Re: Inflation, deflation and the “persistently strong” Loonie

Milton Friedman famously postulated, “inflation is always and everywhere a monetary phenomenon”.   To believe in deflation is to believe that the money supply will actually contract rather than the rate of growth merely slowing from historically high levels which is all that is happening currently.   Rather than contract, I believe that there are two factors that will significantly increase the money supply in the medium term:

  • Excess Bank Reserves:  The global banking system has been flooded with cash that is currently accumulating on central bank balance sheets as “excess reserves”.  Banks will obviously begin to lend again and through the multiplying effect of fractional reserve banking will significantly increase the money supply.   If they do not do so voluntarily we expect them to come under government pressure to do so.  I do not believe that the political will exists to extract these funds from the banking system.   For example, the Swedish Central Bank recently cut nominal rates on excess reserves on deposit to NEGATIVE 0.50% in order to force banks to lend.
  • Fiscal Deficits: Massive Keynesian style spending/deficits planned – current projections by the World Bank are that government deficits will accelerate to 9% of global GDP in 2009.  Government is stepping in as borrower and spender of last resort.

Prior to 1971 when the US and the world went off the last remnant of the gold standard you could argue that there was at least some restraint on printing money. We have now arrived at a point in financial history where there appears to be no immediate restraint on money printing compounded by the fact that there is no stable (non-inflating) fiat currency with sufficient market size to act as a safe haven/competition and widespread belief amongst governments and central banks that inflation will actually be a good thing for the economy.   The track record of the central banking community with respect to inflation/eroding the purchasing power of fiat currency is virtually perfect.   The economist, Ludwig Von Mises once quipped “Government is the only institution that can take a valuable commodity like paper, and make it worthless by applying ink.”

Its important to remember that inflation is not incidental to what the governments and central banks of the world have been doing during the crisis.  They’re not saying, “Let’s bail out the banking system even if that is inflationary.”   The banking system has been flooded with excess reserves with the expectation that these will be lent and the money supply increased.  I would argue that the banking system is incentivized to create leverage and lending and so I can’t see that all this money sits on the sidelines indefinitely.

On top of the excess reserves parked in the system, the governments of the world are now effectively dictating that if the private sector will not or cannot borrow the reserves they have pushed into the banking system then they will borrow them.  Hence we have fiscal deficits rapidly increasing across the globe.

Canada is not immune from this type of inflationary activity.  Timothy Lane, one of the deputy governors of the Bank of Canada has been floating the idea that the Bank of Canada should use quantitative easing to devalue the Canadian dollar.   Mr. Lane said that a “persistently strong” Canadian dollar will reduce growth.   However, quantitative easing would merely lower the purchasing power of Canadians through inflation as it devalued the Canadian dollar – where’s the benefit?

Does the Bank of Canada really believe you can devalue your way to prosperity?  Ask any inflation stricken country about this theory.  I believe that current Keynesian policies will achieve nothing more than corrosive inflation.  What western economies need is more capital.  Printing money does not create capital.  Worse yet, low interest rates artificially stimulate speculation and consumption rather than savings.  Ultimately, the inflation that money printing creates reduces the pool of available capital causing long lasting harm.

There are lots of complicated and opaque terms for what is being done – quantitative easing, liquidity, stimulus, bail-outs etc  – but strip away the jargon and its simply printing money, borrowing money and spending money. If Milton Friedman, Ludwig Von Mises and history are any guide it will be inflationary.

Equicapita is a Calgary based income trust which manages an RRSP and TFSA eligible SME private equity fund for retail investors.