Money Matters

Note: I originally designed this post as a separate post, but it changed as I continued to write. At one point, I realized that I needed to write the background for the first post of the “Back to Basics” post series, as even in this form there were points left behind that needed to be clarified. Therefore, this post can be read as “Back to Basics, pt. 0”. If you are going to read the series, it’s best to start from this point.

From the beginning, I have been thinking about how to teach the monetary economy, how to shed light on the confusing concepts and concepts that are confused with each other. Later I realized that when people learn monetary economics, they have to unlearn what they believed before.

We, market monetarists, believe that monetary shocks are the primary cause of business cycles, and indeed the only cause of fluctuations in unemployment. Most people don’t believe it, even for most economists this is unclear. The average person tends to think that recessions are caused by major real shocks or financial shocks: asset bubbles burst, 9/11, stock market crashes, natural disasters, etc.

It will probably seem difficult to get rid of these “real” theories at first, but the more you think about it, the more likely it is that the foundations are rotten and can be easily broken down. It is easy to see that 9/11 did not cause the 2001 recession, because the recovery started after 2 months. One of the biggest stock market crises in the last 50 years occurred in 1987, almost identical to 1929, including a recovery in stock prices. The biggest natural disaster to hit a wealthy country in the last 20-30 years was the 2011 Japanese earthquake that killed tens of thousands of people, devastating a large area of Japan and its entire nuclear industry (25% of total electrical energy).

The next two graphs show the unemployment rate 2 years before and after the October 1987 crash and Japan’s unemployment from January 2009 to 2015(the tsunami was in March 2011):

What do we see here? Absolutely nothing. These real shocks do not matter much to business cycles. The tsunami, of course, caused a temporary drop in industrial production, but nothing severe enough to create a recession. You can really see how little real shocks matter if you turn your attention to the labor market. Because real shocks do not cause big jumps in unemployment. Recessions are due to unstable NGDP, which is due to unstable monetary policy(by definition, stable NGDP growth is my definition of stable monetary policy). However, it’s not a tautology that the recessions themselves are caused by monetary policy. It is surprisingly difficult to explain why NGDP instability has caused unemployment to fluctuate so much. Especially when NGDP shocks are caused by quite obvious changes in monetary policy rather than “errors of omission.”

Let’s look at another example. In the US, residential construction fell 50% between January 2006 and April 2008. So what happened to unemployment? It rose from 4.7% to only 4.9%.

Many people, and even some economists, grossly overestimate the importance of real shocks in the business cycle. On the other hand, again, most people and some economists greatly underestimate the importance of monetary shocks. If we’ve got rid of the idea that non-monetary shocks cause recessions, it’s time to talk about monetary policy as the real cause of business cycles.

First, it is necessary to explain why money is important for nominal variables such as inflation and NGDP. After that, we can go back to the business cycle.

The key concept we will use from now on is the value of money, and it is defined as:

Value of money = 1/(Price Level)

This definition actually comes from basic microeconomics. In upper-level micro-lectures, we move away from simple supply and demand curves and start talking about “relative prices” or “real prices.” Therefore, if the CPI rises by 10% per year, then the prices of goods that increased by 8% declined relatively, and those who experienced a 12% price increase relative to their price increase. Relative price is the actual price relative to the price of all other goods in the economy. Now let’s do the same with money. What is the nominal price of money? One. So what is the real price? We call this the purchasing power of money, it shows how many goods you can buy for each dollar. This is only 1/price level. Thus, if the price level doubles, the purchasing power of the money, ie the value, falls by half.

The field of monetary economics exists for a reason – money is the medium of account, the commodity we use to measure all other values. Most textbooks oversimplify this concept by combining the two ideas into “units of account.” Currency banknotes are the medium of account, which is used to measure value. Abstract accounting units such as the US dollar and Euro are examples of units of account.

Because money is good for pricing all other goods, almost every change in the value of money affects changes in price level and other nominal variables. I have to remind you that this is not a “theory”, but a definition. The theory will come later, where we will ask whether government policy makers can control the price level through “monetary policy”.

While studying the monetary economy, the most efficient example on this subject was the metaphors that Irving Fisher used money as a measuring stick. I’ll first give an example with price level, then we’ll see the same example with measuring sticks:

In 1996:
Income $20,000
Price level 1.0
Real income $20,000.

In 2021:
Income = $120,000,
Price level = 3.0
Real income = $ 40,000.

This means that prices have tripled in 35 years, and a person’s income has increased 6 times. He can now buy twice as many goods and services. This is derived as follows:

Real income = $ 120,000 × (1.0) ÷ (3.0).

Let’s see the same example on the measuring sticks, our example would be the height of a child:

In 1996:
Height = 1 yard
Real height = 1 yard

In 2021:
Height = 6 feet
Real height = 2 yards

The child is 6 times bigger in nominal terms, but only twice as tall in real terms. No one would believe it if his father claimed that his son was 6 times taller. This is usually not possible. However, it is claimed that we made 6 times more money in 2021 than in 1996, and they make the same mistake that the father did: 1996 dollars are thought to be the same as the 2013 dollar. But that’s not true, the value of each dollar today is only 2/3 of 1996 dollars. We can say that those who made this mistake suffer from the “money illusion.”

Let’s imagine that we are using something other than cash as money. If oranges were money, a large harvest of oranges that degraded the orange would cause too much “inflation.” In fact, we are experiencing a lot of “orange inflation” when the relative price of oranges falls anyway. And, for example, when the relative value of silver rises, we experience a lot of “silver deflation”. Why do we only care about money inflation and not other types of inflation and deflation? This is a difficult question to answer. Textbooks have two sections devoted to this:

  1. Welfare costs of inflation.
  2. Welfare costs of business cycles.

In theory, measuring sticks don’t matter. No matter what you measure objects with, their actual dimensions do not change. But imagine a country where for some reason people make contracts to supply 100 “units of wheat” within 12 months in the future and units are left unspecified. Or let’s say people agreed to work at 2 units of wheat per hour next year. Suppose, moreover, that the government can change units from pounds to pounds and ounces at any time. In this case, a change in units will definitely affect the public. This is the main reason why monetary inflation is important and orange inflation is much less important. Our measuring stick always changes in value and this causes a lot of problems.

Now that these points are clear, we need to explain why the value of money has changed. In a post series.

Back to Basics, Pt. 4: The role of expectations

In the previous post, we examined the Quantity Theory of Money. We have seen that increases in the rate of money growth lead to high inflation leading to higher speed and lower real money demand. This indicates that when it comes to an increase in the money supply growth rate, in the long run, the price increase will be more than the increase in the money supply. Conversely, when it comes to slow money growth, inflation slows down, which lowers the opportunity cost of holding the base money, so the demand for money increases, and the price increase is less than the increase in the money supply. This is one of the ways expectations play a role in the money and inflation equation.

There are a few more interesting examples. These happen when there is a change in the expected future level of the monetary base but no change in the current base. Here are two examples of this:

  1. A new government is elected and there is an expectation that a lot of money will be printed. This expectation of an increase in the money supply raises prices. A clear example of this occurred between March 1933 and February 1934, when the Wholesale Price Index rose more than 20%, but there was no increase in its monetary base. People correctly expected that the devaluation of the dollar would lead to a higher money supply in the coming years. The increasing current base velocity reduced real money demand and prices increased.
  2. The opposite is also remarkable. This happens when a government injects large amounts of money into the economy but tells the public that it will end as soon as there is a sign of inflation. In this case, the interest rate will drop to zero and the public will hold much larger real cash balances. The best example of this situation occurred in Japan in the early 2000s. By 2006, too much base money was injected, and in 2006 the monetary base was lowered by 20% to prevent inflation from occurring.

The conclusion to be drawn here is that the current path of inflation is affected by expectations too much. But of course, the expectations must be about something, and in this case, they are about the monetary base and the changes in its demand in the future. If we completely ignore the expectations, then we can conclude that the “hot potato effect” drives the long-term relationship between changes in money supply and changes in the price level. However, when expectations come into line, current inflation will be more likely to affect the expected future hot potato effect.

Unfortunately, the role of expectations makes the monetary economy much more complex. This situation causes us to experience a problem that can be called a kind of “indeterminacy problem” or “multiplicity of solutions”. Several different future pathways for the money supply can be associated with any price level. Alternatively, there are many different price levels (including infinity) consistent with any available money supply. Therefore, if the public believes that the money will be declared null and void next week, it may have no value today. Confederate money towards the end of the Civil War is a perfect example of this. So there must be some kind of confidence in the background that money will have purchasing power in the future.

In the next step, we will see that monetary policy not only affects prices but also has real effects and we will examine the reasons for this.

Back to Basics, Pt. 3: The Quantity Theory of Money

In the previous post, we entered the fiat money system. Now we will examine the quantity theory of money.

The supply and demand of the fiat currency is different from the commodity money model(silver or gold) we examined earlier. There are two reasons for this:

  1. In the fiat money system, the government has unlimited control over the money stock and the cost of money production is almost zero.
  2. The demand for money is unit elastic when responding to changes in the value of money.

Inferences from these two factors also change the mechanics of monetary policy. When the gold standard was abandoned, monetary policy shifted to a policy of influencing MOA supply rather than affecting MOA demand (although of course money demand is also affected by Fed policies). The Fed can shift the supply curve to the left at any time through open market operations or loans. Therefore, under the fiat money regime, the supply curve is actually a policy instrument representing the amount of base money.

Simple, right? Unfortunately not. Especially I think OMOs are confusing people and there is a misunderstanding. More specifically:

  1. You may have heard of the helicopter crash metaphor in economics. Some Keynesians believe that the introduction of the currency through a “helicopter crash” or OMOs is much more important and effective than other ways. The term “helicopter crash” was originally used to refer to combined monetary/fiscal expansion. Money to be dropped from helicopters works like “welfare” payments, and this also expands the money stock. But at this point Keynesians are wrong. The financial effects are almost zero significant compared to the monetary impact. While in a normal period it is quite important to increase the base by 0.2% of GDP, it is not equally important to increase the debt held by the public at the same rate.
  2. As I have read, quite a lot of Austrians are concerned about the “Cantillon effects” (Cantillon effects emphasize who gets the money first). The Austrians assume that the lucky group who will get the money earlier will increase their spending. However, there is a misinterpretation here. In such a case, money is not given but sold at market prices. Therefore, the first person to receive the money will not be in a better position than the others and therefore does not have a good incentive to spend much more than others.

These are both due to a common misinterpretation: the idea that injections of money are important and the theory that “people with more money spend more” derived from it. However, this interpretation cannot be more than a confusion of wealth and money.

I will say a phrase that you can often hear in your daily conversations: A billionaire bought a large yacht (or yachts) because he had a lot of money. Here we mean that person is very wealthy. But despite this, the billionaire may have very little cash. A close example can be said of Jeff Bezos and Elon Musk. It has appeared in many places where both are the richest people in the world. But this wealth means wealth: it includes loans, stocks, and many other things. Despite this, neither of them has a fortune as cash as reported in the news. Musk or Bezos, if their stock dropped incredibly overnight, they wouldn’t be that wealthy anymore. Cash is not like that.

So if we really want to grasp the sheer effects of monetary injections(without confusion like financial or Cantillon effects), we must consider a form of injection that doesn’t make anyone “better off”.

Consider this: Let’s say there are 100 million Americans who receive more than $500 check from the government each year. These include tax refunds, veteran benefits, unemployment insurance, state workers’ salaries, social security, etc. there are also payments. The Fed wants to increase the base by $30 billion this year. The Treasury pays 100 million Federal check recipients the first $300 in cash and the rest by check. In this case, people do not receive any additional money compared to the previous ones, only some of the money they receive comes in cash instead of regular checks. If the Fed had decided not to increase the base, $300 would have been paid by check. This is the essence of monetary policy, free from confusion and misinterpretation.

If people don’t want to keep that much cash, they’ll want to get rid of it. But how can they do that? Here we come to the only concept that lies at the heart of money/macro – the illusion of composition. Individuals individually can get rid of unwanted cash, but society as a whole cannot. Why is that? How can we explain this seemingly paradoxical situation?

Let’s consider an example where the Fed raises its foreign exchange stock from $ 200 to $ 400 per person. How can a new equilibrium be reached? In the short term, prices are sticky and of course, short term interest rates can go down. But prices will change over time, and a new equilibrium will be formed, where society is happy to have $400 per person. Okay, but how high do prices have to rise for supply to equal demand at the original interest rate? How can we find that?

We can assume that people care about purchasing power rather than nominal amounts. According to this assumption, prices should double so that the purchasing power of the cash stock returns to its original level. Suppose people are holding enough money ($ 200 for this case) to shop for a week. According to this assumption, prices should increase up to $ 400 for one-week shopping.

The implication from these two assumptions is that prices rise in proportion to the increase in foreign exchange stock. This means that the demand curve for MOA is unit elastic. Unlike fiat money, when the commodity money (silver or gold) is MOA, the demand for these assets will not be unit elastic. The only value of fiat money is purchasing power – unlike gold or silver, it has no value in itself.

This takes us to the Quantity Theory of Money. When you double the money supply, the value of the money drops by half, and the price level doubles. Of course, this simple equation assumes that the demand for money does not change over time. However, the demand for money in the real world also changes. So the following statement is a bit more accurate: “A change in the money supply causes the price level to rise proportionally to where it would have been if the money supply had not changed.” But even this statement is not entirely correct because, in the real world, expected changes in the value of money can cause changes in demand for money.

So what we only can say is this:

Changes that occur once in the money supply cause a proportional increase in the price level in the long run compared to where the price level would be if the money supply changed.

The reason for this statement is that one-off changes in money supply do not change real money demand in the long run. This is a slightly “weaker” version of QTM, but paradoxically it’s the strongest and most defensible version. In my view, QTM is most useful when there are big changes in the money supply and/or in the long run.

In the next post, we will see how shifts in expectations can lead to some wildly inconsistent results with simple QTM(and yet the two are compatible with each other).

P.S: I may not be very clear when talking about “weak” or “strong” versions of the theories. If you don’t get it, here’s the summary:

Every theory has a strong, half strong, and weak version. Here I will explain it only for QTM.

Strong: The money supply and changes in price level are proportional. (constant V)

Semi-strong: An external change in the money supply will cause a proportional change in the price level.

Weak: An external change in money supply will cause a proportional change in the price level in the long run. (This is the version I believe.)

Pro-Market but not Pro-Business

For context, read this.

Here’s my take:

I see GameStop as a giant poker table. The only difference from a regular poker game is that an outsider periodically adds more money to the pot than players have. Everyone is aware that they are (or should) gambling and they have accepted the possible consequences.

I have read that short selling is illegitimate. Nope, it was an excellent thing to do at this point. Moreover, short selling is a legitimate move according to the game rules. If short selling made other people lose money, so be it. While playing poker, can you beat other players or get your money back by force for losing your money?

Actually, what happened is not unique. GameStop had exactly the conditions for this to happen and was to be expected. There have been hundreds of odd stock market movements like this in the last century(of course, this event is unique in another way, but not in that respect).

The same goes for squeezing the shorts. It’s a pre-defined move in the game. When taking short positions, you take a risk and that’s part of the game. It is impossible for hedge funds to not know about them (especially in this case, i.e., when you sell 140% of the outstanding shares at short notice, it is impossible for you to not know this in any alternative universe).

Although I have followed the part up to this point, it didn’t interest me. Thousands of people are gambling at a table, and as usual, some people are losing. The only interesting thing for me was that this time it was organized from Reddit, it had a libertarian notion, and small investors started eating the big fish. But even then I didn’t feel the need to write anything on it.

However, things changed with Robinhood’s move. If you are trying to shut down the game by using an outside power because you lost and others won, that is breaking the rules of the game. Closing the game when you do not win cannot be justified in any way(of course, remember that they usually owe the government their permanent win).

I don’t hate hedge funds or short sellers. Rather, they should be allowed to do their job. But when they get into a risky game and start losing, it is necessary to let them loose.

In fact, this reveals a principle at the heart of classical liberalism: pro-market, not pro-business.
Even though I would describe myself as pro-market, I never thought to define myself as pro-labor, pro-environment, pro-educational, pro-business. That’s not because I think workers, education, or ecology are not worth it (I believe that climate change must be tackled with great violence and, moreover, I find all vegan arguments correct). However, I do not accept many of the policy proposals associated with these positions. Bryan Caplan has a post that reflects my point of view:

What would a non-argumentative definition of feminism look like?  Ideally, feminists, non-feminists, and anti-feminists could all endorse it.  If that’s asking too much, all these groups should at least be able to accept the proposed definition as a rough approximation of the position they affirm or deny.  My preferred candidate:

“feminism: the view that society generally treats men more fairly than women”

What’s good about my definition?

First, the definition doesn’t include everyone who thinks that our society treats women unfairly to some degree.  In the real world, of course, every member of every group experiences unfairness on occasion.

Second, a large majority of self-identified feminists hold the view I ascribe to them.  Indeed, if someone said, “I’m a feminist, but I think society generally treats women more fairly than men,” most listeners would simply be confused.

Third, a large majority of self-identified non-feminists disbelieve the view I ascribe to feminists.  If you think, “Society treats both genders equally well,” or “Society treats women more fairly than men,” you’re highly unlikely to see yourself as a feminist.

About labor rights, for example, I feel the same way as the example of feminism above. I could call myself “pro-labor” as most of the pro-free-market policies I preferred would also be good for most of the workers, but that would be misleading. Positions using the “pro-labor” mark support higher minimum wages, restrictions on labor, restrictions on immigration, and Wagner Act. I am strongly opposed to them. So I am not pro-labor in the commonly used sense of the term. This also applies to the other concepts I mentioned above.

What do I think about the business? In fact, I believe the business community has an essential and irreplaceable function in a free society. But I am not pro-business in the ordinary sense of the term. Indeed, I oppose public policies aimed at things like protection of large enterprises against the competition, bailouts, subsidizing businesses through Ex-Im Bank. I consider this position to be illiberal.

Bryan Caplan had previously claimed that:

Yes, businesspeople are flawed human beings.  But they are the least-flawed major segment of society.  If any such segment deserves our admiration, gratitude, and sympathy, it is businesspeople.  We should be pro-market and pro-business.

Unfortunately, I do not agree with this at all. Overall, I have a modest-favorable view of businessmen: businessmen have as bad tendencies as any person, but the market will contain their worst tendencies. Indeed, some businessmen can help society more than anyone else. But at the end of the day, they are as ambitious and greedy as all of us, moreover, when they get state power behind them, you probably won’t find anything worse than them.

Big-Techs is a good example of that. Freedom of speech, limits of private corps, and social media platforms are intertwined issues. I can’t cover all of these in this post, so I’ll probably write something about it later. However, what happened has shown us once again that corps, when they reach enough power, are as bad as the government and must be fought. The corruption of power is not a problem specific to the government alone. Classical liberals are not just talking about the government when they say that power is corrupt and that the power of force should never grow to this length.

What’s the moral of the story so far? I see people on the internet saying that all this is refuting the hypothesis that the free market is effective, and proves that markets only serve the strong.
Does what happened these days really require me to change positions, or at least rethink my ideas?

A rational person should not cling to his beliefs for emotional reasons and should reassess his beliefs when necessary. Moreover, a rational person should gladly realize that when his position becomes void in the face of new information, he must lose and change his position. Most people, on the other hand, are not rational and often defend them more fervently when they need to change their beliefs and ignore these factors.

I’m not sure if God exists. I don’t think I care about that either. On the other hand, I am surprised when I see people questioning their faith in God because they have lost a loved one so badly. I’m not sure if that made me heartless, but it just doesn’t seem like a satisfactory reason to me. Is this what makes you question your beliefs?

I don’t need to be lectured about emotions, of course, I know enough about how people form their beliefs and the importance of emotions in human nature. For that reason, I don’t believe it is enough. Ideally, when people form their beliefs, they should first question, analyze, compare with other information, and finally believe that this belief is rational. But for a normal person, this sequence is very different. First, we have a belief and then we start looking for arguments to support it.

After the Great Recession, the economics profession abandoned the view that the BoJ was incapable of creating deflation. Instead, the idea that monetary policy is ineffective at zero lower bound was adopted. So far, I have not come across any explanation that well grounds this change of opinion. They talk about the overlap of QE policies with low interest rate policy and low inflation. Well, we could already learn this from the time of Herbert Hoover and the BoJ politics of the early 2000s. Where is the new knowledge that could change the perspective of zero lower bound so abruptly after the Great Recession? The information they claim to have just come across has existed before.

Or let’s consider this. With the events of January 6, many people are more willing to admit that Trump is authoritarian and lawless. But before January 6, this was quite evident.

Now let’s get back to our topic. Is the market anomaly we are experiencing at this time enough to invalidate EMH? I don’t think it’s enough because even in the last 50 years alone, there have been dozens of weird asset price movements caused by some pretty crazy market speculation. If you said that with GameStop, EMH took a big hit and you are questioning your belief that the market is working effectively now, I would tell you that you never set your beliefs on a well/rational basis. This means that you hardly ever study financial history.

John Cochrane has a new post. Check the headline:

Gamestop. 1999 déjà vu all over again?

Cochrane talks about the tech stock “bubble” in 1999 when the NASDAQ rose from 2200 to over 4000.
So what does the 1999 Deja Vu mean? Does it mean that GameStop shares purchased for $325 will be worth $1300 in 2044? I don’t think that is what Cochrane meant.

I recall this example because while 1999 is often viewed as a classic stock price bubble, there is little evidence that tech stocks were valued too much, at least overall. There was no bubble in 1999.
Likewise, Bitcoin has never been a bubble. Although almost no one claimed to be a bubble today, everyone seemed sure of that at first.

Suppose 10% of investments like early Bitcoin or early Amazon were successful and their value increased 1000 times. The rest dropped to zero. A diversified portfolio filled with this type of speculative stock will yield a return well above the market average, possibly a gain of 100 times.

Investors are aware that only a few of these high risk / high reward stocks will do quite well. As a result, they all trade with high prices. In the end, most of these companies are performing poorly, operating through “confirmation bias” to convince most people that they are right about bubbles, even if they are wrong.

Years ago I had no idea what was happening with Bitcoin, and I still can’t claim to really understand. But at least I think I understand that I don’t understand, and that’s enough for me for now. So would you be totally sure that nothing “fundamental” has changed between last week’s GameStop and today’s GameStop?

Herein lies the reason why testing EMH is so difficult. The collapse of what appears to be speculative bubbles is presented as evidence against EMH, but in reality, the theory predicted that the majority of speculative “bubbles” would collapse to achieve the expected rate of return on portfolios including Bitcoin, Amazon, and Tesla. The statement “speculative stock X is very likely to fall in a few years” is in no way equivalent to “speculative stock X is a bad investment.”

It is really difficult for people unfamiliar with economics to see this aspect of market behavior, and as a result the vast majority of people never see it.

As a result, people don’t even think about the EMH question correctly – some look at the so-called “bubbles” and think they can interpret the market from there. The point where they move is the question “Which anti-EMH model is useful for me?”

I was never ashamed to re-evaluate my views on various issues and change positions if necessary.
On the contrary, I do this all the time. On the other hand, although I define myself as a rational person, I would be embarrassed if I encountered information that already existed throughout history as if I had just realized it and re-evaluated my views based on this. Well, what happened these days is based on a right-libertarian and a classical liberal notion. The GameStop thing tells us nothing about whether capitalism is effective or not. However, it is a valuable event, as it shows that especially large corporations and the wealthy associated with the state have no place in the market. Classical liberals perhaps said this before anyone else. Perhaps it is the turn of others to rethink their ideas, not classical liberals.

P.S: I don’t know if you understand the argument I made in this post. So you can test it right here. Here is Bitcoin’s story:

  • A. Single data point versus bubble theories
  • B. Thousands of data points versus bubble theories

The answer is B. This is an absolutely crushing blow to the asset price bubble theories. Destroyer. I have long argued that there is no such thing as a bubble, and Bitcoin alone is a sufficient example. It allows the price of 999 other assets to drop in a world without bubbles. How will you prove that bubbles now exist?

HT: Scott Sumner