The Fallacious Notion of 'Money Supply'
Supply-siders are concerned with the quality of money, not its quantity. Nobody, except the market as a whole, could ever know how much of what kind of money is appropriate to finance expansion without inflation. Jude Wanniski, The Way the World Works
A simple search on Amazon.com for stand-alone VHS videocassette recorders (VCRs) is a mostly fruitless pursuit. Lacking much value in a day of DVDs, the best this writer could find was a used Samsung model for $17.
Why are VCRs cheap? Not because there are too many of them; instead they go for near nothing due to the fact that they’re no longer useful. DVD technology is faster and easier, so nowadays it’s the rare person looking to buy an appliance whose utility was last relevant in the early part of this decade.
But when we consider the value of money much of the commentary today boils down to supply. At times of currency weakness, the conventional wisdom usually blames some monetary authority for creating too much money. Conversely, when a currency is strong, it is often said that money creation is not enough.
At first glance all the above makes a lot of sense. The supply/demand balance is a certain factor in the pricing of goods and services, and seemingly it should apply to currencies.
But with currencies, history tells us that supply is overrated as a cause of strength or weakness. It would be hard to create too much of a useful currency, and it would be hard to create too little of a currency no-one wants.
Monetarism. Ronald Reagan was elected in 1980 on a platform of tax cuts, deregulation and a return to stable money. Though he never achieved his goal of a dollar redefined in terms of gold, Reagan’s stated policy of stable, non-inflationary money led to a collapse in the price of gold before and after his election. Then followed a turnaround from accelerating to decelerating inflation.
This is notable considering commentary from the late Milton Friedman, the father of modern monetarism, in 1983 and 1984. A believer that M1 (currency in circulation and money in checking accounts) told the tale of inflation and economic growth, Friedman pointed to 27 percent annual M1 growth in 1983, and predicted an inflationary outbreak. And then, analyzing a slowdown in M1 growth later in the year, he predicted that a recession would reveal itself around the 1984 presidential elections.
Even though the U.S. economy had begun a bull run in late 1982 that coincided with increasing dollar strength, Friedman’s adherence to measures of supply had led him to make two predictions that proved incorrect. He later admitted, “I was wrong, absolutely wrong” and “I have no good explanation as to why I was wrong.”
The explanation for Friedman’s mistaken predictions was, with hindsight, that monetary aggregates, or the Ms, can be very misleading. In times of inflation, consumers and businesses would be less willing to hold onto money that is quickly losing value. Instead, they would seek to protect their capital in high-interest deposit accounts, or they would invest it in hard assets such as gold. So the monetary aggregates might show a decline in money growth. While that would alarm monetarists as a signal of “tight money,” the reality would be quite different.
Conversely, a strong dollar policy would likely push up monetary aggregates as consumers and businesses would feel more comfortable holding onto money balances secured by a credible unit of account. The aggregates might logically rise in this scenario, and for those wedded to the monetarist doctrine, this would be a signal of inflationary pressures. This signal would be false.
Empirically, the various money aggregates are not accurate as inflation signals. Even if they were, a basic question remains. Most who profess a belief in monetarism decry the fatal conceit of governments when it comes to knowing how to manage the economy. How, then, in an economy comprising infinite numbers of decisions, could they confidently know how many or how few dollars the Fed should create?
Furthermore, 2/3rds of all dollar money balances are held overseas. This means that if the Federal Reserve were to try and curb the amount of dollars in the fifty states, its efforts wouldn’t amount to much. Think of it this way: if the Fed drains one pool of dollars, pools around the world will overflow into the pool just drained.
Interest-rate targeting. Interest-rate targeting by central banks has traditionally been a Keynesian rather than a monetarist prescription. The monetary authority seeks to boost or contract the economy with rate machinations, and many who profess a belief in a strong dollar argue that rate targeting can be used to manage and stabilize the value of the currency. Put simply, to weaken a currency is supposedly to lower the target rate, and to strengthen it is to increase the rate.
It is implicit in the above reasoning that rate targeting is a currency-supply mechanism. This thinking could also be seen as a variant of monetarism.
It all sounds appealing, but then how would rate-targeting advocates explain the fact that the Fed’s monetary base grew just as much in percentage terms in the ’70s as it did in the ’80s? This occurred despite the fact that rates were rising in the ’70s while falling in the ’80s. They also argue that high rates are synonymous with “tight” money. But what would then explain the weak dollar amid high rates in the ’70s, or the fact that the dollar fell more versus gold in percentage terms this decade when the Fed was raising, not cutting rates?
The Bank of Japan has targeted a low bank rate for the last twenty years, and Japanese rates across the yield curve have since the ’70s been much lower than rates stateside. But far from fostering a currency that is cheap relative to the dollar, the yen has risen over 130 percent versus the greenback over the time in question. If high rates signify monetary tightness, or currency strength, then why is it that weak currencies are traditionally lent out at high rates of interest while strong currencies are normally lent out more cheaply?
It’s demand rather than supply that drives the quantity of money. Treasury Secretary Henry Paulson has said that currency values merely reflect the economic outlook of the country issuing them. But how then would we explain the yen’s strength since the ’80s amid a seemingly never-ending recession? Germany has long been said to be the “sick man of Europe” with high rates of unemployment, but the Deutschemark prior to the issuance of the euro was the very picture of strength and stability.
What this tells us is that neither “supply,” nor the health of the economy, nor the level of rates matters much when it comes to the value of money. Whether the Bank of Japan issues a lot of yen or very few, at high rates of interest or low, the Japanese currency will remain relatively strong versus the dollar as long as markets see this scenario as preferable to American protectionism.
Conversely, a country like Argentina might issue very little in the way of Argentine pesos, but given the country’s historical ineptitude when it comes to currency management, the peso would remain cheap and unused owing to its bad reputation as a store of value. To focus on the supply of pesos is to miss the point altogether.
Looked at from the U.S. perspective, the Fed’s balance sheet has expanded by hundreds of billions since the spring, and although the world is allegedly awash in dollars, the greenback’s value has actually risen in terms of most foreign currencies, as well as gold and other commodities. Once again, money supply doctrine has proved wanting when it comes to explaining the value of the dollar.
Even the one traditionally monetarist agency of the U.S. government, the St. Louis Federal Reserve Bank, has shifted from its historically exclusive focus on the money aggregates: “Our models and our discussion focus not on the quantity of money but on the purchasing power of the dollar … We do not have to pay attention to the quanitity of money today because policymakers are paying attention to its price, by focusing on inflation and inflation expectations.”
So what makes money useful? And why do certain currencies hold their value relative to others, compared to others that become cheap?
Consider two scenarios involving the definition of the dollar. In the first scenario, the dollar issued by the Federal Reserve possesses a “hard” definition communicated by the U.S. Treasury department. For simplicity, suppose that U.S. dollars were defined as 1/500th of an ounce of gold and that the Treasury would redeem them for gold at that price. In that scenario, it’s a good bet that the various monetary aggregates would skyrocket.
In the end money is significant only as a measuring rod enabling the trade of real items. So if the dollar had a stable value, it’s safe to say that many around the world would be eager to hold, and transact in, dollars. And for those presently holding gold, there would be a big rush out of the yellow metal in favor of a currency defined in terms of the metal.
Not only would M1 go through the roof, which would scare those in thrall to monetarism, but rates across the yield curve would likely fall given the dollar’s newfound reliability as a store of value. Rate-target advocates would see low rates as a signal of “cheap” money, but with the dollar possessing a gold definition, that wouldn’t be the case at all.
In short, the world would be awash in dollars, awash precisely because the greenback would attain its greatest use as a stable “ruler” of sorts fostering all sorts of dealmaking and trade. The supply of dollars would be irrelevant so long as Treasury backed its definition.
Conversely, consider a dollar lacking such a definition. Imagine a Treasury that has no opinion when it came to the dollar’s value, that it should be free to float to various price points free of intervention, verbal or otherwise. And imagine that over a 7-year period the dollar’s value bounced from 1/253rd of an ounce of gold, to 1/480th oz. in October of 2005, to 1/1000th oz. last July, to 1/780th of an ounce as of this writing. The policy just described is ours today.
It’s fair to say that such a currency lacking any kind of definition or monetary authority support would quickly lose utility. Remember, money is a measuring stick. When its measure is variable and directionless, it would be understandable that irrespective of supply, it would have diminishing use in a world economy that values certainty.
The consensus of many in the hard-money world has been that there have been too many dollars issued by the Fed, that we’ve had a situation of “too much money chasing too few goods.”
Far from it. Rather than too much money in our economy, we’ve had a currency that lacks definition. Not excessive quantity, but insufficient quality. That is why, seeking to protect their wealth in a floating environment such as ours, investors naturally move to the sanctuary of hard assets, including gold, art and property.
Policy implications. Returning to VCRs, they aren’t cheap due to oversupply, but because they’re no longer useful. In much the same way, today’s U.S. dollar isn’t cheap thanks to the supply of too much money. Instead, the dollar is cheap owing to a lack of definition, or the absence of an official policy which makes it dependable as a medium of trade.
In short, any policy meant to reduce the supply of money in order to boost the dollar will fail if not met with a specific Treasury commitment to preserve a strong and stable unit of account. If we make the dollar useful, its value will stabilize.