Rules

From Billy's of 16 March, 2011:

The national government of Japan can always afford to purchase concrete, wood, steel, glass, health care, road contractors etc as long as those resources are available for sale in Yen.

There is no question about that. It issues the currency as a monopoly provider (that is, as a consolidated treasury/central bank unit). It doesn’t make any sense to say that the issuer of the currency can be constrained in terms of using that currency.

Intrinsically that cannot be the case. Politically, it is a different matter and the politicians might attempt to put themselves in a straitjacket and pretend that they have to spend on a quantity rule...

Billy's argument, as always, is that the government "can" print money enough to buy whatever it decides it needs. "There is no question about that," he adds, but "Politically, it is a different matter."

Politicians "pretend that they have to spend on a quantity rule." Billy always says stuff like that, suggesting politicians should use their judgment about spending, rather than a quantity rule. I would bet he loses a lot of readers because of it. Politicians obviously need some kind of spending constraint, some kind of rule.

But I'm not sure Billy objects to politicians using a rule, really. I suspect he objects to them using a rule that is wrong. At least, that is my objection.

The accepted rule -- the wrong rule -- says that if there is inflation, somebody's been printing too much money. This is a major rule. We even have an institution created specifically for the purpose of making sure we have just the right amount of money in the economy, not too much money.

Some people today want to "end" that institution. Why? To restore financial stability to America's economy. Largely, because the Fed has failed to prevent inflation.

But ending the Fed is like shooting the messenger. The problem is the message. The problem is the rule that is used to prevent inflation, the quantity rule. You know: Printing money causes inflation. That rule.

Sure, the Fed is more than just a messenger. The Fed acts on the rule. But if the rule is wrong, it is the rule that must change. If we just end the Fed, best-case, we set up some other system, apply the same rule, and again get a result we don't want.

The correct solution is not to end the Fed, but to change the rule. So the question is: What is wrong with the existing rule?

The problem with the existing rule is that there could be something else, other than printing money, that is causing inflation. Something like the use of credit.

The Old Rule

The rule we use now says that if there is inflation, then we must reduce the quantity of money. As I have noted before, the rule is open-ended: It provides no lower limit to the quantity of money.

So then if something other than printing money is causing inflation -- if the use of credit is causing inflation -- then our rule will cause us to drive the quantity of money down to too low a level. Below optimum. Below reasonable. Below the minimum we need to keep our economy working, even. With this rule, as long as there is inflation, there is no limit to how low we may drive the quantity of money.

Furthermore, since the rule does not address the actual cause of inflation, the policy can never be successful. All it can do is undermine economic performance.

The history of the U.S. economy since World War II shows that we have in fact driven the quantity of money to an extremely low level (see Graph #1.) History also shows we have allowed debt to climb to an extremely high level (Graph #2).

Graph#1: Not Enough Money	Graph#2: Too Much Credit Use

Debt is the measure of credit in use. If we have a lot of debt, it means we have a lot of credit in use. And credit-use can cause inflation. In the Arthurian view, it is credit-use, not printing money, that caused the inflation of the past 40 years.

We stuck by our rule and drove money to an impossibly low level. And then to keep our economy working we used more and more credit in place of that money. This is the reason we have so much debt today, and so much trouble to pay it off.

The New Rule

The time has come to abandon the old, open-ended rule. It hasn't worked anyway for a long time. We never did end the inflation. We need a different rule to tell us how much money we need in our economy. We need a new rule.

The new rule is a lot like the Laffer Curve. Remember the Laffer Curve? It said there is a particular tax rate that will generate the most revenue. It said that other tax rates -- higher or lower -- generate less revenue.

The new rule is like that. The new rule says there is a particular ratio of debt relative to M1 money that will generate the best economic performance. It says other ratios -- higher or lower -- give us less satisfactory economic performance.

Let's say instead: a narrow range, not a particular ratio of debt to M1 money.

The new rule takes into account both money and credit-use. The old rule said if there is inflation there is too much money. But the old rule never did stop inflation. And obviously, the old rule did nothing to prevent the excessive use of credit and the excessive accumulation of debt.

The new rule says we must consider both money and credit-use, we must keep the ratio between the two at a level that gives us maximum economic performance, and that we should increase or decrease the quantity of "money and credit-use" together, as needed to fight inflation.