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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:
MV=PT
Where:
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.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United
States, Japan,
and the Middle East. About the Book: Gold:
The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is
available at bookstores nationwide, from all major online booksellers, and
direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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