Thursday, June 18, 2009

Money Out of Thin Air

In a guest column on FindLaw appearing later today, I take on the questions of whether the Fed is printing money "out of thin air" and, if so, whether that is bad. (Answers: (1) Yes, because that is how money is always created. (2) No.) In that column, I pick up on an argument that I mentioned in passing in a Dorf on Law post back in April: Doesn't the Fed cause inflation when it increases the money supply? In my FindLaw column, I set aside the intervening steps of the argument and simply point out that reality has been very unkind to the argument that inflation and money creation are directly related. In this post, I'll discuss those intervening steps to show that the Fed's current policy is both sensible and reversible.

Most people who took an undergraduate economics course will probably remember the equation MV=PQ. Like most of what we learn in college, however, the meaning of that equation has probably been lost in the mists of time. Known as the Quantity Equation, this is a mathematical identity that says that the number of dollars (M, or Money Supply) multiplied by the average number of times that each dollar is spent (V, or Velocity) equals the average price of a good produced in a given year (P, or price level) times the quantity of goods produced in a year (Q, real gross domestic product). There are a couple of variations on this equation, and some textbooks use a different letter for Q; but this is the most common form of the quantity equation.

Two steps of college-level math turn the equation into a linear approximation: money growth + velocity growth = inflation (price growth) + GDP growth. Moving from the Quantity Equation to a version of the Quantity Theory requires assuming that velocity growth and GDP growth are either fixed or predictably changing, which then means that money growth and inflation are directly related. Given the strong intuition that rampant and uncontrolled money growth must certainly be inflationary (see Germany in the 20's, many South American countries in the 70's and 80's, etc.), it is easy to convince students that the theory can be used as an actual predictive tool for U.S. monetary policy. It cannot.

As it turns out, in this country velocity growth is anything but fixed or predictable, and the predictions that money growth is inevitably inflationary (or that increases in money growth must increase inflation) simply do not hold up to empirical testing. Sometimes the relationship holds up, but other times it doesn't. In the current situation, we have the Fed creating large amounts of money (but see below), and real GDP has been falling (the definition of recession), which would result in inflation if velocity weren't falling. But velocity growth is falling. Hence inflation has stayed in check. If the economy starts to grow, real GDP growth will soak up some of the upward pressure on prices, and the Fed can pull back on money growth.

Actually, there is an additional empirical difficulty with the "more money causes inflation" story. As Paul Krugman pointed out in his column on Monday of this week, there is a difference between the type of money that the Fed can control and the type of money that shows up in the equation above. The Fed controls the "monetary base," which is the sum of currency and the (mostly electronic) money that banks have on reserve. We usually imagine that there is a nice linear relationship between the monetary base and the quantity of money that is ultimately available for spending; but again, that relationship is much more tenuous than many people thought. (Krugman points out that, in the Great Depression, the monetary base doubled while prices fell 19%.) If the banks don't lend out the money that they have in reserve (which they currently are not), the monetary base does not ever become the kind of money that shows up in the MV=PQ equation, and any inflationary pressure from increasing the money supply cannot even get started because there really is not a big increase in the money supply.

Until President Obama took office, the quantity theory had faded in importance even among those who called themselves monetarists. Although Alan Greenspan completely missed the importance of financial regulation, he clearly understood that the mechanical inflation story is no guide for policy. Ben Bernanke, who we might recall was appointed Fed chair by George W. Bush, also understands this.

Of course, it is possible that inflation could return. One way for that to happen is for the variables that I described above all to turn in the wrong direction at once. Given that much of the "money" the Fed has created sits in bank reserves, and given that the Fed has nearly direct control over those reserves, it is well situated to pull the plug on any incipient inflation in a very timely way simply by shrinking the monetary base as much as necessary. I am not predicting that the Fed will respond perfectly, but this is not a situation where you have to wait months or years for the effect to be felt.

In short, the intuitive story driving the fears about the Fed creating "money out of thin air" and thus ensuring a future of ruinous hyperinflation breaks down completely in the face of both evidence and theory. I am usually not a "don't worry, be happy" kind of guy, but this is really a case where the Fed is doing the right thing and can reverse course as the situation evolves.

-- Posted by Neil H. Buchanan


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