The recent fiscal actions taken by the U.S. are not just remarkable in scale, but also in form. A sizable chunk of the historic $5t in spending actually ended up in the hands of the general public via various types of transfer payments and grants. That money was essentially created out of thin air by the Fed and then spent into the economy by the Treasury. Observing the Fed’s growing balance sheet offers a glimpse as to the scale of the printing, but it does not reveal where the money ends up. Generally speaking, the created money ends up as a deposit liability in the banking system. Banks must file detailed regulatory reports on their deposit liabilities, so it is possible have an idea of the type of depositors who ultimately benefited from the government’s largess. In this post we first review the GFC era policy response, show how the distribution of money this time is now more favorable towards retail, and suggest that this change is contributing to inflation.
Last Time Was Different
During the GFC the stock market and real estate market crashed and would not recover for a few years. One way to look at a market crash is as a sudden surge in the demand for money. A typical person’s asset holdings include real estate, stocks, bonds, and cash. Real estate, stocks, and bonds all fluctuate in value but $1 in cash is always $1. When sentiment shifts, people sell their volatile assets for assets that are not volatile. However, the amount of cash in the system is relatively fixed in the short-term while valuations of other assets can assets soar. This mismatch means that when there is a surge in the demand for money, a large crowd of paper wealth is competing for a limited amount of cash. This requires investors to rapidly lower their selling price to obtain the cash. Thus asset prices crater.
In this context, the official sector’s response was to add money into the system. Most money is created by commercial banks when they make loans, but at that time the banking sector was on life support and could not create money. The Fed stepped in with QE and bought a significant amount of Agency MBS, and later Treasuries. QE adds reserve assets (money for banks) and deposit liabilities (money for non-banks) to the banking system. This allowed bank deposits to grow even as banks were not able to extend credit. The Treasury also issued trillions in Treasury securities, which are a form of money in the financial system. These actions helped meet the public’s demand for money. Note that while there was more money in the financial system, the net worth of most people was still lower due declines in their financial assets. Growth and inflation during this period was unremarkable.
$1.5 Trillion in Helicopter Money For Retail
This time around massive stimulus is proceeding even though the banks are in good shape and household net worth is at all time highs. In addition, this time the government offered substantial payments to the general public. The demand for money was acute in March 2020, but it quickly faded while the policy response continued. The different context and distribution of money suggests that a lot the new money will be spent on goods and services.
The marginal propensity to consume varies by wealth, where the wealthy tend to save more of their income and the less wealthy consume more of their income. Airdropping trillions of dollars to retail suggests increased spending on goods and services, while airdropping trillions to the institutional community suggests increased spending on financial assets. Bank regulatory filings break out deposits by account size, making it possible to roughly estimate how much of the newly created deposits ended up in the hands of retail (assumed to have less than $250k in their bank account). Some of the increases shown here will be due to bank credit creation, but bulk will be the result of government action.
The post GFC round of deposit creation went almost exclusively to the institutional community, with the level of retail deposits little changed. It should not be surprising that economic growth was subdued at the time, as the public did not actually have more money to spend. This time around the institutional community continued to be the dominant recipient of the newly created money, but deposits held by retail also increased by $1.5t ($1.2t in banks and savings associations, and $300b in credit unions that are not in the graph). The trillions of free money in part filtered to the American public.
The economic impact was predictable. Annualized consumer spending reached all time highs, housing prices increased 15%, and the stock market (especially retail favorites) soared to record highs. The public’s purchasing power increased significantly in a short period of time, and will remain at an elevated level until prices adjust higher.
Inflation is a Political Choice
The Fed cannot directly create inflation because it does not have spending powers, but the fiscal authorities have the power and motivation to spend. They easily pushed CPI to 13 year highs by spending trillions on goods, services, and transfer payments. This can continue because sovereigns in a fiat system have no budget constraints (only political constraints) – the central bank can always finance their spending. (Note that this also gives the Fed less control over inflation, as fiscal spending is indifferent to interest rate hikes.)
A view that inflation is transitory is fundamentally a political view that the free money will stop flowing. Yet, the Administration has been unambiguous in its desire for trillions more in spending. Free money is what the public desires, and a winning political platform. A cultural shift has occurred where the deficit hawks that were once a fixture on the political landscape have all gone extinct. The flow of the most recent fiscal stimulus is ebbing, but the authorities are already discussing the next stimulus program. History suggests that the spending will not just continue, but accelerate.