The Quantity Theory of Money
Friedrich von Hayek once declared in an interview with the BBC that (paraphrasing), "it would be a misfortune for the field of economics if people ceased to believe in the quantity theory of money, except if they were to ever take it literally" (the comment starts at 1:24 in the video below):
Friedrich Hayek on Milton Friedman, the quantity theory of money and the need to take money issuance out of the hands of government.
What exactly did Hayek mean to convey by this statement? In order to fully understand what Hayek was trying to get at, let us consider the tautological equation of exchange on which the quantity theory is based:
M * V = P * Q,
... whereby M represents the money supply, V the so-called "velocity of circulation," P the price level and Q the real goods and services on which money was spent. In other words, the totality of money spent on goods equals the totality of prices paid on said goods. The reason why Hayek thought everybody should be aware of it is simply that one of the conclusions evident from the equation is that the supply of money will have an effect on prices. The reason why he thought it should not be taken literally is a bit more involved, but extremely important. In the interview Hayek mentions the problem posed by the aggregation of economic quantities. Statements based on such aggregated quantities are really not very meaningful. Unless one were to know and be able to convey the details of every exchange in the economy, one really arrives at meaningless numbers. Of course such omniscience is impossible. The dispersion of knowledge in the market economy was held by Hayek to represent the major impediment to central economic planning. He contended that it was simply impossible for anyone to have the all-encompassing knowledge that would enable him to "plan" all or even part of the economy. It is equally impossible to simply aggregate the prices paid for disparate goods in definitive transactions under specific circumstances and arrive at sensible data. Hayek was very critical of attempts to describe the economy by econometric methods and held that economists attempting to mathematically model the economy pretended to know things that are inherently unknowable.
Mises notes in Human Action that the equation of exchange leads to the false conclusion that money is neutral. It indicates that the "general level of prices" rises or falls commensurately with an increase or decrease of the money supply, but that overlooks that changes in the money supply don't influence all prices at the same time or to the same degree. The notion of proportional increase in the "general price level" is thus misleading. In chapter XVII, Mises states:
“Instead of starting from the actions of individuals, as catallactics must do without exception, formulas were constructed, designed to comprehend the whole of the market economy.
Elements of these formulas were: the total supply of money available in the Volkswirtschaft; the volume of trade – i.e., the money equivalent of all transfers of commodities and services as effected in the Volkswirtschaft; the average velocity of circulation of the monetary units: the level of prices. These formulas seemingly provided evidence of the correctness of the price level doctrine. In fact, however, this whole mode of reasoning is a typical case of arguing in a circle. For the equation of exchange already involves the level doctrines which it tries to prove. It is essentially nothing but a mathematical expression of the – untenable – doctrine that there is proportionality in the movements of the quantity of money and of prices.
In analyzing the equation of exchange one assumes that one of its elements - total supply of money, volume of trade, velocity of circulation - changes, without asking how such changes occur. It is not recognized that changes in these magnitudes do not emerge in the Volkswirtschaft as such, but in the individual actors' conditions, and that it is the interplay of the reactions of these actors that results in alterations of the price structure.
The mathematical economists refuse to start from the various individuals' demand for and supply of money. They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics.” ('Volkswirtschaft' = "the national economy," ed.)
(Our emphasis)
Mises then notes that the purchasing power of money can not be mechanically deduced from the services it renders, just as the prices of various vendible goods can not be explained by their "objective use value" - rather it is the demand of individual economic actors for goods that influences the price structure. Similarly the demand for money on account of the services it is expected to render, based entirely on subjective value judgments, is what imparts purchasing power to it. It is not the rendering of these services as such, as implied by the velocity of circulation concept. The problem, so Mises is that the attempt to look at the economy from a holistic point of view is doomed to failure. If e.g. the supply of money is increased, then this has an effect on the actions of individuals who react on their own subjective concerns – they do not deliberate on the effects their actions may have on the economy as a whole.
Everybody has a certain demand for cash holdings; these cash holdings are accumulated to enable the acquisition of goods and services at a later date. As Mises explains, money is in fact never "circulating" – it is always held by someone. Moreover, the same laws of supply and demand that govern exchange ratios between vendible goods also determine the purchasing power of money. The quantity theory of money is based on recognizing this fact and that is its merit – the problem lies in its holistic and mechanistic approach to describing this relationship.
The Regression Theorem
Building on Carl Menger's theory on the origin of money, Mises developed the regression theorem. Menger noted that money did not originate overnight as a result of governmental decree. It seems indeed highly improbable that a society mired in an inefficient barter economy would one day experience the switching on of a light bulb in the heads of its government officials informing them magically of the advantages of adopting indirect exchange and inducing them to introduce money by decree. Rather, what happened was that economic actors discovered that the problem of the coincidence of wants could be best dealt with by acquiring a good of very high marketability that could be exchanged for other goods as needed, and thus serve as a medium of exchange. As Menger writes in "Principles of Economics," ch.VIII, 1.:
“As each economizing individual becomes increasingly more aware of his economic interest, he is led by this interest, without any agreement, without legislative compulsion, and even without regard to the public interest, to give his commodities in exchange for other, more salable, commodities, even if he does not need them for any immediate consumption purpose. With economic progress, therefore, we can everywhere observe the phenomenon of a certain number of goods, especially those that are most easily salable at a given time and place, becoming, under the powerful influence of custom, acceptable to everyone in trade, and thus capable of being given in exchange for any other commodity. These goods were called “Geld” (1) by our ancestors, a term derived from “gelten,” which means to compensate or pay. Hence the term “Geld” in our language designates the means of payment as such.”
"Geld" is the German term for money, which remained untranslated in the English edition of the "Principles" since otherwise the etymological explication would make no sense, ed.
Obviously such a good did not just drop from the sky, but rather was a good for which there already existed a non-monetary demand, which one may call the industrial demand component. The moment such a good was widely adopted as a medium of exchange, monetary demand would add to its value and eventually become the primary component used in evaluating it.
Mises notes that people's ideas about money's future purchasing power are necessarily informed by the experience of the recent past. The amount of cash holding deemed sufficient by individual economic actors will be shaped this experience and forms the basis of their demand for money. People's subjective appraisal of money is derived from its exchange value. As Mises writes in the "Theory of Money and Credit" (TMC), Part 2, ch. 1:
“If we wish to estimate the significance that a given-sum of money has, in view of the known dependence upon it of a certain satisfaction, we can do this only on the assumption that the money possesses a given objective exchange value (1). 'The exchange-value of money is the anticipated use-value of the things that can be obtained with it.' Whenever money is valued by anybody it is because he supposes it to have a certain purchasing power.”
(1) to avoid confusion, Mises explains ibid. further below: “Objective exchange-value, as it appears in the subjective theory of value, has nothing except its name in common with the old idea developed by the Classical School of a value-in-exchange inherent in things themselves.”
In tracing back the exchange value of money, one arrives ultimately at the point in time prior to the adoption of a certain commodity as money. As Mises notes further below in part 2, ch.1 of the TMC:
"The first value of money was clearly the value which the goods used as money possessed (thanks to their suitability for satisfying human wants in other ways) at the moment when they were first used as common media of exchange. When individuals began to acquire objects, not for consumption, but to be used as media of exchange, they valued them according to the objective exchange-value with which the market already credited them by reason of their 'industrial' usefulness, and only as an additional consideration on account of the possibility of using them as media of exchange. The earliest value of money links up with the commodity-value of the monetary material. But the value of money since then has been influenced not merely by the factors dependent on its 'industrial' uses, which determine the value of the material of which the commodity-money is made, but also by those which result from its use as money. Not only its supply and demand for industrial purposes, but also its supply and demand for use as a medium of exchange, have influenced the value of gold from that point of time onwards when it was first used as money.”
(Our emphasis)
Hence today's purchasing power of money is derived from this evolution and conditioned by the demand for cash balances and the supply of money. Modern day fiat money has obviously no industrial demand component, i.e. its purchasing power is conditioned solely by the appraisal of its exchange value. Nevertheless, it has historically developed from a money that did have a non-monetary demand component, as today's bank notes are essentially the remnants of what used to be claims to money proper (i.e., gold). The government simply decreed it would no longer convert such claims into money but that instead the former claims would become money, i.e., continue on as irredeemable money. It should be noted that the major factor that creates demand for fiat money and explains why it is accepted at all is the fact that it is required for payment of taxes. Moreover, it has to be accepted in payment for private debts as well by legal decree.
Carl Menger (1840-1921): his deliberations on the origin of money inspired Mises to formulate the regression theorem.
The Supply of Money
At any given time, the point at which the demand for cash balances and the supply of money intersect determines its exchange value. As Mises notes in Human Action, the absolute size of the money supply is irrelevant; what is relevant is its purchasing power as determined by market processes. A money supply of size X is no less useful than a money supply size n*X. Ceteris paribus, money's purchasing power will simply be greater in the former than in the latter case. No advantage accrues to society at large by having command over a greater rather than a smaller supply of money. In both cases, all the services money can possibly render will be rendered by it. After all, individuals are not interested in merely holding a certain amount of cash balances, but rather a certain amount of purchasing power.
It would be a mistake to believe that money's purchasing power is stable or that it even should be stable. Money is both demanded because economic conditions constantly change and it is in addition itself an agent of further change. On this Mises writes (Human Action, ch. XVII, 5.):
“With the real universe of action and unceasing change, with the economic system which cannot be rigid, neither neutrality of money nor stability of its purchasing power are compatible. A world of the kind which the necessary requirements of neutral and stable money presuppose would be a world without action.
It is therefore neither strange nor vicious that in the frame of such a changing world money is neither neutral nor stable in purchasing power. All plans to render money neutral and stable are contradictory. Money is an element of action and consequently of change. Changes in the money relation, it., in the relation of the demand for and the supply of money, affect the exchange ratio between money on the one hand and the vendible commodities on the other hand.
These changes do not affect at the same time and to the same extent the prices of the various commodities and services. They consequently affect the wealth of the various members of society in a different way.”
As Mises notes, there are two ways in which money's purchasing power can be altered: goods (and services)-induced changes and cash-induced changes. Goods-induced changes can come about due to a shift in demand from some types of goods to others or changes in the supply of goods. Cash-induced changes evidently come about when the money supply is either decreased or increased.
Here it is important to remember a point made above: Changes in the money supply do not affect all goods and services at the same time or to the same extent. Imagine that e.g. the government increases the supply of money and uses the additional money created to buy certain types of goods. The vendors of these goods will be happy, as the prices of these goods will rise due to the additional demand. Other buyers of the same goods will however lose out, as they now must pay higher prices for them. Moreover, the first receivers of the new money will use their higher paper profits to increase their own demand for goods and services and so the money "ripples out" into the economy, affecting various prices in turn. At the end of the process there will not only be a rise in prices in general, but the price relations of various goods and services will be altered as well. Some members of society will profit, others will lose out. Mises notes to this topic (Human Action, ch. XVII, 6.)
“As money can never be neutral and stable in purchasing power, a government's plans concerning the determination of the quantity of money can never be impartial and fair to all members of society. Whatever a government does in the pursuit of aims to influence the height of purchasing power depends necessarily upon the rulers' personal value judgments. It always furthers the interests of some groups of people at the expense of other groups. It never serves what is called the commonweal or the public welfare. In the field of monetary policies too there is no such thing as a scientific ought.”
(Our emphasis)
Regarding the seeming "waste" of the expense involved in digging up gold to use as money, Mises notes that the record of governments with regard to paper money is such that gold mining must be regarded as a minor evil. He notes immediately following the paragraph excerpted above:
“The choice of the good to be employed as a medium of exchange and as money is never indifferent. It determines the course of the cash-induced changes in purchasing power. The question is only who should make the choice: the people buying and selling on the market, or the government? It was the market which in a selective process, going on for ages, finally assigned to the precious metals gold and silver the character of money. For 200 years the governments have interfered with the market's choice of the money medium. Even the most bigoted Etatists do not venture to assert that this interference has proved beneficial.”
(Our emphasis)
If Mises were alive today, he would be forced to grudgingly revise the final sentence. Today's etatists do in fact venture to assert that this interference has proved and continues to prove beneficial. In fact, they demand more interference constantly. Even the hoariest, most disreputable inflationist plans have been revived by modern-day mainstream economists and proposed as a means to restore prosperity in the wake of the recent bust.
In fact, as we know, central banks around the world have – with or without the active participation of commercial banks, depending on the solvency of the banking systems concerned – increased the money supply markedly and artificially lowered interest rates to rock bottom levels. Given the non-neutrality of money, wealth has therefore been redistributed.
However, this is not the only thing that has happened – the false signal given by too low interest rates must perforce have led to renewed capital malinvestment even before there was a chance to liquidate the malinvestments of the preceding boom.
The economy's price structure has been altered enormously as anyone following the evolution of market prices over the past several years can easily ascertain. Central banks are very concerned about so-called "inflation expectations" as they are aware that if enough people begin to expect the inflationary policy to become a permanent feature, there could be a pronounced effect on the demand for money, leading to an unwelcome and more rapid loss of purchasing power. Mises writes regarding the effect the anticipation of a loss of purchasing power brings about (Human Action, ch. XVII, 8.):
“He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief; accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding. As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people believe that they are on the eve of big cash-induced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases. These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does the inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.
But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome.”
A market-based measure of inflation expectations – imperfect though it is – is provided by so-called "inflation breakeven" charts. According to Bloomberg:
“United States breakeven inflation rates are calculated by subtracting the real yield of the inflation linked maturity curve from the yield of the closest nominal Treasury maturity. The result is the implied inflation rate for the term of the stated maturity.”
The reason why we regard these measures as less than perfect is the fact that the "implied inflation rate" refers to expectations regarding a price index constructed by government, since this is what determines the yield paid on TIPS (inflation protected securities). Government has frequently altered the method of calculation of its price indexes with the result that they show much less "price inflation" nowadays than they would according to the calculation methodologies employed previously. It is the expected change in this new price index the charts below are reflecting. There is no guarantee that the government won't alter the calculation methodology again.
Click to enlarge charts
A chart of U.S. 10-year inflation breakeven rates. As can be seen, inflation expectations have risen since the announcement of "QE2."
Five-year U.S. inflation breakeven rates. These are both more volatile and currently at a higher level than their 10-year counterpart.
A general tendency to restrict cash holdings as described by Mises above can today be observed in Argentina (see our previous article on the situation in Argentina). As an aside to this, the government of Argentina has in the meantime developed a very nasty habit of fining economists who dare to publish independent data on the price revolution the inflation has engendered. Clearly this is designed to restrict free speech and leave the government free to lie about how quickly its currency loses its purchasing power. As the WSJ reports on this:
Argentina's government has fined more economists for challenging official inflation estimates in what lawyers call a violation of freedom of speech.
Consumer prices rose 10% in February from a year ago, according to the national statistics agency, Indec. But most economists say annual inflation is closer to 25%, irking government officials who deny inflation is a problem. On Tuesday, the government fined consulting firm Econviews 500,000 pesos ($123,442). It fined the consultancy abeceb.com an equal amount Monday for allegedly publishing inflation estimates that "lack scientific rigor."
"This isn't about methodology or truth in advertising, as the government claims. It's really about silencing dissident voices," economist and former finance undersecretary Miguel Kiguel said in a phone interview Tuesday. The government has imposed similar fines against Estudio Bein & Asociados, Finsoport, MyS Consultores, GRA Consultoras and former Indec official Graciela Bevacqua, who used to oversee Indec's consumer price index. Several other firms said they expect to be fined soon.
"This is crazy. It's a barbarian bid to get economists to avoid estimating anything," said Rodolfo Santangelo, an economist and partner at MyS Consultores.
Government officials have said they hope the fines will deter economists from "deceiving" the public into making poor financial decisions by publishing inflation estimates that differ considerably from Indec's CPI data.
Economists and opposition politicians say the government is muzzling criticism of its own statistical data, which vastly underestimate rising prices.
This par for the course for a country in the throes of an accelerating inflation. Governments intent on continuing the policy will always lash out against critics and resort to all sorts oppressive measures with the intention of deflecting blame. For instance, price controls coupled with the threat of severe punishments if merchants try to circumvent them have been tried since the time of Roman emperor Diocletian. A government that introduces price controls as a rule does so because it pursues an inflationary policy. Not surprisingly, Argentina has already tried price controls as well (under previous president Nestor Kirchner) with the effect of producing shortages (unexpected by the government, expected by economists). As Bloomberg reported at the time:
Argentina's price controls are triggering shortages of milk, meat and other foodstuffs on the shelves of the nation's supermarkets. The Center for Consumers Education, a non-governmental watchdog group, was unable to conduct its weekly survey of basic food prices last week because many of the items it counts aren't available in supermarkets, said Claudio Boada, the center's vice president.
"We are seeing serious shortages in Buenos Aires and throughout the country,” Boada said in a telephone interview in Buenos Aires. “The price control policies seem not to be working and producers probably prefer to hold onto their goods instead of selling them at lower prices.”
In the meantime – and numerous corporate bankruptcies later – Argentina has lifted price controls and replaced them with subsidized loans to the country's meat producers – a new intervention intended to cure the ills of the previous one.
As we have said in connection with Argentina, it provides us with an excellent real time case study. It is worth noting that the inflation has engendered a boom. Supporters of inflationist policies always tend to point to the emergence of such booms as a mark of the policy's success, while remaining silent about the price that must eventually be paid for it. What they overlook or suppress is the fact that during the boom, scarce capital is consumed. As it were, extreme examples of inflationary booms, such as the post WW I hyperinflation episodes in Germany, Austria and Hungary provide us with very vivid examples of capital consumption. Not only that, they also show why political and monetary authorities can be seduced into keeping an inflationary policy going even well after it has become clear that it will lead to ruin.
Capital Consumption
In an address to the Boston Chapter of the American Statistical Association in 1934, Fritz Machlup reported on attempts to measure capital consumption in Austria (pdf) between 1913 and 1930. In the decade following the last peace time year preceding WW I, Austria experienced an extended period of money supply inflation that eventually morphed into a hyperinflation and the complete destruction of the currency.
In his address Machlup also explained the theoretical concept of capital consumption and provided a number of illuminating examples. On the maintenance of capital, he said:
A community which maintains its capital intact meets the different kinds of capital depreciation principally in two ways. Normally depreciation by wear and tear and that part of depreciation normally due to technological obsolescence are met by reinvestment out of replacement funds. The depreciation which results from unforeseeable dynamic changes is met only by investments out of new savings. A certain portion of new savings is therefore needed for offsetting unavoidable but unforeseeable capital depreciation. Do great changes in demand really depreciate, really reduce the value of capital of the community as a whole? Is it not true that what the one industry loses another industry must gain? The increased profits of the latter are capitalized, of course. Does this make good the capital loss of the former? It does not. The increased quasi-rent in the under-equipped industry results in an increased demand for liquid funds available for investment. If there is not an increased supply of savings to provide these funds the rate of interest is raised, and the higher rate of capitalization lowers present capital values. We mention these 'abstract' ideas for three reasons. First, a good deal of capital loss in Austria is to be traced to changes in demand resulting from the short-sighted protectionism in the new national states succeeding the old monarchy. Second, capital consumption is in itself a change in demand, the demand for consumers' goods being increased at the expense of that for producers' goods; hence capital consumption reduced capital directly (by neglect of maintenance) and indirectly (by decreasing the demand for the output of construction industry). Third, in the absence of new saving, mere shifts in demand involve economic decline; in other words, an economy which is stationary in respect to the supply of savings is declining in respect to its capital base; or, put another way, quick change in the objects of consumption without the emergence of new savings is itself a form of consuming capital.”
Machlup noted that if capitalists wanting to consume more than their current income were dis-saving by selling their capital to other people, the dis-saving of some would be offset by the saving of others if it were bought with new savings. In this case individual capital consumption would not equal community-wide capital consumption. Should there be insufficient domestic savings to absorb the dis-saving, then foreign capital might fill the gap (this is certainly a point quite relevant to the U.S. today as well). If the gap can neither be filled by domestic nor by foreign savings, then disinvestment takes place as replacement funds are consumed rather than used for renewing worn out capital. Machlup then proceeded to name the various factors that provided incentives for entrepreneurs in Austria at the time to engage in capital consumption. He listed inter alia the over-taxation of incomes and of production which were the result of vast increases in public spending, the forcing up of wage rates and social benefits and the payment of unearned dividends by corporations. In addition he provided a very illuminating example regarding miscalculations due to inflation. This was especially pertinent to the Austrian case, as the primary members of the 'Central Powers' alliance of World War I all fell prey to hyperinflation after the war. As Machlup explained:
"In spite of ordinary bookkeeping, inflationary price increases lead to insufficient replacement reserves. An example will make it clear. A manufacturer owned a plant worth one million crowns. He used to write of 100,000 crowns a year for depreciation; that is, 10%. As inflation raises prices and costs, and as the costs of an equivalent plant would run up to two million crowns, the customary replacement quota represents only 5%; and the reserve, after the whole plant has been written off, allows the renewal of only half the equipment. If inflation raises prices to the fourteen-thousandfold, as was the case in Austria, the replacement reserve of a machine is just large enough to buy one new screw.
But does inflation not increase profits and therefore the ability to build up reserves? I wish to emphasize that those money profits are delusive profits; if parts of them are considered real profits – that is, as a base for increased consumption – capital is consumed.
Capital consumption is still better illustrated in the case of working capital. A dealer bought a thousand tons of copper. He sold them, as prices rose, with considerable profit. He consumed only half of the profit and saved the other half. He invested again in copper and got several hundred tons. Prices rose and rose. The dealer's profit was enormous. He could afford to travel and to buy cars, country houses and whatnot. He also saved and invested again in copper. His money capital was now a high multiple of his initial one. After repeated transactions – he always could afford to live a luxurious life – he invested his whole capital, grown to an astronomical amount, in a few pounds of copper. While he and the public considered him a profiteer of the highest income, he had in reality eaten up his capital.”
Machlup mentions that malinvestment of capital is of greater importance in the "case of credit inflation than of governmental inflation." This is a reference to the fact that the trade cycle is usually set into motion by the expansion of fiduciary media by the banking system in lending to businesses. A malinvestment boom due to bank credit expansion of course ends up consuming capital as well, by drawing resources into economic activities that prove to be unsustainable once the credit expansion ends.
Fritz Machlup, 1902-1983: an Austrian economist who actually hailed from Austria (he lived in the U.S. from late 1934 and became a US citizen in 1940).
