Could QE Be Causing Deflation?

The reason that QE, or money printing, causes inflation is well understood, but could it be the case that, currently, QE is causing a deflation, rather than inflation, of consumer goods prices? I think that there is a good argument for suggesting that it is, and this deflation is the flip side of the other effect of QE, to have caused a massive inflation of asset prices.

The reason that money printing causes inflation is straightforward. The value of a commodity is determined by the labour-time required for its production. Obviously, under capitalism, this becomes modified, as Marx describes, to prices of production, because competition, between capitals, means that capital moves to where the highest rate of profit can be obtained, which changes the levels of supply, of different commodities, increasing the supply of some, where profits are high, and reducing others where profits are low, and consequently changing their market prices, until such time as an average rate of profit is established. But, if we take all commodities produced in an economy, or we take those commodities produced that represent the average, this statement remains true.

The exchange value of commodities, is then a ratio between the values of two different commodities. So, if the value of a coat is 10 hours of labour, and the value of a yard of linen is 5 hours of labour, the exchange value of a coat is equal to 2 yards of linen, just as the exchange value of 2 yards of linen is equal to 1 coat. The exchange value of the commodity, unlike its value, therefore, changes not only because of changes in the labour-time required for its own production, but also because of changes in the labour-time required for the production of the commodity against which it is being exchanged, or compared.

Money is the universal equivalent form of value. In other words, it stands as the commodity against which the value of all other commodities is compared, because it can be exchanged for all other commodities. Consequently, even if the value of all commodities – on average – remains constant, because there has been no change in productivity, the general level of prices can rise, if the value of money itself falls. As Marx sets out, in “A Contribution to The Critique of Political Economy”, although the value of each money commodity, like gold, is determined by the labour-time required for its production, once this money commodity is represented by tokens, the value of these tokens is determined, by the quantity of them thrown into circulation.

If the value of an ounce of gold comes to be represented by a piece of paper, a bank note, this piece of paper will only continue to hold the value of this ounce of gold, so long as only so many of these bank notes are allowed to circulate as would have been the quantity of gold they represent. This is fairly obvious, with a little thought. All of the commodities in circulation, have a value equal to the total amount of labour-time expended on their production. The money thrown into circulation as the means to buy them, cannot then have a greater value than this, because the money only acts as an equivalent form of this value – if we allow for the velocity of circulation, that is the number of times one coin or other token acts to perform such transactions.

If the total value of commodities, available in the economy to be bought, is equal to 10 billion hours of labour-time, but notes are put into circulation with a face value of 20 billion hours of labour-time, then its clear that this would lead to a situation where the face value of these notes was greater than the total value of goods they could buy. This would be true in a socialist economy, just as much as it is true in a capitalist economy. In a socialist economy everyone would be provided with a note entitling them to take out of society's store, commodities equal in value to the labour-time they have contributed – less what has to be deducted to cover various costs. But, if in total the amount of value represented by these notes is greater than the value of commodities to be distributed, there would clearly be a problem.

Where too many gold coins were in circulation, provided they were of the stated weight, and so had the same value as their face value, this excess quantity of gold, simply got hoarded. The coins were melted down for their gold content, to be used as jewellery, or else became gold bullion shipped overseas to buy imported commodities etc. But, this cannot happen with money tokens made of base metals, or paper, or with credit, and bank money. None of these things have value themselves. They can't be melted down to obtain this value, and so they stay in circulation, and the value of the token becomes proportionately devalued. Even though the value of the commodities, whose price it measures – price is just the money form of exchange value – may not change, the prices of all these commodities rises, because the exchange value of the money tokens has fallen, more of them must be given up to obtain any given quantity of other commodities.

This is the basis of how QE causes inflation. It has been seen many times before, throughout history, as governments have devalued the currency, by reducing the weight of gold and silver coins, by printing excessive amounts of bank notes, as happened in the Weimar Republic, Argentina, Zimbabwe and elsewhere. But, for the same reasons set out above, a huge rise in the amount of money tokens thrown into circulation, does not necessarily mean a rise in inflation. If the quantity of commodities thrown into circulation expands massively, then as Marx describes, this requires that a greater quantity or value of money must also be thrown into circulation, so that those commodities can be exchanged, or else that the velocity of circulation of the money rises.

In numerous previous posts, I have indicated that this is what happened over the last 30 years. Productivity rose massively as a consequence of the microchip revolution, that sparked revolutions in other areas, for example, in robotics, communications, the internet, biotechnology and so on. This huge rise in global productivity, slashed the values of commodities, and sent an avalanche of them on to global markets. The huge rise in the quantity of commodities to be circulated, required a huge rise in money supply, and because modern capitalism abhors falling nominal prices, the amount of currency thrown into circulation had to be sufficient to prevent nominal prices falling, as commodity values themselves fell.

The period since the 1980's, therefore saw the values of commodities being slashed, but global prices of commodities did not fall so much, there was no deflation, because the supply of credit and money tokens increased by a larger proportion than the fall in commodity values, i.e. the value of money tokens was reduced more than the fall in the value of commodities. So, why could this process of continued money printing, and, in fact, money printing on a greater scale, now be causing deflation rather than inflation?

The answer is because when money is thrown into circulation, the authorities have no control over what happens to it, where it goes, and what consequences it has. As a result, this money sprayed into the economy is not like fertiliser spread from the back of a tractor, that lands evenly over the field. Rather, this increased liquidity can be attracted to some areas, and repelled from others, or at least can be attracted in far greater masses to some areas than others. The consequence is that the amount of liquidity in some areas can increase, so that prices in these areas are allowed to rise, inflation, whilst other areas may see little increase in liquidity, or even a drain of liquidity, so that in these areas there is deflation.

Take a different but related example. When monetary authorities put notes and coins into circulation, it is necessary to put different quantities of each denomination into circulation, because each circulates in effectively different markets. The quantity of 1p coins put into circulation has to reflect the fact that these coins will be used to buy commodities of very low values, such as 1p chews, or to provide small change. They will not be used to buy motor cars, which, to the extent they are not bought using cheques, credit or debit cards and so on, will be bought with notes of large denominations.

In fact, each note and coin is only legal tender within certain defined limits. Turn up with millions of 1p coins to pay for a car, and the vendor can refuse to accept it, offer a £50 note to a bus driver for a £1 fare, and the same applies. The quantity of each denomination put into circulation has to reflect the quantity, and consequently the total value of transactions, in that area of the market, in which it is to function.

Marx gives an example of this.

“Thus for example in England, copper is legal tender for sums up to 6d. and silver for sums up to 40s. The issue of silver and copper tokens in quantities exceeding the requirements of their spheres of circulation would not lead to a rise in commodity-prices but to the accumulation of these tokens in the hands of retail traders, who would in the end be forced to sell them as metal. In 1798, for instance, English copper coins to the amounts of £20, £30 and £50, spent by private people, had accumulated in the tills of shopkeepers and, since their attempts to put the coins again into circulation failed, they finally had to sell them as metal on the copper market.”

A Contribution To The Critique of Political Economy, Chapter 2

The reason that commodity prices do not rise here, is because the copper in the coin actually has value, and can be realised by melting it down. Suppose, however, the situation is reversed. Suppose, there is a severe shortage of small denomination coins, but there are lots of £5 notes in circulation. Everyone wanting to buy 1p chews will find they have difficulty in doing so, because no sooner will 1p, 2p and 5p coins go into circulation than they will be snapped up, and go out of circulation. Shopkeepers needing to give change to customers will try to hold on to these small coins as much as possible, and will ask customers to pay using these coins rather than notes.

There will be a consequent drop in demand for all those commodities, where there is a lack of adequate liquidity, and a relative rise in demand for all those commodities of higher prices, for which there are lots of £5 notes to cover purchases. The sellers of 1p chews may decide to package their commodities into packs of 100 to sell, so that buyers can hand over a £1 coin, rather than having to scrape together scarce pennies. But, the consequence may then be that in order to get consumers to buy a pack of 100, rather than just buying a couple of chews, the seller has to sell the pack of 100 for £0.90 rather than £1. So, the lack of liquidity, in this market segment, puts downward pressure on prices in that segment. Something similar may well be the case with supermarkets using large quantity discounts, and Buy One get One Free offers to boost sales.

But, this does not explain why QE might be causing deflation of consumer prices, because, after all, there is no indication that there is inadequate amounts of small denomination currency being put into circulation. Rather the problem arises because of where the money pumped into the system has gone, and the effect it has had, which then drains it from other segments of the market.  That depends upon a number of things, for example, the mechanism by which the money is transmitted into the economy, and perceptions of future price movements by economic agents.

There are a number of mechanisms by which the additional money tokens or credit can be transmitted into the economy.  An obvious example, which has applied from the earliest times, long before capitalism, is that the state uses the additional money tokens to finance its own spending, or to cover its debts.  Today, that would mean that a state basically gave some of these devalued money tokens to the workers it employs, and to the firms from which it buys commodities.  These workers and businesses, in turn, then spend these devalued money tokens, so that they pass into the hands of other workers and businesses, and so on.

The major problem with this mechanism, has been that in the UK, and parts of Europe, rather than the state expanding its spending so as to transmit these additional money tokens into the economy, the policy of austerity has been designed to reduce that state spending, so that less additional liquidity is transmitted into the economy, even though more of it has been produced.  As a consequence, more of it simply sits stagnant in bank accounts rather than being circulated, so it cannot act to inflate prices. In fact, on the contrary, to the extent that this money sits in these accounts, it acts to reduce the amount of interest that must be paid to savers to attract funds, which means that savers have less income to spend.  The motivation of central banks, has been clearly stated in the past, that they want people to spend rather than save.  The problem here being that many of those who are able and likely to save, will continue to do so, rather than spend, and to the extent they do spend, they may spend to speculate, in the purchase of shares, or bonds, or property, rather than to increase consumption.

But, the proponents of QE have a second argument, then, as to how this money is transmitted into the economy.  It is that, even if the money is used for such speculation, the consequent increase in wealth for individuals that results, causes them to increase their spending.  People do not just spend more because their income rises, the argument goes, but also because they feel wealthier.  This is the so called "Wealth Effect" first developed by Pigou.

The problem here though, is that even were there any evidence that this effect is real, and there isn't, any additional spending by consumers, over the last 30 years, is likely to have resulted in this additional liquidity flowing into those economies that have increasingly been the suppliers of the expanded range and volume of commodities, i.e. firstly to economies like China, that produced the manufactured commodities, and secondly to economies in Africa, Central Asia, and Latin America that provided them with the raw materials required for that production.

More importantly, as all the recent evidence has shown, the consequence of this Wealth Effect has been to increase the nominal "fictitious" wealth, of the top 0.001%, as against that of the rest of society.  What all economic data does clearly show is that these tiny number of people at the top, have a very low marginal propensity to consume - even if, absolutely, they spend in a most extravagant manner compared to the rest of us - but, they are very likely to use any additional wealth, to simply speculate further!

As a consequence, the perception necessarily develops that the prices of consumer goods will rise very little if at all in price, so productive-capitalists have little incentive to invest large sums of money in additional capacity, and consumers have little reason to spend now, rather than later.  On the other hand, there is every reason to believe that the prices of financial assets will continue to rise sharply, so any available liquidity will tend to be drawn to that form of expenditure, and, in fact, there will be a tendency, even with minimum interest rates and yields, to save, in order to be able to accumulate funds to speculate in these financial assets.

In Capital Volume II, Marx, examining this process of money being transmitted into the economy, took a similar view.  He argued that, for example, when shareholder A sells their £1,000 of shares to B, the £1,000 that was previously in the bank account of B, is now transferred into the bank account of A.  Even if, B, subsequently sells these shares to C, who sells them to D, and so on, at some point, this money will be used instead to fund consumption.

But, in practice, there is no reason why this has to be the case, or at least the paper chase described above, could go on for a very, very long time, before the music stops, and someone is left scrambling for a chair.  If speculators, believe that the price of shares, bonds, houses, or financial derivatives can only ever go up, perhaps with the occasional, temporary "correction", then there is no reason, why A will not sell their £1,000 of shares to B, and use the proceeds to buy £1,000 of bonds, from C, who uses the proceeds to buy £1,000 of property from D, who uses the proceed to buy £1,000 of shares from E in Hong Kong, and so on.  Moreover, at each stage, as existing fictitious wealth simply circulates from one hand to another, additional liquidity being fed into the market simply results in the prices of all of these asset classes rising, even if they may go through cycles, where funds move from bonds to shares, shares to property, property to bonds, and so on, whilst this or that individual share or bond may go up or down, and so on.

Moreover, as Marx sets out in Capital III, the realised surplus value, is divided into profits, interest and rent.  A portion of the profit will be reinvested into additional productive-capital.  The interest and rent obtained by money-lending capitalists and landowners, will be mostly consumed, or loaned out, but it can equally be used for speculation, in the purchase of existing bonds and shares, and land, pushing the prices of these assets ever higher.  There is no reason, especially where the perception exists that commodity prices will not rise in price rapidly, and so there is little reason for large scale additional productive-investment, why increasing masses of realised profits, will not, then simply be paid out as interest and rent - even though the rate of interest and rate of rent itself gets severely squeezed - which in turn, is used for additional speculation, pushing up the price of property and financial assets, which confirms the perception, and creates the basis for yet further speculation in these assets, and thereby draws further liquidity away from the real economy.

In the late 1980's and through the 1990's, the huge rise in productivity referred to earlier, also led to a large rise in the global rate of profit. The massive increase in money printing prevented commodity prices crashing, but simultaneously this money flooded into financial markets. It was encouraged by the deregulation of those markets alongside a number of other measures.

There was a deregulation in credit markets that went along with an encouragement for people to borrow large amounts to buy property. One example, was Thatcher's “Right to Buy” scheme in Britain, but in the US, government backed organisations like Fannie May and Freddie Mac encouraged people, who really lacked the means, to borrow money so as to buy property, which ultimately led to the US sub-rime crash. In both the UK and US, people were also encouraged to massively increase their borrowing to cover things such as Student Fees, and to buy the significantly increased range of consumer goods flooding into markets.

People were encouraged not only to speculate in property by buying houses at massively inflating prices, but also to speculate in the purchase of shares, bonds and other financial products.

Initially, this increase in the amount of money going into the purchase of some of these financial assets could be rationalised. The huge rise in the rate of profit from the mid 1980's onwards, meant that the amount of surplus value that could be paid out in interest, as dividends to shareholders could also be increased sharply, even as an increasing amount took the form of additional productive-capital, in whole new economies in Asia, as well as the development of whole new industries in new technology. But, the extent to which this rise in financial asset prices was outstripping even the sharp rise in the rate of profit was indicated by the fact that this increased mass of interest, paid out as dividends, and coupon interest on bonds, translated into an ever shrinking yield. In other words, the amount of dividends paid out continued to rise, but as the price of shares rose faster, the ratio of the dividend to the share price, the dividend yield, continually fell. The same was true of the yield on bonds. That process has continued until today we have a ridiculous situation where the yield on some bonds is actually negative! In other words, people are paying to be able to lend their money to governments.

A similar thing has happened with property. The price of property has risen to such astronomic levels that not only have a majority of people been frozen out of being able to buy it, but the consequence is that large numbers of people are then forced into renting. Yet, this has caused another serious anomaly. The increase in the number of people renting acts to push up rents, but the price of property has risen so much that, in terms of yield, this return on property has also continued to fall. In fact, rental yields would have fallen much more were it not for the subsidy provided by Housing Benefit. Housing Benefit now accounts for a third of all workers' income. The annual wage bill in Britain is £54 billion, whereas the Housing Benefit bill is £27 billion.

If Housing Benefit was scrapped, either wages would have to rise on average by 50%, or else rents would collapse, sending huge numbers of landlords into bankruptcy, and collapsing the property market.

In the past, this situation would have had a fairly straightforward solution. As the price of shares and bonds rose, so that the yield on them fell, and as this caused a similar fall in rental yields, capital would move away from these forms of speculation, and into actual productive investment. In other words, if I have £1 million, which I use to buy shares, I have loaned out this money-capital, which entitles me to receive the average rate of interest in the form of dividends.

There is a general misconception that has grown up that the owners of shares are the owners of productive-capital. As Marx illustrates, in Capital III, they are not. They are only the owners of fictitious-capital. The owners of the productive-capital, which produces the surplus value out of which the interest, as well as rent is paid, are the firms which issue the shares, and whose representatives are the functioning capitalists, the professional managers of those firms.

Because, this loanable money-capital can be used to speculate in shares, or bonds, or in property the yield on these forms of speculation will tend towards the average rate of interest, because if the yield is higher in one form of speculation than another, the owners of this fictitious capital will move it from where the yields are lower to where they are higher. But, ultimately if yields are falling, there comes a point whereby the owners of money-capital decide that instead of simply using it for speculation, it makes more sense to use it for actual productive investment.

If the average rate of interest falls to say just 1%, the return I obtain on my £1 million of shares is just £10,000. If, however, I use my £1 million to set up my own company, and use this money-capital to buy actual productive-capital (a factory, machines, materials, labour-power) the return I now obtain on it is not determined by the average rate of interest, but by the average rate of profit. The average rate of profit may be say 10%. In that case, I will view the 1% I would otherwise have obtained on my loanable money-capital, as a cost of setting up this business, but as I now obtain £100,000 in profits from the investment of my £1 million, I'm likely to see this as well worthwhile.

But, over recent years this has not happened for one very good reason. The owners of this loanable money-capital have become disinterested in the yield they obtain on their loanable money-capital. It has become more or less insignificant to them. That is signified in relation to property, for example, by the vast swathes of London property, of expensive apartment blocks left empty, because the owners have no interest in obtaining rental income, but only in the potential for huge capital gains. What does it matter if I only obtain £1,000 in dividends on my £1 million of shares, if during the year, the value of those shares rises by 20%? In that case, I appear to have become £200,000 better off, even if my income from this wealth has remained the same or fallen.

And, this mindset is fostered, because for the last 25 years central banks have acted to prevent the one thing that could have caused it to be questioned. Central banks have acted to prevent financial bubbles, and property bubbles from bursting, and they have done so by printing money, by pumping increasing amounts of liquidity into circulation. By doing so, they have made the speculation in shares, and bonds and property a one way bet. Consequently, whenever liquidity is pumped into the system, anyone with any sense buys these assets rather than using it to buy commodities, whether for consumption or for productive investment. In fact, such a one way bet means that liquidity elsewhere in the system, must tend to be drained from these other uses, in order to feed this speculation. People will reduce their consumption of other commodities, at least relatively, in order to speculate in the purchase of shares, as part of a mutual fund, a pension scheme, and so on, or just to buy overpriced property, or to borrow to become a buy to let landlord and so on.

Liquidity is then drained from the real economy, to feed this insatiable demand for speculation. The more liquidity is drained from the economy for the purchase of commodities, the more this acts to cause a deflation of prices in that area, just as a lack of 1p coins acts to deflate the prices of penny chews, and just as the influx of liquidity into the financial and property market causes a further inflation of the bubbles within them. The more potential money-capital is tied up in speculation, the less goes into productive investment, to increase the mass of profits, which means that not only does the liquidity not feed into an increase in these commodity prices, but also nor does it feed into the required increase in productive investment and generation of profits, so as share and bond and property prices rise further, the same or diminished mass of profits translates into a further reduction in yields.

Central banks, seeing a deflation of consumer prices, then respond by pumping even more liquidity into the economy, liquidity, which again necessarily floods into speculation, on the justified belief that asset prices are a one way bet, which in turn reduces yields even further, without doing anything to increase productive investment, employment, or consumption, or the generation of additional profits. Its why we have seen record low levels of share issuance, as companies have preferred to use their cash balances for such speculation rather than to invest in additional productive-capital, and to use cash balances for the buying back of their own shares.

It is the same situation that Engels describes in 1847.

“The thirst for speculation of manufacturers and merchants at first found gratification in this field, and as early as in the summer of 1844, stock was fully underwritten, i.e., so far as there was money to cover the initial payments. As for the rest, time would show! But when further payments were due — Question 1059, C. D. 1848/57, indicates that the capital invested in railways in 1846-47 amounted to £75 million — recourse had to be taken to credit, and in most cases the basic enterprises of the firm had also to bleed.”

(Capital III, Chapter 25)

So long as, QE acts to put a base under these financial asset prices, and is able thereby to prevent a collapse of those markets, increased liquidity pumped into the system is likely to drain liquidity from productive investment, and will thereby act to cause a deflation of commodity prices in that sector, sluggish growth in employment and wages, whilst continuing to cause a hyper inflation of financial asset prices. Of course, 2008 showed that central bankers are able to act as God forever in this arena, no more than in any other. Ultimately, reality strikes back, and the longer the fantasy has been maintained, the bigger the shock, when it arises.  When that happens and the real financial meltdown occurs, it will create the conditions where this ocean of liquidity will burst through the financial land bridges that have constrained it, and as the velocity of circulation rises, there will be a rapid shift from disinflation and deflation, to rapid inflation, that the central banks and financial markets are currently totally unprepared for.