## Monday, May 16, 2011

### Fun with Numbers

JzB writes:

Having some specific stable quantity of money in the base seems totally unrelated to inflation.

Let me show you how to make base money and inflation seem related. First, you grab the FRED graph for base money:

 Graph #1

You divide it by a measure of output like GDP, because prices are proportional to "the quantity of money relative to output."

 Graph #2

Then you add a second line to the graph, to show the price trend. I'll use the CPI:

 Graph #3

You can see already that the red and blue lines are very similar:) To make this more obvious I will multiply all the blue-line values by a constant, to magnify the line and get a better comparison:

 Graph #4

Next, to convert the output numbers to real output, multiply the blue-line numbers by a price index. This is just like what Milton Friedman did in Money Mischief:

 Graph #5

There ya go. Now there seems to be some relation between money and inflation! However, it is pretty easy to see that until the crisis of 2008, prices (the red line) were going up faster than the money/output ratio. We can fix this by replacing base money with a faster-growing money. Milton Friedman used M2. I'll do the same:

 Graph #6

Look at that! Now there seems to be a striking similarity between prices and the money/output ratio! Wasn't that easy?

Before anybody misinterprets the above post, let me clarify a few things. First of all, my sense of humor is generally inaccessible. But there is the title. And there is my insistence on making the one set of numbers "seem" like the other. And there is the little smiley face. Those are clues.

The big joke occurs between graphs #4 and #5, where I arbitrarily introduce the conversion of output to real output. Yes, I 'defend' it by saying that's what Milton Friedman did. And it is. But that doesn't mean I think it is good arithmetic.

The use of "real" output in this calculation is completely out of place. As I attempt to show, the similarity of money/output to the price-trend arises because of it -- because it factors the price trend into the money/output ratio!

// Update 19 May 2011

For the short form of this critique of Friedman's MRTO graphs, see The Friedman Factor.

LiminalHack said...

"First of all, my sense of humor is generally inaccessible."

LOL, very good! Nice and dry!

Seriously though, not sure what the point is here. If the FED hadn't kept increasing the amount of base money between the end of the war and 2007, then the credit expansion would have come to a sudden halt.

As discussed before, if base money seems unrelated to inflation to you then that's because there are plenty of other forms of liquidity that affect prices, including bank debt, shadow banking liabilities, government bonds and so on. Obviously if you take a banking system and guarantee most all its liabilities then a lot less base money is needed than in the non insured case, at least until the system has achieved maximum extension. It seems you never consider the turnover of money (a term I prefer to velocity), that is you focus on stocks not flows.

Going back to basics, if you think there is too much debt and too little money how would you propose to change that? Add more base money? Raise rates? Increase capital requirements?

What would the outcome of these actions be and would they result in a stable system which places a practical upper limit on total debt?

The Arthurian said...

Thanks :)

Seriously though, not sure what the point is here.

My point is not to dispute the relation between money and inflation, but rather to show that Milton Friedman's famous graph is junk. It has the properties of a hoax, though I'm confident it is only bad arithmetic.

Conceptually, thinking about the economics involved, it makes perfect sense to look at the ratio of money to "real" output. But mathematically, it makes no sense at all. Taking inflation out of output reduces the output-trend by a pattern that has the shape of the price-trend.

Then, using inflation-adjusted output (as opposed to actual output) in the denominator of a fraction skews the resulting trendline in a pattern that again, has the same shape as the price-trend. But this time, the price-trend is factored INTO the result. This is elementary-school arithmetic.

In other words, the trend we see in Milton Friedman's graphs of money relative to output looks like the price-trend NOT because of the money and NOT because of the output, but because of the price-trend that he factored into his result. Thus I can achieve a similar effect using, for example, population instead of the quantity of money.

I think this is HUGELY significant. The chief implication is that any focus on M2 as the source of inflation is baseless. As you know, the Federal Reserve itself for a time focused on M2 in its effort to control inflation.

If the FED hadn't kept increasing the amount of base money between the end of the war and 2007, then the credit expansion would have come to a sudden halt.

I think the Fed should have increased base-money more between the end of WWII and 2007. I think their sudden change of heart in 2008 is evidence that supports this view.

As discussed before, if base money seems unrelated to inflation to you then that's because there are plenty of other forms of liquidity that affect prices, including bank debt, shadow banking liabilities, government bonds and so on.

Yes. These are the ones that increased too much. The ones that helped the financial sector become too big. The ones we call "debt".

If we could do it over, my way, we should have increased base-money about TWICE as fast between 1947 and 2007, and increased these other forms of liquidity HALF as much.

The inflationary effect of increased base-money growth would have been offset (plus or minus) by the reduced growth of 'other liquidity'.

Plus, we would have only half the debt we have now. And if this re-balancing of money had moved us closer to the optimal monetary balance, I think inflation would have been lower, and unemployment higher, since the 1970s.

Going back to basics, if you think there is too much debt and too little money how would you propose to change that?

Congress must start creating policies that encourage people to pay off debt faster than we do. Give me a tax deduction for making two extra payments on my mortgage. (It would have been better to do this 20 years before the crisis.) Reduce the demand for credit, and reduce the accumulation of debt at the same time.

It is essential to distinguish between new uses of credit, which help the economy grow, and old accumulations of debt, which do not.

Liminal Hack said...

Paying debt off faster doesn't alter the potential stock of debt that can be accumulated, since after I have paid of my debt "early" I'm ready to take on a new loan "early" or even hold two loans in pay them off in parallel.

Liminal Hack said...

"If we could do it over, my way, we should have increased base-money about TWICE as fast between 1947 and 2007, and increased these other forms of liquidity HALF as much."

Hmm, I'd say that just would have got us from there to here, twice as fast. There is no reason to assume that double the rate of increase of base money would have had any effect on accumulation of other monetary aggregates.

The Arthurian said...

"Paying debt off faster doesn't alter the potential stock of debt that can be accumulated, since after I have paid off my debt "early" I'm ready to take on a new loan "early" or even hold two loans in pay them off in parallel."

The key word in that sentence is "after".

[responding to my idea to double the growth of base-money and halve the growth of total debt during 1947-2007]:

"Hmm, I'd say that just would have got us from there to here, twice as fast."

Where is your "here"? My objective is to reduce the level of debt per dollar (DPD). Doubling the growth of base-money and halving the growth of debt would have reduced DPD to a quarter of its present level, no?

"There is no reason to assume that double the rate of increase of base money would have had any effect on accumulation of other monetary aggregates."

There is some reason to assume that incentives to accelerate the repayment of debt would have an effect on accumulation of those monetary aggregates.

There is some reason to think that increasing the growth of base-money would offset the downward pressures created by the slower growth of debt. The net gain from this transition is a reduced factor-cost of interest, leaving more income to split between wages and profits.

Jazzbumpa said...

A few thoughts, in no particular order.

1) At the risk of taking this way too seriously, the key operative word in my quote is STABLE. I was disputing Liminal's (apparent) claim that the mere existence of a money base is inflationary. Your whole argument is based on changes over time, which is exactly unlike what I was talking about.

2) You are illustrating a specific case of the hazards of using ratios. I guess this is a subtle point, because some people just don't get it.

3) I guess your whole point is the ratio of total debt to base money, since base money is the narrowest definition of money that is not debt generated. In so doing, you are attempting to distinguish between base (= "real") money (I suppose) and debt (= {virtual/ephemeral/imaginary} money. Implicit in this characterization is the idea that there is an optimum value for this ratio. I say that because the economy cannot function if it is debt-free.

How does one determine that optimum?

Granted some sensible answer, lets have a look at finance sector debt.

In the graphs in this Wikipedia article, you can see that finance sector debt is over 100% of GDP, and their net worth is trivial, at those times when it isn't actually negative.

(Stacked graphs are a bitch for my aging, bifocal-laden eyes, but it looks as if finance sector dept (per GDP) really took off, around 1984, While most other sectors debt was stable or shrinking. Looks like household debt also grew, but less dramatically.)

This is what is causing a stagnating economy. a) The debt burden is finance sector generated. b) lending for investment is way down. c) Financial tail chasing distorts the economy, which d) increases the wealth disparity in the population, which e) necessitates an increase in household debt.

The current tax code, which is essentially flat, all things considered, besides overtly favoring the tail-chasers, aids and abets all of the above.

My solution is to reinstate all the financial controls that have been eliminated over the last 35 years, and let the economy grow into it's debt, rather than taking any additional reduction moves now.

We are in the lowest inflation of my life-time (except for the post WWII recession) with both nominal and real interest rates at historic lows. We are tottering on the brink of deflation and economic collapse.

But austerian Rethug policies will drive us into depression, fascism, and neo-feudalism.

WASF,
JzB

Jazzbumpa said...

It is essential to distinguish between new uses of credit, which help the economy grow, and old accumulations of debt, which do not.

I don't think this is the right focus. While the old accumulation of credit must be serviced, going forward, I'd rather look at sound and unsound uses of credit. Credit for real investment in business, education*, infrastructure is sound. Credit for discretionary spending is much less sound (though justifiable, if the debt can be serviced) Credit for financial tail chasing is death to the economy.

*his should be gov't NOT individual.

Cheers!
JzB

The Arthurian said...

LiminalHack said...

"Credit for financial tail chasing is death to the economy."

That is what you get when we pretend that a fundamentally non scarce item such as numbers in a central bank computer are actually scarce enough to attract a yield.

Nature/Human Nature/Common Sense rebels.

I hope you have not mistaken any of my posts to infer that I am some kind of rabid libertarian.

The Arthurian said...

Hey Lim...
This is gonna be a compliment.

"I hope you have not mistaken any of my posts to infer that I am some kind of rabid libertarian."

Nope. From the start I took you for an MMT guy. But I was not sure (and therein lies the compliment) because you use your own words rather than those of Warren Mosler or one of the other high priests of the cult.

There are only clues, like your phrase "numbers in a central bank computer."

That, and you seem to have a lot of trouble seeing the cost that is associated with debt.

Well... mostly a compliment.

The Arthurian said...

Jazz, you quoted me:
"It is essential to distinguish between new uses of credit, which help the economy grow, and old accumulations of debt, which do not."

And you responded:
"I don't think this is the right focus. While the old accumulation of credit must be serviced, going forward, I'd rather look at sound and unsound uses of credit."

You had a really good statement the other day about three categories of credit goodness (or badness). It was really clear, and I meant to compliment you on it. (But I'm not sure where I saw it.)

Anyway, my 'new versus old' evaluation is compatible with your 'good versus no good' evaluation. Both standards could be applied via policy.

But if I understand it right, the 'good no good' evaluation applies only to new uses of debt. I mean, at this point what's done is done.

The Arthurian said...

Jazz: "But austerian Rethug policies will drive us into depression, fascism, and neo-feudalism."

And dark age. It's all part of the cycle of civilization. As it was in the beginning, is now and ever shall be, world without end. Amen.

Greg said...

"And dark age. It's all part of the cycle of civilization. As it was in the beginning, is now and ever shall be, world without end. Amen."

This cycle is not predetermined, rendering us helpless to stop it. It is all due to our choices, our policies, our (mis)understanding of human nature and our deference to authority figures who have no business being in charge. I cant go on believing we are stuck in a repeating cycle and are helpless to stop it. We simply need to lift the veil form our eyes and see what bad choices we've made in putting ourselves here. We CAN control where we want to go to a much greater degree than we give ourselves credit for.

BTW, Liminal doesnt sound like an MMT guy to me.

The Arthurian said...

Hi Greg!

"This cycle is not predetermined, rendering us helpless to stop it..."

Carved into picnic table: "No Fate"

I absolutely agree. However, given the fixity of human nature, continuation of the cycle is the most likely outcome.

I am pretty sure that even the people you and I most disagree with -- austerians, say -- think they are doing what needs to be done to prevent the end of civilization.

"BTW, Liminal doesnt sound like an MMT guy to me."

...because he doesn't use those stock phrases :) Well, I expect you're a better judge of that than I.