How governments around the world are creating inflation as they increase the money supply

To create inflation you need to create money first.

Last month, I wrote about how the authorities in the developed world would both create inflation and also take administrative action to prevent a rise in interest rates. That they are already in the process of creating inflation is evident when we properly understand their new role in creating money.

From the outbreak of COVID-19, governments of the developed world have assumed a growing control over making money. Government’s have put in place guarantees for commercial bankers that compensate them, with public money, for losses on loans to the private sector.

Bankers can now extend risk-free loans to the private sector, and they are doing so in the pursuit of profit. As a result, money is being created.

It was a man from Iona Station, Ont., the economist and diplomat John Kenneth Galbraith, who most eloquently explained how banks create money and why they do so:

“The discovery that banks could so create money came very early in the development of banking. There was that interest to be earned. Where such reward is waiting, men have a natural instinct for innovation.”

Galbraith went on to note: “The process by which banks create money is so simple that the mind is repelled.”

When a banking system lends money, it needn’t fund those loans from its existing deposit base or any other funds it has access to. When the loans of the banking system increase, new money is created in that process.

So, when the banking system increases its total lending, it transfers newly created deposits to the borrower and the total amount of money in the system expands. There are, of course, limits to how much money a commercial bank can create. These limits are imposed by various regulations and also depend on demand for loans at the existing interest rate, which has been determined usually by the central bank.

Central bankers have primarily held these reins and have thus been able to influence just how much money is being created by the commercial bankers. Like a coachman, they have steered their team of horses to create the quantum of money that they have assessed as appropriate for the economy.

Then, in 2020, everything changed as governments stepped in to control bank lending and create money.

In the COVID-19 emergency, governments mounted the trusty steads of money creation — the commercial banks — and drove them in the direction necessary to prevent a private sector credit crisis.

The reins from the coachman are now largely ineffectual; instead, the spurs of government, in the form of the guarantees on bank loans to companies and individuals, drive bank credit expansion and thus money creation.

Money is now being created by governments, through their de facto control of bank lending, and these newly loaned funds are in the hands of primarily small companies and the households that will very likely spend and not save them. The sudden acceleration in the growth of money is remarkable.

The best available guide to the total amount of money in the world is provided by the aggregate broad money statistic published by the Organisation for Economic Co-operation and Development (OECD).

A year ago, the total amount of money in the world was growing at a rate of six per cent year on year; it is now growing at almost 19 per cent year on year. This is the highest growth in world money supply since the late 1980s when OECD inflation was close to 10 per cent.

Due to widespread lockdowns, much of this money remains idle and is showing up as ever higher savings balances in the household sector and elsewhere. There is nothing in the historical record to suggest that all of those money balances will be transformed permanently into higher savings.

As lockdowns end, most — probably not all — of these balances will be spent and there will be too much money chasing too few goods and, in particular, too few services. If that analysis is correct, then the world faces an economic boom when lockdown ends. The good news is that will also, probably with a lag, bring lower unemployment.

The crucial impact from this monetary revolution is not just that more inflation is coming, it is that the control of commercial bank lending lies increasingly with the government. That governments often have agendas unconnected to the purely commercial is news to no one.

There will be those who are delighted that the government can now play such a key role in allocating bank credit, depending upon which projects they deem eligible for government credit guarantees. For instance, more credit for the greening of the economy is highly likely to result from this change in policy.

For people who look at this revolution from the perspective of business or as an investor, there is a problem. This monetary revolution means that, increasingly, credit will be rationed rather than priced. In the United Kingdom, the government, in conjunction with the financial regulator and the central bank, is already composing a list of what ventures are to be considered productive and those considered unproductive.

Having drawn this line in the sand, policies will be adopted to favour one form of financing over the other. Investors will now have to be wary of investing in sectors likely to be deemed unproductive and where increasingly equity finance will have to replace debt finance. In such a situation, returns on capital will likely decline and the supply of new equity may depress the price of the existing equity. If you are running any business reliant upon debt financing, as most asset heavy businesses are, now is the time to consider whether such financing will always be available, at any price, if the government is involved in the credit allocation process.



Perhaps governments will stop offering credit guarantees to banks and we will revert to the old system where the coachman or coachwoman, seeks to control the quantity of money in the economy.

It is more likely that governments will run in fear of ever withdrawing the credit guarantees to banks and risk a collapse in bank lending and money creation. Governments may soon realize the huge political possibilities of allocating credit to the regions, industries, people and even political cronies most likely to support their re-election.

As Galbraith reminded us: “Where such reward is waiting, men have a natural instinct for innovation.” This applies whether these men be bankers or politicians. The result is likely to be too much money and, as a consequence, too much inflation.

Russell Napier is chairman of Mid Wynd International Investment Trust and runs a course in investing at The Edinburgh Business School. He is a freelance contributing columnist for the Star.