques home to people (private sector), which all of a sudden find their bank deposits have gone up by the same $100 without any liability (!) immediately attached to it.

In other words, the government blew a hole in its balance sheet but increased people’s net worth!

Governments create the very money the private sector uses, so it does not ‘‘need’’ to save or find money before it spends.

Our self-imposed accounting rules require deficit spending to be ‘‘financed’’ by bond issuance, which banks can just absorb swapping reserves for bonds.

In One Picture, Here Are Your REAL ECONOMY Money Printers

Banks - when they lend aggressively to the private sector, creating new credit which can be spent.

Governments - via deficit spending: cutting taxes or sending cheques so households and corps can spend more.Annual Change in Financial Assets

Now you see why all they told you about money printing is wrong.

Central Banks DO print money - but financial money, which is not inflationary.

And if the US would ''pay back all its debt'', it would subtract huge resources from the private sector - easier said than done!

The Dangers of Excessive Real-Economy Money Printing

Government deficits and bank lending increase the spending power of the private sector in a meaningful way.

It would be nice to receive cheques from the government each year, or to get cheap loans for years on end.

But what’s the main danger of excessive real-economy money printing?

Inflation.

US YoY CPI Inflation

My global credit impulse index (orange) measures the amount and the pace of real-economy money printing in the 5 largest economies in the world.

It leads to rapid changes in inflation with an 18-month lead time.

The coordinated, gigantic fiscal and credit expansion of 2020-2021 culminated in excessive real-economy money printing which led to a vicious inflation spike in 2022.

The limits to government deficits and credit creation are inflation and real resources.

Excessive deficit spending and bank lending create too much money for the private sector, and if the supply of labor and real resources can’t expand rapidly enough we get sharp bouts of inflation.

Conclusions

People handle money every day.

But they barely understand how our monetary system really works.

Universities, economists, and mainstream media keep perpetrating false myths:

''Central Banks print money and cause inflation''.

''The US must pay back its debt or it will go broke''.

The reality is that there are two different tiers of money: financial money and real-economy money.

Central Banks do print money - but financial money, which is not inflationary.

The amount of financial money has zero influence on the real economy.

Financial money printing is used to oil the monetary plumbing mechanisms.

Governments (fiscal deficits) and banks (lending) print real-economy money.

They can increase the spending power of the private sector in a meaningful way.

But the risk of excessive real-economy money printing is inflation.

Excessive deficit spending and bank lending create too much money for the private sector, and if the supply of labor and real resources can’t expand rapidly enough we get sharp bouts of inflation.

***

This article was originally published on The Macro Compass. Come join this vibrant community of macro investors, asset allocators and hedge funds - check out which subscription tier suits you the most using this link.

Latest comments

Beans dont necessarily cause gas…
rofl.
QE is a tool to lower long rates. it supressed the term premium by creating a scarcity. It had an effect on credit conditions, activity and inflation
More MMT propaganda
did Kamala write this?
Unrestrained hubris.
correct, according to his thinking our taxes would never go up and all the money that makes it to me is fun money.
Purchasing power of your money goes down when theres more money in circulation. Thats inflation.
quite bizarre
scusami Alfonso, se la BCE non avesse comprato titoli di stato italiani, non avremmo avuto la spesa pubblica che abbiamo purtroppo avuto e nemmeno l,'inflazione che stiamo combattendo
the reason they called it microdosing is because you're only supposed to take a very little bit of it! You be tripping bro😵‍💫
what? this is the basic stuff each economy school consider as true, it is nothing shocking or new or something like that. but I admit the article is poorly writen.
Apparently tou, similar to the author, need to read a book or two.
You should be relieved of your duties on this platform for this garbage.
Like saying, in order to stop the ships from rising in perpetuity, instead of cutting off the water supply, one instead must make the anchor stronger.
top signal article
You must work for Federal Reserve!
inflation by definition is the growth of money supply. God, I hate academics.
Find an old Oxford dictionary and you'll understand that inflation is the expansion of the money supply and credit. General rising prices are a consequence of inflation. In a normal economy prices should be stable or trend down as people become more productive but unfortunately the government and big finance have robbed the gains of efficiency and has left the general population with the scraps (some technology advanced) and declining living standards in some cases (it was possible to raise a family of 3/4 on a single salary 50 years, today it's almost impossible)
Milton Friedman said - Increasing the money supply to follow a limited number of goods, means each unit of good now costs more. Because each unit still occupies the same percentage of the whole and the pool of money that makes up the whole has increased. Thus each unit commands more money. That's Inflation.
Completely False information your perpetuating! The main driver of inflation is always government printing of money which devalues the currency. There are other factors that can increase the cost of goods but nothing as directly related as to devaluing the Dollar by printing more money. It's been like this since the 30's since abandoning the gold standard!
correct, according to his thinking our taxes would never go up and all the money that makes it to me is fun money.
money printing is inflation of the money supply.
yes all the liquidity just went to wallstreet to trap the bears, but not affecting the real life and inflations, Bidenomics was so great!
Greedy rat bastards cause inflation. End of story. No need for blah blah filler bullshit
Risk Disclosure: Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.
© 2007-2024 - Fusion Media Limited. All Rights Reserved.