Money vs. Mechanics

A surprising number of people tell me that quantitative easing is deflationary. Their reasons and political affiliations are diverse but, a comment like this left on Scott Sumner’s blog, captures that sentiment well:

Why would investors be convinced of inflation? Mortgage rates going down and longer term rates going down as a result of QE might not be enough to make people confident at all. Maybe prices go down instead of up because of lower interest costs. The private sector may want to deleverage so lower rates might not help at all.

Economics is all about identifying the “perverse consequences” of straightforward policy. So it’s also remarkably easy to contrive an example where something like quantitative easing – through various effects, expectations, etcetera – ends up making “prices go down instead of up because of lower interest costs”. Normally you’d argue back with empirical evidence to the contrary. 

But that quantitative easing can be inflationary isn’t even about economics. It’s about physics. 

All wealth, including the Fed’s balance sheet, is a claim on future returns from land, labor, and capital. Therefore, when the Fed purchases assets, it is increasing its claim on future output, denominated in some nominal aggregate. As the Fed continues its purchases, literally only two things can happen: we get inflation, or violate the Laws of Physics. 

Imagine that quantitative easing is not inflationary and the rate at which the Fed’s balance sheet grows exceeds the income deflator. Not too long from now, the Fed’s claim on future income will exceed what is physically and scientifically possible under standard physical laws.

The real value of the Fed’s claim on future activity is limited by inflation. And since we can’t violate physics, it stands to reason that quantitative easing must cause inflation. Think about it this way. Imagine the government cut every existing tax and met its obligations by printing money. Either we get inflation, thereby foiling the plan, or we find a way to finance the world’s biggest army, most extensive insurer, most expensive healthcare system, and strictest jailor with pieces of paper. 

Or, as Scott Sumner puts it, prices will either increase, or the Fed will own the universe. I honestly prefer the latter.