Friday, July 22, 2011

The Useless Quantity Theory of Money

"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 can see why it's bullshit. While it may be "technically" true if it's assumptions are true, the assumptions are rarely, if ever true.
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