H ERE IS A potted history of recent economic policy and inflation. In the 2010s central banks created vast amounts of money through their quantitative-easing ( QE ) schemes, while governments enacted fiscal austerity. Inflation in the rich world was mostly too low, undershooting central banks' targets. Then the pandemic struck. There was plenty more QE . But the truly novel economic policy was the $10.8trn in fiscal stimulus implemented worldwide, equivalent to 10% of global GDP . The result was high inflation. The rich country that has splurged the most, America, has had the most inflation. With consumer prices rising at an annual pace of 6.8%, the Federal Reserve on December 15th was forced to acknowledge that inflation had become a big threat.
At first glance, this apparent supremacy of fiscal policy is awkward for fans of Milton Friedman's view that inflation is "always and everywhere a monetary phenomenon". Central banks, not governments, are charged with hitting inflation targets. But does the experience of the pandemic show that inflation is really fiscal?
One way in which fiscal stimulus boosts inflation is by strengthening households' and firms' balance-sheets, making them more likely to spend. Suppose the government raises cash from investors, who receive bonds in exchange. Then it hands out the money to households, returning it into circulation. Netting off, it is as if the government has just given out new bonds. Whether those bonds truly constitute new wealth for the private sector is the subject of an old theoretical debate. When the government runs up debts the public could also expect to pay higher taxes in the future—a liability that offsets their newly created assets. Yet in reality it is clear that fiscal stimulus leads to more spending.
Now introduce a new step into the thought experiment. The central bank, implementing QE , creates new money with which it buys the bonds that the government has given out. So when you net everything off, the government is not giving out bonds. It is giving out cash. This is not far off the policy mix during the pandemic. The tsunami of fiscal stimulus was accompanied by bond-buying of almost equal magnitude: central banks in America, Britain, the euro zone and Japan have together bought more than $9trn in assets. The result has been a surge in deposits at commercial banks. In America they have risen from around $13.5trn in early 2020 to around $18trn today. As early as the spring of 2020 some monetarist economists, such as Tim Congdon of the University of Buckingham, pointed to surging measures of broad money, which includes bank deposits, and warned of inflation to follow.
So far, so Friedmanite. But which leg of the policy matters more: the fiscal stimulus, which boosted aggregate household wealth, or QE , which ensured the infusion was of cash and not of bonds? There is probably something special about infusing households' balance-sheets with cash, says Chris Marsh of Exante Data, a research firm. He has suggested that a "rediscovery" of monetarism could be in the offing after the pandemic.
Other economists, however, argue that QE is mostly ineffective, except in periods of acute financial stress, such as the "dash for cash" in spring 2020. Suppose that once that crisis had passed central banks had shrunk their balance-sheets quickly, but had still promised to keep interest rates at zero for a long time. It seems likely that America's enormous fiscal stimulus would, by boosting household wealth, still have driven up spending and prices.
Yet believing in the impotence of QE compared with fiscal stimulus is in fact consistent with monetarism—if you expand the definition of money. Distinguishing the electronic money created by central banks from debt securities issued by governments is increasingly difficult. This is partly because when interest rates are close to zero, they are closer substitutes. It is also because most central banks now pay interest on the electronic money they create. Even if rates were to rise, so-called "interest on reserves" would still leave electronic money looking a bit like public debt.
The reverse is also true. Investors value government debt, especially America's, for its liquidity, meaning they are willing to hold it at a lower interest rate than other investments—much like the public is willing to accept a low yield on bank deposits. As a result "it seems more accurate to view the national debt less as a form of debt and more as a form of money in circulation," wrote David Andolfatto of the Federal Reserve Bank of St Louis in December 2020. He also warned Americans to "prepare themselves for a temporary burst of inflation" in light of the one-off increase in national debt during the pandemic. If money and debt are substitutes, just swapping one for another, as QE does, might provide little stimulus, consistent with the experience of the 2010s. But expanding their combined supply can be powerfully inflationary.
Right on the money
The logical extreme of this argument is known as the "fiscal theory of the price level", created in the early 1990s (and in the process of being refreshed: John Cochrane of Stanford University has written a 637-page book on the subject). This says that the outstanding stock of government money and debt is a bit like the shares of a company. Its value—ie, how much it can buy—adjusts to reflect future fiscal policy. Should the government be insufficiently committed to running surpluses to repay its debts, the public will be like shareholders expecting a dilution. The result is inflation.
Explaining today's high inflation does not require you to go that far, though. It is enough to look at recent deficits, rather than to peer into the future. Yet it is striking that economists like Mr Andolfatto who focused on the supply of government liabilities foresaw today's predicament while most central bankers, whose eyes were fixed firmly on labour markets as a gauge of inflationary pressure, did not. The past decade has shown that when interest rates fall to zero, it takes more than just QE to escape a low-inflation world. Still, Friedmanism lives on. ■
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This article appeared in the Finance & economics section of the print edition under the headline “Of Milton and money”
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