The July minutes from the Bank of England showed that the Monetary Policy Committee considered the need to ease policy further. Fed chairman Bernanke’s recent semi-annual testimony to Congress was at pains to point out that the US authorities have further monetary policy firepower at their disposal if they wish to exercise it — though one can question the stimulus potential of some of the options available.
The European Central Bank (ECB) continues to provide unlimited liquidity to the banks that
need it, and in the wake of the somewhat Pangloss-like “stress” tests, several banks will still have to depend on the ECB.In short, the printing presses of the world’s major central banks are unlikely to fall silent in the near term. Cash will continue to be printed.
Does this mean that central banks are monetizing debt, and attempting to debase the value of paper money? To a “gold bug” this is certainly the case, and metal — or paper promising metal — is all that they trust.
Between October 2008 and March 2010, investors have put some US$187 billion into gold, on the most catholic of definitions — gold bars, coins, medals, retail, jewelry, ETF and COF holdings.
Gold bugs would seem to be suggesting that inflation shocks lie just around the corner, and that faith
in fiat (or paper) currencies is literally not worth the paper that it is written on.
However, most competent economists do not agree with the gold bugs. Indeed, economists tend to regard gold bugs as behaving in a somewhat irrational manner.
Inflation, in the Organization for Economic Cooperation and Development (OECD) economies at least, is just not a credible threat. For one thing, it makes no sense for an OECD government to try to monetize debt.
Trying to inflate away government debt will not work.
The prevalence of inflation linked securities in outstanding government debt, combined with the short duration of conventional bonds means that (absent hyperinflation) bond markets can always punish
an inflationist government far faster than inflation can improve the debt ratio.
Spare capacity in the global economy is a further force for weak inflation. Most inflation in the major economies of the world is driven by domestic labor costs. Around 70 percent of the inflation of Europe or America comes down to European or American labor.
Commodities are a relatively small proportion of the total inflation rate. Imported goods make virtually no difference at all to inflation, whatever the hysterical claims of trade protectionists.
With spare capacity in labor markets — otherwise known as unemployment — as high as it is, there
is little prospect of meaningful wage inflation. In several economies, labor costs are actually falling. This does not suggest a rising inflation surprise.
It is not just economists who are skeptical of the fears of inflation and the corresponding lure of the yellow metal.
It turns out that the gold bugs are in a distinct minority — and this is what really matters. Economists need to be far more concerned about the behavior of “paper bugs”.
What is a paper bug? A paper bug is just like a “gold bug”, but they prefer the convenience of cash to metal. Paper bugs seek to hold paper money as an asset class.
Like gold bugs, paper bugs do not seek to hold paper as an asset on the grounds of its purchasing power alone, but also because of some intrinsic attribute, in the case of paper, its liquidity.
Institutions are clamoring to hold paper money as an asset. Indeed, one could argue that faith in fiat currency (and consequently demand for paper currency) has never been so strong.
US banks’ excess reserves (i.e. demand for cash from just one investor class in one currency) rose over $1.1 trillion from the start of the crisis to the end of Q1 2010.
This is, of course, over six times the increase in demand for gold. When we consider what other US investors, and European banks, and other European investors are demanding in terms of cash, the flight into paper becomes overwhelming.
This is the critical point for economists. The swarms of paper bugs hovering over the financial markets are creating an unprecedented demand for paper. Printing money has never, ever created inflation, and it never will.
It is not the supply of paper money that creates inflation, it is the supply of excess money (when money supply exceeds money demand) that creates inflation.
The actions of central banks, from Bernanke’s testimony through tothe Bank of England minutes, indicate that they are simply responding to increased money demand at the moment.
This is not inflationary, though, we must hope, it can be construed as anti-deflationary.
At the moment, paper bugs are stomping on gold bugs. We had better hope the world’s central banks keep supplying cash.
If not, the world economy could be badly stung.
The writer is deputy head, Global Economics, UBS Investment Bank.
