Printing money seems like a no-brainer. Surely it’s extremely obvious that printing money is a recipe for disaster that will result in hyperinflation. Surely the obvious action is to not print money and therefore avoid inflation. Yet every year, every country prints money. Why? Surely the money supply should be fixed. What possible reason could central banks have for risking massive inflation? Why do we print money?
The first and most obvious reason for printing money is to replace old notes in the system. Notes get worn down through use, so it’s necessary to print new ones to replace them. Take a moment to think through why we do this and what would happen if we didn’t. Businesses would start to suffer from a cash flow problem. It would be harder to pay bills and wages, and spending as a whole would slow down. As spending is what drives the economy, this means the economy would slow down. In this sense, printing money is a bit like oiling the gears of an engine, it helps the whole system run more smoothly.
This leads onto the second reason we print money. This is because a growing economy requires it. Think about it, if the economy is getting bigger (through economic and population growth) then there is a greater demand for money. As there are more people, there are more customers. As they are more goods being produced, there must be an increase in the amount of money to buy these goods. If the money supply does not increase, then the economy creates bottlenecks which act as a brake on growth.
Most people assume that printing money automatically leads to inflation without thinking through the steps of how this happens. If you do, you realise there can be exceptions to this rule. Let’s say the government prints a lot of money and puts it into the bank. The bank then lends this money out to people who spend it. Here’s the crucial part. Inflation will occur if demand exceeds supply. If there are more people willing to buy the goods than the shops can sell, then businesses will raise their prices.
However, it should be clear that there is a big hole in this logic. This will only hold true if businesses are at or near full capacity. If there is significant unemployment of resources, then there will not be large amounts of inflation. If a business is struggling and near bankrupt with a large amount of unsold stock, then an increase in demand will not lead to a price rise. If factories are not running at full capabilities but instead are in a slow period, then they can easily increase production in the short run without increasing prices. In other words, if the economy is not at potential output, then printing money may not lead to inflation.
This describes our current situation. The economy is not at full capacity, most businesses are in a slow period. Inflation is very low and demand is weak. Hence the large increase in the money supply in America (called Quantitative Easing) has not led to run away hyperinflation despite the warnings of Austrian Economists. This is because the economy is so weak that it can absorb the increase without resulting in inflation. Even more important is the role of the banks. As I mentioned before, newly printed money is usually deposited in banks. However, if banks are near bankruptcy they will be unwilling to make new loans, so the money supply may not actually increase if money is printed. Why do it then? Well if the newly printed money is held as deposits, it helps the banks starve off insolvency and collapsing, which would bring the rest of the economy down with it.
So is printing money bad then? Well yes and no. As I discussed, there are times (like right now) when it doesn’t lead to massive inflation but can actually help boost the economy and give it a stimulus. So does that mean we can print our way out of recession? Well, no. You see, printing money only works if the economy is under-capacity, at a certain point the limit is reached and after that inflation kicks in. So if a business is operating at 50% of possible production, an increase in demand is helpful and doesn’t lead to inflation. However, once it reaches 90% or thereabouts, it cannot keep up with demand and will have to incur extra costs to meet demand, causing prices to rise. So a little money printing isn’t damaging, but too much is (a rule that applies to most things in life). So what is the right amount? The problem is no one knows for sure and there is a great deal of hit-and-miss in the process.
Even when inflation does occur, this isn’t always a bad thing (I’m referring of course to moderate single digit inflation). It acts as a spur to the economy to keep it going. For example if you know that something will cost more tomorrow than it does today, then you will buy it today. This keeps the shop in business and its staff in a job. The Irish housing market is an example of this system in reverse. House prices are declining, so no one is buying houses (why would you when it will be cheaper next month?). This means businesses in the housing sector go bankrupt because no one is buying, leading to unemployment and economic decline. The lack of inflation causes uncertainty and slow down. What the housing sector needs is rising prices, so although it sounds counter-intuitive, inflation would be a good thing for it. Inflation is also good for reducing the size of debts, which is a good sign in our heavily indebted economy.
Now hopefully, you’re still following me, but you might be thinking about Weimar Germany. Didn’t printing money lead to massive hyperinflation and Hitler? Well, that’s an example of a policy taken to an extreme. I’m not suggesting unlimited money printing, only a moderate amount. Anything taken to an extreme will be disastrous. (And it was the mass unemployment of the Great Depression that lead to the rise of the Nazi Party who were insignificant during the Great Hyperinflation). When you look at examples of hyperinflation in history they almost always happen during times of political instability and war. The chart below lists the worst hyperinflations in history and it is clear that almost all occur when the state was on the verge of collapse, mostly around the time of the First and Second World War and the collapse of the Soviet Union. (Zimbabwe is the main exception in that it wasn’t at war, though it was very politically unstable). Simply printing money by itself is never the sole cause.
So that’s why we print money. It may sound strange and a recipe for disaster, but it is actually a necessary part of the economy, especially in times of recession. When the economy is not fully using its resources, it can provide a necessary boost. So long as it is kept under control, there is no reason to fear massive inflation. So it turns out there is a method in the madness after all.