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Friday, May 23, 2003

A Treatise on Political Monetarism

Morgan Stanley's Robert Alan Feldman gives a quick runaround on the four standard approaches to deflation. Needless to say there is a fifth institutionalist (demographic) one, but, well never mind. Brad certainly gets a look in though:

The monetarist school of deflation relies on Irving Fisher's equation of exchange, MV=PY - money x velocity = prices x output. The simple application of this theory suggests that if you raise M, then P will rise too. Thus, to end deflation, just raise money. Simple.

Or is it? What measure of money are we talking about? And what measure of prices? At a more subtle level, there are some hidden assumptions here. How do we know that P will go up, and not Y? (Higher Y is not a bad thing -- but the purpose here is to discuss deflation, not real growth. Would the problem of deflation be solved if real growth were 10% and deflation 5%? Not necessarily.) Most important, the “M up leads to P up” view assumes that velocity is constant. Old Chicago Monetarism “did not believe that the velocity of money was stable and did not believe that control of the money supply was straightforward and easy.” (See J. Bradford DeLong, “The Triumph of Monetarism?” Journal of Economic Perspectives, Winter 2000.) Rather, it was “political monetarism” (DeLong’s term) which argued “not that velocity could be made stable if monetary shocks were avoided, but rather that velocity was stable.”

Is this model “relevant to the contemporary world”? It all comes down to the stability of velocity. At least in the case of Japan, velocity has been horribly UNstable. Mere instability is one thing, but in fact, in Japan’s case, velocity has been endogenously unstable. Every time the Bank of Japan has printed more money, people just stick the money under their mattresses. In short, M up leads only to V down. The key reasons are worry about the solvency of the financial system, and poor returns in the real economy. Until confidence in financial institutions can be restored, and until resource allocation in the real economy improves enough to pay interest, raising M will not help. This is not to deny that monetarism has its times and places. However, to the extent that other countries suffer from weak financial systems (the US not so much, Europe rather more), monetarism will not work. To the extent that other countries suffer from poor resource allocation (the US to some extent, Europe much more), monetarism will not work. In my view, the monetarist approach is not “relevant to the contemporary world” in the sense that Keynes used this phrase.
Source: Morgan Stanley Global Economic Forum

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