Luis de Molina on the Quantity Theory of Money

I always thought the Quantity Theory of Money was a discovery of the 18th century Enlightenment, one of the first intellectual achievements of the new science of political economy.

However, I recently stumbled across a “Treatise on Money“ by the 16th century Jesuit theologian Luis de Molina which contains, among other economic ideas, a concise statement of the quantity theory as well as some empirical evidence for it.

Molina is best known for coming up with a clever solution to the theological problem of reconciling the omniscience of God with the free will of humans: God, Molina reasoned, knows exactly how humans would behave in any given hypothetical situation (this kind of knowledge Molina called scientia media, „middle knowledge“). In other words, God is the perfect economist: He has complete knowledge of all His creatures’ preferences, their beliefs and their cognitive biases, and therefore can predict what choices they will make freely when faced with any possible budget constraint. This idea helps solving a number of important theological problems, like the issue of predestination or the theodicy.

Anyway, Molina was not only a great theologian, but also a superb economist. For instance, he clearly understood the logic of supply and demand in determining market prices and also saw the logic of no-arbitrage conditions. And here is his explanation of differing price levels in different places:

There is another way that money may have more value in one place than in another: namely, when it is more abundant. In equal circumstances, the more abundant money is in one place so much less is its value to buy things with, or to acquire things that are not money. Just as the abundance of merchandise reduces their price when the amount of money and quantity of merchants remains invariable, so too the abundance of money makes prices rise when the amount of merchandise and number of merchants remain invariable, to the point where the same money loses purchasing power.

And here is his evidence for the theory:

So we see that, in the present day, money is worth in the Spanish territories much less than what it was worth eighty years ago, due to the abundance of it. What was bought before for two today is bought for five, or for six, or maybe for more. In the same proportion has the price of salaries risen, as well as dowries and the value of real estate, revenues, benefices, and all other things. That is exactly why we see that money is worth much less in the New World, especially in Peru, than in the Spanish territories, due to the abundance there is of it. And wherever money is less abundant than in the Spanish territories, it is worth more. Neither is it worth the same in all parts because of this reason, yet it varies according to its abundance and all other circumstances. And this value does not remain unaltered as if it were indivisible, yet fluctuates within the limits defined by the people’s estimation, the same as happens with merchandise not appraised by law. This money’s value is not the same in all parts of the Spanish territories, but different, as ordinarily it is worth less in Seville—where the ships from the New World arrive, and where for that reason there is usually abundance of it—than what it is worth in other places of the same Spanish territories.

A perfect prediction (self-congratulation)

Three years ago, Christoph Zwick and I wrote a paper about the sustainability of Austria’s public debt. Under our preferred model, we forecasted the debt-to-GDP ratio, which at the time stood at slightly over 80 percent, to recede towards 60 percent within the next decade. We concluded that the long-run probability distribution of Austrian public debt given current data indicated no cause for alarm. How good was our projection?

Well, the new Austrian minister of finance just held his budget speech, in which he announced a zero budget deficit in the coming years. Assuming the government follows through on this plans, this would indeed bring down the debt-to-GDP ratio to 62 percent, exactly as our main projection predicted.

Here is the finance ministry’s proposed budget path:

Bildschirmfoto 2018-03-21 um 09.00.09

And here our main projection from the paper (note that the initial debt level is slightly lower due to different definitions of public debt; the dark and light blue areas indicate the 75 and 95 percent probability bands around the median, which is in black):

Bildschirmfoto 2018-03-21 um 08.54.12

Ladies and Gentlemen, this is what a perfection prediction looks like.


Debt crises in a monetary union: the case of Indiana

As Europeans we tend to think of America as new, young, and modern, whereas in Europe everything is old and traditional. At least that’s what I thought, until I noticed this while driving around in the American Midwest:


The license plate celebrates the 200th birthday of the State of Indiana in 2016. 200 years! This means, in a sense, Indiana is older than many of the states of the European Union. In 1816, Germany was still a patchwork of small territories, loosely connected through the German Confederation – of which Austria was a part. Italy was merely a geographical description – the process of Italian unification had not even begun. Greece was just a province of the Ottoman empire. Belgium, until 1815 known as „Austrian Netherlands“, was part of the United Kingdom of the Netherlands. France did exist as a nation then, however, while the people of Indiana lived for 200 years under the same political system and only once made marginal changes to their constitution (more about this below!), the French during the same time went from the post-Napoleonic Bourbon monarchy to the Second Republic to the Second Empire, then back to the Third Republic, then to totalitarian rule under the Nazis, and finally back to Fourth and now the Fifth Republic. As far as I am aware, there is no European country which has had the same constitution for the past 200 years without interruptions or major changes – the single exception I can think of is the United Kingdom which always had the same constitution: none.

There is another striking fact about the history of Indiana. Indiana has been in a monetary union with the rest of the United States for as long as it existed. And during its early history, it has had its own debt crisis which bears a striking resemblance to the recent history of the much younger European monetary union.

When Indiana became a State in 1816, it was mostly a wilderness at the margin of civilization. The only major road in the country was the Buffalo Trace – literally a trace created by migrating bison herds. Population was only 65,000 initially, but growing fast. The government of the young state decided to take the country’s infrastructure into the 19th century. And 19th century infrastructure, they figured, was going to be canals. So, they launched a giant public investment program, called the Mammoth Internal Improvement Act, spending 10 million dollars (equivalent to 260 million current dollars, roughly 100% of GDP at the time) on canals and toll roads. The heart of the project was the Wabash & Erie Canal connecting the Great Lakes with the Ohio River. „Crossroads of America“  was the official state motto of Indiana.

To finance these projects, the governor of Indiana, a certain Noah Noble, had a plan: some money was to be raised by selling public lands, some by raising taxes, and some by borrowing from the Bank of Indiana, which was partly state-owned. The Bank of Indiana refinanced itself by issuing bonds, backed by the state, at the London exchange.

Initially, the plan looked like a big success. The construction works employed many thousands of people and provided a stimulus for the economy. Borrowing costs were low and spirits were high. But soon, problems started to appear. It turned out that the government had greatly underestimated the costs of building the canals, mostly because they failed to take into account the damage done by muskrats who burrowed through the walls of the dams. Critical voices in the State Congress regarded the canals as a total waste of money. Railroads, they argued, were the future! Nobody seemed to listen.

And then, in 1837, a financial crisis broke out. The crisis was triggered by the Bank of England which, in an attempt to curb the outflow of gold and silver reserves, raised interest rates. This had a direct impact on Indiana whose borrowing costs skyrocketed. It also had an indirect effect: since the United States was on a gold and silver standard, American banks were forced to follow the Bank of England in raising interest rates, which led to a credit crunch and a nation-wide recession. (A classic example of a monetary policy spillover effect!)

The combination of stagnant tax revenues, exploding construction costs and rising interest rates meant that State of Indiana was effectively bankrupt at the end of 1841. So they sent the head of the Bank of Indiana to London to negotiate a restructuring of the debt. The creditors agreed to a haircut of 50% of the debt. In exchange, Indiana handed over control of most of the canals and roads, many of them still unfinished. The Wabash and Erie Canal was held in trust to pay off the remaining debt. It operated until the 1870s yielding a low profit, but was soon made obsolete by – the railroads which turned out to be the key infrastructure of the 19th century.

The conclusion Indiana drew from this was that the long-run costs of government borrowing far exceed the short-run benefits. Which is why in 1851, they adopted an amendment to their constitution, forbidding the State government to get into debt (except in cases of emergency).

I’d say there is a thing or two our modern European states can learn from this story.