The Quantity Theory of Money and Fears of Inflation Are Nonsense

We rarely get to conduct scientific experiments in economics, but for the last 3+ years The Federal Reserve has unintentionally conducted a test of an economic theory called the “Quantity Theory of Money” (QTM). QTM makes some very specific predictions – predictions that Ron Paul, conservatives on Wall Street, and others have been repeating a lot.  Unfortunately for them, QTM has failed the test.

First, some background on the theory. The QTM is and has been one of the foundations of both monetarist thought and Austrian economic thought.  In it’s base form, it’s based on an accounting identity that must, by definition, be true.  The notation sometimes varies, but the quantity theory of money is based on a definition called the equation of exchange.  This equation goes like this:

M times V = P times Q
where:
M: Money supply
V:  velocity of money, or the number of times the average dollar changes hands and is spent during the same time period as Q is measured.
P:    price level
Q:   real GDP (sometimes real National Income, Y, is used – same thing essentially)

So what does the equation say?  If you look at the left hand, M x V, you get a representation of the total spending in the economy.  It’s how much money was in circulation times the number of times that money was spent.  The right side, P x Q, gives us the value of nominal GDP.  It’s the value of all the real stuff we bought (Q, real GDP) times the Price level P which translates it into today’s prices.  Put the two sides together and you’ve got total nominal spending in money terms must be the same as the total value of the things we bought.  Duh.  Of course it is.  It’s an identity.   It’s the macro equivalent of saying that if I spend $5 each time (M) on 7 trips to the grocery (V) to buy 70 apples (Q) at $0.50 each (P), then I will spend $35 on $35 worth of stuff.

As an identity definition it’s not really very interesting.  It’s when economists begin to use it as a model of future outcomes that problems arise.

The typical way QTM is used, and the simple way folks like Ron Paul and a lot of folks who are upset at Federal Reserve efforts to stimulate the economy, is by thinking of what happens when M, the money supply, is suddenly increased.  The thinking is that an increase in M must result in an increase in P in order to keep the equation balanced.  This is the foundation of modern inflationary fears in the last  few years.  Typically folks using the QTM this way don’t say things like “an increase in M must lead to an increase in P”.  They say things like “The Fed is printing money like mad and that’s going to lead to inflation”  since an increase in the price level, P, is how we measure inflation.

But there’s actually four terms in this equation.  Any of them can change.  That’s where assumptions come in.  The advocates of QTM, whom I’ll call “inflation-phobes” for the moment since they’re always fearful of inflation, make some strong assumptions.  They assume three big things.  First, they assume that the velocity, V, is constant.  In other words, according to them, you and I always spend our money at exactly the same rate. Suppose I spend my whole paycheck every two weeks now.  They assume that I’ll always spend my whole paycheck every two weeks no matter how big or small that check is or whether I’m suddenly fearful of losing my job next month.  The evidence for the constant velocity assumption is weak.  You be the judge using the St.Louis Fed data:

To me, that doesn’t look constant.  If V is constant, then any increase in M also increases spending, MxV.  But if V isn’t constant, then an increase in M can be offset by simultaneous slowdown in velocity.

The next assumption is that real GDP is always at capacity.  In other words, there is no unused capacity in the economy such as unemployed workers or empty office buildings or factories running only 1 shift when they can run 2.  This is assumption is essential to the inflation-phobes because it means that Q can’t be increased.  This is necessary to their desired outcome because it would imply that the only way for PxQ to rise to meet an increase in MxV is by having P increase.  I won’t go to the trouble of showing data and graph to prove that Q isn’t at capacity.  If you have doubts, see last week’s update on employment and GDP.

There’s one more unstated assumption by the inflation-phobes.  They assume that any increase in base money, which is primarily the bank reserves The Fed makes available to commercial banks, will necessarily translate into M1, money in circulation among the public.  This too is a bad assumption.  There times, like the last 3 years, when commercial banks don’t want to or can’t lend.  In times like this bank reserves just sit there on the books safely tucked away from any kind of productive economic activity or spending.  The Fed can push reserves onto the banks’ books, but it can’t turn those reserves into loans or spending by customers. Another weakness in this assumption is the idea that even if the money ends up in private hands it will be used for spending on goods and services. Instead, what we’ve seen is that much of what little lending the big banks have been doing has been to finance financial market trading and speculation – things like oil futures.  Speculating in oil futures isn’t the same thing as actually refining and selling oil.  The speculation doesn’t create jobs and isn’t part of the circular flow. Production is.

So we’re back to the question of testing the QTM theory.  The QTM theory of money as inflation-phobes express it, says that increases in base money (M) necessarily must result in inflation (increases in P) at some time in the near future.

In 2008 and 2009 The Federal Reserve expanded bank reserves greatly.  It expanded the monetary base dramatically.  The Fed invented a variety of new names and methods for doing it, although almost all of them involved The Fed buying some kind of bond, security or financial asset.  If the QTM theory and the hard-money inflation-phobes are right, there should have been a dramatic increase in inflation.  They predicted it.  Again and again.  It simply hasn’t happened.  Paul Krugman put together an nice little graph showing the failure of the QTM theory:

The thing is, of course, that the past three years — the post-Lehman era during which the Fed presided over a tripling of the monetary base — have been an excellent test of that model, which has failed with flying colors. Here are the data — I’ve included commodity prices (IMF index) as well as consumer prices for the people who believe that the BLS is hiding true inflation (which it isn’t):

A couple of notes: for the commodity prices it matters which month you start, because they dropped sharply between August and September 2008. I use the IMF index for convenience– easy to download. (Thomson Reuters I use when I just want to snatch a picture from Bloomberg). But none of this should matter: when you triple the monetary base, the resulting inflation shouldn’t be something that depends on the fine details — unless the model is completely wrong.

So, we’ve had a test, a pretty substantial test of the Quantity Theory of Money and the assumption that any increase in monetary base must lead inevitably to an increase in prices and inflation.  The theory has failed.  It should be put to rest.  Milton Friedman, a man as responsible as any other for pusing QTM, once famously claimed that “inflation is anywhere and everywhere always a monetary phenomenon”.  He was clearly wrong, there’s more involved than just base money growth.

Brief History of Macroeconomics and The Origins of Freshwater vs. Saltwater Economics

I and others, particularly Paul Krugman, occasionally make reference to “freshwater” vs. “saltwater” economics.  Here’s a little background to explain the terms and, I hope, shed a little light on current disputes in macroeconomic theory.

First, let’s go back in time.  The stuff that economists study, namely the economy, economic behavior, and markets, really emerged as it’s own discipline in the 1700′s with Adam Smith.  It had always been a topic for philosophers to discuss. Even Aristotle writes about the topics.  But it didn’t really emerge from “moral philosophy” into it’s own field of study until Smith.  Originally Smith and the subsequent economists such as Ricardo focused on markets and what we now  call microeconomics with a nod towards questions of political economy (public policy and the whole economic system).  The industrial revolution was in full swing.  The economic system wasn’t really “capitalist” because nobody knew what that was yet.  It wasn’t until the mid-1800′s that the word capitalism becomes commonly used.   Note:  Adam Smith was not a capitalist.  According to the Oxford English Dictionary, the earliest recorded usage of “capitalist” comes in 1792 in France, well after Smith wrote the Wealth of Nations.  

Then in the years just after the Napoleonic wars, England suffered some very severe financial crises and depressions involving the collapse of canal-building businesses.  At the time, Smith’s famous treatise was now 40-55 years old.  The authors now called economists argued about it’s causes and the policies needed to right the economy and restore full-employment.  The center of the debate revolved around questions of “whether there could ever be such a thing as a general glut of commodities”.  In other words, was it possible that the now industrialized economy with it’s newly enlarged banking sector and wide circulation of paper money could be too efficient?  Would such an economy always produce willing buyers for all the goods that sellers wanted to supply?

Two views emerged. One of them, later called “Classical” becomes the dominant thinking in economic circles.  The Classical view denies that long-term high unemployment is even possible as long as the government balances it’s budget and follows a laissez-faire policy of not interfering in markets.  A very mechanistic view of the economy as being constructed of self-adjusting markets that always return to equilibrium evolves.  The Classical view supports a very liberal (old sense) and anti-regulation view of government policy.

Critics existed but they failed to dominate the debate.  Karl Marx in the mid-1800′s writes some scathing critiques of Classical economics focusing on how the mechanism of market equilibrium cannot and does not work as described in labor markets.  Yet despite the critique, the Classical economists continue to dominate policy making and academic circles.  The debate, however, becomes more polarized with the Classicals of the late 1800′s and early 1900′s pushing even more extreme anti-government, pro-market policy positions and models than their Classical predecessors advocated. Many of the critics of capitalism and Classical economics move to the opposite end of the spectrum and embrace socialist, communist, or fascist/syndical economics, in effect taking a position that market capitalism is so fatally flawed that it must be completely replaced by a system of planning by the government.

Despite the dominance of the Classicals, there were always some economists laboring, researching, and writing about the cycles of business and the workings of money and banks.  They just didn’t get much attention or have a comprehensive framework to distinquish themselves from either the Classicals or the planned economy types.

Then came Keynes and the Great Depression.  Classical economics denied The Great Depression could happen – much like University of Chicago economists in 2010 who claimed that today’s high unemployment is the result of workers suddenly choosing to voluntarily have leisure instead of a job.  Keynes writes a powerful book called The General Theory of Employment, Interest, and Money.  Macroeconomics is born.

Keynesian macro focuses on a total systems approach to the economy instead of just assuming that whatever works in a micro perspective in each market will make the total system work.  Keynes attempts to avoid the fallacy of composition. Keynes’s analysis shows that an industrialized, capitalist market economy with a financial/banking sector is inherently unstable.  It tends to have cycles – business cycles.  It’s beyond the intent of this post to explain the reasons, but the bottom-line was that Keynes identified a role for active government and central bank policy to maintain full employment  and stable prices.  Keynes rapidly gained converts in economics and soon the field was split into microeconomics and macroeconomics.

The success of Keynesian economists and Keynesian policies in the 1940′s, 1950′s and 1960′s led to dominance of Keynesian viewpoints.  But there were two subversive trends underway that would eventually reverse the Keynesian dominance and return the Classical viewpoint to dominance.  One was an attempt to build a comprehensive mathematics framework for all economics built on the math of Newton’s physics.  This effort, called the neo-classical synthesis, originally focused on microeconomics.  But eventually it turned it’s attention to putting Keynes’s ideas into the same optimizing-behavior mathematics.  Unfortunately, Keynes himself was long dead by now and unable to clarify what he “meant”.  Some ideas are forced onto him that weren’t necessarily there in the original (such as insisting on static equilibrium).  The second trend was a small group of economists who never agreed.  They were in effect Classicals in exile.  Led by Milton Friedman at University of Chicago and Friedrich Hayek, they launched a two-prong attack.  Hayek’s attack led to what we call Austrian economics today and is often embraced by extreme libertarians.  I won’t get into that here, there’s not enough time.

Friedman’s initial attack focused on re-writing our understand of The Great Depression.  Friedman works to show that monetary policy by the central bank was at fault for the Depression, implying that a laissez-faire government fiscal policy would be best.  Friedman’s disciples at Chicago and elsewhere expanded the attack by insisting on “micro-foundations” in all macro-economic theories and models.  By micro-foundations, they mean that the only acceptable basis for a macroeconomic model is one that is based only on the micro ideas of perfectly rational individuals acting on perfect information with perfectly rational expectations about the future and the nature of the economy.  By the mid-1970′s the Friedman posse was clearly winning the academic wars, in part because their position lent itself easily to using neo-classical synthesis  mathematics and because it was consistent with “micro-foundations”.

Friedman originally took a modified Classical position.  Classicals denied that either fiscal or monetary policy could affect or correct the performance of the whole economy.  Friedman pushed the idea that fiscal policy wouldn’t work but that monetary policy would.  Eventually the next generation of Friedman students and disciples went further and returned to the Classical position that neither fiscal nor monetary policy would work.

As it turns out, these newly re-ascendant Classicals, now being called New Classicals, inspired by Friedman, often taught at universities located inland near some kind of “freshwater”.  The remaining supporters of Keynesian viewpoints, now under severe attack, taught at schools nearer the ocean.  Then in 1976 R.E. Hall pens a paper called Notes on the Current State of Empirical Macroeconomics and identifies this split and associates freshwater and saltwater with the split.

As I see it, the major distinguishing feature of macroeconomics is its concern with fluctuations in real output and unemployment. The two burning questions of macroeconomics are: Why does the economy undergo recessions and booms? What effect does conscious government policy have in offsetting these fluctuations? These questions define the issues considered here. I will further restrict my attention to structural approaches, and will avoid discussion of the reduced-form approach, including its recent sophisticated manifestation (7).

As a gross oversimplification, current thought can be divided into two schools. The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity). The old division between monetarists and Keynesians is no longer relevant, as an important element of fresh-water doctrine is the proposition that monetary policy has no real effect. What used to be the standard monetarist view is now middle-of-the-road, and is widely represented, for example, in Cambridge, Massachusetts.

1To take a few examples, Sargent corresponds to distilled water, Lucas to Lake Michigan, Feldstein to the Charles River above the dam, Modigliani to the Charles below the dam, and Okun to the Salton Sea.


 

Choice and Welfare

Is Economics (mainstream, neo-classical economics) moral?  Does increasing choices necessarily increase welfare?

Professor Ed Glaeser of Harvard defends his view of the economics profession in the New York Times recently against charges that economists have “no moral compass or core”. He maintains that:

Improvements in welfare occur when there are improvements in utility, and those occur only when an individual gets an option that wasn’t previously available. We typically prove that someone’s welfare has increased when the person has an increased set of choices.

He quotes both Adam Smith and John Stuart Mill. Economists on the defensive with the public always like to quote Adam Smith.  I am not so sure Adam would appreciate their summary of his views. But Ed mostly quotes Milton Friedman, including this snippet.

In the last century, Milton Friedman offered “freedom is a rare and delicate flower” and “a society that puts equality — in the sense of equality of outcome — ahead of freedom will end up with neither equality nor freedom.”

I don’t really agree with Glaeser. I believe economics (and economists) has (or should have) a singular moral purpose: to discover how to increase the well-being of people in this world. I happen to think that choice and freedom is an essential element of well-being, but I don’t buy the idea that well-being arises solely from choice. If I am starving, my well-being is better enhanced by access to a single, nourishing adequate meal than if I were to instead only have access to multiple but-all-inadequate alternative meals.

I found this rebuttal of Glaeser’s arguements by Richard Green to be interesting.  I’m not sure he hits the problem head-on, but it’s close.  I also think the comments are fascinating as well and urge readers to them.

I will leave it to others to dispute the notion that more choices are always better than fewer.  But I can’t help but think that it is to easy for those of us who are tenured professors to extoll the virtue of free choice, for the simple reason that we get so many, well, choices.  We get to choose what we write, we to a large extent get to choose what we teach inside our classes, and we can piss our deans off and pay fairly little in the way of consequences.  We might not get a raise or we might have to teach a class that we would rather not, but this is all small beer.  We can make an awful lot of choices and still be economically secure.

Now consider the administrative assistant at a corporation who has a boorish boss and a sick kid.   The company she (he) works for has a good health insurance plan, but if she were to leave, she would find herself unable to get coverage at a reasonable price.  Does she really have choice?

Consider the West Virginia coal miner who goes into a dangerous mine every day, and whose life expectancy is shortened with each hour worked underground.  Now consider the fact that the miner grew up in a West Virginia town with a poor school in an environment where going to college was a rare phenomenon.  Does that miner have a choice?

I could go on, but I think the point is fairly clear.  There are times when government intervention could expand the choice set up a large number of people.

Ed does point out how government can improve choice sets, and for that he deserves credit.  But the more fundamental problem is that market economies produce large institutions that have limited markets inside of them, and therefore sometimes have hierarchies that can be as inhospitable to personal liberty as government bureaucracies.  Elinor Ostrom’s Nobel win in 2009 shows that the economics profession is beginning to recognize this problem,  but I am not sure Ph.D. students are broadly encouraged to study it.

Personally I had always thought that increasing choice was desirable only because, and only to the extent that, it was instrumental in achieving higher welfare. Yes, freedom and choice enters into the “utility function” as a good in it’s own right, but so do other goods such as love, health, security, and the ability to produce or grow.  It is not clear to me that choice necessarily trumps these other goods, nor is it clear that these other goods can only be gained from some abstract freedom of choice that Friedman espouses.