Private Credit and Inflation

By James H. Nolt

In my economics classes decades ago, I remember several times hearing the phrase that inflation is caused by “too much money chasing too few goods.” Prices spiral upward when money is created faster than the totality of goods and services that a society produces. In ordinary speech, this is often referred to as “printing money,” which suggests the idea that inflation occurs when governments print too much money in relation to economic output.

As a rough approximation of one possible cause of inflation, this is not wrong, but it does not really characterize the general problem of inflation or deflation. The major cause of inflation through history is credit (not just money) expanding faster than real output. Money, in the form of printed paper currency, is just one form of circulating credit, and not always the most important. In fact, it is less important today than it was centuries ago when there were actually famous cases of credit over-expanded by literally printing money, as with assignants during the French Revolution and greenbacks during the American Civil War.

Today, with few exceptions, the expanded printing of actual money is not the cause of inflation, but merely an accommodation to it. That is, if consumer prices are rising ever higher, naturally, more paper currency or currency in higher denominations will be needed to perform its role in small-scale, non-credit economic transactions (plus some large-scale illegal ones, like drug dealing).

Inflation is better understood as too much credit chasing too few goods. If it is easy to get a credit card and consumers feel optimistic, their rate of purchases is little constrained by the paper currency and, in fact, even by the balance in their checking account (remember, these together are M1. Likewise, if business is profitable and many businesses find it is easy to borrow to expand more, many businesses will seek loans or issue securities (stocks, bonds or bills) to cover purchases of new machinery and other means of production, regardless of their current bank balances.

The money supply is not a primary determinant of spending power, but credit and the optimism to use it are.

Conversely, when economies crash, it is not because governments suddenly stopped “printing money,” or bank balances suddenly dipped. It is because private banks and other creditors tightened credit.

Credit is not arbitrarily tightened. This is a strategic decision. Each potential creditor makes the decision of how much or how little credit to grant, but most are influenced by perceptions of overall conditions and the credit behavior of major creditors, mostly private, but sometimes also including the government and its central bank.

When credit is tightened broadly across a society, spending will fall and so will some prices. Which prices fall depend on what sort of credit has been most curtailed and which prices have been most inflated by credit-fueled demand.

For example, during the 2008 crash, asset prices, except those of high-quality bonds, fell the most. Consumer prices fell too, but not nearly as much. Thus, the Consumer Price index (CPI), the most common measure of inflation, registered only a small dip in prices, whereas indices of stock prices fell much more, as did real estate prices and especially bonds backed by risky real estate mortgages.

Each economic downturn is somewhat different in character depending on where confidence and credit is most curtailed. Economists and the media focus most on the CPI, but this measure is of relatively limited usefulness for most capitalists because their wealth is more affected by movements in asset prices rather than consumer prices. If I own 100,000 shares of Exxon stock, then stock price swings will affect my wealth and economic behavior, including my ability to repay debts, more drastically than any changes in the CPI.

What is especially volatile is not the gray averages that draw the attention of economists, but the extremes, especially, the extremes of debt leverage. It is the profit and vulnerability of extreme bull and bear positions that most drives economies to the precipice of crisis.

Extremes of debt leverage are vulnerable to a private credit squeeze regardless of what the central bank is doing. If creditors lose confidence in the bullish games that investors are playing, they can pull the credit and crash individual firms, entire markets, or even entire economies if the problem is broad enough.

It is tempting for many to look for a moral lesson here, as if good morals will maintain healthy economies, but this is not a morality tale. In classic Machiavellian fashion, it is balance of power, not morality, that sustains transient stability. It is the inevitable changes in that balance that propel economies into booms (when few complain) or busts, when the money being made from the boom irresistibly tempts bulls to become overextended and thus vulnerable to bearish creditors whose own wealth will be eroded if they fail to act.

Thus, to understand the potential dynamics of crisis, the most important factor is not macroeconomic indices like the growth of M1 relative to GDP, but the extreme positions of bears and bears and their interconnections. However, knowing much about private strategic positions is never easy. It is to their advantage to act deceptively. It is their legal right of privacy to avoid disclosure. If these things were easy to know, the future direction of the economy would be easier to anticipate, though still impossible to predict exactly, because it involves strategic interaction of contending forces.

Yet it is possible for a political economist who understands broadly how investors can make money in any given situation to anticipate what bear and bull interests likely exist. Then, as you gain bits of data, you can fill out your expectations about who is playing what roles and what range of actions are likely to them. This method is much more like the study of war and strategy than it is like what most economists do.

Next week I will start to employ the methods of political economy that I have introduced in this blog to practical problems in the contemporary world economy. One of the most dramatic at this moment is the Greek crisis, so I will treat it first. Why did Greek debt spin out of control? Why did it crash in value and then recover most of its value? Why are the Greek government and other EU leaders apparently at loggerheads? Better answers to such questions are possible when we go behind the politicians’ speeches and look at investor stakes.



James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Wikimedia Commons]

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