Liquidity & inflation, lessons from the 1940s
Comparisons between the current downturn and the Great Contraction of 1929-33 have multiplied as commentators and investors have tried to forecast the recession’s likely depth and duration. But as the U.S. economy shows signs of stabilising and attention switches to future inflation the more useful comparison is actually with the 1940s.
The massive build up of highly liquid assets (cash and bank balances) during the Second World War is the closest parallel to the current escalation of bank reserves as a result of quantitative easing programmes in the United States and elsewhere around the world. The relatively modest pick up in consumer prices after the war ended may hold lessons for the outlook for inflation over the next five years.
There is a risk the commodity markets may have over-estimated the speed with which excess liquidity will be transformed into higher inflation and higher prices.
The outbreak of war was accompanied by an unprecedented build up of liquidity in the U.S. financial system. Deficit-financed spending on armaments and the war effort finally eliminated the persistent under-employment of the previous decade and ensured strong growth in corporate revenues and household incomes.
At the same time, households and firms had little opportunity to spend the money. The Federal Reserve imposed strict limits on consumer credit from September 1941 onwards. Consumer durables disappeared from the shops as the government first restricted then banned production of motor vehicles, refrigerators, washing machines and other electrical appliances for civilian use to conserve output capacity for the war effort.
The result was a massive increase in cash and bank balances. After having been flat for the previous 20 years, the amount of cash in circulation quadrupled from $6 billion to $25 billion between 1939 and 1945. Bank deposits more than doubled from $43 billion to $101 billion (Click here for PDF).But while inflation rose when wartime price controls were lifted, the increase was nowhere near as much as expected given the massive overhang of liquidity which had built up.
To paraphrase Arthur Conan Doyle about the dog that did not bark at night time, the surprise was not that inflation rose so much after the war, but that it rose so little.
Consumer prices rose just 8 percent in 1946, 14 percent in 1947 and 8 percent in 1948, and actually declined in 1949 — and this was after the removal of extensive price controls that had limited increases for 5 years. There was no inflation outbreak.
In terms of the standard monetary equation (MV=PT), where changes in the money stock (M) and demand for liquid balances (cash and bank deposits) (V) are related to changes in output (T) and the price level (P), the increase in currency and bank deposits (M) was largely absorbed by an increased desire to hold liquid balances (a fall in V) by firms and households even after the war was over.
In non-technical terms, increased demand for liquid balances persisted for several years after the conflict had ended and helped mop up the increased amount of cash and bank deposits.
Increased demand for liquid balances ensured most of the extra liquidity created during the conflict remained safely bottled up within the banking system.
In their seminal “Monetary History of the United States”, Milton Friedman and Anna Jacobson Schwartz attributed increased demand for savings in the form of currency and bank deposits to widespread fear about a resumption of the depression and mass unemployment once wartime spending ended.
Even though the economy continued to grow strongly, households behaved as if another slump was imminent, and chose to save rather than spend accordingly.
Experience after the Civil War and World War One had taught them to fear the war’s end would be accompanied by a sharp recovery driven by speculation and inventory building, promptly followed by an equally sharp downturn.
Worries about a return of unemployment caused households and firms to hold far more cash than had been the case in the 1930s. As a result, much of the “excess liquidity” which caused policymakers to fear a surge in inflation was not, in fact, “excess” at all.
Only when the outbreak of the Korean War (1950) removed the spectre of unemployment and deflation did the liquidity overhang become a severe problem for inflation and monetary policy, forcing the Fed to begin a sustained campaign of interest rate increases and other measures to mop up excess liquidity.
The Friedman-Schwartz interpretation highlights the importance of household and corporate expectations when deciding how much liquidity in cash and bank balances the private sector wants to maintain, and whether increases in the money supply will have an impact on inflation.
So long as households and firms fear recession and unemployment, high demand for liquid balances and a cautious approach to spending and borrowing will prevent even sharp increases in the money supply from becoming inflationary. Only once the threat of renewed slump and unemployment has receded will money supply growth start to show in spending and prices.
The current build up of huge amounts of liquidity in the banking system as a result of quantitative easing, and soon from the monetisation of a substantial proportion of the government’s budget deficit, is resulting in a similar liquidity overhang.
But the experience of the 1940s suggests the market may be over-estimating the inflationary potential.
Everything depends on how far the searing experience of the past 18 months produces a lasting shift in saving and borrowing behaviour, or is quickly forgotten.
But over the next 18 months, fear of unemployment and the risk of a double-dip recession are likely to restrain corporate and individual spending, as well as bank lending, keeping many of those apparently excess bank reserves safely bottled up in the banking system.
Even beyond that, the need to rebuild devastated portfolios and a more cautious approach to spending and saving could result in a one-off increase in demand for currency and bank balances that will soak up some if not all of the recent rise in money supply.
The medium-term (3-5 year) outlook is still for faster rate of inflation than the advanced economies have been used to over the past decade (perhaps 3-4 percent per year). But expectations of a huge inflationary breakout may prove wide of the mark.
If true, corporate bonds at good spreads over benchmark government rates could provide unexpectedly attractive returns to investors. But investors betting on a resurgence of commodity prices could face a longer wait than anticipated, with contango payments in the meantime eroding the advantage of any eventual rise in the flat price.