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Printing Money Shaped2

Although sometimes nicknamed “dead presidents” different denomination US Dollar bills do not all carry the portrait of a president: the $100 bill pictured above sports Benjamin Franklin, who was many things in life, but never President of the United States. Nor was Alexander Hamilton, portrayed on the $10 bill.  Of the seven denominations in current circulation ($1, $2, $5, $10, $20, $50 and $100), the other five have presidents on them, three of whom were also generals (Washington, Jackson and Grant).  There are five other denominations which are no longer circulated (if they ever were): they are for $500, $1,000, $5,000, $10,000, and $100,000. Of those, only the $10,000 is not adorned with a presidential face: instead it is Salmon P. Chase who is immortalised there.

Milton Friedman was a famous economist.  Although there is no question that as economists go, he was undoubtedly a good one, as most economists go he also held some pretty dismal views.  And I call them dismal not for the classical reasons (which are downright obnoxious[1]), but because some were just wrong, some misleading, and some have led to all sorts of social and political problems.  For the moment we will focus on just one (egregious) error.

Take one of his most famous sayings, usually partially quoted as “Inflation is always and everywhere a monetary phenomenon”. He actually went on to make his meaning more precise by adding “in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.  That precision helps us to be certain that he was plainly wrong.  And the very special way in which he was very very wrong indeed highlights a particular arrogance that is all too common among (at least how we use the words of) dead economists: for he totally disregarded one of the key variables in the monetary equation that he helped to make famous (and discussed below).

Unfortunately one of the residual memes from the otherwise widely discredited vogue of monetarism that reigned over the policies of too many central banks in the last quarter of the last century is that if we let the money supply grow faster than the growth in GDP, we are inevitably heading for an increase in inflation. Indeed the recent few years have seen and heard any number of scaremongering predictions, often from “reputable” economists that the US (among others) is heading for hyperinflation. Plenty of politicians have jumped on this bandwagon because it suits their ideology however witless the driver of the wagon.

It is true that various measures of money supply in various countries have expanded at historically high rates: so how can I be so sure that the predictions of hyper (or even simply high) inflation are so wrong?

The first point to make is that so far there have indeed been rapid increases in money supply…. But nowhere have they resulted in equally (or even vaguely) rapid surges in inflation. In fact various measures of inflation are at historical lows in the US. We are still waiting.

The second point to make is that “so far so good” is not a panacea: it is after all what the apocryphal jumper from the top of the tall building is heard to say as s/he passes the 5th floor on the way down, and the point of the joke is precisely that in the end the jumper comes to no good!

The key to understanding what is going on is to look at why anyone might think the way Milton Friedman does above.

The idea that prices and the amount of money around are closely linked is even enshrined in our thinking at the level of “common sense”: we talk about “too much money chasing too few goods”, and it seems obvious that if such a thing is allowed to happen, then that excess of money will force the price of the goods up.

I have always found it a good way to understand an idea simply to take that idea to what I call its pathological extremes.

In this instance I would ask: how does the chasing affect the price? i.e. what happens if the money doing the chasing is doing it very slowly?  What happens if the money is chasing sooooo slowly that it is hardly moving at all? In fact, what happens if the money stops moving: i.e. what happens to the prices of goods if no-one spends any money at all (for whatever reason: we may all be saving all our money for a rainy day during a particularly dry spell)?

Well if no one spends any money, then no goods get sold, which results in a backlog of goods, reducing most people’s desire to produce any more goods since the ones already around are not selling.  So if no one spends any money, prices certainly do not go up, HOWEVER much money there is not doing the chasing!  If anything prices will go down (in an attempt to tempt people into spending, and in an attempt to reduce the overhead costs of having the goods in the shop, or in a warehouse), and fairly obviously economic activity will slow down too! And note that this will happen however much money is pumped into the system or “printed”. You cannot force people to spend if they do not want to, and if they do not spend then prices will not go up.

So obviously, in this extreme “pathological” case, where money does not get spent, there is NO relationship between increasing the amount of money and increasing the price of goods.

And actually, that is in fact how this theory of the relationship between money and prices SHOULD be.  The classical way of expressing the relationship is thus :


I haven’t used a formal equation before in this blog, and I will not often do it… but sometimes we have to put into formal pictures what we experience.

The formula above translates into English really quite easily, and its truth is really quite intuitive: it states that the amount of money in the system (M) TIMES the rate at which it gets turned over/spent (i.e. its “velocity” V) is EQUAL to the price of goods (P) TIMES the quantity of goods (Q). We can go a little further without unduly oversimplifying the idea by pointing out that over any period the change in PQ is the practical equivalent of GDP (i.e. over any given period the value of the goods produced in a country IS its GDP).  Equally we should note that if we are interested in inflation (which measures the change in prices or P) then we must be looking at the changes: the change in the amount of money over a period, times the rate at which it gets spent is equal to the change in prices times the number of goods produced in that same period.

The first point to note is that just increasing M certainly does not necessarily mean that we are increasing P, for we could be increasing Q, or decreasing V or witnessing any number of different combinations.

The second point to note is that, in fact, in a healthy economy (i.e. one growing at its naturally sustainable rate with minimal inflation), you would naturally expect M (the money supply) to increase.

It should be reasonably obvious that if velocity is dropping (i.e. people are not spending as fast as before), then prices are most unlikely to be going up, even if we pump money into the system.  In other words, Friedman’s famous dictum manages to completely miss the importance of the velocity of money, as though that were completely irrelevant. And the problem that Milton had was precisely that he thought that velocity was indeed irrelevant on the grounds that it seemed to have remained remarkably stable for a very long time in the US.

M2 V before CrisisNot as stable as Milton thought [2]

 Even if that were the case (and it kinda depends on how you measure velocity), a basic thought experiment such as the one described above should have been enough for  a genuine seeker after truth to realise that observed long-term stability does not imply that instability is impossible (ask anyone living on the San Andreas fault).

The fact is that during this crisis the velocity of money has significantly diminished. Worse: the trend of velocity seems to be heading lower, indicating that the propensity to spend is still diminishing.M2 V in Crisis

And that means that the likelihood of new money leading to increased inflation has also diminished, even without new production.  And the whole point of injecting new money into the system is to channel it NOT into higher prices, but into higher PRODUCTION…. which as I have pointed out already is usually the reason why we want money supply to increase in a healthy economy. 

Far from condemning us all to hyperinflation, the “quantitative easing” of a number of central banks (such as the Fed, the Bank of England, the Bank of Japan, and to a lesser extent the European Central Bank) is designed to prime the pump of increased production, in the hope of dragging the various economies out of their lackadaisical recoveries into ones where unemployment drops back to significantly lower levels. And the drop in the velocity of money is only one reason why this policy is exceedingly unlikely to lead to inflation: I will mention a number of others in coming posts.


©Copyright Chris Golden July 2013

[1] First used by Thomas Carlyle when arguing for a reintroduction of slavery…..

[2] Source: FRED (Series ID: M2V)