Tyler Cowen recently linked to a post by Ashwin claiming that the US might now be a credit economy, and that this weakens the old quantity theory of money. This hypothesis is based on two misconceptions. Here Ashwin quotes Alex Leijonhufvud:
The situation that Wicksell saw himself as confronting, therefore, was the following. The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand. This omission had become a steadily more serious deficiency with time as the evolution of both “simple” (trade) and “organized” (bank-intermediated) credit practices reduced the role of metallic money in the economy. The issue of small denomination notes had displaced gold coin from circulation and almost all business transactions were settled by check or by giro; the resulting transfers on the books of banks did not involve “money” at all.
If we were moving to a credit economy then the demand for currency and base money would be declining. But it isn’t, indeed it is higher than in the 1920s. Admittedly this is partly due to the Fed’s decision to pay interest on reserves. But even the currency component of the base is larger than in the 1920s, even as a share of GDP! It is not true that the various forms of electronic money and bank credit are significantly reducing the demand for central bank produced money.
Here Ashwin quotes Claudio Borio and Piti Disyatat:
The amount of cash holdings by the public, one form of outside money, is purely demand-determined; as such, it provides no external anchor. And banks’ reserves with the central bank – the other component of outside money – cannot provide an anchor either: Contrary to what is often believed, they do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments.
This is a common misconception, especially among Keynesians and MMTers. It is true that central banks often set a short term interest rate target, and that once this target is set short run changes in the base are endogenous. But if that’s all they did then the price level would become indeterminate. Instead, they use their monopoly control over the base to move interest rates around in such a way as to target the price level. Because money is neutral in the long run, a given change in the monetary base will produce a proportional long run change in the price level and NGDP. Borio and Disyatat did acknowledge that rates are adjusted to target macro goal variables, but they failed to see the implication of that observation.
This can best be explained with an analogy. In 1973-74 the OPEC oil cartel decided to increase the price of oil from $3 to $10 a barrel. At the new price, quantity supplied was completely demand determined, OPEC responded passively to consumer demand at that new price point. OPEC had no short run control over the supply of oil. But that’s not at all what economists think is “really going on.” OPEC was able to raise prices by virtue of its ability to sharply reduce would oil supply. When we teach this in class, we show a leftward shift in the world oil supply curve. Or we might show a monopoly diagram with OPEC picking the output point where MR=MC. In either case, they are only able to control prices by controlling quantity. Indeed they could have even decided not to set an official price, and instead merely set a sharply reduced output level—the effect would have been the same.
When the Fed eases monetary policy we generally notice them cutting their fed funds target. But the exact same effect would occur if they simply increased the base, and let the fed funds rate fall in the free market. Indeed they basically tell their trading desk to adjust the base as need to keep market rates at a desired level. But it doesn’t have to be that way—they could just as well tell the New York trading desk to adjust the base as needed to keep CPI futures contract prices at a 2% premium over the spot level. In that case no one would say; “the Fed controls the CPI by controlling the CPI.” They’d say; “the Fed controls the CPI by adjusting the amount of base money in circulation.” Today people say; “The Fed controls the CPI by controlling the fed funds rate.” In fact, they control the CPI by controlling the size of the monetary base in such as way as to produce a monetary base and interest rates that are expected to lead to 2% inflation.
There will probably always be money; a pure credit economy is unthinkable. Without money there is no price level, because the price level is defined as the average price of goods in terms of money.
PS. Some might object that a higher proportion of currency is now held overseas. But nothing in the QTM requires currency to be held in the country where it is produced. Double the currency stock and the price level will double, ceteris paribus, regardless of where currency is held.