Do Central Banks (Really) Create Inflation?

by Michael J. Howell5. March 2013 08:50
It's a provocative title worthy of the John McEnroe stabbing retort 'You cannot be serious?' Indeed, the linkage between Central Banks and inflation must the most accepted 'fact' in economics. However, for some policy-makers right now, perhaps in deflating Eurozone or deflation-weakened Japan, creating inflation would be high on their wish list. Consider the four major crises of the past century: (1) Weimar Germany; (2) 1930s America; (3) 1974/5 Britain, and (4) 1990s Japan. All four suffered banking crises and faced huge debt problems, and all four saw similar policy responses with Central Banks significantly expanding their balance sheets, or much like today's QE. But two cases were inflationary and two were deflationary. Jury out? The defining feature is not the scale of the money printing, but who holds the debt? In the deflationary cases - America and Japan - the private sector was largely the debtor, but in the two inflationary cases - Germany and Britain - the largest debtor was unquestionably the government. Here is the lesson. When the private sector is in debt they will attempt to pay off their debts with any surplus cash printed by the Central Bank. In economic parlance the marginal utility of means of settlement money is high. But when the private sector carries low debts, they have less need for new cash and will tend to spend it, thereby creating inflation. The moral here is two-fold. First, Central Banks are not a sufficient condition for inflation, because they need the government to act as the 'helicopter'. Second, we much watch out for inflation to pick up once private sector debts have been run down and if the Central Banks continue to monetize. That is our risk.

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