I wrote as following in a letter to the Wall Street Journal in response to an op-ed piece by John Cochrane a formidable youngish economist very much in the Chicago School tradition – where he was a professor. He is now a Senior Fellow at the Hoover Institution. You can follow his blog Blog: http://johnhcochrane.blogspot.com/
Incidentally I have not yet had any acknowledgment from the WSJ – nor do I expect them to publish my letter.
Here is an answer to Cochrane’s (WSJ, August 1st ) question – … does money alone drive inflation? Money (mostly) in the form of deposits in banks held by households and by firms, on behalf of their shareholders, is clearly an asset of the depositor and a component of their wealth. Because the deposit liabilities issued by the shareholders of banks are not expected to be repaid (net wealth goes up with bank deposits because they are expected to grow with the economy and the demand for deposits and will not have to be repaid or be expected to be repaid). Similarly as Cochrane posits, government bonds, or any paper issued by a government, that are never expected to be repaid by taxpayers, are another component of wealth. An excess supply of net money (deposits) or an excess supply of net bonds- over and above the willingness of wealth owners (savers) to hold those assets –would lead to an increase in the demand for other assets and goods and services- and so generally higher prices for goods, services and other assets as portfolios are adjusted to excess holding of money or bonds. That is lead to inflation.
But where could the excess supplies of money and or bonds come from? As Cochrane indicates only and always from a fiscally undisciplined government. A fiscal theory of inflation is essential in explaining all inflations everywhere. It is hardly an original concept.
A fiscally constrained government can call on its central bank and its private banks to fund all the bonds it wishes to issue. The central bank most simply might directly fund the government by buying its additional paper and crediting the government’s deposit account with it. Which, as the Treasury deposits with the central bank run down as the government spends more, would increase the cash reserves of the banks. And their ability and perhaps willingness to lend more- including to the government. And if extra bank lending ensued by banks flush with extra cash, the supply of bank deposits would increase by a multiple of the additional cash deposits injected into the system.
Or the central bank could at its initiative supply (lend) extra cash to the banks so that they may be willing to fund the government with the same influence on the supply of bank deposits as the government spends more. And if the increase in the supply of deposits – bank liabilities and of government paper – bank assets – exceeded the willingness of the public to add to their deposits or bonds – inflation would follow. The deposit liabilities of the banks and their loans to government (bonds) would be increasing at a similar rate. The banks, perhaps more than a wider set of financial institutions, would be holding many of the extra bonds issued by governments- particularly in many countries mostly without a well-developed bond market but very vulnerable to fiscal difficulties and high rates of inflation. Inflation is not an American invention.
Inflation is explained by the inter- actions of governments, banks and the wealth owning public. The exchange of a hugely increased supply of extra deposits held by US banks with the Fed (QE) (cash) for extra private or publicly issued securities after 2010 was restrained – it was understandably not a risk loving lending encouraging time for the US banks after the GFC. The money multiplier (M2/Cash Reserves) collapsed – and the supply of deposits grew slowly and more or less in line with the demand for extra deposits issued by the banks, so avoiding much inflation. But not incidentally of share or real estate prices that were on a tear. Predicting inflation will always demand a close watch of fiscal policy – of the supply of and demand for government bonds in wealth portfolios – and of the behavior of banks- central and private. It will always be complicated.