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Saving Monetarism from Friedman and the Keynesians

Monetarism is a good idea that has been poorly executed. At its heart, the core principle of monetarism is that “money matters” to economic outcomes. More specifically, money creation, in excess of growth in real output, is the leading cause of inflation over long periods of time.

This is a “good idea”, an idea that has been shown to be true in hundreds of empirical studies. Unfortunately, monetarism has largely faded from view due to its one key underlying weakness: its inability to correctly articulate the transmission mechanism from money creation to inflation.

Monetarism’s failure in this regard stems from the fact that most advocates of monetarism were (and still are) in-the-closet Keynesians.

Monetarism, as it is presented in the textbooks today, is built on a foundation of Keynesian theory. More specifically, monetarism accepts wholeheartedly the inherently Keynesian notion that supply and demand for money determines the interest rate.

For all the great work done by Milton Friedman, Friedman never challenged this core principle of Keynesianism. And yet, it is this one flawed Keynesian principle that undermines the true potential of monetarism.

The view of The Money Enigma is that monetarism needs to be reinvented. This reinvention needs to start at the most fundamental level by recognizing that (a) the price level is a function of both the market value of goods and the market value of money, and (b) supply and demand for money (or more specifically, supply and demand for the monetary base) determines the market value of money, not the interest rate.

The market value of money is the denominator of the price level. Creating too much money, relative to output growth, over long periods of time reduces the market value of money, thereby raising prices as expressed in money terms. This is the primary transmission mechanism from too much money to inflation. The Keynesian view of the transmission mechanism, namely that too much money lowers interest rates and creates “too much demand”, is at best a secondary transmission mechanism.

A Quick Overview

The view of The Money Enigma is that the price level is a ratio of two market values: the market value of the basket of goods (“V_G”) and the market value of money (“V_M”). The market value of goods is the numerator of the price level: as the market value of goods falls, the price level falls. The market value of money is the denominator of the price level: as the market value of money falls, the price level rises. This theory is called “Ratio Theory of the Price Level” and was discussed in last week’s post.

At the most basic level, Ratio Theory implies that the inflationary outcome of any policy action needs to consider the impact of that policy on both (a) the market value of goods, and (b) the market value of money.

Historically, most monetarists have focused only on the impact of money creation on the numerator in our equation: the market value of goods. In essence, the traditional monetarist view is that base money creation leads to lower interest rates and, in turn, lower interest rates lead to an increase in aggregate demand. This lift in economic activity leads to “tightness” in the system as demand outpaces supply, the market value of goods rises and, therefore, prices rise.

This “monetarist” view is, in fact, an inherently Keynesian view of the world. In essence, it is a modified version of the view that inflation is created by “too much demand”.

The only real adaption by the monetarists is that it is too much money that creates too much demand which, in turn, leads to higher prices as the economy pushes up against its capacity limits. Moreover, this view implicitly assumes that money creation can not create inflation if the economy does not “overheat”.

The problem with this view of the monetary transmission mechanism is that it denies any role for the impact of money creation on the market value of money, the denominator in our equation.

Traditionally, monetarists have left themselves no other choice but to ignore the role of the “value of money”. The reason for this extraordinary oversight is that most monetarists, including Milton Friedman, ascribe to the view that supply and demand for money determines the interest rate. There is no role for the “market value of money” in current monetarist thinking because monetarists don’t recognize the market value of money as a variable in their equations nor do they recognize that supply and demand for money determines the market value of money. Therefore, monetarists are left with only one avenue to explain the impact of money on the price level: more money equals lower interest rates equals too much demand equals higher prices.

The view of The Money Enigma is that this (Keynesian) transmission mechanism is, at best, only a secondary transmission mechanism. This sequence of events can lead to higher prices, but it is of secondary importance.

The primary transmission mechanism from money creation to inflation is far more direct. Supply and demand for money determines the market value of money (see recent post “Supply and Demand for Money: Where Keynes Went Wrong”). Creating “too much money” leads to a fall in the market value of money and a rise in the price level.

Over long periods of time, creating too much money, relative to output growth, leads to a direct reduction in the market value of money. The market value of money is denominator of every money price in the economy. Therefore, as the market value of money falls, the price level rises. This is the primary transmission mechanism and is the primary reason for why base money growth in excess of real output growth leads to a rise in the price level over time.

Monetarism needs to throw out Keynes’ liquidity preference theory playbook and focus on what really matters: the impact of money creation on the market value of money. Once monetarists begin to do this, we can have a much more sensible debate about the role of monetary policy and the risks of aggressive monetary policies such as quantitative easing. Moreover, monetarists may be able to construct a better model to explain why significant levels of monetary creation lead to high inflation on some occasions but not on others, an issue we will discuss briefly at the end of this article.

But before we continue with this debate, let’s step back and see put these ideas in context.

Why Do Prices Rise?

Before we can begin a discussion about the role of money in price level determination, we need to be able to answer a simple microeconomic question: “why do prices rise?”

Let’s ignore complicated macroeconomic theory for a moment and think about the price of apples in money terms. What could explain a rise in the dollar price of apples?

In order to answer this question, we need to ask a more fundamental question: “what is a price?”

A price is a ratio of two quantities exchanged.

The price of apples, in dollar terms, is the ratio of two quantities exchanged: a quantity of dollars for a given quantity of apples. For example, the price of an apple might be two dollars for one apple.

At the most basic level, this ratio of quantities exchanged is determined by the relative market value of the two items that are being exchanged. More specifically, the ratio of the two quantities exchanged is the reciprocal of the ratio of the market value of the two goods. This relationship is illustrated in the slide below.

What does this means in non-technical language? Well, all the formula above is really saying is that if one apple is twice as valuable as one dollar, then the price of one apple, in dollar terms, is two dollars.

That’s not rocket science. If one thing is worth twice as much as another, then you will have to offer two of the second thing to purchase one of the first thing.

What makes the slide above slightly more technical is the way in which the property of “market value” is being measured.

Price is a relative measurement of market value: a price measures the market value of one good in terms of another. However, it is also possible to measure the market value of a good independently of the market value of another good by adopting a “standard unit” for the measurement of market value.

In the slide above, V(A) and V(B) represent the market value of goods A and B respectively as measured in terms of a “standard unit” for the measurement of market value. In this sense, both measurements can be considered to be absolute measurements of the market value of A & B.

The measurement of market value is an important and somewhat complex subject. I highly recommend that you read the following post “The Measurement of Market Value: Absolute, Relative and Real” when you have some time.

So, let’s return to the original question: “Why do prices rise?”

If price is a relative expression of the market value of two goods, then there are two primary reasons for why the price of a good may rise. The price of one good (the “primary good”), in terms of a second good (the “measurement good”), may rise for one of two basic reasons: either (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

The first explanation for a rise in the price of the primary good should be obvious. If the primary good becomes more valuable, then it will require more units of the measurement good to purchase it.

The second explanation is less obvious and, for some reason, seems to evade professional economists. If there is no change in the value of the primary good, but the measurement good becomes less valuable, then it will require more units of the measurement good to purchase the same number of units of the primary good.

In our money-based economy, the good most often used as the “measurement good” is money. The market value of all things is measured in money terms. Therefore, if the market value of money (the measurement good) falls, all else remaining equal, it will require more units of money to purchase the same basket of goods and services.

In the slide above, we have isolated the market value of the basket of goods and the market value of money by measuring each in terms of a “standard unit” of market value (a theoretical and invariable unit). By doing this, we can clearly see that the price level is a function of two variables: (a) the market value of the basket of goods, and (b) the market value of money.

How Does Creating Money Impact the Price Level?

Let’s think about this question using the Ratio Theory framework presented above. How might creating money impact: (a) the market value of the basket of goods (the numerator of the price level); and (b) the market value of money (the denominator of the price level).

(a) Impact on The Market Value of Goods

Arguably, we might expect that an expansion in the monetary base leads to an increase in the market value of goods. I use the term “arguably” because it is not clear, nor certain, that an expansion in the monetary base leads to an increase in the market value of goods.

When money is created, that money is used. In the current system, the central bank uses that money to buy government fixed-income securities, thereby raising the price of those securities and lowering the interest rate on those securities.

The Keynesian view is that this process of creating money and using it to suppress interest rates leads to higher aggregate demand (more consumption, more investment). This increase in demand leads to tightness in the economic system that, in turn, leads to higher prices and wages.

As is common with Keynesian theory, this analysis seems quite plausible. Unfortunately, it also misses half of the picture.

The view of The Money Enigma is that lowering interest rates increases both aggregate demand and aggregate supply.

When the central bank lowers “the interest rate”, the central bank effectively lower the required return on capital across the entire risk spectrum. This is a subject that was discussed in a recent post titled “Interest Rate Manipulation and the Illusion of Prosperity”, so I won’t discuss it in too much detail here. But the bottom line is that when the Fed buys government bonds, it creates a domino effect across all risk assets, raising the price of those assets and lowering the expected/required return on those assets.

Lowering the required return on capital leads to an increase in aggregate supply. At the margin, a lower required return on capital allows more new businesses to be formed and allows more existing business to expand capacity.

If both aggregate demand and aggregate supply curves shift to the right, then the impact on the market value of goods is likely to be negligible. While there may be an increase in economic activity, that increase in economic activity is met with an increase in capacity. Therefore, the net effect on the market value of goods is likely to be small.

In summary, contrary to Keynesian wisdom, expanding the monetary base and using this money to buy government securities may have little to no impact on the market value of the basket of goods, the numerator in our price level equation. Moreover, while there may be some short-term positive impact on the market value of goods, that impact is unlikely to be sustained on a longer term basis: ultimately, aggregate supply will react to the increase in demand.

(b) Impact on the Market Value of Money

If an increase in the monetary base is unlikely to have any significant impact on the market value of goods, then how does an expansion in the monetary base lead to inflation? The view of The Money Enigma is that the answer to this question involves an analysis of the impact of money creation on the market value of money, the denominator of every money price in the economy.

The view of The Money Enigma is that, over long periods of time, growth in the monetary base that is in excess of growth in real output will lead to a decline in the market value of money and that it is this decline in the value of money that is primarily responsible for the rise in money prices over long periods of time.

This notion represents what one might consider to be a “pure” or “true” monetarist perspective on the world: a version of monetarism that is unadulterated by the Keynesian worldview.

The challenge for this pure version of monetarism is explaining why the market value of money depends on the level of the monetary base relative to real output. After all, why should it matter to the value of money if money growth dramatically exceeds real output growth?

The answer to this question involves a reexamination of economic theories regarding the nature of money.

The view of The Money Enigma is that fiat money is a financial instrument: fiat money derives its value from it contractual properties. More specifically, fiat money represents a proportional claim on the future output of society. In more slightly technical terms, the fiat monetary base is a special-form, long-duration equity instrument issued by society under an implied-in-fact contract.

The key phrase in that last paragraph is “proportional claim on the future output of society”. To its holder, fiat money represents a variable entitlement to the future economic output of society.

One way to think about this is to imagine that future economic output is “the pie” and each unit of the monetary base represents “a share of the pie”. Clearly, each unit of money is more valuable if either (a) there is a bigger pie, or (b) there are fewer shares to that pie.

In slightly more formal terms we can say that the market value of fiat money depends upon long-term (20-30 year) expectations of the path of real output relative to the monetary base. The market value of one unit of fiat money will become more valuable if either (a) people decide that future real economic growth will be stronger than previously expected (“there will be more pie”), or (b) people decide that the growth of the monetary base will be lower than previously expected (“there will be fewer shares of the pie”).

This is a complicated subject which is addressed in several recent posts including “Money as the Equity of Society”, “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

In the short term, the market value of money is highly sensitive to changes in these long-term expectations. This shouldn’t be surprising: the value of any long-duration asset (equities, property, 30-year bonds) is highly sensitive to small changes in long-term expectations.

Similarly, one of the unexpected but important implications of this theory is that in the short term, the market value of money can be highly insensitive to the current level of the monetary base. A massive increase in the monetary base can have little or no impact on the market value of money, particularly if that increase in the monetary base is perceived to be “temporary” in nature.

However, the other implication of this theory is that over very long periods of time, the market value of money will fall if the growth in the monetary base far exceeds the growth in real output.

These observations can explain why quantity theory of money works in the long term but not in the short term. “Too much money” (relative to real output) will reduce the market value of money over long periods of time, but not necessarily over short periods of time. It is this decline in the market value of money that is the key driver of higher prices and inflation.

In summary, the challenge for monetarism is to retake the high ground in the economic debate. There is a clear path to do this, but it involves the recognition that the price level is a relative measurement of market value: the market value of the basket of goods in terms of the market value of money. Once the “value of money” is isolated as an independent variable, the challenge for monetarists is to provide a credible theoretical framework for the determination of the market value of fiat money.

Why Is There a Lag Between Money Printing and Inflation?

The experience of the last five years has clearly demonstrated that an expansion in the monetary base doesn’t necessarily lead to an immediate rise in the price level. While the Federal Reserve has increased the monetary base in the United States by roughly five-fold over the past five years, inflation has remained subdued.

However, does this mean that inflation will be contained if the monetary base remains at these high levels? Furthermore, does the experience of the last five years imply that the long-term relationship between money and inflation is dead?

In each case, the answer is “no”.

Many financial market commentators seem to believe that the long-term relationship between base money and the price level is “broken”. Indeed, the prevailing view seems to be that the level of the monetary base is irrelevant to inflation, provided that the economy does not “overheat”.

The view that “money doesn’t matter” flies in the face of what is arguably the strongest empirical relationship in macroeconomics. While economists like to pontificate about the importance of the “output gap” in the determination of inflation, the fact is that the empirical evidence supporting the relationship between the output gap and inflation is weak and statistically tenuous.

John Hussman, a fund manager and economist, discusses the absence of evidence for the output gap/inflation relationship at length in his post “Will the Real Phillips Curve Please Stand Up?” Similarly, Professor John Cochrane discusses the non-existent relationship between the output gap and inflation in his excellent article “Inflation and Debt”.

In contrast, dozens of academic studies have repeatedly demonstrated a strong and statistically important long-term relationship between the monetary base and the price level. While it is a well-recognised fact that the relationship between money and inflation is weak in the short term, the long-term relationship between money and inflation is a core empirical observation described in every serious economics textbook.

If the long-term relationship between money creation and inflation is not broken, then this raises an obvious question: when will inflation in the United States “catch up” with the expansion in the monetary base? However, in order to have any hope at answering that question, we need to answer a more general question.

Why does inflation tend to lag money creation?

In order to understand why inflation tends to lag increases in the monetary base, we need to explore two fundamental concepts:

The price level depends upon the value of money, and
The value of money depends upon confidence.

We will explore each of these ideas in more detail in a moment, but first, let’s explain how these ideas can be used to explain the delay between monetary base expansion and inflation.

The value of money is the denominator of every “money price” in the economy. All else remaining equal, as the market value of money falls, the prices of goods and services, as measured in money terms, will rise.

When a central bank prints more money, it may or may not have an immediate effect on the value of money. The reason for this is that the value of money depends upon a series of long-term expectations regarding the future of the economy and the future of the monetary base (or, more technically, the expected future path of the “real output/base money” ratio).

If markets believe that the increase in the monetary base is “temporary”, then such an increase may have little impact on the value of money. Furthermore, if markets believe that the actions taken by the central bank will increase the long-term growth rate of the economy, then such actions may even lead to an increase in the value of money. In other words, if the central banks actions are perceived to be temporary and these actions boost confidence in the economy, then printing money may have a slightly deflationary effect, at least in the short term.

However, what happens if expectations shift? What happens if markets start to realize that the “temporary” expansion in the monetary base is actually a “permanent” expansion in the monetary base? The value of money will begin to fall and, all else equal, the price level will begin to rise. Such a fall in the value of money can be quickly compounded if, simultaneously, the market becomes more pessimistic about the long-term economic prospects of society.

Currently, investors are very optimistic about the future of the US economy and seem to believe that the Federal Reserve is “on track” to reduce the monetary base over the next 5-10 years. This perception has supported the value of the US Dollar, which in turn, has been one of the major factors suppressing prices in the US.

But what happens if market confidence starts to slip? It is easy to imagine a scenario one year from now, where the US economy begins to weaken and markets start to doubt the ability or willingness of the Federal Reserve to significantly reduce the monetary base. If this does occur, then the value of money (the value of the USD) will begin fall, maybe gradually at first, but then more precipitously. As it does, inflation will begin to rise. While global deflationary forces may continue to put pressure upon the market value of goods/services, a significant decline in the market value of money can easily overwhelm this phenomenon, leading to a significant rise in prices.

Let’s step away from the US for the moment and think about what might happen in a small, less advanced economy that engages in money printing. The act of printing money tends to create an immediate boost in economic activity and an immediate boost in confidence (regardless of how that new money is spent). The simple fact is that as newly created money is flushed through the economy, jobs are created and people feel better about the economy and the world around them. Sometimes, this effect is so powerful that people believe that the economy will continue to grow strongly even as all this extra money is gradually retired at some point in the future. Consequently, the value of money is supported and the inflation is contained.

However, as historical experience has taught us, printing money rarely has any lasting effect on the growth of the economy. After a few years pass, people in our small, less advanced economy begin to realize that growth really isn’t that good (all the old problems remain) and that the economy is only being sustained at its current levels by the sustained creation of money. In other words, the economy has become addicted to the money-printing drug.

Inevitably, this collapse in confidence leads to a collapse in the market value of money. The exchange rate collapses and prices, in local currency terms, surge higher.

Inflation lags money printing because expectations can take a long time to change. The value of a long-duration asset (money) depends upon long-term expectations and it can take many years for changes in long-term expectations to occur.

Does this same principle apply to advanced economies? Absolutely.

The price level depends upon the value of money, and the value of money depends upon long-term expectations. Printing money may not have an immediate impact on the value of money because it does not have an immediate impact on long-term expectations. Rather, it may take several years before the markets begin to lose faith in the grand plans of policy-makers. But when the market does lose faith, the value of money can erode rapidly and prices can rise swiftly, even at time when real economic activity is falling.

For those readers that are interested, let’s briefly explore this argument in more technical terms. We have glossed over two important ideas that deserve further consideration.

The first idea is that the price level depends upon the market value of money.

More specifically, the market value of money is the denominator of every “money price” in the economy: as the market value of money falls, the price level, as measured in money terms, rises.

In order to understand this concept, it helps to think about the determination of prices in a barter economy. Let’s assume we have a two-good economy that produces only apples and bananas. What determines the price of apples in banana terms? Is it the market value of apples as determined by supply and demand for apples, or is it the market value of bananas as determined by supply and demand for bananas?

The answer is “both”. The price of apples in banana terms depends upon the market value of the primary good (apples) and the market value of the measurement good (bananas). All else equal, as the market value of the measurement good (bananas) falls, the price of apples, as measured in banana terms, will rise.

Economics struggles with this concept because it fails to recognize that the property of “market value” can and should be measured in the absolute. Every price is a relative expression of two market values. We can measure the market value of each item being exchange in absolute terms and plot supply and demand for each good in absolute terms. This somewhat abstract concept is explained in great detail in The Inflation Enigma, the second presentation in The Enigma Series.

Just as the price of apples in banana terms depends upon both the market value of apples and the market value of bananas, so the price of apples in money terms depends upon the market value of apples and the market value of money. If the market value of money falls, then the price of apples, in money terms will rise.

We can extend this microeconomic theory of price determination to a macroeconomic level. If the market value of money falls, then, all else remaining equal, the price of all goods and services in the economy will rise. This is the “Ratio Theory of the Price Level” as developed in The Enigma Series.

The second leg of our argument, namely “the value of money depends upon confidence”, requires a much more technical discussion. There isn’t time in this post to cover all the elements of this second leg of the argument. However, we can briefly touch on the key ideas.

The view of The Money Enigma is that money is a special-form equity instrument. Fiat money derives its value from the liability that it represents. More specifically, money is a long-duration, proportional claim on the output of society.

The easiest way to think about this is to compare money to shares in a corporation. A corporation can issue fixed or variable entitlements against the future economic benefits it creates (future cash flows). Similarly, society can issue fixed or variable entitlements against its future output.

Money represents a variable entitlement to the future output of society. If the markets believe that there will be a lot more claims issued in the future, then the value of each of those claims will fall. Conversely, if people believe that economic growth will be stronger in the future, then the value of each of those claims will rise.

Critically, fiat money is a long-duration asset. The value of fiat money depends primarily upon expectations regarding the long-term future growth rate of base money relative to real output.

Changes in the current level of the monetary base are largely irrelevant to the value of money. What really matters are expectations regarding the level of the monetary base in 20-30 years and, similarly, the expected growth in real output over that extended period.

Therefore, in the short term, it is possible to dramatically expand the monetary base with little impact on the value of money. The value of fiat money depends on long-term expectations of the “real output/base money” ratio. If market participants believe that an expansion in the monetary base is only temporary, then it should have little impact on the value of money.

The notion that fiat money represents a proportional claim on the future output of society is discussed at length in The Money Enigma, the first paper in The Enigma Series. Those readers who are interested in a more technical discussion of the long-duration nature of money should read The Velocity Enigma, the final paper in The Enigma Series.

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