Dr Sam Peng, Head of Subject—Economics
To understand the world around us and make it a better place has always been the ultimate purpose of an Economics education. The current economic problem and its management invites us to rethink ‘money’—probably one of the least understood economic concepts that holds the key to understanding many of our issues today and tomorrow.
At the time of writing this article, the world is suffering from the worst cost of living crisis in more than 30 years. Headline inflation in Australia had reached 6.8 per cent in the year to August 2022, with food, housing, and transport costs in eight capital cities surging by 9.3 per cent, 9.5 per cent, and 8.5 per cent respectively (ABS, 2022). In many other parts of the world, inflation is much worse. Annual inflation is nearly 70 per cent in Sri Lanka and more than 80 per cent in Turkey, where shortages of essentials such as food and medicine have driven many more people into poverty (Bloomberg, 2022a; b). The US is also hit by record-high inflation (8.3 per cent in August 2022), which has pushed the US Federal Reserve to jack up interest rates from 0.25 per cent to 3.25 per cent in merely six months (Forbes, 2022). Such aggressive moves have forced central banks around the world, including the Reserve Bank of Australia (RBA), to follow suit, which further increases the risk of an economic recession.
But why is inflation so high, and how does increasing interest rates help? The most prevalent and popular narrative is based on demand and supply analysis, which attributes high inflation, or price rises, to supply shocks and demand spikes. The logic is intuitive—market prices are determined by supply and demand; when supply (of food, energy, etc.) decreases due to supply shocks, for example, the Russia-Ukraine war, the COVID-19 pandemic, bushfires, floods, and labour shortages; and demand increases due to massive government stimulus, extremely low interest rates, and economic recovery from the pandemic recession; prices go up. Although raising interest rates has little effect in resolving supply bottlenecks, it can discourage spending (i.e., demand) and therefore ease inflation. As for the economic slowdown or recession that may also result from the dampened demand, it is just an unfortunate ‘trade-off’ we must make.
What is missing in this narrative is the role of money. After all, inflation is essentially money losing value due to its oversupply. Yet, what is money, where does it come from, and what determines its value? You will find most definitions of money are given from the perspectives of its functions and forms, such as ‘something generally accepted as a medium of exchange, a measure of value, or a means of payment.’ (Merriam-Webster, 2022); ‘a medium of exchange that functions as legal tender; the official currency, in the form of banknotes, coins, etc, issued by a government or other authority’ (Collins Dictionary, 2022). What these definitions fail to point out is that the nature of money in use today, the so-called fiat money, is ‘credit’ and that is created through debt (Martin, 2013; Goldstein, 2020). When the central bank prints money, it is essentially issuing government-backed ‘IOUs’, whose value is determined by the number of real goods and services they can be redeemed for. Such ‘credit’ is then relayed and expanded by banks extending loans, that is, creating new debts.
Through the lens of ‘money’, the current cost of living crisis is really a debt crisis, fuelled by the unprecedented expansionary monetary and fiscal policies since the pandemic. In Australia, the cash rate was dropped from 0.75 per cent pre-COVID to a historic low of 0.1 per cent to facilitate public and private debt expansion (RBA, 2022a). In addition, the RBA also funded $224 billion in federal government debt, as well as $57 billion in state and territory government debt through its Bond Purchase Program (RBA, 2022b). On a global basis, easy credit conditions, and monetised fiscal policies, which have included tax cuts and government spending funded through ‘money printing’, have resulted in an unprecedented increase in public and private debt. Globally, the debt-to-GDP ratio soared by 28 per cent in 2020 alone (IMF, 2022). Viewed from a monetary perspective, this means the money expansion was not matched by real economic growth—the IOUs cannot be redeemed for the same amount of goods and services. Hence, money loses value, causing inflation.
To make matters even more dire, the dominant position of the US dollar in the global financial market means monetary expansion by the US does not only increase its domestic debt, but also the dollar debt in foreign markets. With the US Federal Reserve hiking interest rates aggressively, the debt burden in these markets grows too. This is further aggravated by the fact that when the debtor countries compete to buy the US dollar to pay their debt, the US dollar appreciates in value. Currently, the US dollar is at a 20-year high and increasing still, which increases imported inflation even more in the debtor countries and makes their debt even harder to pay back (Russell, et al, 2022). It is not surprising to see that countries with the highest inflation, for example, Turkey and Sri Lanka, are also countries where the dollar debt represents a large proportion of their GDP (Russell, et al, 2022).
The most concerning element is not the current predicament itself, but rather, the debt-based monetary system that underpins it. In such a system, monetary expansion to support economic growth always associates with debt expansion, which increases the vulnerability of the economy due to moral hazard, inefficient allocation, and supply shocks. Modern Monetary Theory (MMT) suggests that the government could simply create more money without consequence (Mosler, 2021). Its validity is clearly tested in this current debt crisis. History shows that when debt expansion outpaces real economic growth, or when a chain of credit is overstretched, the value of the money itself will be eroded, thus causing a financial crisis.
ABS. (2022). Monthly CPI indicator rose 6.8% in the year to August. Retrieved from https://www.abs.gov.au/media-centre/media-statements/monthly-cpi-indicator-rose-68-year-august
Bloomberg. (2022a). Turkey Braces for More Inflation Angst. Retrieved from https://www.bloomberg.com/news/newsletters/2022-09-05/turkey-inflation-angst-saudi-crypto-ambitions-egypt-default-risk
Bloomberg. (2022b). Sri Lanka Inflation Accelerates to 69.8% in September. Retrieved from https://www.bloomberg.com/news/articles/2022-09-30/sri-lanka-inflation-accelerates-to-69-8-in-september#xj4y7vzkg
Collins Dictionary. (2022). Money. Retrieved October 02, 2022, from https://www.collinsdictionary.com/dictionary/english/money
Forbes. (2022). U.S. Dollar Hits 20-Year High: Here’s What That Means. Retrieved from https://www.forbes.com/advisor/investing/fed-funds-rate-history/
Goldstein, Jacob. (2020). Money: the true story of a made-up thing. Atlantic Books, London
IMF. (2022). Global Debt Database. https://www.imf.org/external/datamapper/datasets/GDD
Martin, Felix. (2013). Money: The unauthorised biography. The Rodley Head, London.
Merriam-Webster. (2022). Money. Retrieved October 02, 2022, from https://www.merriam-webster.com/dictionary/money
Mosler, Warren. (2021). White Paper on Modern Money Theory. Retrieved from http://moslereconomics.com/mmt-white-paper/
RBA. (2022a). Cash Rate Target. Retrieved from https://www.rba.gov.au/statistics/cash-rate/
RBA. (2022b). From QE to QT – The next phase in the Reserve Bank’s Bond Purchase Program. Retrieved from https://www.rba.gov.au/speeches/2022/sp-ag-2022-05-23.html
Roubini, Nouriel. (2022). The Stagflationary Debt Crisis Is Here. Retrieved from https://www.project-syndicate.org/commentary/stagflationary-debt-crisis-is-here-by-nouriel-roubini-2022-10
Russell, Karl, Rennison, Joe, and Karaian, Jason. (2022). The Dollar Is Extremely Strong, Pushing Down the World. Retrieved from https://www.nytimes.com/interactive/2022/07/16/business/strong-dollar.html