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"If the government creates money all it'll do is cause inflation and we'll all suffer."  This is one of the deadliest lies we've been told for the last 40 years.  For centuries, philosophers and economists thought that any increase in money would always increase prices.  John Maynard Keynes pretty much set the record straight on that about 80 some years ago.  But the idea has been resurrected in the last few decades and is now mainstream again.  It's this rationale that conservatives use to justify destroying social programs, budget cuts, and the basis for the current debt "ceiling" discussions in Washington.  What makes the idea so insidious is that it makes sense on the surface.  With most things, the more of something there is, the less it's worth.  But unlike most things, money has no intrinsic value.  That makes it fundamentally different.  Below I will show you the modern re-emergence of this theory and why it is bullshit.

Money has no value until it is spent.  What that means is that only at the time of purchase does it have an effect on inflation.  For instance whether a single dollar bill is spent 4 times, or 4 dollar bills are spent once, the effect is the same.  To give an example of what I mean, let's look at two scenarios:

One day, a cold man buys a coat from a coat shop for a dollar.  Now let's say the owner immediately gives that dollar to one of his employees as their salary for the day.  The employee then turns around and buys a coat as well.  The shop owner then takes that dollar and buys lunch at a cafe.  The owner of the cafe then takes that dollar to the shop and buys a coat.  Finally, the shop owner takes the dollar to the owner of a billboard and buys advertising.  The billboard owner then takes that dollar and buys a coat with it.  On the way home the shop owner buys a book with his dollar from the bookstore.

In the second scenario.  Let's change the order.  The cold man, the cafe owner, the employee, and the billboard owner all come in to the coat shop in the morning and buy a coat for a dollar.  At the end of the day, the shop owner takes those 4$ and pays his employee's salary of 1$, buys dinner at the cafe, buys his billboard ad, and gets his book.  That's 8$ worth of activity from 4 single dollar bills.

In both scenarios, the end result is the same.  4 people have coats, the shop owner has payed his one employee, gotten a meal, has advertising, and bought a book.  That's 8$ worth of activity from a single dollar bill in the first scenario, and 8$ worth of activity from 4 single dollar bills in the second scenario.  How is that possible?  Doesn't more money always mean higher prices?  In short, No.  The rate that money is spent also has an impact on prices.  As far as prices and demand is concerned, a single dollar being spent 10 times has the same effect as 10$ being spent once.

This is something that economists have know for a long time.  They even have a fancy, glazed-eye inducing formula to represent it.  Money Price Formula  They eventually boil the formula down to this.  MV=PQ.  In their own convoluted way, what economists are trying to say is that, All existing Money(M) multiplied by the average number of times it is spent(V) is equal(=) to the amount of goods in the economy(Q) * the average price of those goods(P).

For example, if in a small town there are only 10 physical dollars(M) and each dollar is spent 3 times(V) then that means there was 30$ worth of activity.  So if there were only 3 things bought(Q) in that village(say a toaster, a coat, and a lighter), then their average price would have to be 10$(P).  If there were 6 things bought, then the average price would have to be 5$.  M times V must always equal P times Q.  M * V = P * Q.  This equation is non-controversial among all economists.  It is logical and self-evident.

This finally brings me to the lie we've been told for decades.  Some guy, decades ago, took that equation MV = PQ and said something to the effect, "well, if you 'assume' that the velocity of money is constant and that the economy cannot(or will not) increase the amount of goods, then any increase in the money supply will only serve to increase prices".  Algebraically, it makes perfect sense.  If you assume that 'V' and 'Q' are constant, then making M bigger would HAVE to make P larger.  Thus was born the Quantity Theory of Money.  You probably see the problem with this already.  'V' and 'Q' are most certainly not constant!  (Funnily enough, that same guy still managed towin a Nobel prize in economics.)

'V' or the velocity of money is not constant.  That's why during the start of a recession the federal government can run huge budget deficits and still see 'P' or prices go down.  When people feel insecure about the economy, households save money in case of a layoff, and businesses don't risk new investments.  The rate money is spent goes down and in the case of 2008, completely eclipsed the increase in the money supply created by budget deficits.

The other assumption that 'Q' is constant is also bullshit.  An increase in money or spending rate can make the number of goods in the economy(Q) go up instead of prices.  Think of a car factory being inundated with requests for more parts.  Instead of increasing prices they could add a third shift.  As long as there are enough unemployed workers to hire for the third shift, the increase of MV will affect quantity(Q) and not prices(P).  Q would increase instead of P as long as the ability to increase supply exists.  If there aren't enough workers (or some other constraint), then the factory would have to raise prices.  This situation would exist when there is almost no one who is unemployed to be hired for the third shift.  You might be asking "why wouldn't the factory just increase prices and reap all those profits?"  The answer is that if the factory just increased prices they would be susceptible to some other factory adding a third shift and keeping their prices low - or as economists like to put it, "firms increase quantity before prices to maintain their marketshare".

Now you should be able to see the absurdity about worrying about rising prices when unemployment is so high.  High unemployment means that 'Q' isn't at it's highest.  Therefore increasing 'M' via federal budget deficits will have very negligible effects on 'P'.  Instead new jobs will be created and we can enjoy the increased goods without increased prices.  Only when the economy is maxed out will budget deficits start increasing prices. It is at that point that we can start worrying about budget deficits and debt "ceilings".  Worrying about them before that happens is stupid.

I've tried to show in the most logical way I am capable, of why we shouldn't fear increasing the amount of money at times like this.  Now that you've seen the basis for the "Quantity Theory of Money" and the assumptions that it relies on, I hope you see that it is bullshit.  While it may be "technically" true when its assumptions are true, the assumptions it relies on are rarely, if ever, true.   I hope you can also use this knowledge to explain to your right-wing and (more importantly) not-so-right-wing friends why they don't have to feel uneasy about budget deficits.  That way you can pivot back to talking about unemployment.  This is the sort of thing that Obama and congressional Democrats should be doing, but since they aren't, it's up to us and other grassroots activists to do so.

Much of this analysis is based on Modern Monetary Theory (MMT). It's a (relatively) new "Post-Keynesian" economic school of thought.  If you're interested in learning more, please follow our group, Money and Public Purpose.  Also, there is a small, but growing MMT wiki that is worth checking out.

Originally posted to Money and Public Purpose on Fri Jul 22, 2011 at 06:02 AM PDT.

Also republished by The Democratic Wing of the Democratic Party.

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Comment Preferences

  •  You Sort of Designed (0+ / 0-)

    Two scenarios with the intention of spending $8 both times.  If what you say is true, then there's no point in increasing the money supply in the first place, because it generates zero stimulative activity.

    If you quadruple the amount of money in the system and it results in zero new goods or services being purchased, what was the point?  If there's no new spending, then no new jobs are created.  If no additional coats are purchased, then the coat maker doesn't need to order additional inventory to make coats from next month, etc.

    •  Designed to demonstrate Velocity (2+ / 0-)
      Recommended by:
      Ashaman, psyched

      I designed the two scenarios to demonstrate the concept of velocity of money.  As a concept, the velocity of money is rarely ever discussed or even implied when it comes to inflation discussions.  Instead all we hear about is the "quantity" of money.

      The federal government creates money by spending it.  When it spends it gets something for it(more roads, tanks, food, coats, garbage pickup, etc...).  Therefore you are increasing 'Q' when government spends.   I was not suggesting that creating money is always offset by lower velocity.  If I came off that way that's a failure of my writing.    What I was trying to get at is that the velocity of money is something to consider when discussing inflation and spending limits.

      Our Dime Understanding the U.S. Budget

      by maddogg on Fri Jul 22, 2011 at 06:20:03 AM PDT

      [ Parent ]

    •  Increasing the money supply (1+ / 0-)
      Recommended by:
      psyched

      isn't in itself stimulative. It depends on what you do to increase it. For example, if you're the Fed and you create $600B in new money and then swap that 600B for Treasuries denominated at $600B, by buying the them and adding to bank reserves, then that is not stimulative because it is only an asset swap and doesn't add any net financial assets to the private sector.

      On the other hand if you're the Treasury, and you spend the $600B on unemployment payments, infrastructure, or a Federal Job Guarantee Program, than that kind of spending is stimulative because it adds the $600B to private sector net financial assets. So, Treasury fiscal spending is stimulative, but monetary policy has only a very minor effect on the economy.

      You'll probably ask whether if Treasury spending is stimulative why would it not cause inflation? Because we have nearly a 30% output gap in the private economy right now, or as Maddog put it we are very far from full employment. So, increased demand from the Government spending will increase supply, without causing inflation.

  •  rational arguments in the morning! (2+ / 0-)
    Recommended by:
    maddogg, psyched

    I'm for it

    Youth lives by personality, age lives by calculation. -- Aristotle

    by not2plato on Fri Jul 22, 2011 at 06:48:09 AM PDT

  •  Great piece (1+ / 0-)
    Recommended by:
    psyched

    Simple and very cogent presentation of the quantity theory of money, and why it's false as a general rule.

  •  In truth (1+ / 0-)
    Recommended by:
    maddogg

    None of those variables are capable of being isolated from one another in a real economy.  And in fact, that formula is simply the price=demand/supply identity in a different form.  M*V is simply demand, q is supply and p is price.  In a recession, V drops, but so does q.  Increasing M to counterbalance the fall in V usually increases both q and p, but the extent to which p is increased over q, or vice-versa, depends on the capacity to increase q and competition in producing q.  If there is no capacity to increase q, then p will go up instead.  Likewise, if there's no competition to hold p down, then p will increase preferentially to q.  Households will always choose to raise their prices over increasing production unless they have no alternative.

    What is required is an argument that it is appropriate to fiddle with M during a recession when the problems are with V and q.  My gut tells me that if a decline in V is both a response to and a cause of the decline in q, then the appropriate response is not to increase M to offset the decline in V, but to increase V by taxing the folks that are slowing V down, and spending it on people who will speed V up.  Increasing M when the problem is with V will have bad consequences with p when V starts picking back up.

    From such crooked wood as that which man is made of, nothing straight can be fashioned. -Immanuel Kant

    by Nellebracht on Fri Jul 22, 2011 at 11:08:45 AM PDT

    •  Good Analysis (1+ / 0-)
      Recommended by:
      Nellebracht

      Very good analysis.  This is  the kind of discussion that the country should be having.  Instead they in the mainstream media and Capital Hill are arguing about how to keep 'M' low without actually discussing if that's even a good idea.

      With your first paragraph I don't disagree with anything you said.  It's pretty much a statement of fact as far as I'm concerned.  I only have comment on your second paragraph.

      I personally don't see a problem letting 'M' go up in the short term during recessions.  Mostly because I think we can make 'M' go down in the short term as well.  Capitalist economies have shown time and time again to have up and down business cycles.  It's time to quit pretending otherwise and learn to deal with it.

      Our Dime Understanding the U.S. Budget

      by maddogg on Fri Jul 22, 2011 at 01:55:56 PM PDT

      [ Parent ]

      •  Ups and downs (0+ / 0-)

        Productivity in general certainly does have seasonal and cyclical ups and downs, and when enough downs coincide, you can get a very temporary recession.  The thing is, V compensates for those swings.  As q goes up, so does V in balance, and likewise, as q falls, so does V in response.

        The problem with increasing M in the short term, and then drawing M back down as V picks up, is that there is precisely one way for the government to draw M back down, and that is to shrink its balance sheet (increase taxation or decrease spending or both).  Just like wages are "sticky," so too are tax rates and spending levels.  It might be more politically feasible to increase M now by increasing spending without increasing taxes, and then increase taxes when V and q start to pick up, but what happens if V and q don't pick up?  We can argue about whether or why (or if) V and q will increase if there's an increase in M, but the fact is that they might not, and that's regardless of the existence of an output gap.  An increase in M might lead to a decrease in V, while p and q remain unchanged.  

        Economically, it's pretty easy to make the case that an increase in V leads to an increase in q, and vice-versa.  It's harder to make the case that an increase in M leads to an increase in q, without some economic or regulatory mechanism to hold p down and without some mechanism that maintains V.  Essentially, if the government taxes and spends badly, it can lead to an increase in M and a decrease in V, while p increases and q decreases.  That would be the worst possible outcome, but it can only be avoided by focusing on V, rather than M.

        From such crooked wood as that which man is made of, nothing straight can be fashioned. -Immanuel Kant

        by Nellebracht on Fri Jul 22, 2011 at 03:32:40 PM PDT

        [ Parent ]

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