In yesterday’s column, I outlined the problem that now confronts the Fed – the direct consequence of monetary expansion along unconventional lines – and Allan Meltzer’s proposed solution. In this column I shall outline the monetary model that, in my judgment, defines the terms on which the Fed must retract its over-expansion, and the public choice model that will determine why required monetary contraction is unlikely to occur. In tomorrow’s column, I shall outline the predictable consequences for the economy of the United States.
The key monetary theory question that must be addressed is: can the Fed contract the money supply significantly without imposing a short-run increase in the rate of unemployment? The one word answer is, no. The relevant model is that enunciated in 1971 by maestro Milton Friedman in The Journal of Political Economy under the title: “A Monetary Theory of Nominal Income”. Friedman’s paper is technical, but I shall explain it as simply as possible by reference to a basic quantity theory equation:
where M is the quantity of high-powered money, V is the income velocity of circulation of that money (defined as the number of times money turns over in the real economy during a specified time-period), P is the aggregate price level, and Y is the level of real output or gross domestic product.
As written above, the quantity relationship is not an equation but an identity; that is to say, it will always hold just as 2 always equals 2. It becomes an equation, a falsifiable hypothesis, if you will, by asserting something more specific about the nature of the relationship. For our purposes, three alternative sets of assertions are worthy of consideration:
In the first case, advanced by Irving Fisher during the 1920s, V and Y are constants, determined outside the system. So any change in M, upwards or downwards, impacts P, and P alone. This is known as the classical dichotomy, namely that only real factors impact the real economy and nominal factors affect only the nominal values of real factors. If Fisher’s theory were to hold, then Bad Ben indeed could contract the money supply without impacting adversely on Y (and unemployment levels). But alas, it does not hold, as was demonstrated conclusively over the period 1979-1982 when Paul Volcker’s monetary contraction lifted the level of unemployment in the United States to 10.8 per cent, well above the level currently observed in 2010.
In the second case, advanced by Maynard Keynes in 1936, or rather by his undisciplined so-called disciples during the 1940s and 1950s, P and Y are constants determined outside the monetary system and M and V always completely offset each other. If M rises, V falls and vice versa. So, one cannot push or pull on a string, and monetary policy is completely ineffective. If this theory were to hold, Bad Ben could do whatever he liked. No one would care. His interventions would exert no impact on the economy. Unfortunately for Bad Ben , however, the theory is false, as Friedman and Schwartz’s magnificent Monetary History of the United States clearly demonstrated. Inflation is always and everywhere a monetary phenomenon.
In the third case, correctly advanced by Milton Friedman in 1971, if M changes, then V moves somewhat in the same direction, accentuating any shift in M. This combined movement on the left-hand side of the equation manifests itself in a same direction movement on the right-hand side, primarily on P, but somewhat on Y, in the short-run. In the long run, the LHS movement impacts solely on P alone (the return of the classical dichotomy). This is the theory that almost all Americans embrace, as Wall Street reactions to Fed statements clearly demonstrate. It is the theory that puts Bad Ben in the hole, and that should concern all of us as the Fed ponders what to do about impending inflation.
So the definitive response is that Professor Meltzer is right. Bad Ben undoubtedly confronts a trade off between lower inflation and higher unemployment if and when he enters the money market to mop up the excess supply of money that he has so recently loaded onto the US economy.
As I have mentioned earlier, Bad Ben‘s dilemma is worse than this. Because he purchased toxic mortgage-based securities instead of Treasury notes, when expanding the money supply, no doubt he will attempt to sell those back to the market should he decide to attack inflation. But suppose the market values those securities at zero, as well they might, and as the failure of the TALF program suggests it will. Bad Ben will be unable to make a dent in the supply of money by his pathetic yard sale. He may be forced to sell off all his remaining Treasury notes, effectively bankrupting the Fed, while still leaving significant inflationary pressure in the US economy. By that time Bad Ben would be political toast, a prospect that has considerable public choice significance for Bad Ben‘s predictable decision when inflation bites.
Finally, I turn to the public choice issues that surround the Fed’s choice between inflation and increased unemployment. A fundamental insight from public choice is that politicians always prefer solutions that involve concentrated benefits and dispersed costs over solutions that involve concentrated costs and dispersed benefits. That preference is indelibly ingrained in the gene pool of political survivors. Think now about Bad Ben‘s alternatives. If he attacks inflation successfully with his toxic assets, he raises mortgage interest rates directly, by saturating the market with existing mortgage securities. Down comes the housing market once again, this time coupled to a dramatic collapse in the commercial securities market. The population at large benefits to a much more limited immediate extent from reduced inflation. Dear Readers, this scenario wipes out Obama in 2012 and Democrat-majorities in Congress for decades to come. What do you think that Bad Ben will do given his track record at the Fed?
In my concluding column, tomorrow, I shall outline just what Bad Ben predictably will do and the consequences for the United States economy.