This is a follow-up to “24/7 Money Printing at the Fed? Misconceptions and Consequences.“
For a longer list of monetary / macro-related notes, please see the most recent related note here.
My prior note regarding the nature of “money printing” sparked an interesting debate with a friend, which forms the basis of this current post.
As a reminder, my prior note argues that the Fed is not currently engaged in “money printing” in the physical sense. What the Fed is actually doing is more like money transformation, which is carried out by converting mostly treasuries and bonds (which the Fed does not consider as “money”) into cash. While this is “money printing” according to the government, I argued that this overstates what the government is doing since every $100 it “prints” requires someone to give up an equivalent amount of assets as well. As a result, can we really say the government is “printing” money? Money transformation seems like a more appropriate description. I also argued that this may also be the reason why general inflation has been limited, while asset inflation has been rampant. By “printing money” this way, the Fed has effectively reduced the universe of investable assets (by buying up treasuries and bonds and locking them away) and hence driving up the value of the remaining investable securities while not actually adding more “money” to the world. More liquidity, yes. But not more “money”, in my humble opinion.
A close friend, however, brought up an interesting counter argument. Even if the Fed is only transforming money (from $100 worth of Treasuries into $100 worth of cash), the value of the remaining investable assets still goes up in value even though the Fed has not directly interacted with them simply because the Fed has reduced the investable universe and outstanding supply. Has the Fed not therefore created “money” for all the remaining holders of those assets?
At the time of this debate, I admitted that this is quite possibly true and that the Fed does end up creating “money” over time even if not in the very moment in which a quantitative easing transaction is carried out.
But upon deep reflection, I’ve realized that it’s actually not true.
While the Fed creates the conditions for asset price inflation by reducing the investable universe, ultimately the money that drives that inflation has to comes from somewhere else.
Since the Fed does not introduce new “money” into the economy during the process of quantitative easing, the money that drives up the asset price therefore has to come from somewhere else.
For example, let’s imagine you are the lucky investor with $100 worth of Treasuries with the opportunity to transact with the Fed. The Fed gives you $100 in exchange for your $100 worth of Treasuries. Your savings have not changed, but you’ve become more liquid. Your Treasury has been quantitatively eased…The Fed takes your Treasury and locks it up in a safe place, effectively removing it from the economy.
Now, let’s imagine you actually want to own the Treasury again. Well you’ll need to go out and buy it. But since there are now less Treasuries available, you’ll need to pay more than $100 to own the same Treasury again. After asking around, you discover that the lowest price that someone is willing to sell it to you is $105.
But since you only received $100 for your prior Treasury, in order to own that asset, again, you now need to bring $5 more. And that $5 more had to come from somewhere else.
This somewhere else could be…your savings, your consumption, your other investable assets, or debt.
But the most important thing is that it had to come from somewhere else!
And by driving asset prices up, this process deprives liquidity (and inflation) from somewhere else!
The $5 that now goes into the value of that Treasury is no longer $5 that could have been spent on consumption, for example.
So my innocent question is this: While the Fed creates the conditions for asset price inflation, where does that money and asset price inflation come from? Is this simply the absorption of inflation that would have happened elsewhere? And by doing so, is this process creating potential deflationary pressures somewhere else by removing money that could have gone into other things (consumption, for example)?
And lastly, it is important to keep in mind that equities are not normal goods. For the average person, equities are Veblen goods. In economics, a Veblen good is otherwise known as a luxury good – The higher the price is, the more people want to buy it (empirical data suggests this is true – markets tend to have momentum…when the markets / stocks go up, more people get interested and want to buy driving it up further, and when markets / stocks go down, more people want to sell and get out driving it down further).
So if we take that last final logical step…if equities are Veblen goods, in which people want to buy it the more it goes up…what is the ultimate effect of the Fed creating conditions for asset price inflation?
Is the Fed not only driving up asset prices and sucking up liquidity from somewhere else but inadvertently creating a positive feedback loop where this process runs faster and faster and faster as it goes on, sucking up ever more liquidity and depriving inflation that would have happened somewhere else?
My prior note argued that the Fed is not creating inflation at the moment because it isn’t actually “printing money”. But what if the Fed is actually creating deflationary pressures in the general economy because it is driving asset price inflation, and in order for asset prices to inflate, it must absorb money from somewhere else including the money that may have gone into consumption at the margin?
What if the Fed is actually creating deflation instead of inflation in the general economy?