Thursday, May 20, 2010

The Growth That Never Comes

Jerry continues:
Maybe it has to do with "the cost of money" rather than the "amount of money"? something like "cost-push inflation" - but i don't know what that is. The only way that inflation makes sense to me is if it's the ratio of "dollar bills" to "value" (loaves of bread or something). If there are 100 dollars per loaf of bread, then bread is probably going to cost 100x more than if there is 1 dollar per loaf of bread. What is the explanation the other kind of inflation?

The world is so fully committed to Milton Friedman's "quantity theory" of inflation, that my mind is not able to comprehend any other explanation. For example the last sentence in this excerpt --

Also, my personal favorite money multiplier analogy starts with the observation that a checking account dollar is actually a call option on a green paper dollar, with a strike of zero and no expiration. Option pricing theory says that the issue of options does not systematically reduce the value of the base security, since options do not affect the assets and liabilities of the issuer of the base security. In the same way, the quantity of checking account dollars does not affect the value of green paper dollars, since the Fed's assets and liabilities are unaffected by the actions of private banks.

-- from Mike Sproul's comment (the 3rd comment to the 17 April post) on Williamson's new monetarism blog. I just can't get my head around it.

But that's okay, as the quantity theory makes good sense to me. It makes sense at least two ways:

1. A change in the quantity of money can induce a change in total spending, and it is spending that affects the level of prices.

2. The more there is of something, the less valuable we find it, even... if it's... money.

But wow, it was hard to write those last four words. I must say, I don't know anyone who is willing to support the dollar by refusing a bonus or a raise or a windfall. So, maybe there's only one way the quantity theory makes sense to me.

Good enough. I buy it. Still, there are other parts of Friedman's argument that give me trouble. In Money Mischief he writes:

"The initial side effects of a slower rate of monetary growth are painful: lower economic growth and temporarily higher unemployment without, for a time, much reduction in inflation. The benefits begin to appear only after one or two years or so, in the form of lower inflation, a healthier economy, the potential for rapid noninflationary growth.. The 1980s provide a clear example of this sequence."

"The side effects of a cure for inflation are painful... The basic reason why the side effects occur is because variable rates of monetary growth introduce "static" into the information transmitted by the price system."

Static? Sometimes Friedman's arguments are less rigorous than they ought to be.

I don't dispute the quantity theory. I take it as a "given." But suppose something weird happened...

Suppose it came about that we needed, oh, less than 2% annual money growth to keep inflation acceptably low, but for some reason we also needed more than 4% money growth to keep the economy growing at a satisfactory rate. This would be a problem.

Not would be, as I see it. This is a problem, a problem of long standing, standing since the days of LBJ and Nixon. But lets just suppose it's a problem, and see where that takes us.

It takes us to a familiar haunt: We cannot get growth enough to keep unemployment low. We can't get growth enough to balance the budget. We can't get growth enough to keep living standards climbing. We can't get growth enough, period. But still we have inflation -- too much inflation, for too many years.

And we cannot solve the problem.

Let's say the only thing that causes inflation is too much money, whether by printing or borrowing. Too much money, Jerry: your "ratio of 'dollar bills' to 'value.'" And we know it to be true. But every time we cut money growth to stabilize prices, we create a recession. And Friedman was wrong: We never get the "rapid noninflationary growth" he promised. We never get the Golden Age.

The problem isn't "static" generated by messing with the money supply. The problem is that we need an inflationary rate of money growth in order to get the economy to grow at all. In other words: There is a problem on the growth side, a problem that demands more inflation that we find acceptable.

The growth-side problem is rising cost. Rising cost inhibits growth. And it turns out that creating some inflation compensates for rising cost and gets us a little growth.

The "compromise" solution has been to settle for more inflation and less growth than we want. This inflation is created by "too much money" as you understand it Jerry, but it is driven by a cost problem. That's how we get cost-push inflation. Because without the inflation, we just don't get the growth.

The only other known solution is to restrict money more, and fight inflation better, and lie to ourselves about the growth that never comes.

The correct solution -- the Arthurian solution -- is to admit that the problem is a cost problem on the growth side, recognize that excessive reliance on credit is the source of the cost problem, and solve the problem by reducing our reliance on credit. The correct solution is not compromise. It is victory.

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