No high inflation or fiscal crisis in the US but …
The US is now all set to have yet another fiscal stimulus; this one is worth $1.9 trillion. The public debt-to-gross domestic product ratio has shot up from about 60 per cent before the global financial crisis (GFC) in 2007 to about 130 per cent in 2020. And, yet there is no sign of a fiscal crisis or even high yields on government securities.
The monetary base issued by the Fed had jumped from less than $1 trillion before the GFC to more than $3 trillion by early 2020 and then to about $5 trillion by the end of the year. But inflation has hardly gone up. Why?
Let us see the essence of the story in a simplified way but from a broad perspective. Briefly, the US real gross private domestic investment has grown from 2006 to 2019 at only 1.69 per cent per annum, compared to 4.11 per cent from
1950 to 2006! Given very low investment, savings look excessive. The “excess” savings are, in one way or another, getting invested primarily in government securities. The government thereby finances the high fiscal deficit. The latter is required to maintain aggregate demand in the US economy, which is needed because investment demand is low in the first place.
It is interesting that because private savings are more than private investment, there has been a high demand for government securities. Given this voluntary market demand, there is hardly any question of a fiscal crisis in the US.
The above argument about the domestic situation in the US is consistent with, but not the same as, the much-talked about view that the US dollar is a reserve currency globally and so the US government is able to avoid a fiscal crisis.
Let us come to inflation now. It is not well known that around the time of the GFC, the Fed had not printed any abnormal amounts of currency in circulation with the public. Furthermore, even the money stock M2 (currency plus bank deposits) had not deviated very much from its normal growth path till early 2020. It is only the reserves which had expanded massively. This is why the so-called monetary base (currency plus reserves) had shot up. But shouldn’t this have been inflationary?
Given the low real investment, in one way or another, the banks have had excess of deposits over lending. So, the banks needed some outlet for investing. If banks invested too much directly in government securities at the prevailing low interest rates, they would run a serious interest rate risk. So, the banks ended up holding excess reserves at the Fed and the latter invested in government securities. So, in all this, the Fed is, in effect, acting as an intermediary between the banks and the government. This may look surprising but note that the Fed is the central bank. The usual focus is on its being central but it is a bank (intermediary) too. And, we know that intermediation by itself cannot be inflationary. To see this more clearly, consider a counterfactual.
Suppose that the Fed did not end up acting as the intermediary; imagine that the banks made such investments directly. Then the Fed would not have invested in government securities or issued reserves on a large scale; the Fed balance sheet would not have expanded massively. It is easy to see here that the inflation rate would not have jumped.
Now comparing the counterfactual and the actual situation, which just includes financial intermediation, we can see more clearly why there was no jump in inflation in the US. It is true that the US interest rates have been very low. However, this has less to do with the financial system being “awash with liquidity” than with the fact that investment is low in the real sector.
It is true that the US experience in 2020 after the pandemic hit is a bit different. Money stock, and not just monetary base, has jumped up — thanks to factors like cheques being sent by the administration to the people. The banks hold large additional deposits but bank lending has not shot up. So, funds are not “chasing too few goods” and inflation has not jumped (though significant asset price inflation has indeed occurred).
Let us come to the main point now. It is not well understood by many people that the critical element and the basic backdrop in which the prevailing policies in the US are not leading to a fiscal crisis or high inflation is what this column considered initially. It is the low real investment and relatedly the low GDP growth in the US for close to 15 years now. And, economic growth matters even in the US.
We can draw our conclusions for policy-making in India.