March 18, 2016

Money, Liquidity and the Gold Standard, Part 1

Money and monetary policy are among the "hotter" topics in economics. The one man to thank for this in good part is Milton Friedman, the de facto founder of monetarism as a sub-theory of economics. 

Friedman's career, long and worth every ounce of respect, brought monetary thinking and the policies of central banks to the forefront of economics. He was certainly known for much more than monetarism, but his contributions there alone are enough to count as lifetime achievement. Yet partly because of the field he chose, he also became a politically controversial figure. 

That, however, was not entirely because of his work.
At the time when he rose to global stardom and was awarded the Nobel Memorial Prize in Economics (1976) the modern, post-World War II world had become acquainted with hyper-inflation. The harrowing experience with runaway prices from the Weimar Republic had been thought to be a thing of the past, yet Latin America proved the world wrong. Europe and the United States had a close encounter with inflation in the early 1970s.

Friedman's monetarism offered a straightforward recipe for dealing with inflation: keep the central banks from printing excess amounts of money. His theory, which is one of the most intriguing objects of study for an economist, has often been reduced to the so called "quantity theory of money":

M*V = P*Q

It is disrespectful to Friedman to confine his theory to this equation, but it can be used as a policy-oriented representation of basic monetarist thinking. From the left,

M = Money supply
V = The velocity with which money moves through the economy
P = An aggregate price level
Q = Total volume of production in the economy.

The idea here is to, essentially, explain inflation of any kind, and specifically hyperinflation. The velocity of money is assumed constant and the total volume of production is assumed to only change over the long term. Prices, on the other hand, are flexible, as is money supply. Therefore, any increase in the supply of money leads to a proportionate increase in the price level.

According to the quantity theory equation, tight money supply will keep inflation low. 

By contrast, lavish money-printing, as under the Federal Reserve's Quantitative Easing (QE) program, is predicted to lead to high inflation. Here, monetarist thinking has definitely penetrated the public mind. Many conservatives, and especially monetarist libertarians, were vocally critical of the Federal Reserve during the QE years precisely because they feared hyper-inflation in the United States. 

Hyper-inflation never happened. If anything, inflation trended lower during QE than in the decade prior. 

Does this mean that the quantity theory, and perhaps even monetarism in itself, is wrong? In fact, the European Central Bank has created its own little Quantitative Easing program with negative bank overnight lending rates following several years of rapidly expanding money supply. Measured as a ratio toward GDP, the European version of Quantitative Easing has at times been growing money supply twice as fast as the Federal Reserve. 

Is this further evidence that monetarism fundamentally is wrong?

With all the respect I have for Milton Friedman, I will not conclude that he was wrong. That would be audacious on my end. However, his theory does run into problems when confronted with a reality where his theory should be highly predictive, yet turns out to be the exact opposite.

The problem here is at the core of the theory. To make a complex argument simple, monetarist theory thinks of money as a carrier of value. I work an hour digging drainage for a farmer's corn field, and he pays me $10. Those ten dollars now represent the value of my work. I can now carry the cash to a store and buy myself a nice pair of sneakers. 

In this capacity, money serves a perfectly understandable, common-sense function. We need to be able to carry the value of our productive activities - employed labor, entrepreneurship or capital investments - over to products we want to buy. For that to happen, we need a "value carrier instrument", i.e., money. 

The nice thing about a free-market economy is that it tends to produce as much of everything as we all want to buy. Not only do we get the best possible distribution of all resources (compared to systems where government controls distribution) but we also get price stability. The amount of money available in the economy precisely matches the need to carry value, which in turn matches the value of available resources (food, shelter, clothes and whatever else we buy on a regular basis).

Now, if the central bank starts printing more money than is demanded for value-carrying purposes, all of a sudden there is more money available for consumption. This money makes its way into the pockets of consumers and entrepreneurs (in the form of very cheap loans) whereupon demand for all sorts of products goes up dramatically. However, the economy is not producing any more of any product - the extra money in the economy does not come from value-producing activities but from loans - which, according to monetarist thinking, means that prices of existing products increase.

In short: printing excess amounts of money leads to inflation. 

So long as we view money as a carrier of value, this theory works well. The problem is that value-carrying is not the only function that money fills. It is also the "anchor" for a spectrum of liquidity.

Again, an element from Keynesian theory allows us to make a nuanced analysis of the economy. The limitation of the monetarist approach to money is that it does not take into account the role that uncertainty plays in economic activity. Again somewhat crudely - though not unfairly - representing monetarism with the quantity theory, the idea that prices are flexible to respond to the printing of new money is fundamentally an idea of an economy without uncertainty. There are two reasons for this:

1. Uncertainty makes people grativate toward sticky prices, i.e., flexible prices are bad for economic activity in general; since people explicitly or implicitly contract prices, the threshold is very high for prices to starts running away as described above.

2. Uncertainty makes people want to hold their assets in as highly liquid a form as they can.

This last point is crucial. To quote one of my true mentors during graduate school, former University of Tennessee, Knoxville economics professor Paul Davidson, "in times of uncertainty, he who hesitates is saved to make a decision another day". Davidson's point is simple: if I have earned $10 and I am not sure what my future financial situation is going to look like, I am better off deciding to buy nothing today so that I can by anything (well, almost) tomorrow. 

This point goes hand in glove with the quote from Keynes where he says that a decision not to buy a pair of boots today is not a decision to buy them tomorrow. It is a decision to spend less today with no commitment to spend tomorrow. The consequence of this deliberate inaction is that I hold onto my money - I keep my value in the highest form of liquidity available. 

Imagine now that the central bank decided to print more money at a time when a substantial share of economic agents - consumers as well as entrepreneurs - have a high preference for "not buying a pair of boots today". What happens to that extra liquidity? It ends up idling in bank accounts, either those of the banks themselves (i.e., they cannot lend it) or as credit borrowed but not spent by families and non-financial businesses. 

Long story short: when people are not inclined to immediately spend all the money they have, the mechanism from newly printed money to inflation is cut off. It is cut off from two ends: from the price end in that people prefer sticky prices to flexible prices; and from the money-supply end in that people would rather let liquidity idle than spend it today. 

In other words, Keynesian monetary theory breaks the link between money supply and inflation. That does not mean that monetary inflation is a non-existent phenomenon. It can occur, but only as a special case. 

Based on Keynesian monetary theory we can better understand Quantitative Easing and how it can pump out money in an idling economy without causing hyper-inflation. 

This does not deter proponents of monetarism and Austrian theory from proposing a return to the Gold Standard. I disagree with any such idea, for reasons that I will elaborate on in the second part of this article.  

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