US economy, monetary policy and recession

Gerard Jackson
BrookesNews.Com
Monday16 May 2005

Supply-siders are warning that Greenspan is recklessly tightening monetary policy and that this move will drive the US economy into recession. The heart of the supply-side argument is that there is no inflation and that Greenspan has abandoned the “price rule”.

However, as I explained in How the Fed’s price rule caused the recession the “price rule” is guaranteed to destabilise the US economy. This so-called “rule” is based on the assumption that a stable price level demonstrates the absence of inflation. It does nothing of the kind.

This dangerous misconception has led to supply-siders claiming that because long-term bond yields are at 45-year lows there is no inflation. But these yields are signally an absence of inflation but belief that the CPI is not expected to rise significantly. These are two very different things, as the 1920s amply demonstrated.

Critics have also pointed to the decline in the price of metals as a harbinger of an impending recession. Although it is true that most metal prices are in decline I would hesitate to use data as heralding slowdown at this stage. But this view ignores the emergence of China and its huge demands on the commodity markets.

A significant fall in demand by China for commodities might lead to a fall in commodity prices even as America’s demand for commodities rose. (Monetary tightening in China suggests that the country’s demand for commodities will fall, if they haven’t already).

Of course critics could be on to something if they could show that the Chinese and US economies were somehow synchronised. In the absence of a simultaneous movement in economic activity between the two countries, however, one would have to determine whether the US economy’s demand for commodities had fallen rather than just commodity prices.

At this point focusing on money supply seems to be a better option. This brings us to a particularly dangerous supply-sider fallacy. In keeping with Milton Friedman’s view that inflation is a monetary problem caused by too much money chasing too few goods they assume that there is no inflation so long as the CPI is stable.

The obverse of Friedman’s view is that increased productivity will absorb the existing money supply and so cause prices to fall. This will then squeeze price margins which will then slow the economy. Hence the need for monetary expansion

Well, as one of Charles Dickens’ characters would have said: “Fiddlesticks”. Money is never absorbed — it is exchanged. When productivity rises average costs fall and so do prices, meaning more goods are exchanged against the same amount of money. Price margins are not squeezed in these circumstances. One need only look at nineteenth century Britain to confirm this fact.

I think the essence of the supply-siders’ error is that they have confused goods-induced falls in prices with deflation. The latter is always caused by a comparatively sustained contraction in the absolute quantity of money.

To argue that the money supply must be continuously expanded is to inadvertently argue in favour of the boom-bust-cycle.

Supply-siders are on stronger ground when they direct their attention to the money. Even here, unfortunately, we find more errors. Some are complaining about the fall in M2. But what matters basically are bank deposits and currency.

To put it simply, the money supply equals currency outside the banks, wherever it is, plus all bank deposits, including any deposits with or by the Fed. (M1 is sufficiently close enough to serve our purpose of being the correct definition of the money supply). Money market deposit accounts, which are considered part of M2, do not add to the money supply nor are financial intermediaries money substitutes.

As Walter Boyd wrote 204 years ago:

By the words ‘Medium of Exchange’, ‘Circulating Medium’, and ‘Currency’, which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exhange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation.

Gerard Jackson is Brookes’ economics editor