Steve Hanke on Hyperinflation, Money Supply, and the Great Unwind

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The following is an edited interview with Steve Hanke, professor of Applied Economics at The John Hopkins University and a Senior Fellow at the Cato Institute in Washington, D.C. Due to his wide influence, expertise on international monetary affairs, and advisory role to numerous governments, Professor Hanke was named one of the twenty-five most influential people in the world by World Trade Magazine.

With the Fed “printing” so much money, why has the U.S. not experienced hyperinflation?

The main thing that confuses people is that the Fed’s contribution to the money supply—that is, what I call “state money”, which is high-powered money produced by the Federal Reserve—is only about 15% of the total money supply. The other 85% is what’s called “bank money”—that’s money or deposits created by private banks. What we’ve had since the fall of 2008, when the crisis started, is the Federal Reserve opened the floodgates and almost tripled the size of its balance sheet and as a result of that, the contribution of state money to the total money supply has gone from 6.5% of the total being produced by the Fed to an amount now equal to about 15%. So, it has increased its contribution enormously, but it’s still small potatoes relative to bank money.

You have another money supply index called Divisia or M4. Can you explain that for our listeners and, since it’s starting to rise, what that means for the economy moving forward?

First of all, what you get from the Federal Reserve is various money supply figures—they don’t report M4 and we’ll get to that in just a minute—but what they do report is a simple-thumb aggregation or, in other words, you simply add up each component giving them an equal weight. So, if you have six components you just add all six of them up to get a total. Now, Divisia [or M4] says that you shouldn’t be aggregating using a simple-thumb but weighting each of the components of the money supply separately according to the degree of “moneyness” attached to that particular component. Now, obviously, something that gets a 100% weighting is cash. That’s money. Then there’s demand deposits at a bank, which get almost 100% and on down-the-line until you get something like Treasury bills, which have a lower weighting. They’re still added in because a Treasury bill can be converted into cash fairly easily and the opportunity cost of doing so isn’t very great since the interest rate is so low. So Divisia gives weights for all the different components—everything that has the quality of money is included in M4 and that is going up—it’s been going up by about 5 or 6% in the last few months—and that will be the best leading indicator of what’s going to happen to the economy and that’s why I think the economy will, in fact, start growing this year a little more rapidly than most people think. If the M4 money supply continues to grow, I wouldn’t be surprised if we see growth reaching almost 3% this year.

Could that be one of the reasons why, for example, the large hedge-fund manager, Bridgewater, is banking on this very thing in the second half of the year? They see stronger economic growth and higher inflation. Would M4 explain what they’re seeing?

In my view, that’s the main thing. Money matters and it’s the money supply that drives the economy… Just looking at the market, I would tend to be quite concerned about the road ahead, however, because we’re already at a very high point now. We’ve made all-time highs, but we also know that as this M4 monetary number starts accelerating and the economy along with it, there’ll be upward pressure on prices and the Fed will start taking their foot off the accelerator; and, as they do, I anticipate that the market is going to start coming down. I think the market has gotten way ahead of itself.

With the Fed’s balance sheet as large as it is, can they unwind it without wrecking the economy or markets?

They’re going to have to be very lucky to not break any China…this one will be very tricky since the balance sheet is so large. We are in an extraordinary situation. Even though state money is only 15% of the total, it’s still very big for the Fed and it’s going to be quite difficult to exit the situation they’ve gotten themselves into. They will have to be quite lucky to exit the China shop without breaking some of it.

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