Saturday, 21 May 2011

Economics Prof says excessive money supply never causes inflation.

John T. Harvey is the Prof. of Economics at the Texan Christian University, and he claims in this Forbes article that money printing cannot cause inflation. I’m sure Robert Mugabwe would pay Harvey handsomely for his advice.

Anyway, the core of Harvey’s argument is on his page 3: paragraph starting “But perhaps the real nail in the coffin “money growth==>inflation” view is…” Here, he claims that excess money cannot be forced onto the private sector because monetary base gets into private sector hands via the purchase of government debt by the central bank from the private sector. And, so claims Harvey, no one can force a sale on anyone. Thus there is no way the private sector can be forced to hold more money than it wants.

The first problem with this argument is that there is not much difference between government debt and monetary base. The former is essentially just a form of interest paying deposit account. And there is a very simple way in which the government / central bank machine can force excess government debt onto the private sector: government just runs a deficit!

That is, the Treasury borrows $X from the private sector and gives the private sector $X of bonds. The Treasury then spends the $X of cash: i.e. the $X of cash flows back to the private sector. So the net result is that the private sector is now up to the tune of $X (in the form of government debt, or “bonds” or “deposit account” – call it what you will).

Assuming that prior to the above $X worth of deficit, the private sector had the assortment of assets it wanted, then after this bout of deficit, the private sector will have what it regards as an excess supply of “cash plus bonds”. It will try to run this stock of assets down by selling bonds and then spending the cash it gets for said bonds. Hey presto: demand rises, and assuming the economy was at NAIRU prior to the $X bout of deficit, then inflation will rise as well (assuming demand rises faster than the economy’s maximum potential non-inflationary level of output).

In the above process, “force” is certainly involved. It occurs right at the start, that is where government borrows $X. Government can pay whatever rate of interest is needed to attract the $X because government can confiscate any amount of money it needs to pay that interest from taxpayers: not that governments (PIG countries apart) actually need to pay exorbitant rates of interest. That is, a rate which is marginally above the going rate will do. Plus, if and when the central bank buys those bonds back, rates subside again.

Harvey then claims on his page 4 that central banks have to accommodate the private sector’s demand for money, the suggestion being the cause/effect runs from the private sector to central banks. Well it’s true that this cause/effect relationship exists. But it is false logic to claim that because there is a cause effect relationship running from A to B that therefor there is no cause effect relationship running the other way! I just spelled out “the other way” above!

Afterthough (22nd May, 2011). Another piece of false logic in John Harvey’s article is his claim at the end of the article that because the inflationary episode of the 1970s was cost push or “wage / price spiral”, that casts doubt on the “money printing causes inflation” idea. I fully agree that that inflationary episode was cost push or “wage / price spiral”, as do many others. But the fact that X can influence Y does not preclude Z (or other factors) influencing Y!



  1. "assuming the economy was at NAIRU prior to the $X bout of deficit, then inflation will rise as well"

    That's the key assumption here. That there is no ability to quantity expand.

    "and then spending the cash it gets for said bond"

    You have no evidence that they will spend the cash on consumption. Instead assets are likely to be repriced as things get shuffled around to a new indifference level, with some actor (probably a bank) left holding the extra reserves.

    You've miss the line from John's post

    "y: The economy can and does come to rest at less-than-full employment. Hence, while it is possible for y to be at its maximum, it most certainly does not have to be."

    They key as ever is your base assumptions.

    You assume full employment and you assume policy changes can force cash to be spent. There is no evidence that is the case in the real world.

  2. Neil, Another of your challenging comments, which I always enjoy grappling with!

    Re my assumption that the economy is at NAIRU, that is simply because the whole debate here is on that assumption. John makes the same assumption when he says “They hoped to buy more goods and services but since, in aggregate, more did not exist…”. That is, the question addressed here is: what happens when a central bank pumps more money into an economy which is already at capacity and can central banks actually do this “pumping”.

    Re the idea that I have no evidence that the private sector will spend extra dosh, several studies show that when households come by windfalls or extra income, they spend a significant portion of it within nine months or so. (Hardly surprising.) See:

    Of course it’s not only the average household whose paper assets get boosted. Banks, employers and wealthy households also gain, and they might well tend to boost asset prices, as you suggest, rather than spend on consumption.

    The above idea, namely that when the private sector’s paper assets are boosted, the private sector spends more is of course central to MMT.

    Re the passage from John Harvey which you quote, this is from the part of his article where he re-defines y,P,T and M. His definition of M is all over the place: he quite obviously doesn’t get the distinction between, or the nature of vertical and horizontal money. He needs to read Billyblog!

    In the first sentence of his re-definition of M, he says money cannot be defined. Well that’s much use if you are trying to be scientific and play with algebraic equations. Actually, its horizontal money which is indefinable. Vertical (i.e. monetary base) can be quantified very accurately.

    Re John’s claim that the economy can come to a rest at less than full employment, he is simply reiterating the basic point Keynes spent his life trying to get across, namely that absent government intervention economies can come to a rest at less than full employment (or to be more accurate, they can take an awful long time to return to full employment).

    That has nothing to do with the preceding argument, which is based, as I said, on the assumption that an economy is at full employment.

  3. I have a question for you Ralph: You say that you "fully agree that that inflationary episode [i.e. stagflation] was cost push or “wage / price spiral”."

    Can you say something more about this? I know that the standard MMT line is that the economy will "quantity expand", as Neil likes to say, when it is below full employment output. How come this didn't happen during the stagflationary episode?

  4. Vimothy, The first reason for thinking that the 1970s/80s inflationary episode was cost push and which everyone cites was the huge oil price hike. I think that is something to do with it, but not the full explanation.

    I can’t speak for the US, but in the UK we practically had trade unions running the country. Union leaders regularly met the Prime Ministers, something they rarely do nowadays. Former premier, Edward Heath actually called a general election based to a large extent on the question as to who was running the country: democratically elected politicians or union bosses. The Wiki article on Heath confirms this.

    Obviously in a wage price spiral, it’s not always easy to say who is to blame: wages or prices (i.e. employers). But p.6 at this url shows that wages as a proportion of GDP peaked in the early 1970s. So I say unions were primarily to blame.

    Unions are now weaker both in the US and UK, and stagflation has receded, which again suggests that union power was an important influence in the 1970s inflationary episode.

  5. The strange thing is we had bad management and militant unions throughout the Butskellite social democratic/one nation post war period with mass employment and not too bad inflation despite the Bretton Woods fixed exchange rate regime economic straitjacket...yet once management got the upper hand,we had punishing interest rates and mass un/der/employment, the link between real wages and labour productivity significantly shifted down several gears.

    It seems to me Union power was doing what it succesfully did maintaining the realwage/labour productivity ratio and our wonderful political/theoconomic elite were all in it together looking after themselves, their own kind, aka the Global Plutocratic Elite! ;)


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