May 6, 2006
We will, over time, take a hammer to all manner of weird monetary ideologies that have grown up over the years. They are practically unlimited in number. One of these ideologies is the notion expressed in the equation:
M is the "amount of money" (left conveniently undefined)
V is a mystery variable commonly termed "velocity"
P is "prices", as if "prices" could be accurately reduced to a single number. For now, we can consider this the GDP deflator.
T is "transactions," as if anybody really knows what transactions are going on. For now, we can consider this "real" GDP. P*T can be generalized as nominal GDP.
This notion is some sort of holdover from the bad old days when people had a goal (utterly mistaken) of trying to make the study of economies into something like the study of thermodynamics, i.e. the construction of steam engines. Even today, gullible young people are encouraged to learn higher math in preparation for graduate work in economics, which is a joke that became unfunny a long time ago. I used to say that one can be a great economist with 8th grade math, but today I suspect even that may be an overstatement.
Now, up above, I said that the equation MV=PT is a "notion" expressed in an equation. The notion expressed, of course, is that one can manipulate an economy via monetary manipulation. Which is of course true; the problem is that you can't manipulate an economy to any good. The effects are all bad.
One of the many problems here is that V is a meaningless fudge ratio. Let me show you what I mean. Instead of M="money," let's say that M="number of hits for Lindsay Lohan on Google". It is a mathematical truism that:
[Lindsay Lohan hits on Google]*[some number]=[nominal GDP]
Or, to use the example in the title of this brief,
["money" arbitrarily defined]*[some number]=[my butt]
Both of these are a mathematical certainty! Both are utterly meaningless! This "MV=PT" nonsense has been around a very long time, as it was also a favorite notion of the Mercantilist thinkers of Britain in the 1600-1750 period, who were also eager to manipulate the monetary conditions of that area, despite that over a century of such manipulation never did much good for anybody. This is what Adam Smith had to say about these issues:
"What is the proportion which the circulating money of any country bears to the whole value of the annual produce circulated by means of it, it is, perhaps, impossible to determine. It had been computed by different authors at a fifth, at a tenth, at a twentieth, and at a thirtieth part of that value."
Today, "money" is typically defined as predominantly short-term lending, and the dollar is in use worldwide, with 80%+ of banknotes now apparently circulating overseas, making the assertion of any relationships of a worldwide currency with the nominal GDP of one country doubly preposterous.
The 1970s and 1980s were the heyday of using "MV=PT" directly. In time we will examine the damage wrought. I will point out, by way of example, that in 1970, the Nixon economists decided that they wanted a 9.0% increase in nominal GDP over the coming year, to get the economy out of the 1970 recession. Didn't "MV=PT" indicate that this could be directly accomplished by simply increasing "M"? Of course, "M" can't be increased directly, as it is typically taken as a measure of short-term credit, so the question became: how much would the Fed increase the base money supply to increase "M" enough to produce a 9.0% increase in nominal GDP? This calculation fell to Art Laffer, then head of the Office of Management and Budget, who did as he was told. Arthur Burns, Nixon's old buddy installed at the Fed in 1970, was given his marching orders, with the result that the Bretton Woods gold standard was blown up in 1971 and the world entered a decade of phenomenally painful inflation.
Of course, the Nixonites just wanted to play games, but the notion of "MV=PT" -- utterly meaningless in itself -- gave them a convenient justification or veneer of respectability with which they could delude themselves and others that what they were about to was in the best interests of all involved.
Then, in the early 1980s, the Fed attempted to control inflation by application of "MV=PT," which was a big mess but ultimately succeeded, because, by that point, what they really waned was a convenient justification and veneer of respectability by which they could undertake a very crude, destructive and sloppy monetary contraction, to end the inflationary period of the 1970s. This enabled them to live out their fantasy that "fighting inflation" required "recession," when, of course, solving an inflation problem should lead to economic boom!
In the 1990s, the Bank of Japan and other economic types (including virtually all foreign commentators) totally failed to understand monetary deflation in Japan as the result of a rising value of the yen since 1985 (the "yen going to Y2" although it actually went to more like three yen!). They thought that a low BOJ target interest rate would encourage banks to increase short-term lending/deposits, thus increasing "M", and hopefully thus increasing "P*T" or nominal GDP. When that plan didn't work, they claimed that the "transmission mechanism was broken," when all that was broken was their fallacious theories. The real solution was to lower the value of the yen by a) announcing such a policy, and b) increasing the supply of base money. They never really got a) right, but finally implemented b) in 2001, in a shy and barely effectual sort of way, after half a decade of pressure mostly from a few foreign thinkers (including me) who got it mostly right. Result? Reflation and recovery!
(By the way, the Japanese government has overshot its mark and already has an inflation problem, which will likely produce some big surprises in the future for them!)
So you see, getting these principles right is very important, and can mean the difference between economic disaster and success.