Market monetarists have a reductio ad absurdum that they like to throw in the face of anyone who doubts the ability of central banks to create inflation. It goes like this; "So, buddy, you deny that central bank purchases can have an affect on the price level? What if a central bank were to buy up every asset in the world? Wouldn't that create inflation?" Since it would be absurd to disagree with their point, the buying up everything gambit usually carries the day.
In this post I'll bite. I'm going to show how a money issuer can buy up all of an economy's assets without having much of an effect on the price level.
Let's return to my Google parable from last week. You don't have to read it, but you should. If you don't have the time, here's a brief summary. In an alternate world, Google stock has become the world's most popular exchange media and all prices are expressed in terms of Google shares. Google conducts monetary policy by changing the return it offers shareholders, thereby ensuring the price level is stable. The reason I'm using a Google monetary world rather than our own is that it cuts through all the accumulated baggage associated with our central bank-dominated monetary discussion. A new set of lenses may let us see a bit more clearly.
Say that financial assets trade at or near fundamental value, where fundamental value is the present value of returns to which assets are a claim. Deviations from fundamental value are fleeting since investors will either buy undervalued assets or short overvalued ones.
Google announces that it wants to double the price level, or, alternatively, to cut the value of Google shares in half. It will go about this by purchasing financial assets until this target has been met. [One niggling detail here is that Google's charter prevents it from consciously overpaying for assets. More on this later]
Google starts printing huge amounts of new shares and injecting them into the economy by buying stocks, bonds, commercial paper, derivatives, and whatnot. Their wallets flush with new Google cash, individuals start to spend away unneeded cash balances, putting downward pressure on Google's share price, and upward pressure on prices. Google's mandated doubling of the price level seems well on its way to being fulfilled.
But something halts the decline. The moment that anxious sellers push Google shares below fundamental value, investors step in and buy all shares offered. No matter how long Google's buying rampage continues, and how large the supply of Google cash in the economy, these investors mop up all unwanted shares. This has the effect of putting a floor under the price of the stock, and vice versa places a ceiling on the amount of inflation that can be created. Thanks to the investment demand for its shares, Google can buy up all the world's assets while hardly causing an increase in the price level.
The reason that investors willingly set a floor beneath Google's stock price is that Google is buying up assets at market prices, as stipulated by its charter. In buying at these prices, Google's fundamental value will never change, no matter how many shares it prints. Say that equity in our Google universe tends to trade at a risk-adjusted multiple of 10x earnings (i.e. a share is worth ten times current per-share earnings). Since Google is prohibited from paying more than 10x risk-adjusted earnings for the assets it acquires, and is itself valued at the same 10x earnings multiple, its fundamental value after each acquisition remains the same. In other words, Google has the same per-share earnings throughout its purchasing campaign. When anxious transactors try to rid their wallets of the excess exchange media created by Google "printing", -- say they drive Google shares towards 9x earnings -- savvy investors will immediately jump in and buy the undervalued stock, enjoying a free lunch until they've pushed Google's price back up to its fundamental value of 10x earnings.
So contra the market monetarist claim, the economy's reigning monetary superpower can print and buy up all the world's financial assets -- yet not cause inflation.
There are a few simplifications I've made here. Acquirers incur transaction costs. Commissions must be paid to investment bankers, for one. Secondly, there really is no such thing as "one market price". Financial assets trade in a range called the bid-ask spread. If Google always buys at the higher ask price rather than patiently waiting to be filled at the lower bid price, then it will consistently lose small amounts on each transaction. This means that after each acquisition, Google's fundamental value will have declined by a few beeps, and investors will bid Google shares down a bit. But this transaction effect is small, nor is it equivalent to the effect that market monetarists are talking about when they refer to central bank power over the price level.
Now back to the real world. Whatever general rules of finance that apply to Google's highly liquid financial media apply just as ably to the Fed's highly liquid financial media. See my previous post on this. So take out every mention of Google share in the above text and substitute it with Fed deposit and the same conclusions can be drawn.
Lastly, just like Google's charter prevents it from overpaying, the Federal Reserve Act specifies that the Fed must buy all assets in the open and liquid market, effectively preventing the Fed from overpaying for assets. So our analogy is more appropriate than one might initially assume.
PS. I'm not saying that central banks can never push up the price level via mass purchases. I'm saying that given a certain set of constraints, a central banker can buy up every single asset in the economy without having much of an effect on the price level. It is interesting that this constraint, embodied in our hypothetical Google's charter, approximates to the rules that actually govern the Fed and other central banks -- namely that assets must be bought at market prices. Remove this constraint and it would be very easy for either Google or a central bank to push up the price level, as my previous post showed.