Wednesday, September 1, 2010

Predicting the Price Level

A key disagreement between the Austrian economists and Keynesian economists is over the consequences of expanding the money supply. Keynesians claim that increasing the money supply will cause a beneficial increase in economic activity, whereas Austrians claim that increases in the money supply cause all manner of bad consequences, one of which is the lowering of the purchasing power of all money currently in circulation. The most visible sign of such loss of purchasing power is a general rise in the price level. Therefore, it is important that the Austrians answer the Keynesians who say that the Austrian monetary theory is wrong, because the government’s pump priming, trillion dollar stimulus spending and the Fed’s massive asset purchases have not caused runaway price inflation. In this essay I will answer this criticism by explaining the fundamental forces at work to explain the relationship between the money supply and the price level and the forces of government intervention that make short term price level predictions impossible.

The Quantity Theory of Money

At the foundation of our understanding of money and prices resides the quantity theory of money. At this most basic level it is axiomatic that the price level is the intersection of the quantity of goods for sale on the market and the amount of money available to purchase these goods. Prices can rise for only two reasons. One, the quantity of money rises faster than the quantity of goods for sale. Two, the quantity of goods for sale drops faster than the quantity of money. Of course the reverse is true about a falling price level. Prices can fall for only two reasons. One, the quantity of money falls faster than the quantity of goods for sale. Two, the quantity of goods rises faster than the quantity of money.

Let’s use a simple example. Assume that there is only one commodity for sale in the economy. One hundred units of this commodity are produced. The money supply consists of one thousand units of currency; we’ll use dollars as our money supply unit. The only price that will clear the market of all goods offered for sale is ten dollars per unit. ($1,000 divided by 100 units) Let us suppose that there is a production improvement that allows the market to produce two hundred units of the same commodity. Then the market-clearing price will be five dollars per unit. ($1,000 divided by 200 units) Likewise, let us assume that the money supply increases to two thousand dollars while the ability of the market to produce goods remains the same at one hundred units. Then the market-clearing price will be twenty dollars per unit. ($2,000 divided by 100 units) From this simple example one can clearly see that, if we admit that the U.S. economy produced more goods today than it did twenty years ago, then the primary reason that prices have not fallen is that the money supply increased concomitantly. Likewise, if prices are higher now than they were twenty years ago and real economic output is essentially the same, then the culprit must be an increase in the money supply. But most of us grant that the U.S. economy produces more “stuff” than twenty years ago. So if the price level is higher, the only explanation is an increase in the money supply. Had the money supply remained stable, the only way that the market could have cleared the larger supply of goods would have been for prices to fall.

(Since 1990 M2 has increased by a factor of 2.62 while nominal GNP has increased by 2.57, which leads one to the conclusion that the economy has not really grown at all in terms of real goods and services in two decades. All of the increase in GNP can be attributed to higher nominal prices caused by an increase in the money supply.)

The Three Uses of Money

The quantity theory of money is at the foundation of understanding money and prices, and it does explain long-term trends. But other factors operating within this foundational theory determine market prices in the short-term. One of those factors is an explanation of the purposes to which money can be used.

There are three and only three uses for money—to hold (hoard), spend, and invest. Of the three, only the combined size of the spend-and-invest components determines the price level; i.e., spending and investing are those components of the money supply that are brought to market to purchase goods available for sale. As the total quantity of spending and investing increase in relation to the quantity of goods and services brought to market, prices will increase. If either or both of these components decrease, prices will decrease. Importantly, if the money supply increases and all of the increase goes into hoarding, the price level will remain the same.

Suppose that the Fed printed enough paper money to give everyone in America one million dollars. Since there are 300 million Americans, the money supply would increase by 300 trillion dollars! Surely that would trigger higher prices! But let us also assume that every American took the money and placed it under his mattress. He did not spend one cent. What would happen? Well, the money supply would increase by 300 trillion dollars, but the price level would remain the same. All the new money would have gone into hoarding and would have no impact on prices.

An Ever-Changing Money Supply

So far our discussion of how money affects prices assumes that there is no intervention by an outside, coercive agent that attempts to manipulate both the total size of the money supply and the three uses of money. Unfortunately that is not the case. The government intervenes regularly and inconsistently in monetary matters, making it almost impossible to point to one or two factors that will have the most impact on prices.

The most important interventionist governmental body is the Federal Reserve Bank, our central bank, which almost always attempts to expand the money supply. It “adds liquidity”, mostly by increasing bank excess reserves. Right behind the Fed is the Treasury Department, which spends the money. Both attempt in various ways to stimulate the economy by ensuring that any increases in money go into the spending and investing buckets and not into the holding/hoarding bucket. Currently the Fed and the government want all of the money to go into the spending bucket exclusively, so that the GDP numbers will rise. You see, the government measures the size of our economy by how much we spend, so it tries to manipulate this number in a variety of ways. The “cash for clunkers” program is a case in point. If nothing else causes one to question this whole paradigm, the government’s claim that destroying still useful, but older vehicles adds to our economic well being should end such naiveté.

It is beyond the scope of this article to explain the many ways that the Fed increases excess reserves and the effect this increase can have over time on the size of the money supply. Let us just say that although the Fed has less than perfect control over the money supply in the short run (and the short run can be years long), it is the size of total reserves and the reserve requirements that establish the outside parameters of the money supply. Typically bank excess reserves are around only $2 billion or less, not a great deal in an economy the size of ours. As of July 28, 2010 bank excess reserves stood at $1.012 trillion dollars! Since we have a fractional reserve banking system, the potential exists for banks to expand our money supply by many multiples of these excess reserves.

Conflicting Government Interventions

But it gets even more complicated! While one department of the Fed tries to expand the money supply, there is another whose actions prevent it—the bank examining force. As the left hand of the Fed hands out reserves to all comers, the right hand ensures that those reserves will not be converted into money via lending. In fact the right hand of the Fed--and other bank regulatory agencies, such as the FDIC--currently exercise a deflationary impact on the money supply. These agencies are forcing banks to charge off suspect loans against capital. When a bank’s capital ratio falls below that required by bank regulations, the bank has only two choices. It can attempt to raise capital, a difficult thing to do these days, or it can reduce the size of its balance sheet by reducing loans outstanding. Loan reduction has a deflationary effect on the money supply.

Add to this structural issue the fact that there really aren’t many good loans out there, which would create new money as desired by the Fed’s left hand, and you can see why all that additional liquidity has yet to reach its potential as the basis of new money. The key word here is “yet”. The potential for a massive increase in the money supply exists, however.

The Risk of Hyperinflation

Now we get a glimpse of what has been happening. The Fed has been adding liquidity mostly in the form of excess reserves. As yet these excess reserves have not been employed by the banking system to support an increase in the money supply via new lending...the bank examining force has blocked this route. The money that has found its way into peoples’ pockets has stayed in peoples’ pockets--it has been hoarded. There is no way to predict the end to hoarding, the end to bank recapitalization, and the end to bank loan problems. But when these deflationary factors do end, American prices will rise as the hoarded money and the increased money created by increased lending flow into spending and/or investing. At that point we will enter what Ludwig von Mises called the “danger zone”. No one will wish to hold depreciating dollars; they will be spent as rapidly as possible, creating the real possibility of what Mises called the “crack-up boom”. Despite the tough talk by Fed Chairman Bernanke, the Fed will be powerless to prevent this debacle. Money will become worthless.

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