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On the Neutrality and Superneutrality of
Money
Today's
mainstream macroeconomic theory typically focuses on aggregate consequences resulting
from policy measures, such as the effect on output and prices of a rise in
the money stock. One crucial assumption is that money is neutral.[1]
Money is said to
be neutral if an increase in the money stock leads to a proportional and
permanent increase in prices and leaves real economic activity (such as
output, investment and employment) unaffected. So, a rise in the steady
growth rate of the money stock is said to lead to an identical rise in the
steady growth rate of prices.
The hypothesis of
the neutrality of money is mostly assumed to hold in the long term, while in
the short-to-medium term
the idea is that a rise in the money stock may well affect economic activity.
This is largely attributable to surprise (and transaction-cost) effects.
For instance, an
unexpected rise in the money stock induces changes in relative prices and
therefore affects consumption and investment. Eventually, however, market
agents adjust their dispositions (wages, contracts, etc.) to higher prices,
and economic activity returns to its original level. So, the new money
increases prices, but it does not increase production.
The
neutrality-of-money hypothesis does not rule out that changes in the money
growth rate may have permanent effects on the level of economic activity. In fact, a
rise in the growth rate of the money stock (from, say, 4% a year to 5% a
year) may be thought of as having the potential of pushing production to a
permanently higher level of output.
Money is said to
be superneutral, if changes in the growth rate of the money supply exert no
effects on output. In other words, the hypothesis of the superneutrality of
money would say that economic activity is independent
of money growth.
From the
viewpoint of the Austrian School of Economics, the hypothesis of the
superneutrality of money must be strongly rejected, first and foremost, for
methodological reasons. To show this, one should start with briefly reviewing
the nature of money.
What Money Really Is
Money is the
universally accepted means of exchange.[2] And as Ludwig von Mises (1881–1973) pointed out: the exchange
function is money's sole function. All other functions — unit of
account, store of value, medium of deferred payment — are merely
subfunctions of money's exchange function.
What is more,
money is a good like any other. It is subject to the law of diminishing marginal
utility. This, in turn, implies that an increase in the stock of
money will necessarily be accompanied by a drop in money's exchange value
vis-à-vis other goods and services.
Against this
backdrop it becomes obvious that a rise or fall of the money supply does not
confer a social benefit: it merely lowers or raises the exchange value of the
money unit. And a change in the money supply also implies redistributive
effects; that is, a change in money stock is not, and can never be, neutral.
An injection of
new money allows the first receiver to buy items at basically unchanged
prices, while those receiving the new money later can buy only at higher
prices. So, first receivers of new money benefit at the expense of later
receivers ("Cantillon Effect").
Further, an
injection of new money necessarily causes a change in relative prices, and
this, in turn, affects the production of consumption and investment goods.
Any change in the money supply — be it free-market money or
government-controlled money — will have the implication outlined above.
However, under a
government-controlled money-supply regime, changes in the money supply are
definitely harmful.
Such a change in the money supply is in violation of the principles
underlying the free market, which secure mutually beneficial exchange
transactions.
As Austrian
economists have pointed out, government money production, where money is
created out of thin air by commercial banks extending circulation credit,
leads to malinvestment, boom-and-bust cycles and a non-market-conforming
distribution of incomes.
By no means less
important, the economic and political ravages that monetary debacles cause
open the door for ever-greater government interventions in the free-market
system. These increasingly undermine and even destroy property rights, and
so, liberty and freedom.
Finally, to
remove all doubt, Mises showed that money cannot be neutral for logical
reasons. According to a praxeological analysis, the axiom of human action
represents an irrefutable truth; in fact, it is an a priori synthetic
judgement in Kantian terms.
The law of
diminishing marginal utility is logically implied in the axiom of human
action — and thus irrefutably true. Money is an economic good, and it
is subject to the law of diminishing marginal utility. And so a rise in the
money supply must also necessarily lead to a decline in its purchasing power
and must cause changes in other economic variables. A change in the money
stock cannot be neutral for logical reasons.
Money and Real GDP in the United States
The
superneutrality hypothesis, viewed from a mainstream economic viewpoint,
suggests that output gains would be unrelated to changes in the money supply
in the long run. And this is indeed what a look at the data suggests.
The charts on the
left-hand (a) side show the relation between annual real-GDP-growth rates and
annual money-growth rates in the United States for the period Q1, 1960, to
Q2, 2009. The charts on the right-hand (b) side depict the relations between
annual real-GDP growth and quarterly changes in annual money-supply-growth
rates (a.k.a., acceleration
rates of money growth).
Annual changes in
M1 showed, on average, a slightly negative relation to real-GDP growth (as
suggested by the basically negative slope of the regression line).[3] In the period under review, a 1 percentage point
rise in annual M1 growth (from, say, 4% to 5%) came with a 0.3 percentage
point drop in annual real-GDP growth. An acceleration
of annual M1 growth (say, from 5% a year to 6% a year) did actually not, on
average, have a bearing on real GDP growth.
The relation
between annual growth of M2 and real-GDP growth shows a positive, however
very small, relation. An increase in the annual M2-growth rate by 1
percentage point (again, say, 5% a year to 6% a year) came with a rise in the
annual real-GDP of 0.11 percentage points, on average.
In fact, one may
say that expanding M2 basically reflects part of the inflation of
financial-asset prices — because M2 basically tracks commercial banks'
circulation credit expansion much better than M1. The relation between an acceleration of annual
M2 growth and annual real-GDP growth was negative on average.
While one should
certainly not get carried away by looking at these admittedly simple
empirical illustrations — after all, it is praxeology that establishes
the truth value of an economic theory logically — nevertheless, these
illustrations reflect important lessons of Austrian monetary theory.
First, in the
past the rise in the money supply was, on average, not accompanied by a rise
in overall production; so the relentless rise in the money supply didn't make
society any richer.
Second, changes
in the money stock were associated with, at times, considerable swings in
output. However, as swings in output gains were, on average, more or less
compensated for by swings in output losses (as implied by the first finding),
this relation bears testimony to the Austrian's conclusion that money-supply
increases through circulation
credit are the predominant cause of the business cycle.
Third, the
continuing increase in the money stock (as reflected by positive growth rates
of the money stock over time) lays bare the inflationary nature of the fiat
money system; the inflation effects include debasing the currency and
redistributing incomes in a non-market-conforming manner.
The Need for Demystifying
Mises was an
advocate of free-market money. Such money would, Mises held, be fully compatible
with the principles guiding the free social order and would minimize
economically disturbing effects when compared to a government money-supply
production (based on circulation
credit).
Perhaps most
important, Mises realised that free-market money was also a protection against the
destruction of the free-market order by government intervention — which
is regularly provoked by monetary debacles, themselves inevitably caused by
government money-supply monopolies.
It is against
this backdrop that the notions of neutrality and superneutrality of money
need to be demystified. Admittedly, both hypotheses are supportive of the
case against an openly visible inflationary monetary policy: they would
acknowledge that more money does not bring more output.
However, the
hypotheses of the neutrality and superneutrality of money rest on a
simplified interpretation of the quantity theory. As a result, they come to
ignore the inflation effects which inevitably follow from the government's
injecting new money into the system.
And as these
inflation effects — and their economic and political consequences
— are overlooked, one loses sight of the economically destructive role
played by central banks: namely, increasing the money supply by creating circulation credit.
And finally, it
needs to be noted that the hypothesis of the superneutrality of money is
expressive of the empiricist-positivist approach of modelling economics
according to the natural sciences. Mises noted,
The sciences of
human action differ radically from the natural sciences. All authors eager to
construct an epistemological system of the sciences of human action according
to the pattern of the natural sciences err lamentably.[4]
Indeed, the method
of natural sciences is inappropriate to the study of economics — which
is a field of praxeology. The methodological spirit conveyed by the
hypothesis of the superneutrality of money therefore promotes false theories
— which, in turn, foster damaging policies.
Notes
[1] For a reference on the discussion in mainstream monetary theory see,
for instance, McCallum, B. T., "Long-Run Monetary Neutrality and
Contemporary Policy Analysis," Discussion Paper No. 2004-E-18, Institute
For Monetary And Economic Studies, Bank of Japan; also Bullard, J. B and
Keating, J., "The Long-run Relationship Between Inflation and Output in
Postwar Economies," Journal
of Monetary Economics 36, no. 3 (December 1995): pp. 477–496.
[2] In this context see Mises, L. v., Human Action, 4th ed. (San Francisco: Fox & Wilkes, 1996), pp.
398–478.
[3] Note that M1 and MZM basically represent the means of payments, or
those bank liabilities which can be converted into the means of payments
rather easily. M2, in contrast, includes also longer-term bank liabilities
(such as, for instance, time deposits), which are typically held for savings
purposes.
[4] Human Action, p. 39.
Thorsten Polleit
Thorsten Polleit is Honorary Professor at the Frankfurt School of
Finance & Management.
This essay was originally published in www.Mises.org. By authorization.
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