By Frank Shostak*
In the recent the wall street journal article “Soaring inflation gives monetarism another look,” Greg Ip writes that a recent spike in inflation is unlikely to cause authorities to re-embrace monetarism. According to Ip, money supply has failed to predict US inflation due to conceptual and definitional issues that have not gone away.
The leader of the monetarist school, the late Milton Friedman, maintained that inflation is always and everywhere a monetary phenomenon. Friedman and other monetarists believed that the key factor in the general increase in prices was the increase in the money supply.
This view has been challenged since the early 1980s because the correlation between inflation and money supply has disappeared. According to Ip in 2020, Alan Detmeister, economist at UBS Group AG and former Fed, found that the correlation of inflation with M2 since the early 1980s was low and that its correlation with both the monetary base and M1 was negative. Most economists stopped using money supply as an indicator of inflation since the early 1980s.
Many mainstream economists have attributed the breakdown in the correlation between money supply and inflation to the unstable velocity of money. What is that? According to the famous exchange equation, MV = PTwhere:
M represents money,
V represents the speed of money,
P represents the price level, and
J for trading volume.
This equation states that money multiplied by velocity equals the value of transactions. Many economists use GDP (gross domestic product) instead of PTthus concluding that
MV = GDP = P (real GDP).
The exchange equation seems to offer a wealth of information about the state of an economy. For example, if one were to assume a stable velocity, then for a given stock of money, one can establish the value of GDP. Moreover, a given real production and a given money supply make it possible to establish the price level.
For most economists, the trade equation is considered a very useful analytical tool. The debates among economists focus mainly on the stability of speed. If the velocity is stable, then silver is considered a very powerful tool to track the economy. The importance of money as an economic indicator, however, decreases once the velocity becomes less stable and therefore less predictable.
However, unstable speed might occur due to unstable currency demand. Most experts believe that since the early 1980s, innovations in financial markets have made the velocity of money unstable. This made the currency an unreliable indicator of inflation.
We believe that the purported failure of money as an indicator of inflation stems from an erroneous definition of inflation and the money supply. This failure has nothing to do with an unstable demand for money, and it is not because people change their demand for money that there is instability. Since an individual’s goals may change, they may decide that it is beneficial for them to hold less money. In the future, he might increase his demand for money. What could be wrong with that? The same goes for all other goods and services – the demand for them changes all the time.
According to Murray Rothbard and Ludwig von Mises, inflation is defined as the increase in money supply from “thin air”. Following this definition, one can see that increases in the money supply trigger economic impoverishment by creating an exchange of nothing for something, which is known as the counterfeit effect.
General price increases are likely to be symptoms of inflation, but not always, however. Note that prices are determined by real and monetary factors. Therefore, it may happen that if the real factors “pull things” in the opposite direction to the monetary factors, no visible price change will take place. If the growth rate of money is 5% and the growth rate of the supply of goods is 1%, prices are likely to increase by 4%. If, however, the growth rate of the supply of goods is also 5%, no general price increase is likely to occur.
If one were to argue that inflation is an increase in prices, one would conclude that, despite the increase in money supply by 5%, inflation is 0%. However, if we were to follow the definition that inflation is an increase in the money supply, we would conclude that inflation is 5% regardless of any price movement.
Define money supply
Before 1980, it was common to use various definitions of the money supply in the evaluation of changes in the prices of goods and services. The criterion for selecting a particular definition was its correlation with national income. However, since the early 1980s, the correlations between different definitions of money and national income have broken down. Some analysts believe this breakdown is due to changes in financial markets, rendering past definitions of money irrelevant.
A definition presents the essence of a particular entity, something that no statistical correlation could ever provide. To establish the definition of money, we need to explain the origins of monetary economics. Money arose because barter cannot sustain the market economy. Money is the general medium of exchange and has evolved from the most tradable commodity. Stakes wrote:
There would be an inevitable tendency that the least tradable of the series of commodities used as a medium of exchange would be discarded one by one, until at last there remained only one commodity, which was universally employed as medium of exchange; in a word, money.
Since the general medium of exchange has been chosen from a wide range of commodities, the emerged currency must be a commodity. Rothbard wrote:
Unlike directly used consumer or producer goods, money must have pre-existing prices on which to base demand. But the only way to do this is to start with a useful commodity under barter, then add the demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold).
Through a continuous selection process, individuals opted for gold as their standard currency. In the current monetary system, the core of the money supply is no longer gold, but rather government and central bank issued coins and notes that are used in transactions when goods and services are exchanged for the money. Therefore, all other goods and services are exchanged for money.
Part of the stock of liquid assets is stored through bank deposits. Once someone places money in a bank’s warehouse, they are engaging in a debt transaction, never relinquishing ownership of the money. Therefore, these deposits, called demand deposits, are part of the currency.
This contrasts with a credit transaction, where the lender waives his claim to the money during the term of the loan. In a credit transaction, money is transferred from a lender to a borrower, but the overall amount of money in the economy does not change due to the credit transaction.
The introduction of electronic money seems to challenge the definition of money. It would seem that deregulated financial markets generate various forms of new money. Nevertheless, various forms of e-money or e-money, such as digital currency, do not have a “life of their own”.
Various financial innovations do not generate new forms of money but rather new ways of using existing money in transactions. Regardless of these financial innovations, the nature of money does not change. Money is the thing against which all other goods and services are exchanged. Once the essence of money is established by excluding various credit operations, one can identify the state of inflation. Price changes will not be relevant here.
Contrary to popular thought, inflation is not an increase in the prices of goods and services, but an increase in the money supply. By following this definition, we can establish that the main damage caused by inflation is economic impoverishment through the exchange of nothing for something. What matters with regard to inflation is not the correlation between the money supply and the prices of goods and services, but the increase in the money supply.
Contrary to popular thought, the essence of money has not changed due to various financial innovations. Money is a thing that is used as a medium of exchange. Moreover, according to Mises’ regression theorem, the historical connection between paper money and gold is what holds the current monetary system together.
*About the Author: Frank ShostakApplied Austrian School Economics’ consulting firm provides in-depth assessments of financial markets and global economies. Contact email.
Source: This article was published by the MISES Institute