On Inflation (& How It’s Not What Happens Next)
Everyone is convinced the dollar is going to inflate because more dollars are entering the system.
That is the question that sparked a succinct Twitter thread by Travis K (@ColoradoTravis) explaining why inflation is not what happens next (emphasis ours):
Let’s take a look at how dollars are born and how they die.
A dollar is ‘born’ when a loan is made against collateral on a bank’s balance sheet. Banks can issue multiples of dollars for every dollar of collateral they have.
It’s this multiplication effect that expands the amount of total dollars.
Generally, banks are limited in how much they can lend – let’s say it’s 10x their collateral. So for every dollar of collateral they have, they can lend 10 dollars.
By so lending, they ‘birth’ new dollars into the system.
As banks lend more, more dollars are created and the money supply increases. This multiplicative lending is the chief driver of total dollars in the system.
Banks lending a lot → more total dollars and inflation.
When do dollars die?
Dollars ‘die’ when debts are paid back. This reverses the multiplication effect of lending, leading to less total dollars in the system and a contraction of total dollars in circulation.
So what is the Fed ‘printer’ doing – creating dollars, right? Actually no, not really.
The printer only increases the collateral banks have to lend against. It does not directly ‘birth’ dollars, only *potential* dollars.
Banks are still the midwives, and the only ones who birth dollars into the system by lending.
The Fed can increase collateral by 1000x but unless the banks lend against that collateral, dollars will not enter circulation for you and I to interact with.
Assume for a moment bank collateral was infinite – then what would drive total dollar amount?
1) Banks’ appetite for lending.
2) Bank customers’ appetite for borrowing.
Now let’s observe that collateral effectively IS infinite, because banks have so much excess reserve capacity they haven’t been near their limits for years.
Total dollar amounts are, right now, only a function of bank and customer debt appetites.
The Fed has made a big show of radically increasing collateral levels, but it doesn’t matter — at least right now.
Not if banks feel weird about lending. Not when people feel weird about borrowing.
Why, then, does it look like inflation out there right now? Two reasons.
First, we just had a brief, manic borrowing pulse as corporates panic-borrowed out of fear. This borrowing was a bit inflationary (more dollars born).
Second, and maybe more important, the government decided people could put debt payments on pause.
This ‘froze’ the dollar death process for a time. Because those dollars haven’t died yet, we have more of them around right now.
But, you see, that dollar death process is beginning to thaw.
Loans need to be paid again soon as the forbearance ends.
A lot of dollars are about to die.
Record numbers of people are losing their jobs, which means in aggregate customers’ appetite for fresh debt is decreasing by a lot.
So the dollar birth rate will decline.
Banks also aren’t really feeling like lending because the economy looks pretty dicey.
This also is not good news for the net dollar birth rate moving forward.
So while, yes, we have just experienced a bit of an inflationary pulse from panic borrowing and freezing the dollar death process that looks like it’s about to reverse in a big way.
When it does there will be less total dollars.
The Fed can’t do anything about this. Banks are already swimming in collateral, more of that won’t do anything at all.
The only thing that can make more dollars now is banks lending more.
So as you watch asset prices go nuts as everyone rushes to get rid of their dollars for fear of inflation, remember – the dollar birthrate looks like it’ll be decreasing for some time to come.
And that means the whole economy will be running on incrementally less of them until banks want to lend and we all want to borrow.
So you might want to hang onto a few of your dollars.
There is a good chance they’ll come in handy here in a bit.
Travis K writes, “this took me a while to understand, and I only got there due to @MetreSteven and @SantiagoAuFund – (thank you both!) “