I recently did a post trying to figure out whether there are any non-quantity theoretic models of the price level. It led to one of the most intense debates I’ve ever seen in my comment section, and even other bloggers chimed in with posts. But no one came forth with a non-quantity theoretic model of the price level. It is very important that any monetary theory be able to explain why prices aren’t 100 times higher, or 100 times lower. Thus I’m more inclined than ever to think the QTM is the best starting point for monetary theory (although obviously it’s not literally true that M and NGDP grow at the same percentage rates.)
I wasn’t able to fully grasp how MMTers (“modern monetary theorists”) think about monetary economics (despite a good-faith attempt), but a few things I read shed a bit of light on the subject. My theory is that they focus too much on the visible, the concrete, the accounting, the institutions, and not enough on the core of monetary economics, which I see as the “hot potato phenomenon.” This is the idea that the central bank controls the total quantity of money, but each individual controls their own personal “money supply.” So if the Fed injects more money into the economy, something has to give to equate money supply and demand. Initially there is too much money in circulation, and people pass the excess balances to one another like a hot potato. This process drives up NGDP, until the public is willing to hold the new quantity of money.
Importantly, it’s very hard for individual people to see how this process works, as the Fed injection of cash doesn’t make anyone richer. They swap cash for bonds, at fair market value. But if no one is richer, why should AD go up?
The easiest way to see the process work is to imagine an economy without banks, where the new money goes right into circulation as currency. Most people can instinctively grasp that more currency, without any increase in real goods being produced, will lead to inflation. But when you add a banking system it’s much harder to see the hot potato effect, because now the new money can show up as either cash or bank reserves. It looks like individuals who didn’t want to hold excess cash, could simply put it in the bank. But of course the bank usually doesn’t want to hold a lot of excess cash (reserves) either, and so you can still have the hot potato effect.
Now let’s look at an example, first from my perspective, then theirs:
The Fed wants to raise the price level by 10%. So they decide to suddenly increase the monetary base by 10%, and then continue on with the same money supply growth rate as before. This should cause a 10% one-time rise in P, and in NGDP, compared to the no-action alternative. But if they actually did this in a modern economy, it would create a big mess. NGDP doesn’t change immediately, so it’s be hard to generate demand for that extra cash. Even so, the Fed can literally force base money into the economy, by selling [I meant buying] bonds. I believe the MMTers, argue that trying to do this would drive rates to zero. That may or may not be true; they tend to overlook that the interest rate isn’t just the price of money, it’s also the price of credit. So a highly expansionary policy can increase interest rates under certain conditions, for certain maturities. But let’s assume rates did go to zero. Then AD would rise, and eventually NGDP would increase 10%. At that point the public is willing to hold the larger cash balances, and the nominal interest rate returns to its original level.
Because this process would be messy, real world central banks would use a much more subtle process, involving signaling. They will signal the desire for 10% higher NGDP though various mechanisms–a higher inflation target, a lower exchange rate, or most commonly, a lower fed funds target rate. If credible, this signal will boost AD. To some that seems like handwaving (the inflation target more so than the interest rate.) It’s actually an implied commitment to provide 10% more base money at that future date when NGDP is 10% higher. But in that case the cause of the higher NGDP (more cash in the long run) seems to occur after the effect (higher NGDP growth.) To many people, that is deeply disturbing. An observant reader will have noticed that cause doesn’t actually follow effect in this case, the true cause of everything is a sudden expectation that future levels of currency will rise by 10%. So cause actually does precede effect.
My hunch is that the MMTers are fooled by this process. They probably have a better understanding of modern central banking than most non-MMTers, certainly better than mine. They see the central bank targeting rates, and when the target changes, there is often almost no immediate change in the monetary base. Instead, things like loans may pick up. To prevent the interest rate from deviating from the target, the central bank is virtually forced to respond to those bank actions by adding more reserves. This makes the monetary base seem endogenous, and in the extremely short run it is, at least under modern central bank practices. In the future, the advent of IOR may make central banking resemble the MMTers model even more closely.
Nevertheless, even though money seems endogenous, it actually isn’t. A permanent peg of the interest rate would leave prices unanchored, or indeterminate. Thus the central bank moves rates around in a fashion that will eventually move the monetary base around in a fashion that will tend to keep P and NGDP on the target growth path. So the base is actually doing all the heavy lifting, even though the specific procedure used by central banks makes it seem like the tail of the dog.
That’s why it’s so important to do thought experiments with monetary regimes lacking a banking system. This allows us to first work out the basic principles of what determines the price level, i.e. what determines the value of money. Once we’ve done that we can ask whether adding banking actually changes anything fundamental. I say it doesn’t, but obviously the MMTers disagree.
Still it seems to me that anyone attacking my position first needs to develop a model of the price level (not inflation, but the level of prices.) I’m convinced that only the QTM can do this, and still explain why Australia and Canada have similar price levels but Canada has more than 5 times as large government liabilities. My answer is that both countries have similar currency stocks (per capita.) And it’s the currency stock that matters; not total government liabilities.
The best way to understand modern sophisticated central banking is to study the most primitive monetary system possible–a medieval king debasing his money in a country lacking banks. The causal chain between debasement and inflation is no different from the causal chain between OMPs of T-securities and inflation, at least in the long run when nominal rates rise above zero.