If you had the ability to compute the long-run stable price level from nothing more than the long run trend of money velocity and a good idea of what potential GDP should be, tied together with a money supply you can count, then any prediction of or for inflation would simply compare current price levels to this calculation. Because price levels must converge at the long run trend any temporary deviation from it would force current prices to adjust predictably over time.
Should current price levels end up below the long run, inflation is inevitable. That is, prices must accelerate from their low current state to reach the more stable longer-term equilibrium.
Is this what’s happening now? Given all the recent “money printing” as well as what’s gone into M2, many believe so. This week’s CPI has only turned the noise up to eleven, including the idea that interest rates are about to skyrocket as a consequence requiring more determined Fed action in the form of yield curve control.
This equilibrium was called P*, or P-star, in a paper originally written in 1989 by Economists Jeffrey J. Hallman, Richard D. Porter and David H. Small (M2 per unit of potential GNP as an anchor for the price level).
Long run velocity was presumed to be relatively easy enough to figure out, as would potential GDP via any number of sophisticated, peer-reviewed econometric models. This left the main question to M, or money supply. Which one?
As the name of their paper answered, M2. By using this one rather than M1, the authors assessed their velocity and real GDP, and then immediately ran into serious problems – in practice. For as much as it had seemed a stable velocity was attainable by mathematical extraction, there was far more doubt and error when put to use.
To begin with, in the first few years following the paper’s publication the entire idea of money velocity was being turned on its head; for a second time. With the S&L Crisis in full mode, and that was just the most obvious problem, what was presumed beforehand to be a stable trend in velocity just went bonkers.
Going back to the earliest days of Economics, economists and Economists alike have searched from the right set of equations which might near-perfectly (though, in reality, they’d sell their mothers for a minimally useful set) describe the utterly complex system that is any modern economy. Quite rightly, money was given a central place right from the very beginning of the enterprise.
There was John Stuart Mill and then Simon Newcomb, the latter how in 1885 had written an extensive treatise illuminating what he called the “equation of societary circulation.”
On one side of this “equation” he situated the real stuff; that is, the level of prices multiplied by some measure of economic transactions. To its opposite, a legit count of all money available augmented by what Newcomb called “rapidity.”
It would be Irving Fisher in 1897 who built further upon this equation with his own, known to us today as the equation of exchange (Fisher even dedicated his 1911 work The Purchasing Power of Money to this influence; “To the memory of Simon Newcomb, great scientist, inspiring friend, pioneer in the study of ‘societary circulation'."). In the later, rapidity got replaced by a more concrete theoretical version we know as velocity.
The desire to seek a more fruitful measurement and judgment of money and its effects, often drastic, on the real economy was – and still should be to this day – easily enough understood. As Fisher wrote in 1911:
“…the evils of monetary instability…periodic changes in the level of prices, producing alternate crises and depressions of trade.
But how would such an instability transmute real economic factors so as to produce the almost regular occurrence of mostly depression? Inflation, on the other hand, was rather easily understood by historical examples going back to antiquity (literally devaluing coins). Wide-scale unemployment, in particular, brought upon by what sure seemed to be deflationary money was a new development for the 19th Century.
Quantity of money just wouldn’t be enough; for during these depressionary episodes it might be there was sufficient stock yet too much of it hoarded by increasingly fearful economic and financial agents; the societary circulation of money would diminish somewhat independently of its supply.
Taking this a step even farther, interest rates were given a central role in each of the bank panics which spawned each depression; “the monetary causes are the most important when taken in connection with the maladjustments in the rate of interest.” Thus, velocity might be best influenced by the rate of interest which should, in theory, keep the system at equilibrium.
The higher the offered money rate, the more whatever money should be supplied into the commercial and financial markets, preserving the idea of an independent, interest rate-governed velocity function. If either supply or circulation of money fell too low, the price (rate) should rise more than enough to make it profitable for those taking money out of circulation to put some or all back in.
In practice, this was nowhere near so straightforward which then led to the development of the modern central bank. Ideally, a public utility whose sole purpose was to monitor economy-wide transactions largely via the notice of interest rate behaviors all the while standing at the ready to supply needed currency holders of money apparently wouldn’t.
Putting this in terms of the equation, to maintain prices and output by offsetting any dangerous drop in velocity (denoted by “high” interest rates) with an increase in money or currency (elasticity).
If you could make the equation on the money side balance so elegantly, say goodbye to depressions or runaway inflation. So why doesn't the Fed or any central bank do this?
The problem with the equation of exchange is that it isn’t really an equation at all; there is no mathematical proof which proves each of its two sides as an equality. The problem with velocity is how there is simply no way to directly measure it. And the problem with the whole idea is that it presumes the world as a static place where the variables are the same, or like enough, forever after.
Such was the specific case in the early 1990’s just after the P* paper tried to resurrect the idea. As even Alan Greenspan told Congress, quite directly for a man who would make a career out of using his mouth extensively if only to ensure no clear message came out of it, that money velocity stuff really had gone totally haywire.
In July 1993, Greenspan testified:
“At one time, M2 was useful both to guide Federal Reserve policy and to communicate the thrust of monetary policy to others…The so-called P-star model, developed in the late 1980s, embodied a long-run relationship between M2 and prices that could anchor policy over extended periods of time. But that long-run relationship also seems to have broken down with the persistent rise in M2 velocity…”
As forthright as the future “maestro” was really trying to be as to the major takeaway, Greenspan still couldn’t help himself being somewhat coy about some of these details which were leading towards it. While it was true M2 had survived, so to speak, the Great Inflation, it was far from the “anchor” Paul Volcker’s successor was attempting to claim.
The Fed post-Volcker came to kinda, sorta look at M2 on occasion but not in any serious fashion. It hung around the FOMC conference table as more of a down-the-list systems check just to see if everything might still be within rather wide tolerances; as one measure among a proliferating number attempting to judge the acceptability of what really became “discretionary” monetary policy.
The aggregate’s immediate predecessor, M1, had been cast aside around 1981 (about fifteen years too late, as I had discussed a couple weeks ago in setting the stage for Nixon’s doomed efforts at halting the Great Inflation in 1971). Why? A big reason was unstable velocity calculations.
Not velocity itself, mind you, the netted result after running every other variable through the modernized versions of various equations that look at economic exchanges. And wouldn’t you believe it, one major part of M1’s doom was the effect of repo market growth upon M1 velocity (below is from the St. Louis Fed’s September 1979 magazine):
“To the extent that RPs [repurchase agreements, or repo] are used to accumulate liquid balances over a period for some anticipated future outlay, they may be more appropriately classified as time deposits rather than demand deposits; such balances would be more appropriately included in the M2 concept of money which includes liquid savings, rather than the M1 concept which does not. Even if it is concluded that RPs are not money (M1), however, the rapid growth of this highly-liquid asset has almost certainly affected the velocity of demand deposits by permitting corporations to obtain desired liquidity with fewer demand deposits than otherwise.”
Repo was and is, of course, a wholesale form of money.
In other words, only calculated velocity was rising. Prices and nominal economic output were going up faster than M1 supply which, because this is treated as an equation, meant a dependent velocity variable had to rise in order to balance it all out. Actual velocity, such that there might be such a thing, was only changing in relation to what was clearly an outdated money supply figure, M1.
As the quoted article laid out, real world companies were turning to less-defined if not unmeasured monetary forms not captured by any overly simplified monetary definition. A more realistic money supply figure wouldn’t have (as when attempting to explain the related shortfall in M1 money demand) produced any deviation in velocity at all.
Interesting, then, how the same problem over a decade later would befall M2! Velocity suddenly rose around 1990 for reasons no one could adequately explain (assuming anyone at the FOMC really wanted to). Policymakers had come to believe they wouldn’t need to – that’s the whole thing behind “discretionary” policy. It was taking the central bank into a realm that wasn’t central banking, at least nothing like what was described traditionally.
Instead, Greenspan’s newfound non-money monetary policy would attempt to “control” the interest rate for money – federal funds in the US case – in lieu of actual money figures that might make sense however you might feel about the modern equations of exchange.
Even so, the idea of “something” which completely changed the way M2 was behaving just might have been more important than the flexible plaything of federal funds targets.
It is a topic hardly anyone investigated, nor were policymakers particularly interested. To their credit, Hallman, Porter and Small gave it a try updating their original P* paper in 1991 (Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run).
We don’t need poseur central bankers for answers; we already know quite a lot about key developments which took place at this same time, starting with the nature of the S&L Crisis itself. The ongoing destruction in depository-type banking meant something more consequential than small-ish local institutions running afoul of their depositors finding out about risky and bad lending idiosyncrasies.
What truly mattered was how this depository predicament represented the point after which a systemic break between the “old” way of money and banking and a “new” way (which wasn’t actually very new by that time) was recognized – at least by those very few paying attention.
To give you a sense of what I mean, I’ll cite a few figures from the Federal Reserve’s Z1, or the Financial Accounts of the United States. Back when it was called the Flow of Funds before 2014, banks were separated into two distinct classifications: Savings Institutions, obviously including the S&L’s; and, Commercial Banks. The latter were “investment” firms or securities dealers more likely to operate in very different ways than traditional depositories, including using “wholesale” interbank money.
The Z1 data shows that total credit market assets for savings institutions peaked during the fourth quarter of 1988 at just more than $1.4 trillion. At the same time, total credit market assets of commercial banks had been $2.2 trillion. The ratio of assets held between the two classes had been largely stable since 1963.
As the S&L matter reached its climax, from that point forward the financial landscape in the US (and around the world) would be dominated by not just commercial banking but other extensions of it – such as off-balance sheet arrangements, also funded wholesale, including such entities as domestic ABS Issuers picked up in Z1 along with so many others which never really found their way onto any official report or into any statistic.
Wholesale money not included anywhere in M2 or even M3.
Already by 1993, when Greenspan was thumping in Congress about M2, the ratio of assets had collapsed for depositories; they now held just $923 billion compared to $2.7 trillion for commercials. ABS Issuers had gone from just $147 billion in assets back in late ’88 to $410 billion by July ’93.
In fact, just a few years later, the second quarter of 1998, ABS Issuers would surpass depository institutions in the amount of credit market assets each held. Meanwhile, commercial bank assets ran further upward to $3.5 trillion by then.
A few months before, in late ’97, Alan Greenspan, now the “maestro”, would recall the M2/velocity fiasco in an address at Stanford University.
“The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates.”
The whole thing from Newcomb to Fisher to the famed monetarist Friedman and leading to the “discretion” of the post-modern central bank had simply broken down. But it did so itself in very predictable fashion, simply repeating what had happened to M1 a few decades before.
Real economy participants in this new wholesale commercial banking world began to use forms of effective money lying outside the boundaries of M2 as commercial banks who offered those forms ascended – putting commercial banks even more to the center of the monetary therefore financial and economic world than they had been when supplanting M1.
Actual real economy velocity didn’t change at all in the early nineties, the nature of the money supply had (V was telling them their problem was a bad M). Interest rates had little to do with any of it. In this instance, in this economic/money model of real economy fundamentals, the Federal Reserve wasn’t even a central bank.
Because of this, over the last fifteen years M2 and its very dependent velocity number have been highly, highly misleading: to give you the perfect example, M2 increased by 6% between the middle of September 2008 and the end of December, an unusually massive rise in “money supply” right in the middle of the worst monetary crisis since the Great Depression.
If we can’t depend upon M’s which only produce bad V’s, even assuming any of this P* stuff is a viable theory, what chance do we have of settling the inflation question absent any useful working model? The Phillips Curve! Ha.
All you need to do is let the commercial banks, or the remnants of what’s left of them after suffering that very monetary crisis, tell you what’s going on in money. The signals they send out into the public, in real time, are surprisingly easy and straightforward to interpret, requiring no math of any kind nor convoluted theories to explain what should be easy numbers.
Yields. Not only are they produced by these same commercial banks, they are derived from the monetary utility priced into what is essential repo collateral.
P* like the equation of exchange, each were nice ideas and noble pursuits. The object of their quest, however, may only be attainable via these other means which puts a very different yet extremely helpful spin on yield curve control.
