I’m not the sort of monetarist who focuses on money supply growth rates, even though I believe changes in the money supply drive nominal aggregates. The reason is that modern central banks tend to adjust the money supply to offset monetary demand shocks. On the other hand I don’t regard the money supply as endogenous, because they don’t fully offset money demand shocks. Nominal aggregates do change.
When I was about 17 I read something by Milton Friedman that had a profound effect on my subsequent development as a macroeconomist. He was discussing the super-neutrality of money, and pointed to one exception; changes in the money supply growth rate will end up changing the rate of inflation, and hence the real demand for money. He showed with some ingenious graphs what would happen if a central bank suddenly slowed the rate of inflation, say from 5% to 0%. This was pre-rational expectations, so he assumed they simply slowed the money supply growth rate. That would lower inflation and raise the real demand for money. Now the central bank could temporarily raise the money supply growth rate to accommodate the public’s higher real demand for money, without triggering higher inflation. But once they had satisfied the demand for higher real cash balances, they’d have to go back to the slower money growth rate, and maintain the lower rate indefinitely. The transition period would probably involve a recession. So it’s slower money growth, followed by a spurt of faster growth, followed by slower growth. That’s what it looks like when the central bank shifts to a lower expected rate of inflation (or NGDP growth, as I’d prefer.) Keep that in mind as you examine this graph, from a study by Michael Darda:
Notice how money growth slows sharply in 2007-08, then a severe recession drives interest rates close to zero, then monetary growth temporarily soars at the end of 2008, and then in recent years it settles to a new and much slower growth rate. The “new normal” in the eurozone.
So the last 5 years show exactly the M1 growth pattern that Milton Friedman suggested (way back around 1970) that you would see if a central bank shifted to a lower trend rate of inflation.
BTW, I feel that my awareness of the super-neutrality of money inoculated me against Keynesian macro, which is what I was taught as an undergrad at Wisconsin. I kept asking (to myself): “If there’s an AD problem, an NGDP problem, why not just increase the money supply growth rate?” A few years later old Keynesianism was dead, as the new Keynesians basically adopted Friedman’s insight. And if a central bank was bound and determined to resurrect old Keynesianism, there is no better way than to drive interest rates to zero and simultaneously institute labor market distortions that raise the natural rate of unemployment.
Sorry for that boring trip down memory lane, Michael Darda’s comments are much more interesting:
As the chart to the right shows, the run on Spanish and Italian debt markets began soon after the ECB began to hike rates. Now, with debt markets under immense strain and inflation expectations collapsing, the Wicksellian natural interest rate has likely collapsed to levels well below where it was this spring, meaning the ECB will have to be much more forceful in easing policy than it was in tightening it if it hopes to get in front of the curve. Taking rates down in 25-basis-point “baby steps” is highly unlikely to suffice at this point.
As we noted yesterday, market-based indicators of inflation risk in the eurozone have collapsed. This is a problem because of the real exchange rate misalignment in the eurozone (i.e., peripheral costs are high relative to core costs): The lower the rate of inflation in the core, the higher the rate of deflation in the periphery. We can see this starkly now in the behavior of German and Italian breakeven inflation spreads: As the German five-year breakeven spread has collapsed to below 1%, Italian breakeven spreads have plunged into negative territory. The ECB’s monetary errors are now creating the real risk of a deflationary collapse in the periphery, meaning that no amount of austerity would be able to balance budgets or reduce deficits.
The surge in corporate bond spreads in the eurozone now suggests that nominal GDP could plunge by 3%-6%, which would be a disaster for both peripheral and core budgets.In short, credit markets have tightened massively in the eurozone; if the ECB does not act in a resolute enough manner to offset this tightening (and, so far, it has not), then it will have to shoulder the blame for presiding over perhaps the largest monetary catastrophe since the 1930s.
And yet most pundits keep focusing on side issues, such as rising government default risk, fiscal austerity, bailouts, fiscal union, eurobonds, etc.
Macroeconomics is normally quite difficult. When NGDP is growing at a steady 5% rate, then macro is like a plate of spaghetti; a dizzyingly complex set of interactions at various financial, economic and political levels. But when monetary policy goes seriously off course, then macro becomes incredibly simple. It’s the falling NGDP, stupid.
Fix that, and only the complicated problems remain!