- Monetary base expansion is a powerful drug. Used correctly and judiciously, it has a critical role to play in the successful management of a complex economic system that relies heavily on fractional reserve banking. However, the powerful and immediate effect of monetary base expansion makes it a highly addictive drug.
- In this week’s post, we will attempt to illustrate the highly addictive nature of monetary base expansion by applying the “seven stages of addiction” model for methamphetamines to the current cycle of monetary base expansion. There are striking parallels between the methamphetamine addiction cycle and the economic/market cycle that occurs following a dramatic expansion of the monetary base.
- “The Seven Stages of Addiction” for methamphetamines are: (1) the Rush, (2) the High, (3) the Binge, (4) Tweaking, (5) the Crash, (6) the Hangover, and (7) Withdrawal.
- The view of The Money Enigma is that markets and policy-makers are currently passing from the “Binge” stage into the “Tweaking” stage, a stage characterized by increasingly erratic (market) behavior and delusions so strong that the participants become disconnected from reality.
- For first-time users, monetary base expansion has a positive and immediate impact on the economy (the “Rush”). This immediate success creates a false sense of confidence among both market participants and policy makers regarding the long-term economic prospects of society (the “High”).
- This false sense of economic confidence fuels more monetary expansion (the “Binge”) and higher levels of current economic activity. Moreover, it engenders great confidence in the value of fiat currency, thereby suppressing prices as measured in money terms. Ironically, this occurs just at the point when the value of fiat currency is most at risk.
- Over time, each additional round of monetary expansion becomes less effective: the market has become accustomed to the drug and every additional dose of the drug has less impact. This occurs right at a point where dangerous extremes in market sentiment have become commonplace. Market behavior becomes increasingly erratic and volatile (“Tweaking”). Markets begin to behave in ways that are “out of character” from a historical perspective and would be impossible without the drug: for example, negative nominal yields on debt securities.
- Finally, the longer-term consequences of monetary base expansion become clear (the “Crash”). As confidence erodes, the value of fiat money falls and prices begin to rise. Policy makers discover that the drug no longer has any net positive impact on the economy and the economy enters into a prolonged period of stagnation (the “Hangover”). In the final stage, new regulations are introduced to prevent the future abuse of such a potent and important policy tool (“Withdrawal”).
A Powerful Drug with an Important Role to Play
Monetary base expansion is an important and powerful instrument for the conduct of economic policy. The ability to create money allows a central bank to perform a “lender of last resort” function that is critical in maintaining confidence in a fractional reserve banking system.
Moreover, the central bank’s ability to “print money” allows the government to respond quickly and decisively when other non-banking crises occur. For example, if a major war started today, monetary base expansion provides the government with a mechanism to quickly finance any emergency war-related spending.
In this sense, we can think of monetary base expansion as the morphine of our economic system. Morphine is a vitally important drug that has clear positive benefits when used judiciously. However, just like morphine, monetary base expansion only tends to mask the symptoms of underlying structural problems, rather than “curing” the patient. Nevertheless, printing money has a clear and positive role to play in times of genuine national crisis.
Unfortunately, monetary base expansion shares another common characteristic with morphine and other powerful drugs such as methamphetamines: it is highly addictive.
Why is Monetary Base Expansion so Addictive?
The history of monetary base expansion abuse is nearly as long as the history of civilization itself. For example, we know that the Roman Empire systematically reduced the gold and silver content in their coins, an act that ultimately resulted in a dramatic devaluation of Roman currency.
Invariably, experiments with currency debasement end badly. So why is the history of civilization littered with examples of currency debasement and money printing?
Monetary base expansion, or “printing money”, has always been an attractive option to politicians and governments. The reason for this is twofold:
- The creation of vast sums of money, seemingly out of thin air, allows politicians and governments to achieve short-term ends that would be impossible without that ability; and
- In the short term, printing money can seem like a “free” source of financing. Printing money allows politicians to avoid raising taxes or issuing more debt to pay for government expenditures. Moreover, if expectations are cleverly managed, then printing money may have no short-term impact on the value of money and, consequently, no adverse short-term impact on the price level.
In many ways, monetary base expansion can seem like a “miracle drug”. It has immediate positive effects on the economy and, at least in the short term, it can appear to have no negative side effects.
This raises an interesting question. If the long-term side effects of monetary base expansion are well understood (expansion of the monetary base at a rate higher than real output leads to inflation), then why is it possible for monetary base expansion to have no adverse impact on the value of money and the price level in the short to medium term?
This is a question that was addressed in a post earlier this year titled “Why is there a lag between money printing and inflation?”
The view of The Money Enigma is that fiat money is a financial instrument and only has value because it is a liability of society. More specifically, fiat money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society.
That’s a mouthful: so what does it mean?
In simple terms, we can think of fiat money as a slice of cake that we hope to eat at some point in the future. The value of fiat money varies according to the expected size of that slice of cake. The cake is future output and the number of slices the cake has to be cut up into is determined by the size of the future monetary base.
The expected size of our slice of future output cake can shrink either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).
So, why is it possible for central banks to print money with no adverse short-term impact on the value of money? The answer is that the value of money depends on long-term expectations.
If market participants believe that an expansion in the monetary base is only “temporary”, then this means that the cake (future output) will be divided up into a small number of slices. However, if expectations shift and the market decides that the expansion in the monetary base is more “permanent” in nature, then our future output cake will need to be divided up into more slices: the expected size of each slice falls and the value of money falls.
In summary, monetary base expansion is a powerful drug that appears, at least in the short term, to have limited negative side effects. This potent combination makes it highly addictive to both markets and policy makers.
Unfortunately, excessive monetary base expansion has terrible long-term consequences, a concept that is (or at least should be) well understood by policy makers and markets.
So why has the Federal Reserve not made any attempt to reduce the size of the US monetary base nearly seven years after in began to experiment with quantitative easing? Moreover, why are markets failing to price assets to reflect the increasing risk of severe inflationary outcomes?
In order to answer these questions, it helps to think about the psychological cycle that accompanies monetary base expansion. This can be illustrated by comparing the monetary base expansion cycle with the addiction cycle associated with methamphetamines.
The Seven Stages of Addiction
1). The Rush – The rush is the initial thrill that market participants and policy makers feel when monetary base expansion is first announced and implemented. For those societies with little recent experience of monetary base expansion, the impact of this new policy is immediate and exciting.
The initial implementation of monetary base expansion has an almost immediate narcotic effect on the markets. Risk assets rally in a knee-jerk reaction as market participants realize that the safety net has been activated. In the case of QE1, markets that had ceased to function, such as the market for mortgage-backed securities, begin to return to life.
In a crisis, there is tremendous pressure on policy makers to appear to be doing something. When monetary base expansion is announced, the immediate political pressure on policy makers is relieved, even if the action is considered by many to be controversial.
2). The High – The early success of monetary base expansion begins to shift the focus of markets away from “risk” and towards “opportunity”. Early doubts about the effectiveness of the policy begin to dissipate. Market participants and policy makers begin to feel more confident in the economic outlook.
This rising confidence begins to feed the delusion that “this time is different”. Rising confidence in the long-term economic future of society not only leads to higher asset valuations and higher current levels of economic activity but also, somewhat ironically, acts to support the value of fiat money, thereby depressing prices as measured in money terms.
As discussed earlier, if fiat money is a proportional claim on the future output of society, then rising levels of confidence regarding the long-term growth of real output will support the value of fiat money. Furthermore, near-term economic strength fuels the belief that the monetary expansion is only a “temporary” phenomenon. A temporary increase in the monetary base has little to no impact on the value of fiat money because fiat money is a long-duration asset.
Those who might have warned against the inflationary consequences of monetary expansion look foolish as rising levels of confidence actually bolster the value of fiat currency and, in turn, create a deflationary environment. This outcome seems to vindicate the bold action of policy makers and sets up the environment for the next stage of addiction.
3). The Binge – The binge is a period of uncontrolled, or poorly controlled, use of the monetary expansion drug. In the context of recent experience, QE2, QE3 and QE Japan/Europe could all be considered to be part of “the binge”.
After the initial apparent success of the experimentation with monetary base expansion, markets and policy makers both start to believe that if a little is good, then a lot must be even better. Moreover, since the initial experimentation occurred without any obvious negative side effects, people begin to believe that it must be reasonably safe to continue with additional stimulus.
The binge is characterised by increasingly aggressive and risk-seeking behavior on the part of markets and overconfidence on the part of policy makers.
Market participants begin to lose touch with the underlying reality of the economic situation. In the case of QE, monetary base expansion allows the Fed to purchase long-term government bonds, thereby pushing up the price on those bonds and lowering the long-term interest rate, or “risk free rate”. This creates a waterfall effect across the entire spectrum of risk assets. As the risk free rate falls, the required return on capital for all assets falls, thereby pushing the price of all risk assets. See “Has the Fed Created the Conditions for a Market Crash?” for a full discussion of this issue.
Markets begin to create myths to sustain the binge. One of these myths is that elevated risk asset prices can be sustained by strong economic growth even when the monetary base is reduced (see article above for why this is a complete fiction). The second myth that begins to take hold is the notion that there will be no adverse inflationary consequences even if the central bank fails to reduce the monetary base from its historically high levels.
This second myth is fed by “economic principles” for which there is little empirical support such as the notion that “inflation is caused by too much demand”. Markets begin to believe that there will never be inflation as long as the central bank prevents the economy from “overheating”: the size of the monetary base is somehow irrelevant, despite the fact that long-term empirical evidence overwhelmingly supports the notion that “money matters”.
4). Tweaking – Market conditions are most dangerous when they cross into the “tweaking” phase, a condition reached when, after a long period of binging, the market begins to experience diminishing marginal returns from the application of additional monetary stimulus.
Judging by historical standards of behavior, markets might seem to have completely lost touch with reality. Markets become increasingly erratic and momentum driven. Asset pricing outcomes that previously might have seemed impossible become commonly accepted. Negative nominal interest rates on government securities and the second coming of a “once-in-a-lifetime” tech and biotech stock bubble are just two of the more obvious symptoms of this delusional-type behaviour.
Ironically, this is also the point where confidence in fiat money is at its highest and sentiment regarding anti-fiat assets (gold and other precious metals) is at its lowest. Despite the fact that the market is still benefitting from a high dosage of the drug in the system, the market is supremely confident that either the monetary base can be reduced with no ill effect or that inflation can be contained even if the monetary base is not reduced. Confidence in policy makers and the economic future of society is so strong that inflation is regarded as a complete “non-issue”.
Nevertheless, warning signs begin to emerge. Various segments of the global markets might begin to break down in a violent fashion. Stock market breadth begins to falter. More and more countries and industries begin to experience difficult economic times. All of these signs are explained away as being special cases, but each new event begins to highlight the underlying fragility of the system.
5). The Crash – The crash occurs as the positive effects of the drug suddenly wear off and the bubble of overconfidence begins to pop.
This sudden erosion of confidence sets up a negative feedback loop that begins to feed on itself, just as the bubble of confidence associated with monetary expansion created a positive feedback loop.
In the first instance, a sudden erosion of confidence leads to a lower risk appetite and a higher required rate of return on risk assets. Asset prices fall and economic activity begins to falter.
When this first begins to happen, markets may comfort themselves in the belief that the central bank will be able to provide more monetary stimulus “if things get really bad”.
However, this loss of market confidence is likely to coincide with a second and very unwelcome development: a sudden erosion in the value of fiat money and an unexpected rise in the general price level.
The view of The Money Enigma is that fiat money is a proportional claim on the future output of society. Therefore, we can think of the value of fiat money as a vote of confidence in the long-term economic prospects of a society.
If people start to believe that their society is built on shaky economic foundations, then they may start to doubt the long-term economic prospects of that society. In that scenario, people might decide that (a) long-term economic growth will be much weaker than previously expected, and (b) long-term growth in the monetary base will have to be much higher than previously expected. This combination of shifting expectations can lead to a sudden decline in the value of money and, conversely, a sudden rise in prices as measured in money terms.
6). The Hangover – At some point, markets and policy makers begin to realize that “this time wasn’t different”. Monetary base growth far in excess of real output growth leads to the same end results as it did every other time: higher inflation.
The required nominal rate of return on risk assets surges higher, leading to forced sales, massive private sector deleveraging and a cycle of declining asset values. Policy makers that seemed to be invincible are suddenly impotent. Real economic activity declines sharply while higher prices erode the general standard of living.
7). Withdrawal – Society vows “never again”. A major new round of regulations are introduced to prevent future generations from repeating the same mistakes. Unfortunately, they will.