André de Godoy: Please explain the relationship between the money supply, the price level, and economic activity.
Antony Mueller: The supply of money determines the price level in the long run. Whether prices will rise or fall depends on the relative variation of the money in circulation compared to the relative variation of the supply of goods. However, one must take into account that the process from the creation of money by the central bank, the so-called monetary base, and the impact on the economy in terms of demand is long and contains a series of variables. These transmitters of the monetary impulse can work in tandem and strengthen the original impulse or, say, may counteract each other. Let me give you an example: over the past fifteen years, the main central banks have practiced the policy of “quantitative easing,” which has expanded their balance sheet by a factor of over five. In the United States, the monetary base rose from $830 billion in January 2008 to over $4 trillion in September 2014 and stands as of now, in January 2020, at $3.4 trillion. Yet this drastic increase has not led to a price inflation and has stimulated economic activity only moderately. The reason for this is that the commercial banking sector did only transform a part of this base money into money in circulation and that the economic agents reduced the transaction velocity. For the monetary aggregate M1, the velocity halved from 10.6 in early 2008 to 5.5 in the fourth quarter of 2019.
Godoy: Authors like Ludwig von Mises and Milton Friedman hold that inflation is a monetary phenomenon. However, I have heard that it is possible to expand the amount of money in circulation without causing negative effects for the economy because inflationary effects could be controlled by the adjustment of the interest rate. Is this true or just a remedy?
Mueller: This is a very confused view. What sense does it make to expand the money supply and then try to control it by raising the interest rate? The result of such a policy is market turmoil and confusion. It is interventionism of the worst kind. Why should the money supply increase anyway? If the supply remains fixed, and productivity rises, prices will fall. That is beneficial deflation. Why should one complain when the goods become cheaper for the consumers? The point is whether price deflation happens slowly according to productivity increases in the economy or abruptly as a hefty liquidity contraction due to a financial market crisis.
Godoy: Why do central banks try to manipulate the money supply?
Mueller: Central bankers have a deep-seated fear of deflation. They presume that a price deflation will lead to an economic contraction. Yet if central banks had left the system alone, such a deflation would be very gradual and not only be not harmful but beneficial for the economy. If the central banks intervene and expand the money supply and implement, as it is the case today, a “zero interest rate policy“ (ZIRP), or even a “negative interest rate policy” (NIRP), a tension builds up between the natural tendency of the prices to fall because of productivity increases and the inflationary money supply. A deep discrepancy builds up between the human time preference and the monetary rate of interest which would converge in a free market without central bank interventions.
Godoy: Would a stable money supply not be too rigid for the economy?
Mueller: One must remember that a falling or rising price level is the result of the difference between the rate of variation of the supply of goods and the rate of variation of the money stock and the velocity of economic transactions. The monetary system has a natural elasticity. Even when the money supply is linked to a fixed supply of central bank money, expansions and contractions of nominal spending will take place. Money has loose joints, but when the monetary base is stable, the system has a definite anchor. There is elasticity of money under a gold standard even when the stock of gold is constant. Different from what we observe today, no long-term and extreme divergences were possible. We must change our present monetary system which is highly dysfunctional.
Godoy: Some prominent Brazilian economists mention the post-Keynesian theory as a counterpoint to the classical quantity theory of money and claim that the so-called modern monetary theory would provide a better model for the present.
Mueller: As I explained above, even when the money supply stays fixed the use of money is volatile, and thus even a gold standard has monetary elasticity. It is wrong to claim that only fiduciary money would provide financial flexibility. The point, rather, is that with an anchored monetary system, the degree of deviation is limited, while under the current fiat money regime there is no constraint. That is the problem with the modern monetary theory. Its adherents praise an anchorless system, because it would allow unlimited funding of government expenditure. Even these theorists, however, recognize the problem of price inflation when the money supply is excessive. In this case, they believe, the government could control price inflation through taxation and then siphon off the excess money. Yet while the adherents of this “new” monetary theory praise anchorless money as a boon because they live under the illusion that the economy is in permanent need of macroeconomic management, the truth is that it is not the free market that produces booms and busts but the intervention of the governments and their central bankers.
Godoy: Could you cite a few examples of how inflation comes about in our day because of the monetary policies that governments have recently pursued?
Mueller: Venezuela is currently a sad example along with the very tragic case of Zimbabwe. Let’s concentrate on Brazil’s neighbor country. Massive government spending, foolish interventionism, and the expansion of the money supply are behind the gigantic price inflation in Venezuela. These policies form part of the grander plan of implementing a “Socialism of the Twenty-First Century.” But what they got was not prosperity and equality but even sharper social divisions, a brutal hyperinflation, and mass misery. Venezuela is the empirical verification of what we have discussed: the process begins with the false promises of social justice and comprehensive welfare. Private property is no longer secure, government intervention is on the rise, and business investment falls. Yet instead of the deteriorating economy inducing the political leadership to change course, government expenditures, based on credit expansion, increase even more and with them rises the money supply. While more regulation and interventionism suffocate the supply side, inflationary demand is on the rise. The country enters a deadly spiral of economic, political, and social crises that reinforce each other. At the very beginning of this process, some illusionary benefits appear, yet after a short while the poorest people are those who suffer most until it also brings down the whole rest of the society in a cataclysmic collapse.
Godoy: From what I’ve gathered, monetary inflation itself is not the problem that causes a raise in the price levels. The problems are people’s expectations and the speed with which transactions happen, is that correct?
Mueller: Well, let us put it this way: the reason for obesity is not the food but how much one eats. The expansion of the money supply is the food. Whether the economic actors take the offer is another question. In this decision expectations play a major role. Here, however, we must consider that expectations do not come from nowhere. They have a point of reference in the economic reality and in the public discourse, including the media. The laissez-faire approach to money does not mean the absence of control. It is rather the present monetary system, with constant central bank intervention and the craving of governments for deficit spending, that is out of control. In contrast to a fiat money system, a gold standard or a similar system with a strong anchor would combine short-term flexibility with long-term stability.
Godoy: The mechanism that uses interest rates to control inflation is actually a way to try and contain price raises in a fiat money system, right?
Mueller: For the policymakers, interest rates are an instrument of intervention while for Austrian economics they should reflect time preference and as such would be the natural rate. Policymakers can only manipulate the monetary rate of interest. What matters is the money supply and the expectations. A higher interest rate makes borrowing more expensive and thus may stop the expansion of the circulation of money in the economy. Furthermore, higher interest rates may change expectations about future price inflation and thus reduce the velocity of circulation. The main point, however, about raising the interest rate is that the central bank has to reduce the monetary base in order to obtain higher interest rates. Central banks cannot just raise the interest rate and leave the monetary base as it was. When central banks target a certain level as their policy rate of interest, they must manage the monetary base accordingly.
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