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 fiat currency’s supply and demand are 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. The Fed may 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 it is quite essential to increase the base by 0.2% of GDP in a normal period, it is not equally necessary to increase the public’s debt 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 says that they will 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, these assets’ demand 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).

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

Back to Basics, Pt. 2: It’s all about appearances

In the previous post, I discussed the gold standard’s phase-out. When we used commodity money, we developed a medium of account (MoA) valid for both gold and cash. This could only occur if one was fixed to the other. Silver was phased out in the nineteenth century, and gold was phased out in 1968, following a rise in gold prices in the second half of the twentieth century. Following this, only the currency remained MoA.

Why is fiat money valuable? This question is actually composed of two distinct inquiries. To begin, how do we define the value of a MoA to society? Second, how does a nominal MoA acquire value? MoA is both a medium of exchange and a store of value. What might an asset performing these functions be worth? Its value as a medium of exchange is probably 1% of GDP, and its value as a store of value is between 1% and 10% of GDP. Thus, how can we be sure? Because MOAs have historically been interest-free. Thus, the stock itself is the net value of the interest for which the cash stock is forfeited. Furthermore, currency reserves typically range between 1% and 10% of GDP.

Occasionally, you will hear someone assert that fiat money is “essentially” worthless. What exactly does this imply? If fiat money loses its function as a medium of exchange, it loses all value. On the other hand, gold and silver are valuable in other fields, and this is not the case for them.

This situation then reveals a more fundamental issue: while the monetary system is unquestionably valuable, this does not explain why an asset is assigned a monetary value. We were unable to deduce its worth from the preceding questions. Numerous theories on this subject may be mutually exclusive:

  1. Unlike t-bills, it has a fixed nominal price, making it suitable for transactions. In comparison to t-bills, they are obtained at favorable nominal values. Private small denomination currency issue may be banned.
  2.  There is some social contract/bandwagon effect at work here. This is probably the most frequently encountered response: Individuals will accept it as money simply because everyone else will.
  3. In an emergency, assistance can be provided. For instance, suppose technological advancements render cash obsolete by 2049. The public may believe that the government will redeem it for some sort of asset in this situation rather than allowing hyperinflation. This can be interpreted as public confidence in the government’s ability to prevent hyperinflation.
  4. The government permits individuals to pay taxes using this unit, thereby legitimizing it.
  5. The unit is backed by assets on the balance sheet of the central bank.

Indeed, all of these theories are compatible with one another. During the final years of the gold standard, the majority of people preferred to pay with cash and small coins. This situation conditioned people to view cash as money. If you were an economist studying inflation in 1968, the demise of gold as a medium of exchange would appear to be a critical decision. On the other hand, the public was unconcerned about this because they were already accustomed to using money as money. Appearance and aesthetics are critical in economics (and politics): if something is used as money, it is money.

Indeed, even if only the social contract/bandwagon effect is sufficient from this point forward, this does not mean that other factors are absent – rather, they are concealed in the shadows. If the public expected the government to begin hyperinflation tomorrow, the value of cash would plummet.

This post has been long enough, so I’ll leave it for the next post to study the money quantity theory. In the next post, we will see how and using what tools the central bank can control the value of money(and naturally, NGDP).

Aggregate Demand is not what you think

Scott Sumner has a new piece arguing that supply and aggregate supply are unrelated and misnamed:

The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts.

When people think about macroeconomics, they often tend to confuse concepts. Frankly, I think that is the reason for this situation. Like aggregate supply, aggregate demand is a terrible term for the concept we use in macroeconomics 101.

When an ordinary person considers macroeconomics, he or she is likely to confuse the terms “aggregate demand” and “quantity of goods and services purchased” (or at least use these two concepts interchangeably). However, there is an important distinction:
Assume there is no change in AD but a decline in AS. We are experiencing a supply crisis (which you can refer to as the Black Death or the Covid-19 pandemic), and even if AD remains constant, the number of goods purchased in stores will decrease. However, the critical point is that this is a decrease in the equilibrium amount; we cannot, under any circumstances, speak of a decrease in AD.

Let us begin with the Black Plague and work our way up to the present. The Black Death resulted in a 30% decline in Europe’s population. In terms of curves shifting to the left, demand for nearly every commodity has almost certainly decreased significantly, and supply curves, of course, have shifted to the left as well. As a result, the relative price remained stable.

So how could the Black Death have almost no effect on aggregate demand? How do we explain this? There were far fewer people in the world, and the demand for each commodity has dropped dramatically. Shouldn’t the aggregate demand also decline?

At this point, the concepts I mentioned above get mixed up and force you to think wrongly. I do not claim that this is anomalous, the first thing that every person who sees the terms “demand” and “aggregate demand” would involuntarily do in his consciousness would be to encode aggregate demand as “the total quantity of goods purchased.” The term we have created forces us to reason wrongly.

Here’s what really happened: The Black Death or any other epidemic doesn’t have the power to kill money, so the money supply probably didn’t change (I’m talking about commodity money, of course). By lowering the V, it may have shaken AD, but this did not have a serious effect as far as we know. What we do know is that the Black Death increased prices and quite possibly lowered real GDP. AD curve did not shift left due to Black Death.

And the same is true for the covid-19 recession. Production of supply chains had been significantly disrupted. However, there was not a big decrease in total demand. Instead, prices rose and real GDP fell.

Here’s what happened in both epidemics:

Most people understand what the concept of demand is at the level of individual products. And most people think that aggregate demand is related to the concept of demand at the level of individual products. It isn’t. They are unrelated. Considering ordinary use, the concept of aggregate demand actually has nothing to do with “demand.”

At the micro level “demand” is a kind of real concept, the amount of Samsung Galaxy Note 10 consumers want to buy at various prices. Aggregate demand is nothing like that. When we talk about AD, we are not talking about consumer goods. AD is a nominal concept related to money. Monetary policy determines the AD and only central banks have the tools needed to solve AD-related problems.

The piece in The Economist is quite important at this point:

But whether the understanding of supply shocks forged in the 1970s still applies is unclear. In practice, the distinction between shocks to demand and those to supply is fuzzy. In a paper published in 2013 that revisited the era of stagflation, Alan Blinder of Princeton University and Jeremy Rudd of the Federal Reserve argue that supply alone cannot explain the soaring unemployment of the 1970s. In fact, they say, price increases had demand effects that mattered more. They raised uncertainty, reduced households’ disposable income and eroded the value of their savings.

So what can be done with these terms that make us confuse concepts and reason wrongly? My suggestion is to call it nominal expenditure(s). We will have a much more useful and accurate term for the concept if we use this term.