Archive for March 2013


Money and Inflation, Pt 3 (The Quantity Theory of Money and the Great Inflation)

Here’s my Russ Roberts Podcast.  Patrick sent me my AEI presentation and my Larry Kudlow interview (67 minute mark, 3/23/13).

There are two aspects of fiat money that make the supply and demand for a fiat currency differ from the commodity money model:

1.  The government has almost unlimited control over the stock of currency, and can produce currency at near zero cost.

2.  The demand for money becomes unit elastic, in response to changes in the value of money (1/P).

Here’s how the money supply and demand graph looks for fiat currency:


Monetary policy has switched from influencing the demand for the MOA (under the gold standard), to a policy of influencing the supply of the MOA (although money demand is also affected by Fed policies.)  The Fed can shift the supply curve to the left or right via open market operations or discount loans.  Thus the “supply curve” is actually a policy tool, representing the quantity of base money.

In the past I used to teach the quantity theory of money with a “helicopter drop” example, but I now see that won’t work—people get the wrong message.  Traditional OMOs also confuse people.  More specifically:

1.  Some Keynesians believe it matters a lot whether the currency is introduced via a “helicopter drop” or OMOs.  The term ‘helicopter drop’ actually refers to combined monetary/fiscal expansion.  Money dropped out of helicopters is sort of like “welfare” payments, and it’s also an expansion of the money stock.  So it’s like paying for a new entitlement program by printing cash and spending it.  But these Keynesians are wrong.  The fiscal effects are utterly trivial as compared to the monetary effect, at least during normal times.  Increasing the base by 0.2% of GDP during normal times is a big deal.  Increasing debt held by the public by 0.2% hardly matters at all.

2.  Some Austrians worry about “Cantillon effects,” which means they think it’s important to consider who gets the money first.  (Although the term also has other meanings). They assume that that lucky group will boost its spending.  Yet the money is not given away, it’s sold at market prices.  So the person getting the money first is not significantly better off, and hence has little incentive to buy more real goods and services.

Both errors share something in common—the notion that money injections matter because “people with more money will spend more.”  But this subtly confuses wealth and money.  In everyday speech we might say; “a billionaire buys a big yacht, because he has lots of money.”  But we really mean he has lots of wealth.  The billionaire might have very little cash.  So if we are truly going to understand the pure effects of monetary injections (without fiscal or Cantillon effects), we have to consider a form of injection that doesn’t appear to make anyone “better off,” so that people would have no obvious reason to go out and buy more stuff.

I’d like to assume that money is injected according to the following formula:  Suppose there are 100 million Americans that get substantial checks from the government each year (more than $200).  These include tax rebates, veterans benefits, unemployment insurance, government worker salaries, Social Security, etc.  A cross section of America.  The Fed wants to increase the base by $20 billion this year.  Have the Treasury pay each of the 100 million Federal check recipients the first $200 due to them in cash, and the rest by check.  In this case people are not getting any additional money, it’s just that some of it comes in the form of cash rather than the usual checks.  If the Fed had decided not to increase the base, the extra $200 would have been paid by check.  That is the essence of monetary policy, with no distracting bells and whistles.

People don’t want to hold that much extra cash, so they’ll get rid of it.  But how?  Obviously not by burning it.  Now we come to the concept that lies at the heart of money/macro—the fallacy of composition.  Individuals can get rid of the cash they don’t want, but society as a whole cannot, at least not in nominal terms.  How do we reconcile that seeming paradox?

Take an example where the Fed doubles the currency stock, from $200 to $400 per capita (shown in the graph.)  How do we reach a new equilibrium?  In the short run prices are sticky, and short term interest rates might fall.  But over time prices will adjust, and the public will reach a new equilibrium where they are happy holding $400 per capita.  How much do prices have to rise for supply to equal demand at the original interest rate?

If we assume that people care about purchasing power rather than nominal quantities, then prices must double, so that the purchasing power of the stock of cash returns to its original level.  Say that people used to hold enough cash to make one week’s worth of purchases ($200.)  Then prices must rise until one week’s worth of purchases costs $400.  In other words prices rise in proportion to the rise in the currency stock.  And that means the demand curve for the MOA is unit elastic.  In contrast, when silver (or gold) was the MOA, the demand for those assets was not unit elastic.  Currency is special.  Its only value is its purchasing power—it has no industrial uses at all (unlike gold.)

The assumption of a unit elastic demand for currency leads to the Quantity Theory of Money.  If you double the money supply, the value of money will fall in half, and the price level will double.  Of course this assumes the demand for money does not change over time.  But money demand does change.  It would be more accurate to say; “a change in the money supply causes the price level to rise in proportion, compared to where it would be if the money supply had not changed.”  But even that’s not quite right because (expected) changes in the value of money can cause changes in the demand for money.  So all we can really say is:

One time changes in the supply of money cause a proportionate rise in the price level in the long run, as compared to where the price level would have been had the money supply not changed.

That’s because one time changes in the money supply probably don’t shift the real demand for money in the long run.  This is a somewhat weaker version of the QTM, but is the most defensible version.  In my view the QTM is most useful when there are large changes in the supply of money, and/or over the very long run.  Especially when there are large changes in the supply of money, year after year, over a very long period of time. In other words, international data over a long period during the global Great Inflation.  Robert Barro’s macro text (4th ed.) has the perfect data set for thinking about the QTM; 83 countries, over roughly 30 years, when inflation rates were very high and varied dramatically from one country to another.  Here are the top 10 and the bottom 10 on the list:

Country     MB growth    RGDP growth    Inflation   Time period

Brazil              77.4%             5.6%                 77.8%        1963-90

Argentina        72.8%             2.1%                 76.0%        1952-90

Bolivia             49.0%            3.3%                  48.0%        1950-89

Peru                49.7%             3.0%                 47.6%        1960-89

Uruguay          42.4%             1.5%                 43.1%         1960-89

Chile               47.3%             3.1%                 42.2%        1960-90

Yugoslavia       38.7%             8.7% (FWIW)     31.7%         1961-89

Zaire               29.8%             2.4%                  30.0%       1963-86

Israel               31.0%             6.7%                 29.4%        1950-90

Sierra Leone     20.7%            3.1%                  21.5%        1963-88

.  .  .

Canada            8.1%              4.2%                  4.6%         1950-90

Austria             7.1%             3.9%                   4.5%         1950-90

Cyprus            10.5%            5.2%                   4.5%         1960-90

Netherlands      6.4%             3.7%                   4.2%         1950-89

U.S.                 5.7%              3.1%                   4.2%        1950-90

Belgium           4.0%             3.3%                   4.1%         1950-89

Malta               9.6%             6.2%                    3.6%        1960-88

Singapore       10.8%            8.1%                     3.6%        1963-89

Switzerland       4.6%             3.1%                   3.2%        1950-90

W. Germany     7.0%             4.1%                    3.0%        1953-90

Homework for today:

Answer the following 5 questions and you’ll understand the QTM:

1.  Does the “eyeball test” provide more support for the QTM in the low or the high inflation countries?  What does this tell us about its actual applicability to each group?  How does its relative applicability to each group depend on which of the definitions of the QTM (discussed above) is used?

2.  In 71 of the 83 countries the money growth rate exceeds inflation, and in 12 the inflation rate exceeds the money growth rate.  Explain why the ratio is so lopsided.

3.  The gap between money growth rates and inflation exceeds 10% in only one of the 83 countries (Libya–not shown.)  Why does the gap rarely exceed 10%?

4.  Do most of the twelve cases where inflation exceeds money growth occur in low or high inflation countries.  Explain why.

5.  Explain what sort of inflation data would better explain the gap: average inflation rates, the change in the inflation rate, or changes in the expected inflation rate.

I’ll answer tomorrow in the next post.  The commenter with the best set of answers gets a gold star.

Recommended reading

David Glasner has done some excellent posts on the relationship between Keynes and Hawtrey during the 1920s and 1930s.  Like David, I’m a big fan of Hawtrey.

Tyler Cowen has a post showing that it can be done—New Zealand has abolished deposit insurance.  They were also the first to do inflation targeting.  Let’s hope their “open bank resolution” regime also catches on.

Matt Yglesias gets the entire Cyprus–Germany thing exactly right.

Ed Dolan provides a good survey of everything you need to know to understand the Cyprus crisis.  I especially liked this comment:

Although some kinds of financial losses may net out against one another, when the dust settles, we find that there are real losses behind all the paper. For example, behind the 2008 financial crisis in the United States, Ireland, Spain and several other countries there were wild overinvestments in real estate. Houses and condos were built that no one wanted to buy, at least not for enough to pay for the bricks and the wages of the bricklayers. In Cyprus, funds supplied by bank depositors were used to buy Greek government bonds, which, in turn, were used to pay the salaries of Greek bureaucrats to do work that critics claim was unproductive and overpaid. There is no way to recapture that wasted labor now..

I’d guess the Department of War Defense wastes more resources each year than the US wasted during the entire housing bubble.  I’ve always found it implausible that allocating a few hundred thousand excess workers to home building in the mid-2000s, and a few hundred thousand too few workers to services and manufacturing, has any bearing on why the US economy has performed poorly in the 4 years since 2009.  Adam Smith said something to the effect that “there is a great deal of ruin in a nation.”  He should have added; “as long as the central bank keeps NGDP gradually increasing.”

David Brooks on prediction:

Suppose you’re asked to predict whether the government of Egypt will fall. You can try to learn everything you can about Egypt. That’s the inside view. Or you can ask about the category. Of all Middle Eastern authoritarian governments, what percentage fall in a given year? That outside view is essential.

Most important, participants were taught to turn hunches into probabilities. Then they had online discussions with members of their team adjusting the probabilities, as often as every day. People in the discussions wanted to avoid the embarrassment of being proved wrong.

In these discussions, hedgehogs disappeared and foxes prospered. That is, having grand theories about, say, the nature of modern China was not useful.

If you asked me why I believe China will become a developed country, these would be my top 5 arguments:

1.  Taiwan

2.  Hong Kong

3.  Singapore

4.  South Korea

5.  Japan

Strongest argument against:

1.  North Korea

PS.  I use to be very skeptical when I read reports that China wouldn’t overtake the US in total GDP until 2029, or 2040, or whatever.  It always seemed to me like it would be much sooner.  Now the OECD seems to agree—putting the date at 2016.  Earlier this year I did a post claiming it had already happened.  Glad to see the conventional wisdom moving in my direction.  Of course it will still be far from developed.

PPS.  Want to see my top six arguments for why North Korea will eventually become developed?

PPPS.  Non-economic, but recommended—Roland Kelts compares Japan, Britain, China and America.  Also, I just finished “Cezanne: A Life” by Alex Danchev.  I’m not a big fan of biographies, but the second half of the book is recommended if you have an interest in Cezanne, or in the art of painting.  And doesn’t one imply the other?  There are painters that are towering talents (Titian, Rubens, Rembrandt, Van Gogh, Picasso) and those whose best work seems inexplicable, a sort of minor miracle (Piero della Francesca, Velasquez, Vermeer).  I put Cezanne in the second group.  How did he do THAT?

Kudlow on market monetarism

As a moderate supply-sider, I’ve always been a fan of Larry Kudlow.  (Although he’s a bit more of a true believer than I am.)   However in recent years I’ve disagreed with his views on monetary policy.  TravisV sent me a Joe Weisenthal piece suggesting that Kudlow is becoming more sympathetic to market monetarism:

CNBC host Larry Kudlow is a throwback to an ’80s-style supply-side conservative, who has maintained that any interference in the free market is damaging, the dollar should be strong, and inflation is the primary evil against which the Fed should be on guard.

.  .  .

But following the election of 2012, and the improvement in the economy, the fever is breaking a bit, and a new strain of thinking on monetary policy is infecting the mainstream right.

And today in The National Review, Kudlow makes a stunning admission: Ben Bernanke might have been right all along.

Kudlow’s piece draws on the hot school of “Market Monetarists” who draw on the work of Milton Friedman to endorse the idea that the best Fed policy is one that pursues a Nominal GDP target.

This idea, that the Fed should pursue a stable Nominal GDP path has fans on Wall Street (Goldman’s Jan Hatzius is one), in academia (Scott Sumner, David Beckworth, Michael Woodford), at the Federal Reserve (Janet Yellen, the likely next Fed chair has all-but endorsed it), and various corners of the media (Ramesh Ponnuru, Ryan Avent, and Matt O’Brien).

Kudlow isn’t totally sold on it yet, and he’s still worried about gold prices and King Dollar, but he writes:

… if I have this story right, the market monetarists want the central bank to enforce a nominal GDP growth rule, which will avoid both deflation and inflation, and thus give fiscal incentives breathing room for a more rapid job-creating expansion.

I don’t agree with Bernanke’s unemployment target or his criticism of lower government spending. But I confess that he may have the monetary-stability story more right than I originally thought.

If gold remains soft, and King Dollar steady, perhaps the former Princeton professor deserves a little more credit. He may have gotten that story right.

In all seriousness, this is very cool. People don’t change their mind nearly enough, especially in the realm where politics meets economics.

A big share of the credit here for this shift definitely goes to Jim Pethokoukis, who has been using his perch at AEI to school conservatives about monetary policy, and to debunk the idea that Bernanke is some crazy reckless dove who is not worried about inflation at all.

In fact, Pethokoukis is holding an event tomorrow at AEI, featuring Ryan Avent, David Beckworth, and Scott Sumner on revamping the Fed and the idea of market monetarism. You’ll be able to watch it live online at noon, and hopefully get a glimpse of new monetary ideas on the right that aren’t all about hard money.

It’s been a very busy period for me.  I did a one hour Econtalk with Russ Roberts that should be up on Monday.  Yesterday I did the AEI panel.  I was also interviewed by a Brazilian journalist.  And today at 11:45am I’m scheduled to be interviewed on Larry Kudlow’s radio show.  I believe it’s WRKO in Boston (syndicated nationwide.)

PS.  I agree that Jim Pethokoukis deserves a lot of credit for selling market monetarist ideas to conservatives.

PPS.  I plan to spend the next week or so working on taxes—so blogging will be slow.  Another reason to abolish the income tax and replace it with a progressive payroll tax!!

I will get to the comment backlog today.

Ryan Avent on the Fed’s timidity

I’ve done many posts making the following two arguments:

1.  Interest rates will remain low for the foreseeable future.  The “new normal” during the 21st century will be unusually low real interest rates on Treasury securities, and short term nominal rates are likely to hit zero in future recessions.

2.  The Fed tends to follow the conventional wisdom—at any given time Fed policy is roughly what a consensus of respected macroeconomists favors.

I’ve argued the Fed needs to adopt a new policy regime going forward—interest rate targeting won’t work at low rates.  One option is a higher inflation target, although I’d prefer NGDPLT.

Bill Woolsey sent me a Ryan Avent post that suggests the Fed has all but admitted that interest rates will be lower going forward, and that in retrospect a slightly higher inflation target (or some other option) might have been better, but it’s up to the academic profession to come up with the new regime.  Here’s Ryan:

At today’s post-meeting press conference, I attempted to ask Ben Bernanke whether the FOMC was concerned about the lack of a cushion between the fed funds rate and the ZLB and whether the FOMC had considered adjusting policy to address the issue””by raising the long-run inflation target, for instance. His answer, essentially, was that the Fed had only just announced its 2% inflation target and had no plans to change it. And he reckoned that weighing the costs and benefits of ZLB events with an eye toward computing the optimal inflation target was a matter for academic debate. Some research suggests that at low inflation rates an economy will hit the ZLB more often than was previously assumed, he noted, which might make the cost-benefit trade-off of a higher target more attractive.

Fair enough; monetary economists have and will continue to debate these points. But the issue is not merely academic. Most of the other questions at the press conference concerned the problem of continued high unemployment and the Fed’s assessment of the risks of unconventional policy. We are living the consequences of the ZLB and the Fed’s best estimates have America right back in the same hole when the next recession hits. If the Fed is simply waiting for academia to sort things out, that’s really disconcerting. Alternatively, if the Fed is actually pretty comfortable using unconventional policy and not particularly worried about rolling it out again during the next downturn then one has to ask why it isn’t doing much more now to address unemployment.

The answer doesn’t have to be a higher inflation target. It can be a commitment to treat the current target more symmetrically (that is, to err above as often as it errs below). Or it could be a switch to an NGDP level target. But right now, the Fed’s answer seems to be: get used to nasty recessions and insufficient monetary responses, suckers. At least until academics tell us its safe to try something new.

PS.  I’ll have limited time for blogging over the next month or so.  Several people sent me the Bank of England’s critique of NGDP targeting.  Market monetarists have already addressed all the objections they raised.  But the one that made me smile was the fear that the public might not understand a policy of keeping the total aggregate income of the British people growing at 4% per year as well as they “understand” inflation targeting.  Then the report presented this graph showing British inflation zooming far above target since 2008.  We also know that the BoE is looking for excuses to be even more expansionary.  That’s fine, I also think policy should be easier in the UK.  But looking at that graph does anyone seriously believe the British public understands what the BoE is up to?  On the other hand if they looked at a graph of NGDP (which has slowed sharply), wouldn’t that make it easier to explain to the public why they want to ease?

Update:  It was a Treasury report, not the BoE.

Screen Shot 2013-03-20 at 10.09.37 PM

PPS.  Another Ryan Avent post presents this graph:

Screen Shot 2013-03-21 at 8.22.37 AM

Do Keynesians really believe Britain’s problems are due to fiscal austerity?

Money and inflation, Pt. 2 (Why does fiat money have value?)

The previous post described the long phase-out of the gold standard.  During the commodity money era we developed a dual medium of account (MOA), both gold and cash were MOAs.  For there to be two media of account, the price of one in terms of the other must be fixed.  Once gold prices started rising in 1968, only currency remained a medium of account; gold became a mere commodity.  (Silver was demonetized in the 1800s.)

Why does fiat money have any value at all?  This is actually two subtly different questions.  First, what is the value to society of having a medium of account?  And second, how can a fiat medium of account have value?  The MOA generally serves as a medium of exchange, and to some extent a store of value.  How valuable is an asset that fills those roles?   A medium of exchange is probably worth something like 1% of GDP, and as a store of value the MOA is worth another 1% to 10% of GDP.  How do we know this?  Because MOA traditionally didn’t pay interest, and hence the net present value of foregone interest from holding the entire stock of cash is simply the currency stock itself.  And currency stocks tend to be about 2% to 11% of GDP.

Thus if the nominal interest rate was 5%, and the currency stock was $1 trillion, then the (opportunity) cost of holding currency was $50 billion per year in foregone interest.  That could be viewed as the flow of liquidity services provided by currency (unfortunately including the flow of tax evasion services.)  If you divide this perpetual service flow by 5% to get its net present value, you get $1 trillion, which is the currency stock.

So what do people mean when they say that fiat money is “intrinsically worthless?”  They mean it has no value if it loses the role of being the MOA, whereas gold and silver had significant value in other areas of life.  (I.e. Confederate paper money after the Civil War.)  So this begs the deeper question:  Yes a monetary system is valuable, but what explains why this particular asset is accepted as money?  What gives it value?  There are several theories, which are not mutually exclusive:

1.  Its nominal price is fixed (unlike T-bills), which makes it convenient in transactions.  It comes in convenient small denominations (unlike T-bills).  Private small denomination currency issue may be banned.

2.  There is a sort of social contract/network effects/focal point thing going on.  People accept it as money because others accept it as money.

3.  There is an implied backing in an emergency.  For instance, if technological change was expected to make cash obsolete in the year 2047, the public may believe (correctly in my view) that the government would redeem it for some sort of real asset, rather than allowing hyperinflation.  One could think of this as the public having confidence that the government will do what is necessary to prevent hyperinflation in the future.

4.  The government allows one to pay taxes with currency.

5.  And in deference to Mike Sproul, because the cash is “backed” by assets on the central bank balance sheet.  (I don’t think this one matters, but it’s arguably related to point 3.)

Obviously all 5 reasons may be true, and they may work together.  It’s also worth discussing the peculiar evolution from gold-backed currency to fiat dollars.  I own a 1928 $20 bill, which looks almost exactly like a 1995 $20 bill.  Indeed pretty much like a just issued twenty, except Jackson’s portrait was smaller in the 20th century.  But the 1928 and 1995 twenties were radically different.  In 1928 the public viewed gold-backed currency as we would view personal checks;  “an interesting piece of paper–now let’s see if we can take it to the Treasury (or bank) and get some real money.”  In 1928 “real money” was gold, whereas in 1990 we took a personal check to the bank to try to get “real money” in the form of cash.  So the monetary system evolved one level, what was considered debt in 1928, is no longer viewed as debt.  Cash is now the ultimate form of liquidity.  Cash can’t be cashed into anything more liquid.

Under the modern gold standard people actually used relatively little gold for transactions, mostly preferring cash and small coins.  So they got used to viewing cash as money.  To an economist studying inflation, the 1968 decision to end gold’s role as a medium of account seemed momentous.  But the public just yawned—they were already used to cash being the only MOA of relevance to their lives.  Appearances are very important—if something is regarded as money, it’s money.

From that point on “the social contract/network effects” story was probably enough, but clearly other factors like implied backing/stable monetary policy are lurking in the background.  If the public suddenly expected a policy of hyperinflation to be adopted in 2014, the value of cash would collapse right now.

This post has already run too long, so I’ll do the quantity theory of money in the next post.  We’ll see how the central bank can control the value of money (and NGDP), by changing the currency stock.