Cullen Roche has an end of year post up in regard to inflation.

Brad Delong rightly slams Austrian economist Robert Murphy this morning for a bet he made in 2009 regarding inflation. Murphy stated that headline inflation would hit 10% by January 2013. Well, here we are with 24 hours to go and the latest monthly CPI reading is 1.8%. I don’t want to just pile on Murphy with personal attacks. Instead, I think it’s constructive to understand why this prediction was wrong because it’s at the heart of an important economics and finance understanding

Headline inflation, does actually mean the headline number in the CPI, that’s the number that the average man in the street understands from the term. In which case, Murph’s call for 10% headline inflation is way off.



Here is the inflation rate from 2009 till today. The compounded rate is 3.5%, which gives +/- the 9.4% change trough to peak, which is pretty close to your 10% rate.

Am I arguing apples to apples? No not really, but the point is this: neither are the other chaps.

If we jump in the Google time machine we can see what was said back in 2009 that was so wrong. Murphy was working from the same premise that many economists work from. He saw the Fed flooding the banking system with reserves and assumed that this would cause inflation. He said

Well the Federal Reserve was and still is flooding the banking system with new reserves. It has created inflation. Lots of inflation.

Murphy states:

“In order to keep those reserves from working their way back into the hands of the general public (where they can start pushing up prices), the Fed will have to raise the interest rate it pays to persuade the banks to keep the reserves parked at the Fed. But this simply postpones the day of reckoning, as the troublesome stockpile of excess reserves grows even faster.”


Looks correct.

Cullen states:

This is not correct and it displays a huge flaw in the model that Murphy is working with. It’s worth noting that Delong and others are working under a model that actually isn’t that different (though their “liquidity trap” theory has stated that the Murphy model is temporarily broken). Both models are wrong.

Not correct. Really. What you soon come to appreciate about Cullen Roche is that he makes large numbers of unsubstantiated statements. Very rarely does he provide any evidence. This is a case in point.

Monetary Realism starts from an understanding of modern banking. We understand that the US monetary system is essentially privatized. In other words, the money supply is controlled almost entirely by private banks whose ability to create loans creates deposits which are the primary form of money we all use. The money supply expands and contracts (mostly expands) in an elastic form based on the public’s demand for loans

Fractional reserve banking. Agreed. The money supply however is controlled by the Federal Reserve. The banks, cannot inflate without the support of a Central Bank. The Central Bank relies upon government to allow the Central Bank to break the law through breaking of contracts.

The flaw in the Murphy model is that he assumed that reserves are somehow related to a banks ability to loan money. He specifically shows the scary chart of M1 going parabolic and then states in clear terms that this money will work its way into the public.

Cullen Roche also likes to misquote people. Murphy, if you read him, is clear on the subject. Reserves are “related” to the banks and inflationary money creation via loans. When a bank creates a new loan, it reserves a fraction of that loan as a demand deposit in the Federal Reserve system. Higher loans are causative of higher reserves.

Cullen wrong again.

This is really important so I am going to cover this point again. There are two types of money in our monetary system. Banks deposits (the money we all use) are inside money because it is created inside the private sector (controlled by an oligopoly of private banks).

Controlled by the Federal Reserve.

Outside money facilitates inside money and exists in the form of cash, coins and bank reserves. This money comes from outside the private sector. It is supplied by the government to facilitate the use of inside money. Cash, for instance, is issued by the US Treasury to allows member Fed banks to stock vaults for customers who wish to draw down their bank accounts for transactional convenience. Coins serve a similar purpose.

Essentially true, but irrelevant.

Reserves are a bit different. Reserves exist solely because of the Federal Reserve System. And they serve two purposes – 1. helping banks settle interbank payments; 2. helping banks meet reserve requirements. Bank reserves are just deposits held on reserve at Fed banks. You can think of reserves as existing in their own market that is totally separate and inaccessible to the non-bank private sector. In other words, reserves are the money banks use to do business with one another

Reserves are a bit different…so something that is going to illuminate our understanding of the banking system?

Reserves: [i] facilitate interbank settlements and [ii] meet reserve requirements.

That’s it? That’s Cullen’s big insight? You have to be kidding me. Let’s look at something else that “reserves” could be used for. If you know the reserve ration mandated by the Federal Reserve, and its not a secret, you can then calculate quite accurately the outstanding loans and leverage built into the banking system. From that, you can take your GDP number, and calculate your Keynesian “multiplier”. There are lots of things bank reserves can tell you. Of course another is in a systematic default, how much deflation will occur, and from that your contraction in GDP.

Cullen is clueless.

But more importantly, banks don’t lend their reserves. Banks lend based on their solvency or capital constraint. Reserves are merely an asset of the bank. When the Fed implements monetary policy like QE they don’t change the capital position of the banks. They swap a t-bond or MBS for a bank reserve.

Of course they don’t. The reserves are caused by loans being made. Notice here, this is just Cullen rambling on. This is not Cullen examining what Murphy said. I guarantee to you Murphy never stated that the banks loaned their reserves. That however seems to be the inference made by Cullen, which is an untrue inference.

This doesn’t change the net financial asset position of the private sector.

But it can. So wrong again Cullen.

If the bank is holding an MBS that has defaulted and is worth say $0.20 on the dollar, and the Federal Reserve swaps that for a shiny new Treasury worth $1.oo on the dollar, has nothing changed?

The bank literally has the same capital position it did before this policy was enacted. So, the bank can’t create more inside money than it could have before.


And we know that this outside money (reserves) doesn’t flood out into the private sector because it is used ONLY by the interbank system. Anyone who understood this in 2009 (as many of us did) knew that Murphy was wrong because his understanding of the system was wrong

Correct…and where, or when, did Murphy state that it did? Again, simply making inferences that are based on zero evidence. To make an inference you require evidence, not simply arbitrary statements.

So, as we’ve seen time and time again, misunderstanding modern banking and money has resulted in very bad predictions. Unfortunately, I still don’t see many people agreeing on why Murphy and others were wrong. That’s not progress

So as we’ve seen, time and time again, Cullen talks and talks, but provides no evidence to support his assertions. I suspect that nothing will change in 2013.