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Why monetary fallacies destabilise economies
Gerard Jackson
In Do No Harm (National Review on Line, 20 September 2005) Lawrence Kudlow and William P. Kucewicz argued that “Excess money in the economy is the root cause of inflation”. This statement is absolutely correct. Unfortunately, what followed was not. They then went on to contend that the low rate of “surplus money…explains why core inflation remains low”. (We can calculate excess money by comparing the rate at which the money supply grows with the rate of GDP growth).
It is clear that Kudlow and Kucewicz think that “excess money” is any quantity that raises the price level. This view raises questions about the nature of money and how it influences prices and production. Irrespective of what Kudlow and Kucewicz obviously believe, these questions have not been settled by orthodox economic thinking. The result has been the so-called business cycle. First and foremost, it must never be forgotten that money is a medium of exchange –– everything else is secondary to that vital fact.
It should therefore follow with crystalline clarity that if any commodity cannot be used as a medium of exchange it cannot be money and should therefore not be included as part of the money supply. Unfortunately including non-monetary commodities as party of the money supply is exactly what central bankers and the vast majority of economists do.
In his Y2K Money: Inflationary or Not? (Jewish World Review 23 November1999) Larry Kudlow refers to MZM (money of zero maturity, meaning financial assets with zero maturity). These assets include those that can be redeemed at par on demand. So if I have a MZM $1000 MZM asset I can immediately redeem it without suffering a penalty or capital loss. It can be easily seen that MZMs cover a wide range of assets that can be easily exchanged for money.
Now I emphasised exchanged because in order to obtain money we must first offer something for it. This is why it is an egregious error to include MZMs as part of the money supply. Anything that has to be exchanged for money cannot be money. Although goods exchange for other goods through money –– the medium of exchange –– money does not exchange against itself. We do not exchange dollars for dollars or pennies for pennies. In plain English: any asset that has to be sold to obtain money cannot be money.
M2 suffers from the same problem. This definition of money includes money market deposit accounts. The error here should be self-evident. Putting money in market funds means to buy a money market asset. If I invest in a money market fund it gets the money and I get an asset. The money supply remains completely unchanged, just as it would if I used the money to buy a plasma television set.
The same thing happens with M3, which the RBA defines as M1 plus “certificates of deposit”, “term (excluding CDs)” and “other”. But CDs are credit instruments and not money. The same goes for “term” and “other”. If the speed by which an asset can be converted into money is used to define it as money, then my DVD collection should also be included in the money supply. If these economists and central bankers had studied Carl Menger’s 1871 groundbreaking work on the nature of money (Principles of Economics, LibertyPress, 1994) a great deal of confusion and economic pain could have been avoided.
This confusion has led to the fallacy of the stable price level, according to which the money supply should be manipulated so as to keep the CPI at a constant level. One of the reasons behind this dangerous policy has it that unless the money supply grows to accommodate expanding production the economy will slow.
The classical economists fully understood that there was no such thing as too much or too little economy. It was their insight, now forgotten by nearly all of the profession, that the money stock was always used to the maximum extent. Therefore, increasing the quantity of money added nothing to economic welfare, though it undoubtedly benefited those who were the first to receive it.
Price stabilisers would argue that this cannot be so if the price level is stable. This argument reminds me of the 1848 gold discoveries. When the gold flowed into England it caused a rapid increase in general prices. From 1857 prices fell somewhat and then remained comparatively stable until 1870 when they rose significantly until reaching their peak in 1873 when a secular downward trend in prices emerged until it was reversed in 1896. (The period 1870-1873 was marked by an inflationary boom. This explains the rapid rise in prices).
The Sauerbeck general price index (1900 = 100) shows that from 1873 to 1886 prices fell from 148 to 84, a massive 43.3 per cent drop. On reflection it becomes clear that “the nineteenth century was a period of peace, of unprecedented increase in numbers and rapid economic expansion”. (David S. Landes, The Unbound Prometheus, Cambridge University Press, 1987 edition).
Despite a chorus of dissenting voices. The Economist among them, John Cairnes described in a series of articles he wrote between 1857 and 1863 the economic effects of the gold discoveries, starting from when the gold was mined to when it was finally spent. Using the Cantillon approach he analysed the distributive effects of the gold discoveries as well as the effects on prices.
Unfortunately, because prices stabilised interest in the effects of the gold discoveries waned. What one might call proto-stabilisers argued that because prices had ceased to rise no damage had been done to the economy. However, Cairnes explained that when one took into account all the relevant factors, particularly rising productivity, prices would have been much lower compared “with, say eight or ten years ago”.
Once production once again began to expand faster than the gold supply prices resumed their downward trend –– and did so for more than 20 years. The nineteenth century makes it clear that the ‘stabilisers’ fears that falling prices brought about by increased productivity would have a depressing effect on the economy are entirely baseless.
Moreover, monetarists overlook the fundamental point that inflating the money supply has unhealthy ‘redistributive’ consequences. Their ignorance of this matter is unforgivable considering that in about 1730 Richard Cantillon explained in considerable detail how this process works its way through an economy (Essay on the Nature of Commerce in General, Transaction Publishers, 2001).
Making it worse is their failure to see that a ‘stable’ price level is not evidence of an absence of inflation. This is one reason why inflation is so insidious. It can do its destructive work of distorting production and the pattern of incomes behind a deceptive veil of what appears to be constant prices. This is something that Cantillon, Cairnes and others have seen with commendable clarity.
Sticking to the definition of money as a medium of exchange we conclude that the money supply for Australia consists of M1 plus government deposits, including state RBA deposits.
Note: Readers frequently ask why I don’t bring these economic facts to the attention of the Liberal Party. I assure them that it is not for the want of trying. It is truly dispiriting to have some party member –– or should I say party animal –– dismiss my endeavour with a haughty: “We don’t bother with that sort of gumph”. Then there is: “We have our own “experts’” or “our advisers deal with that kind of thing”, and so on. One only has to listen to the party’s bigwigs, who probably don’t give a damn about ideas anyway, to realise just how low its intellectual standards have fallen. So much for party’s “advisers” and “experts”.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 26 September 2005