For a long time after the Fed started quantitative easing, I assumed that it would lead to high levels of inflation. But that didn’t happen. So I thought about it and tried to understand what might be wrong with the models that say actions like QE will cause high inflation. The basic model says that if the money supply increases, everything else held constant, the result will be inflation. The greater the increase in the money supply, the greater the rate of inflation. But everything else never stays constant. The economy is much more complex than simple models. There are many variables. For example if the economy is growing at the same rate as the money supply, there shouldn’t be any inflation. I’ve come up with a few ideas about some variables that need to be considered in this situation.

The size of the economy based on the US dollar is underestimated. A significant portion of economic transactions in other parts of the world are done using the US dollar, such as petroleum and other commodity exchanges. There are also other countries which use the US dollar as the main currency or an alternative currency. The US dollar is the dominant reserve currency, that is, governments and institutions around the world hold US dollars. In addition, black market international transactions frequently use the US dollar; picture suitcases of dollars being used in illicit trade. There is no way to measure it, but there is no doubt that the world wide economy that runs on US dollars is huge and growing. This extended economy lends significant support to the value of the US dollar and the effect of increases in the money supply is distributed across this much larger economy and not just the US economy.

Due to the rapid increase in technology which increases efficiency, we have seen a constant increase in the size of the US economy and the world wide economy for decades.

The value of a currency is sticky. With so many people and so many transactions being involved, it can take a long time for price changes to ripple through the economy. The larger the economy the longer it takes. It is possible we haven’t seen the eventual outcome of recent changes to the currency.

Part of hyperinflation is a loss of faith in the currency. A large enough portion of users need to lose faith at the same time. That is difficult when the people involve are so many and so spread out. Some may lose faith here or there, but if they watch and see that no one else is concerned, they start to think there was nothing wrong; it was just them being overly cautious. So for all the people who need to be involved to doubt at the same time, there needs to be a trigger event. Without a trigger event, it becomes unlikely that we will see mass exodus from the US dollar.

Abandoning the dollar is even more unlikely because there really isn’t another currency to replace it. If other countries’ currencies are doing worse and other economies are doing worse, then even though the US dollar should be doing poorly based on the high rate of money printing and low interest rates, the comparison to the other choices out there make it look good. People can’t stop using the dollar unless they can perform transactions in some other currency. So the need for a medium of exchange and the lack of competition means people have no choice but to use it. We may see a slow decline as people start to use other currencies around the world, and as transactions which had been based in dollars (for example petroleum) start to be traded in other currencies. But I don’t expect a mass exodus because there is nowhere else to go.

I think it is possible for Bitcoin to gain acceptance worldwide and replace the dollar as the currency of choice. The fact that it is easier and cheaper to transport money between different countries using Bitcoin than the dollar is helping bitcoin gain market share.  As Bitcoin gains greater acceptance, the rate of acceptance will increase. It is only a matter of time. One of the stumbling block is the ability of people to afford the technology (cell phones) to use it since it doesn’t work as a physical transaction, which is where paper dollars excel. As more and more people get cell phones, using Bitcoin for everyday transactions becomes easier and easier.

Some of the increase in the money supply isn’t being used to purchase things. Inflation happens because more money is chasing after the same goods. A lot of the money is just sitting at the Fed as reserves. After the recent bust in loans going bad, lending institutions are likely gun shy about making questionable loans. The Fed can expand its balance sheet but if the banks don’t lend out their money (either because banks hesitation to take on risk and/or borrowers hesitation to take on debt) then the money supply doesn’t increase much.

While increasing the money supply, the Fed was offsetting some of the money destruction that happened when a lot of loans went bad during the financial crisis. Yes, they were pumping money into the economy, but it was replacing money that was leaking out. So we shouldn’t necessarily expect a significant impact on the economy.  It would be like saying building 1000 houses is going to lower the price of housing, without taking into consideration that 1000 houses just burned down. It is going to be a wash. I’m not saying they Fed was just replacing money. I’m saying it is a variable that needs to be taken into consideration.

How much of the destruction of an economy suffering hyperinflation is due to the currency changes and how much is due to an oppressive government? When a currency starts to see high inflation, it is usually in concert with deficit spending and a big government. Taxes, regulations, and price controls hurt an economy. As an economy gets worse, government usually increases their influence over the economy in an attempt to fix things. This of course makes things worse.  What if the unemployment rate and the health of the economy are more a result of the level of government control than a result of the management of the currency? Frequently in countries that see a large expansion of the money supply as a response to government debt and/or a slow economy, the bad economy is due to oppressive government interference which has hobbled the economy, and the addition of destabilizing the currency pushes the economy off the edge into collapse. Since the level of business regulation in the US is not high enough to destroy the economy, the expansion of the money supply may not push it over the edge.

This is not to say that the increase in the money supply is harmless. On the contrary, it harms the majority of people in multiple ways. First, the increase in the money supply, whether to finance government debt or corporate debt, erodes away at the value of everyone’s money. Secondly, this distorts the lending market by increasing the supply of money available to be borrowed. This reduces the price of loans (interest rates) leading to riskier investments and asset bubbles. This causes all sorts of capital misallocations. That is, investments which wouldn’t receive funding in a distortion free market now get funding, enabling them to use, and drive up the price of, scarce capital resources which are then more expensive or not available for better investments. This means the economy is not operating as efficiently as it could, which hurts everyone except the few beneficiaries (a minority) of this misallocation.

The lesson here is that the economy is vast and complex, so it is difficult to make predictions. We knew that, but sometimes we forget when making or reading predictions.