Why the Quantity Theory of Money Can Be Wrong


Paul Kaplan: I’m Paul Kaplan, director of research at Morningstar Canada. I am pleased to have a conversation today with Larry Siegel on several topics of importance to investors. Larry is a leading thinker and prolific author on investment topics. In the late 1980s and early 1990s, Larry and I worked together at a small consulting firm called Ibbotson Associates, which Morningstar acquired in 2006, and I’ve remained friends with him ever since. After his time at Ibbotson, Larry served as director of investment research at the Ford Foundation. Since then, he has been Gary P. Brinson Director of Research for the CFA Institute Research Foundation. Larry, thank you for joining me today for this conversation.

Laurence Siegel: You’re ost welcome.

Kaplan: In 1997, we co-authored an article entitled “Good and Bad Monetary Economics, and Why Investors Need to Know the Difference”. In this article, we relied heavily on Milton Friedman’s version of the quantity theory of money. This theory says that inflation occurs when the supply of money increases faster than the price-adjusted demand for money. Like Friedman, we have adopted Irving Fisher’s theory that nominal interest rates partly embody expected future inflation. More recently, you have adopted an alternative theory, the price-level fiscal theory, which links inflation to a government’s fiscal policy. First, what does Friedman’s theory say? And what do you find wrong with him?

Headquarters : Well, Friedman’s theory is very powerful in explaining much of what has happened to prices around the world and over very long periods of time. So you really have to find something wrong with a long-established, well-tested theory to suggest that maybe you should use a different theory. I went to the University of Chicago in a high school partly because Milton Friedman was there. I didn’t study directly with him for a really lame reason, i.e. I found out in the first few weeks that he was a very difficult proofreader and my chances of getting a better grade than a C were tiny. So I took other economics courses, but basically I learned Friedman’s work.

What happened – two things happened. The first is that the quantity theory of money has failed a few times, which I’ll get to in a minute. The other is that it only really explains prices when money in Friedman’s formal sense of noninterest-bearing cash and bank deposits, and maybe a few other things, is the only medium of exchange. in the economy. And when he did his job between, say, 1935 and 1970, and then he spent the rest of his life finding it, money was pretty much the only thing circulating in the economy that you could buy things. And that started to change. I was sitting with a group of people having dinner a while ago, and the bill came through. It was very big. And I was asked to put in some 20s, quite a few 20s. And like everyone else, I said I had no money. All I have are credit cards. In other words, bank credit, which Friedman did not consider money. But it contributes to the demand for everything we ate, and the new theory needs to have a much broader definition of money, or you can’t use it. So now we have money market funds, cryptocurrencies, hedge funds, hedge fund stocks, or the S&P 500 could be the money. The home equity line of credit I have could be cash. And so, the theory becomes obsolete in this way. But you could fix it by redefining money. And what John Cochrane, Eric Leeper, and later Coleman and I have said is there’s a different effect at work, and it’s a real attempt to overthrow Friedman, which I say with a lot of apprehension because he was one of the two greatest economists of my life. The other was Gary Becker.

What the quantity theory has failed to do is explain the low rates of inflation after the massive monetary stimulus of 2008 and 2009, 2010 and so on, really through the very recent past. Until about the last year or two we had hardly any inflation and the quantity theory of money would have said that the inflation should have been very large and dramatic and should have happened quickly, the lag between monetary stimulus and rising prices being historically around nine months, not decades. And I’m going to give credit to Leeper and Cochrane because Tom Coleman and I are just the advocates. We didn’t think of that. What they said is if you go back to Adam Smith, he said what makes money valuable is the willingness of governments to accept it in payments and in payment of taxes. Now that seems trivially stupid because money has a million other users who are more important than that. But it is the use that gives money the effect it has on prices according to fiscal price-level theory because money is a form of government-issued security.

Now, how do you analyze a title? You look at security support, which in this case is the government’s ability to raise funds through taxation that is more than it spends, the government’s primary surplus. Thus, the present value of all future government primary surpluses is the fundamental value of a government bond, a security issued by the government. And in today’s environment where deposits pay interest, it’s just another form of government bond with a shorter duration. I told you it was complicated. So fiscal theory simply says that if you can somehow estimate or get from an external source the present value of all those primary surpluses, that equals the total stock of government bonds divided by the price level. In other words, it is the real value of the bonds. So that’s tax theory. It tells you the price level. B/P = the number of bonds divided by the price level is the real value of the bonds which is S, which is the present value of all future surpluses.

Now, what proof is there that it works? It’s hard to know what the current value of surpluses is, because it’s an estimate of what governments are going to do in the future, and governments will basically do whatever they want. But we have evidence from the past. In 1923 and 1924, Germany went into hyperinflation because the government was printing money to pay its bills. He had failed to pay his bills normally, that is, to tax people at a rate sufficient to pay the bills. So they just printed money and paid the bills with that money. What happened is that the economy slid into hyperinflation. And not like we have, that’s pretty bad. But that’s where you might have a wheelbarrow full of Reichsmarks and you thought you were going to do all your shopping with the wheelbarrow. But by the time you got to the grocery store, all you could buy was an egg. Thus, the monetary system completely collapsed.

At some point in late 1923 the German government led by their, I assume, President Stresemann decided to stop spending more than tax revenue because they decided on the basis of something that would end to hyperinflation and it did. It stopped almost literally overnight. Prices have become stable. And that would not have been predicted by the quantity theory of money because the money supply continued to increase. What happened is that the budgetary situation became favorable for a stable currency. Thus, the budgetary situation having been rectified, the currency became stable and Germany began to recover from hyperinflation. So this is the event that really triggered people looking for an exception to the quantity theory of money. When you have an exception like this, which is very big and obvious, you start to wonder if the theory is good in the first place, and that’s where Leeper and Cochrane got their idea of ​​a good budget theory. that there were some precursors. If you look back in the history of economic thought, you see little bits of it from Adam Smith and many other ancients like him.

Kaplan: Thank you, Larry, for this very interesting discussion. Thank you for taking the time to talk to me about these issues and looking forward to talking to you again.

Headquarters : It’s my pleasure. And let’s talk about it as soon as possible.


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