For several years, predictions about hyperinflation have pervaded the media. Yet consumer prices have only risen a total of 2.7 percent over the past three years, compared to 12.6 percent over the three years before, and 8.5 percent over the three years before that. Where is the hyperinflation, and why hasn't it shown up yet?
The Federal Reserve Act of 1913 created 12 regional banks, effectively owned by private member banks, plus a Board of Governors appointed by the president and confirmed by the Senate. This system has the power to create money by issuing credit in exchange for reserve assets. These assets once included gold, but the primary asset the Fed now purchases is government bonds, the debt of the federal government. In exchange, the Fed issues currency (i.e., the $970 billion in Federal Reserve notes currently outstanding, printed by the U.S. Treasury and deemed legal tender) and deposits in the reserve accounts of member banks.
When the financial sector melted down in 2008, the Fed did something unprecedented. It began to purchase massive amounts of government bonds, and even mortgage-backed securities and other nongovernment assets. The monetary base more than tripled as a result, rising from $870 billion in mid-2008 to $2.68 trillion now. By comparison, the monetary base only rose by a total of 8 percent in the three years prior.
Those with a simple mechanistic view of the economy see this expansion as inevitably leading to inflation, and these fears have been one of the major factors underlying the recent asset price bubble in gold. But these fears are largely misplaced, at least for the time being. What we are seeing is the complete opposite of hyperinflation.
Price inflation results when the supply of money outpaces demand, and people look to spend the excess money they don't want to hold. When hyperinflation takes hold, people are afraid to hold money and similar assets, and they spend what little money they hold as quickly as possible.
Money is not just currency. It primarily consists of deposits, which are created when banks make loans, people use that credit to buy things, and sellers deposit the money back in the bank. This goes on in a cycle called the deposit expansion process, and the total money supply is many times the original amount of credit issued by the Fed. The measure called M2 currently stands at $9.5 trillion, about 3.5 times the monetary base.
When banks stop lending, the money supply shrinks, and the result is price deflation like we experienced in the Great Depression. When prices fall and people aren't buying, firms can't pay back their loans, and that makes banks even more fearful of lending. Unemployment rises, and the cycle continues.
The ratio of M2 to the monetary base was 8.1 in 2005, and 8.9 in 2008 when banks were still lending like crazy. Had the collapse in lending been allowed to spread, the price level might have fallen by more than half. Such a deflationary spiral would have made the Great Depression seem like a mere trial run for the big one.
What happens after a financial crisis is that government bonds become the only safe asset around, and the government becomes what Minsky called the borrower of last resort. In spite of the recent downgrading of U.S. Treasury bonds, they still look like a safe bet compared to everything else. Prices for long-term government bonds have risen, pushing annual yields for 10-year Treasuries below 2 percent. This would not be happening if major investors expected any significant inflation.
Now everybody wants to hold public debt, not private. They also want to hold money, not spend it or lend it. European government debt is not quite so attractive, due to chronic borrowers like Greece, and most other countries that might be considered safe places to park money don't borrow much, so there are few of their bonds to buy. The result is that U.S. money supply can barely keep up with money demand, and price inflation slows as a result.
Are there future risks? Once banks have deleveraged most of their bad assets, and the economy has finally recovered, they should start lending again. Once investors are no longer afraid of more bad financial news, they may be willing to hold other assets. Then, and only then, the Fed will need to back out of its current intervention, and bring the monetary base back down to normal by selling off some of its new reserves. As long as people can manage a little faith that they can do this, there is no reason any of us should be hyperventilating about hyperinflation.
• Professor Elliott Parker is chairman of the Economics Department at the University of Nevada, Reno.