Increasing money supply increases nominal income, boosting real output and/or prices.

The role of money supply in inflation and economic activity is complex. Cause and effect is uncertain—does money
supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply
of money? Central banks control the monetary base, a narrow measure of the money supply made up of currency
plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base,
credit creation, nominal income and economic activity is unstable.

A significant problem is that velocity of money or the rate of circulation has slowed. Banks are not using the reserves
created and money provided to increase lending. The reduction in velocity has offset the effect of increased money
flows.

The desire to increase inflation is also driven by fear of deflation. Economists measure the economy’s ‘output gap’,
the difference between total demand and the economy’s potential to produce goods. When demand exceeds supply,
inflation rises. When demand is less than supply, inflation falls (disinflation). In the extreme circumstances it becomes
deflation, where prices start to fall.

Deflation makes it difficult to manage excessive debt. Cash flows and earnings fall making it harder to service existing
borrowing.

Debt must be paid back in money that is now more valuable as it gains in purchasing power. Nominal interest rates
fall but after adjustment for inflation rates, real interest rates are high, discouraging borrowing. Falling prices
discourage non-essential consumption, as the same item is likely to be cheaper in the future. For a central banker, in
an economy with high debt levels, inflation is the dream, deflation is a nightmare.

Milton Friedman famously argued that ‘helicopter drops’ of money could be used to encourage spending and avoid
deflation. A student of economic history and an acolyte of Friedman, Ben Bernanke restated the principle in 2002
arguing that ‘under a paper-money system, a determined government can always generate higher spending and
hence positive inflation’.

The Fed justifies QE as insurance against the risk of deflation. But inflation levels remain modest, particularly if the
effect of higher commodity prices is stripped out. In practice, creating inflation or even arresting deflationary
tendencies is difficult. After many years and several rounds of QE, Japan still hovers on the cusp of deflation.

Ironically, if QE created the necessary inflation or inflationary expectations, then it would push up interest rates,
potentially choking off economic recovery.

After the Fed launched QE2, long-term US interest rates rose sharply, driven by fears of high inflation in the future.
The hoped for fall in mortgage rates and generally lower interest rates did not occur to the extent anticipated. Since
the announcement of QE2, 30-year Treasury yields have increased by around 0.60%. The average 30-year mortgage
rate has gone up from 4.25% in August 2010 to over 5% by January 2011.

Side dishes…
Criticism of QE has focused on the risk of Weimar like hyperinflation. Debasement of a currency through debt
monetisation can lead to very high levels of inflation.
In reality, the low velocity of money, the lack of demand and excess productive capacity in many industries means the
inflation outlook in the near term remains subdued. Inflation will only result if bank lending accelerates and aggregate
demand exceeds aggregate supply. America’s output gap is between 5% and 10% and considerably more
monetisation would be necessary to create high levels of inflation.

QE’s real side effects are subtle. It discourages savings, drives a rush to re-risk, encourages volatile capital flows into
emerging markets and forces up commodity prices.

Low interest rates perversely discourage saving, at a time when indebted countries, like America, need to increase
saving to pay down high levels of debt. Low interest rates reduce the income of retirees or others living off savings,
further reducing consumption.

Individuals saving for retirement received this piece of quixotic advice from Charles Bean, deputy governor of the
Bank of England: “Savers shouldn’t necessarily expect to be able to live just off their income in times when interest
rates are low. It may make sense for them to eat into their capital ... Very often older households have actually
benefited from the fact that they’ve seen capital gains on their houses.” In retirement, it seems everyone should sell
their houses, take up residence on the streets or in a public park and live off the money released.

Low rates have driven a rush to increase risk, in search of higher returns. In January 2011, the difference between
interest rates on speculative or non-investment grade corporate bonds and investment-grade debt fell to around
3.50%, the lowest level since November 2007. In 2010, companies sold a record $286.7 billion of junk bonds to
investors driven by the need for higher rates. The search for yield extends to stocks and also structured products,
where investors take on complex returns in return for additional returns.

The rush to re-risk has reduced general lending standards. Practices that contributed to the global financial crisis,
such as “covenant lite” loans with low protection for lenders, have re-emerged. Under-pricing of risk is also evident,
creating the foundations for future problems.

Financial fetishes…
Voodoo was originally a religion that developed in America’s south, based on African beliefs syncretised with
Christianity. Voodoo incorrectly became associated with exotic superstitions and occult practices. Unscrupulous
practitioners made a fortune charging money for fake good luck charms or talismans kept to ward off evil — fetishes.
Voodoo economics, such as QE, resembles fetishes, objects believed to have supernatural powers. Despite evidence
to the contrary, these financial fetishes are predicated on the belief that the theories and models are correct, policy
makers know what they are doing and the actions will be effective.

In the voodoo belief system, a zombie is a fictional monster, usually a reanimated human corpse with normal
appearance but no will of its own, controlled by a powerful sorcerer. Increasingly, the global economy risks entering a
zombie phase. The economy appears to be functioning. In reality, it is moribund and stagnant, manipulated by central
bankers and policy makers to give the appearance of normality.

In Ferris Bueller’s Day Off, Sloane ask Ferris: “What are we going to do?” Ferris replies memorably: “It’s not what we
are going to do! It’s what aren’t we going to do!” As policies fail or prove ineffective, desperate policy makers merely
apply them in larger doses or dream up new fetishes. QE2 is likely to be followed by further rounds of QE and other
forms of voodoo economics.

If current policies fail to spur growth and inflation, then governments will borrow or print more money to increase
spending, transferring funds to households or cutting taxes, building infrastructure or even writing off the face value of
mortgages and other debt. If that fails then they can purchase other riskier assets. The Bank of Japan’s strategies
now include buying stocks, lending to companies and providing even more money to banks to boost their capital and
lending capacity.

In extremis, the central bank could charge people for holding money, forcing them to spend it by placing expiry dates
on currency. Policy maker’s actions are shaped by Josh Billings’ observation: “The thinner the ice, the more anxious
is everyone to see whether it will bear.”

The economic policy debate, at its core, is about the limits to human knowledge of the economy and the ability to
control it. The global financial crisis and the policy response are increasingly exposing the limits to both. As author
Richard Collier once remarked: “All motion is cyclic. It circulates to the limits of its possibilities and then returns to its
starting point.”

Economists, central bankers and governments reject limits to their knowledge and powers. Their thinking mirrors the
following exchange in The Dark Knight (the latest instalment in the Batman franchise):

Alfred: Know your limits, Master Wayne.

Bruce Wayne: Batman has no limits.

Alfred: Well, you do, sir.

Bruce Wayne: Well, can’t afford to know ‘em.

Central bankers and policy makers would do well to heed Josh Billings’ advice: “I have lived in this world just long
enough to look carefully the second time into things that I am most certain of the first time.”