This is a companion article to Debt Hysteria. You may also find that one useful.

Governments around the world have increased their spending in the wake of the coronavirus. Their tax revenues have also declined sharply. As a result their borrowing has gone up – and some of that has been enabled by Quantitative Easing, which some people refer to as ‘money-printing.’

Many people are fearful of this – feeling that simply creating money out of nothing is defying some fundamental law of economics or principle of financial prudence. And we have all been told so many times that “there isn’t a magic money tree” that Quantitative Easing (QE) feels as if it just can’t be right. Some have even gone so far as to claim that hyperinflation is a likely consequence.

Are they right to be worried? Will QE really lead to hyperinflation?

Happily, not. Not only is hyperinflation not inevitable, it would require massive policy failures to create it. In fact, contrary to what most of us have been led to believe:

  • Money is always created out of nothing;
  • A little more inflation might be a good thing;
  • Hyper-inflation is only a risk if we let supply collapse.

I understand that there is quite a lot in this post which may seem very alien. You may find it very hard to believe. If you do, don’t dismiss it out of hand, take a look on the Bank of England website following the links in the article and read what they say. Then decide.

Money Is Always Created Out Of Nothing

Nobody knows more about money than the Bank of England, unless perhaps it’s the Bundesbank, which says the same thing. And the Bank explains money creation extremely well.

The system of money that we use today is known as a fiat currency, from the Latin word meaning let it be. The fiat money system has been in place since the early 1970s. Before that, the dollar, sterling and most other currencies were backed by gold. Then in 1971, Richard Nixon ended dollar convertibility into gold.

Before 1971, in principle, you could take $1.00 and ask for it to be converted into an equivalent amount of gold. Now you can ask for another dollar. A dollar today has value only because the US government says it has value, because there is a legal duty to pay taxes in dollars and therefore – if no other reason – people need them, and because society as a whole accepts that it has value. The same is true of other currencies.

Fiat money is created out of nothing in three main ways:

  1. a central bank (e.g. the Bank of England or the US Federal Reserve) can have coins minted and banknotes printed – the value (£10) of a £10 note has come from nowhere: it has not been transferred, it has been created;
  2. the central bank can create money electronically;
  3. commercial banks can create money electronically by making loans – and this is how the vast bulk of all money is created.

As the Bank of England explains:

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

According to the Bank of England, 97% of the UK’s money is created out of nothing by commercial banks making loans. Even if you have studied economics, this may sound strange.

As the Bank says,

“The reality of how money is created today differs from the description found in some economics textbooks: rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits; in normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

And if you haven’t, then it probably sounds even more mind-boggling.

So what actually happens? A commercial bank has a balance sheet that looks something like this:

(For simplicity, I have lumped all the derivatives and other financial instruments together under the headings of ‘other assets’ and ‘other liabilities’ because they are not really relevant to this analysis).

Imagine that you are one of the bank’s customers, and that the bank agrees to grant you a loan. At the instant they make the loan (before you have used any of it to buy anything) the bank’s balance sheet now looks like this:

The new loan appears as a new asset on the assets side of the balance sheet, and your deposit account is credited with the same amount on the liabilities side (so the balance sheet still balances).

Both sides of the balance sheet are now larger than before, and that extra is new money that has just been created at the touch of a keypad.

As stated above, this is where 97% of money comes from. The other 3% is notes and coins.

The fact that money is created in this way and in such quantities does not necessarily cause a problem with inflation – in fact, in many countries, in recent years, inflation has been below target.

A Little More Inflation Could Be A Good Thing

Even if it did cause inflation to rise a bit, that might actually be beneficial. (We will look at when it might cause inflation to rise in just a minute).

Inflation is such a dirty word that it is hard to imagine that it might be better to have a little more of it. But having more money oils the wheels of the economy and history suggests that a little more inflation might actually be better.

Money oils the wheels of the economy

The economy is the system that we have, as a society, put in place to create and distribute the valuable goods and services which our population needs. At its simplest, we can think of this system as having two sides:

  • supply, which is all those firms, companies, agencies and individuals who provide goods and services, and
  • demand, which is people and organisations that require them.

Inflation happens when we have more demand than supply – too much money chasing too few goods. If we could supply more, people and organisations could meet more of their needs and wants. (Assuming we can target the supply at the demand). If we can’t supply more, and demand rises, prices rise too.

In a pure market economy – in which 100% of provision was carried out by private sector companies and firms – money would be the only way of matching supply with demand. A business only perceives a ‘need’ if that need is backed by money. If the demand is backed by money, supply can see it; if it is not backed by money, the demand is invisible. In this sense – and of course in this sense only – poor people have no needs.

If we knew that money was distributed in such a way that people’s needs were matched by the amount of money they possessed, this would not matter. But as a matter of observation, many people are poor and so their needs are invisible. This is bad for them, of course, and it is also bad for businesses, because it means there is a large amount of invisible demand from which they cannot benefit.

And this invisible demand tells us a great deal about the UK’s economic performance. Our lack of growth is not fundamentally down to a failure to supply, but to a failure to make demand visible.

People often say that the UK underinvests in the future. And this is true.

But businesses only invest under two circumstances:

  1. they need to invest in productive capacity to continue to meet demand; or
  2. the investment will enable them to reduce their cost base.

In an environment in which there is a large and growing amount of invisible demand, the first reason becomes less relevant, and the only way that businesses can see to grow their profits is by reducing their costs. That lack of visible demand has been increasingly the case in the UK over recent decades.

As you can see, the growth rate of real GDP per capita varies significantly from year to year. But if we look at the last three 20-year periods – and particularly the last one – we can see evidence of declining growth.

If you were running a business in the 1960s or 70s, you could expect the economy to be growing at almost 3% per capita. On top of that, population growth of 1% would give you around 4% real growth in the economy year-on-year. So if you could maintain your market share, you would get 4% real growth in your revenues. And inflation was running at about 6% on average, so without any need to be a business genius, your accounts – which were not usually inflation-adjusted – could easily show 10% year-on-year growth. You would feel confident to invest – and most businesses did so, to the extent that capacity grew on average at about 4% per annum.

But if you have been running a business in the last 10 years, you’ve never seen the economy grow by even 2% per capita and on average it has been closer to 1%. Add 1% population growth and you have a still-uninspiring 2% real growth rate. And inflation has also been lower, averaging under 2% for that period, which means your accounts will only be showing 4% year-on-year growth. It’s not surprising that you invest much less in growth than your predecessors – you just can’t see the demand to invest for.

The real problem in recent years has not been that businesses couldn’t increase capacity fast enough to supply more, it is that they couldn’t see enough demand to justify the investment.

And there is a real risk that this problem is about to get worse as a result of the economic damage to the balance sheet of ordinary families and many businesses during the corona-contraction.

Now of course, in reality, our economy is not a pure market economy, it is a mixed economy, which means that some of the provision of goods and services is carried out by government agencies and other arms of the state outside the market economy. Unlike the US, for example, most healthcare services in the UK are provided by the National Health Service – and they are free at the point of delivery. You do not need to have money for your needs to be met.

So one solution to the problem of invisible demand might be for the state undertake far more provision of goods and services. If you were a Communist, this would probably be the solution you would think of first.

But if, like most people, you weren’t, you would probably ask if there was another solution.

And there is. But it is likely that it would involve higher inflation.

Having a little more inflation might be better

The other solution would be simply to make sure that ordinary people have enough money to make their demand visible. The government could simply create enough new money to prevent household balance sheets suffering (and therefore large amounts of demand becoming invisible) and businesses’ balance sheets suffering (and the supply capacity of the economy diminishing). This is particularly important to prevent the coronavirus contraction from doing irreparable damage to both sides of the economy.

If government acts in this way, supply will remain intact and demand will remain visible. The economy will still function, it will still grow, and it will still meet the needs of the population.

Looking at post-war history gives us a clue as to what this might look like in practice.

The Golden Age of Capitalism was the period from 1945 – 1980; and the age of Market Capitalism was the period from 1980 – 2015. As you can see, economically, the Golden Age was far more successful. The economy grew faster both overall and per capita. More importantly to people, median household income grew much faster and long-term unemployment was much lower.

But inflation was higher.

And we constantly hear stories about ‘debasement of the currency’ with the terrifying implication that inflation will make everybody poorer. If we take the US, inflation was running at almost 5% per annum during the 35-year period of the Golden Age. And on the face of it, that does seem scary: if we assume that the inflation was exactly 5%, to keep the maths easy, and think about the purchasing power of $100 at the beginning of that period compared with the end, we see that $100 in 1980 would buy only the same goods as $18 could have bought you in 1945!

But then we need to remember that the figures in the chart represent real growth – i.e. after adjusting for inflation. Your real income would have been increasing at almost 3% per annum, which means your nominal income was increasing at almost 8% per annum.

If you were on an annual income of $2,000 in 1945, you would have seen that rise to about $30,000 by 1980. Sadly, because of inflation that would only buy you the same as $5,600 in 1945 – but, still, you would be getting on for three times better-off than you were at the start of the Golden Age.

If we now repeat the experiment for the age of Market Capitalism, we get a different picture. Inflation was running at only around 3% so $100 in 2015 would have bought the same as almost $36 in 1980. That sounds a lot better on the face of it – your currency has been ‘debased’ far less.

But if you were on an income of $30,000 in 1980, that would only have risen to $118,000 in 2015. Even worse, it would have bought you the same as $36,000 in 1980 – you are only 1.2 times better-off in real terms than you were at the start of the age of Market Capitalism.

In fact, using the precise numbers gives an even starker comparison. But this simple approximation is enough to show that, if the price of higher growth is a bit of inflation, that price is well worth paying.

If this is the case, why do so many wealthy and successful people worry so much about inflation? Here, for example, is hedge fund manager Paul Singer:

“Check out London, Manhattan, Aspen and East Hampton real estate prices, as well as high-end art prices, to see what the leading edge of hyperinflation could look like.”

And he is partly right. Whereas normal people have seen inflation of less than 2% and wage growth of less than that, the wealthy have seen their wealth rise at about 6% per annum, but almost all of that has been eaten up by luxury goods inflation.

Inflation is caused by too much money chasing too few goods. For ordinary people, having too much money is really not a problem. For the ultra-wealthy, it has driven targeted inflation.

Hyper-Inflation Is Only A Risk If We Let Supply Collapse

Now, at this point, you may be thinking, “that’s all very well if we just have a little bit of inflation, but what about hyperinflation? Have you forgotten about Germany, Zimbabwe and Venezuela?

Hyperinflation is extremely high and continually rising inflation, where ‘extremely high’ means over 50% per month. We discussed above how inflation can eat away at the value of money – but hyperinflation is on a completely different scale. If the US had hyperinflation at 50% per month, the value of $100 would be reduced to just $0.77 after only one year. That is nothing like the figures we saw before.

The German hyperinflation of 1923, during the Weimar Republic, is probably the most famous – though actually not the worst – episode of hyperinflation in history. So it’s worth making sure that we haven’t forgotten about that.

Just in case the details may not be fresh in your memory, here is the historical background:

“In early 1923, German workers embarked on a prolonged general strike as a protest against the occupation of the Ruhr by French troops. Despite its parlous economic condition, the Weimar government decided to support this strike by continuing to pay striking workers. It did so by increasing print runs of banknotes, a policy the government had been using intermittently since 1921.

Government economists understood the dangers of flooding the economy with paper money, so the policy was intended to be temporary. But as the Ruhrkampf continued into the summer and autumn of 1923, no alternative way could be found to address the crisis. Paper money was continually pumped into the German economy, leading to devaluation and hyperinflation.

By mid-1923, the nation’s central banks were using more than 30 paper factories, almost 1,800 printing presses and 133 companies to print banknotes. Ironically, the production of paper money became one of Germany’s few profitable industries. At the height of the crisis, Germany’s state governments, major cities, large companies, even some pubs were all issuing their own paper money”

The results were truly dreadful. Here is a chart showing the number of paper Reichsmarks required to buy a single gold Reichsmark.

As you can see, a Reichsmark became essentially valueless, losing far more value in just one year (1923) than it had in the high inflation of the previous five years.

What was the root cause of this hyperinflation? It wasn’t simply high government debt and high rates of borrowing – several European countries suffered from that at the same time, but they did not all suffer from hyperinflation.

If we remember what causes inflation – too much money chasing too few goods – we can begin to understand what might cause hyper-inflation.

In the German case, a general strike without workers’ pay would have caused enormous damage both to the supply side and the demand side of the economy. The German government’s response protected the demand side by providing money, but did not solve the supply side problem. This of course generated inflation.

The government was unable to find a solution to the inability of the supply side to produce the goods and services that Germany needed both domestically and in order to trade internationally and pay reparations. Instead, it continued to act as though the problem was merely insufficiency of demand, and printed more banknotes.

And this is not an isolated example. In fact in every well-documented incidence of hyperinflation, there has been a combination of a damaged supply side of the economy coupled with a government which looked only at a demand side solution. As the Economist explains,

“The problems begin with a [supply side] ‘shock’ to the economy. It might be a slump in oil prices, as in the case of Venezuela, or a slump in farming output, as in the case of Zimbabwe. The shock sets off a chain of events. Tax revenues evaporate, leaving a hole in public finances. The government fills it by printing money. The increase in the supply of money pushes up inflation. That is bad enough. But what accelerates this process, turning a jump in prices into hyperinflation, is the impact of inflation on government revenue. Because taxes on income or sales are typically paid after they accrue, a period of high inflation leads to a fall in their real value. So the government resorts again to financing its budget deficit by printing more money.”

Hyperinflation is not impossible for us, but it would require serious mismanagement of the economy. First the government would have to allow a significant contraction in supply capacity – for example by allowing large numbers of businesses to go bankrupt during the corona-contraction – and then attempt to supply the needs of the population by printing ever larger amounts of money.

The preventive measure, which the government has been taking so far, is to protect both sides of the economy: take active measures to prevent enormous damage to productive capacity; and at the same time prevent unnecessary suffering today and inadequacy of demand tomorrow by protecting the finances of ordinary people.

Preventing inflation in the long-run means being unafraid to protect the economy today.


We should not fear inflation, in fact we should aim for a little more. Creating another Golden Age would require nominal growth in GDP of around 8-9% per annum. That would be good for the population and it would be good for business – but it would also mean higher inflation.

We ended the article on debt with a quotation from Lord Turner. Here is a bit more of that same quote:

“Inadequate nominal demand is one of very few problems to which there is always an answer. Central Banks and governments together can always create nominal demand in whatever quantity they choose by creating and spending fiat money.

Doing so is considered taboo – a dangerous path toward inflationary perdition. But there is no technical reason money finance should produce excessive inflation, and by excluding this option we have caused unnecessary economic harm… Money finance of fiscal deficits is technically feasible and desirable, [and] it may be the only way out of our current problems.”

You now understand more about inflation than most politicians.

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