"Best diss of the Quantity Theory of Money comes from Keynes", commented Toby Nangle on Twitter, referring to this paragraph from Keynes's Open Letter to Roosevelt (Toby's emphasis):
The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.
But is Keynes really dissing the Quantity Theory of Money (QTM)? Well... no. He is objecting to the way in which it is used, and the policies that are derived from it.
The QTM itself is an identity:
MV = PY
where M is the quantity of money in circulation, V is its velocity, P is the general price level and Y is output.
As this is an identity, it tells us nothing at all about the direction of causation. Indeed, in this form, MV is the dependent variable and should be regarded as responding to changes in PY, not vice versa.
But the identity can equally be written PY = MV. And in this quotation, Keynes himself uses it in this way:
Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed.
We can use the QTM to explain this. If M is fixed, then when Y is rising either V must rise (money must circulate faster, which implies people spending more frequently) or P must fall. But when P is falling, people tend to delay purchases, which slows the velocity of money. So falling P tends to be associated with falling, not rising, V. Thus, if M is fixed, Y will eventually stagnate or even fall. M should be allowed to rise as Y rises, keeping the price level stable.
So, far from dissing it, Keynes in effect used the QTM himself.
And yet he is definitely critical of it. So what is he really complaining about?
His objection is to ACTIVE expansion of the money supply in order to stimulate output. This is apparent from the final sentence:
It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.
Putting this differently, we can say that although holding M fixed eventually prevents Y from rising (limiting factor), increasing M when Y is stagnant does not necessarily kick it into rising. Whether it does, depends on people's willingness to increase spending.
Apologists for the QTM tend to insist that increasing the money supply must stimulate spending: if people have more money they will spend it, duh. But this depends on other things. Really rather fundamental things, in fact.
The first concerns what we mean by "money". In its pure monetarist form - and I confess I have used it in this way myself - M is defined as the monetary base, M0. Arch-monetarists will tell you that increasing the monetary base increases economic activity, so all that is needed to get economies moving after a slump is lots and lots of QE. I'm afraid on this I am in agreement with Keynes. It is bunk. Increasing the monetary base alone is incapable of getting economies moving. A brief glance at Japan is more than enough to tell us this.
The problem is that in the modern monetary system, only a small proportion of money in circulation is monetary base. The rest is what we call "broad money", which is created by banks in the course of lending. And when banks are damaged, they don't lend. No, let me widen that. When private sector balance sheets are damaged - people are over-indebted, their credit ratings are shot to pieces and they are struggling to service their existing debts - banks don't lend and people don't borrow.
It's self-reinforcing: banks tighten credit standards to shore up their highly risky balance sheets just when the balance sheets of households and businesses are at their most fragile. We blame banks for not lending, while simultaneously demanding that they make themselves less risky: we blame businesses for not borrowing to invest in new capacity, while simultaneously encouraging households to cut back spending in order to pay down debt and save for the future. And into the middle of this steaming pile of double standards and conflicting messages, we pour enormous amounts of monetary base, in the mistaken belief that it will encourage banks to lend and people to spend. The truth is that it has very little effect on either.
Banks do not use monetary base for lending. Adding huge quantities of monetary base to the system does not make them lend. Again, a brief glance at anywhere that has been doing QE in any quantity is easily enough to tell us this. Broad money creation does not depend on the amount of M0 in the system. It depends on the willingness of banks to lend, and the willingness of households and businesses to borrow. And that depends on the health of private sector balance sheets. When private sector balance sheets are badly damaged, broad money stagnates, and no amount of monetary base will make any difference.
Keynes did not explain exactly why adding monetary base to the system makes no difference when private sector balance sheets are damaged. For that insight, we need to look to Richard Koo. But Keynes understood the effect. Adding monetary base to the system when banks do not want to lend and people do not want to spend is like "pushing on a piece of string". Or perhaps like leading a horse to water. If the horse does not want to drink, it will not, even if it is presented with the River Nile.
But central banks can also add broad money to the system, if they buy securities directly from businesses and households rather than from banks. Does this work any better?
Not much, frankly. And this brings me to my second fundamental point. If what you want is to encourage people to spend, you must increase the money available to those most likely to spend it.
Simply buying the assets of the rich is not going to make much difference to economic activity. They will spend the money, yes - on other assets. But down at the grass roots level, businesses will still be struggling to find anyone to buy their goods and services, because the people who buy these things are not the rich - they are ordinary people who are underpaid, over-indebted and struggling to make ends meet. The people most likely to spend, given more money, are the poor, not the rich. So I might take a more nuanced view than Keynes. Loosening the belt can make the belly fatter, if the way in which the belt is loosened means the people with more money to spend are those most likely to spend it.
This may or may not mean an increase in broad money. It could simply mean redistribution of existing broad money. Soak the rich, in short. Or tax their unproductive investments (yes, I know, this is heresy).
Insufficient attention is paid in QTM-land to distributional niceties. And yet the distribution of money is as important as its quantity. If the majority of the money in the economy is held by a few, who circulate it among themselves to buy investment assets, then adding more money inflates the prices of those assets while output stagnates and the prices of goods and services used by ordinary people fall.
So helicopter money would be far better than QE as a monetary stimulus. But as John Kay points out, helicopter money is deficit spending, really. And this brings me to my third fundamental point.
Expanding the monetary base with QE while simultaneously reducing government spending and raising taxes to "fix the fiscal finances" is a wash. No, it's worse than that. It transfers money from households who would actually spend that money on goods and services, and businesses who would invest it for future growth, to banks and the rich, who only spend it on assets. The wealth effects from inflated asset prices may at the margin encourage more spending among those foolish enough to borrow (or dis-save) on the strength of unrealised capital gains, while the depressed interest rates that are the inevitable consequence of inflated asset prices may also encourage borrowing by those who would struggle to service debts if interest rates were higher. I am constantly amazed that any policymaker thinks that such unwise behaviour is to be encouraged.
Deficit spending would be both safer and more effective than flooding banks with reserves and blowing up asset price bubbles. But we have tied ourselves into a ridiculous straitjacket because of wholly unjustified fear of government debt. So now we propose helicopter money and "people's QE" as a way of doing deficit spending while pretending we are not. Is anyone really fooled?
I leave the last word to Keynes, from the same letter to Roosevelt.
In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months. Could not the energy and enthusiasm, which launched the N.I.R.A. in its early days, be put behind a campaign for accelerating capital expenditures, as wisely chosen as the pressure of circumstances permits? You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.
Deficit spending - even dressed up as helicopter money - is a whole lot less scary than stagnation and lost output. Get on with it.