Monetarism

Monetarism is an economic theory most closely associated with Milton Friedman, winner of the Nobel Prize in economics in 1976. Its basic tenet is that changes in the money supply are the most important cause of changes in GDP. These GDP changes, when measured in dollars, can be broken into two components: a “real” component, which produces actual gains, and an “inflationary” component, which is illusory. The real plus the inflationary equals the nominal increase, measured in total dollars.

Friedman’s contribution was to show that increasing the money supply in order to increase output would work only up to a certain point; beyond that, any nominal gains would be inflationary and not real. In effect, the Fed could print money to get nominal growth, but there would be a limit to how much real growth could result. Friedman also surmised that the inflationary effects of increasing the money supply might occur with a lag, so that in the short run printing money might increase real GDP but inflation would show up later to offset the initial gains.

Friedman’s idea was encapsulated in an equation known as the quantity theory of money. The variables are M = money supply, V = velocity of money, P = price level and y = real GDP, expressed as:

MV = Py

This is stated as: money supply (M) times velocity (V) equals nominal GDP, which can be broken into its components of price changes (P) and real growth (y).

Money supply (M) is controlled by the Fed. The Fed increases money supply by purchasing government bonds with printed money and decreases money supply by selling the bonds for money that then disappears. Velocity (V) is just the measure of how quickly money turns over. If someone spends a dollar and the recipient also spends it, that dollar has a velocity of two because it was spent twice. If instead the dollar is put in the bank, that dollar has a velocity of zero because it was not spent at all. On the other side of the equation, nominal GDP growth has its real component (y) and its inflation component (P).

For decades one of the most important questions to flow from this equation was, is there a natural limit to the amount that the real economy can expand before inflation takes over? Real growth in the economy is limited by the amount of labor and the productivity of that labor. Population grows in the United States at about 1.5 percent per year. Productivity increases vary, but 2 percent to 2.5 percent per year is a reasonable estimate. The combination of people and productivity means that the U.S. economy can grow about 3.5 percent to 4.0 percent per year in real terms. That is the upper limit on the long-term growth of real output, or y in the equation.

A monetarist attempting to fine-tune Fed monetary policy would say that if y can grow at only 4 percent, then an ideal policy would be one in which money supply grows at 4 percent, velocity is constant and the price level is constant. This would be a world of near maximum real growth and near zero inflation.

If increasing the money supply in modest increments were all there was to it, Fed monetary policy would be the easiest job in the world. In fact, Milton Friedman once suggested that a properly programmed computer could adjust the money supply with no need for a Federal Reserve. Start with a good estimate of the natural real growth rate for the economy, dial up the money supply by the same target rate and watch the economy grow without inflation. It might need a little tweaking for timing lags and changes in the growth estimate due to productivity, but it is all fairly simple as long as the velocity of money is constant.

But what if velocity is not constant?

It turns out that money velocity is the great joker in the deck, the factor that no one can control, the variable that cannot be fine-tuned. Velocity is psychological: it all depends on how an individual feels about her economic prospects or about how all consumers in the aggregate feel. Velocity cannot be controlled by the Fed’s printing press or advancements in productivity. It is a behavioral phenomenon, and a powerful one.

Think of the economy as a ten-speed bicycle with money supply as the gears, velocity as the brakes and the bicycle rider as the consumer. By shifting gears up or down, the Fed can help the rider accelerate or climb hills. Yet if the rider puts on the brakes hard enough, the bike slows down no matter what gear the bike is in. If the bike is going too fast and the rider puts on the brakes hard, the bike can skid or crash.

In a nutshell, this is the exact dynamic that has characterized the U.S. economy for over ten years. After peaking at 2.12 in 1997, velocity has been declining precipitously ever since. The drop in velocity accelerated as a result of the Panic of 2008, falling from 1.80 in 2008 to 1.67 in 2009—a 7 percent drop in one year. This is an example of the consumer slamming on the brakes. More recently, in 2010 velocity has leveled off at 1.71. When consumers pay down debt and increase savings instead of spending, velocity drops as does GDP, unless the Fed increases the money supply. So the Fed has been furiously printing money just to maintain nominal GDP in the face of declining velocity.

The Fed has another problem in addition to the behavioral and not easily controlled nature of velocity. The money supply that the Fed controls by printing, called the monetary base, is only a small part of the total money supply, about 20 percent, according to recent data. The other 80 percent is created by banks when they make loans or support other forms of asset creation such as money market funds and commercial paper. While the monetary base increased 242 percent from January 2008 to January 2011, the broader money supply increased only 34 percent. This is because banks are reluctant to make new loans and are struggling with the toxic loans still on their books. Furthermore, consumers and businesses are afraid to borrow from the banks either because they are overleveraged to begin with or because of uncertainties about the economy and doubts about their ability to repay. The transmission mechanism from base money to total money supply has broken down.

The MV = Py equation is critical to an understanding of the dynamic forces at play in the economy. If the money (M) expansion mechanism is broken because banks will not lend and velocity (V) is flat or declining because of consumer fears, then it is difficult to see how the economy (Py) can expand.

This brings us to the crux. The factors that the Fed can control, such as base money, are not working fast enough to revive the economy and decrease unemployment. The factors that the Fed needs to accelerate are bank lending and velocity, which result in more spending and investment. Spending, however, is driven by the psychology of lenders, borrowers and consumers, essentially a behavioral phenomenon. Therefore, to revive the economy, the Fed needs to change mass behavior, which inevitably involves the arts of deception, manipulation and propaganda.

To increase velocity, the Fed must instill in the public either euphoria from the wealth effect or fear of inflation. The idea of the wealth effect is that consumers will spend more freely if they feel more prosperous. The favored route to a wealth effect is an increase in asset values. For this purpose, the Fed’s preferred asset classes are stock prices and home prices, because they are widely known and closely watched. After falling sharply from a peak in mid-2006, home prices stabilized during late 2009 and rose slightly in early 2010 due to the policy intervention of the first-time home buyer’s tax credit. By late 2010, that program was discontinued and home prices began to decline again. By early 2011, home prices nationwide had returned to the levels of mid-2003 and seemed headed for further declines. It appeared there would be no wealth effect from housing this time around.

The Fed did have greater success in propping up the stock market. The Dow Jones Industrial Average increased almost 90 percent from March 2009 through April 2011. The Fed’s zero interest rate policy left investors with few places to go if they wanted returns above zero. Yet the stock rally also failed to produce the desired wealth effects. Some investors made money, but many more stayed away from stocks because they had lost confidence in the market after 2008.

Faced with its inability to generate a wealth effect, the Fed turned to its only other behavioral tool—instilling fear of inflation in consumers. To do this in a way that increased borrowing and velocity, the Fed had to manipulate three things at once: nominal rates, real rates and inflation expectations. The idea was to keep nominal rates low and inflation expectations high. The object was to create negative real rates—the difference between nominal rates minus the expected rate of inflation. For example, if inflation expectations are 4 percent and nominal interest rates are 2 percent, then real interest rates are negative 2 percent. When real rates are negative, borrowing becomes attractive and both spending and investment grow. According to the monetarists’ formula, this potent combination of more borrowing, which expands the money supply, and more spending, which increases velocity, would grow the economy. This policy of negative real rates and fear of inflation was the Fed’s last, best hope to generate a self- sustaining recovery.

Negative interest rates create a situation in which dollars can be borrowed and paid back in cheaper dollars due to inflation. It is like renting a car with a full tank of gas and returning the car with the tank half empty at no charge to the user. Consumers and businesses find this difficult to pass up.

The Fed’s plan was to encourage borrowing through negative interest rates and encourage spending through fear of inflation. The resulting combination of leverage and inflation expectations might increase money supply and velocity and therefore increase GDP. This could work—but what would it take to increase expectations?

Extensive theoretical work on this had been done by Ben Bernanke and Paul Krugman in the late 1990s as a result of studying a similar episode in Japan during its “lost decade.” A definitive summary of this research was written by economist Lars Svensson in 2003. Svensson was a colleague of Bernanke’s and Krugman’s at Princeton and later became a central banker himself in Sweden. Svensson’s paper is the Rosetta stone of the currency wars because it reveals the linkage between currency depreciation and negative real interest rates as a way to stimulate an economy at the expense of other countries.

Svensson discusses the benefits of currency war:

Even if the … interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy…. A currency depreciation will stimulate an economy directly by giving a boost to export . . . sectors. More importantly . . . a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future.

Svensson also describes the difficulties of manipulating the public in the course of pursuing these policies:

If the central bank could manipulate private-sector beliefs, it would make the private sector believe in future inflation, the real interest rate would fall, and the economy would soon emerge from recession The problem is that private-sector beliefs are not easy to affect.

Here was Bernanke’s entire playbook—keep interest rates at zero, devalue the dollar by quantitative easing and manipulate opinion to create fear of inflation. Bernanke’s policies of zero interest rates and quantitative easing provided the fuel for inflation. Ironically, Bernanke’s fiercest critics were helping his plan by incessantly sounding the inflation alarm; they were stoking inflation fears with language no Fed chairman could ever use himself. This was central banking with the mask off. It was not the cool, rational, scientific pursuit of disinterested economists sitting in the Fed’s marble temple in Washington. Instead it was an exercise in deception and hoping for the best. When prices of oil, silver, gold and other commodities began to rise steeply in 2011, Bernanke was publicly unperturbed and made it clear that actual interest rates would remain low. In fact, increasing inflation anxiety reported from around the world combined with continued low rates was exactly what the theories of Bernanke, Krugman and Svensson advocated. America had become a nation of guinea pigs in a grand monetary experiment, cooked up in the petri dish of the Princeton economics department.

The Bernanke-Krugman-Svensson theory makes it clear that the Fed’s public efforts to separate monetary policy from currency wars are disingenuous. Easy money and dollar devaluation are two sides of the same coin, and currency wars are part of the plan. Easy money and dollar devaluation are designed to work together to cause actual inflation and to raise inflation expectations while holding interest rates low to get the lending and spending machine back in gear. This is clear to the Chinese, the Arabs and other emerging markets in Asia and Latin America that have complained vociferously about the Fed’s stewardship of the dollar. The question is whether the collapse of the dollar is obvious to the American people.

Fundamentally, monetarism is insufficient as a policy tool not because it gets the variables wrong but because the variables are too hard to control. Velocity is a mirror of the consumer’s confidence or fear and can be highly volatile. The money supply transmission mechanism from base money to bank loans can break down because of the lack of certainty and confidence on the part of lenders and borrowers. The danger is that the Fed does not accept these behavioral limitations and tries to control them anyway through communication tinged with deception and propaganda. Worse yet, when the public realizes that it is being deceived, a feedback loop is created in which trust is broken and even the truth, if it can be found, is no longer believed. The United States is dangerously close to that point.

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