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.

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Draghis Nullzinspolitik, Friedmans Regel und die deutsche Presse

Die deutsche Presse ist völlig aus dem Häuschen. Nein, nicht wegen der andauernden Flüchtlingskrise, auch nicht wegen Griechenland, nicht einmal Fußball ist der Grund des Aufruhrs. Der Grund ist die jüngste Entscheidung der Europäischen Zentralbank den Hauptrefinanzierungssatz (vulgo Leitzins) von 0,05% auf 0,00% zu senken.

Na mehr brauchst’ nicht.

Die Süddeutsche Zeitung titelt „Draghi kennt keinen halt mehr“, die Welt legt noch eins drauf: „Mario Draghi raubt der Welt des Geldes das Fundament“, „Ist das Mario Draghis letzte Schlacht?“ fragt Spiegel-Online und die FAZ raunt: „Wie geht es weiter mit dem Euro?“

Nun, wie ich auf diesem Blog schon früher einmal festgestellt habe, macht Geld eben verrückt – sogar die biedere deutsche Wirtschaftspresse. Aber hier scheint mir das Maß der monetären Manie neue Höchststände zu erreichen. Nehmen wir den „Welt“-Artikel her. Dieser wirft Draghi vor Inflationserwartungen zu schüren – in deutschen Augen die schlimmste Sünde für einen Geldpolitiker – und erklärt ohne jeden Anschein von Ironie nur wenige Zeilen davor, dass die Niedrigzinspolitik weitgehend wirkungslos gewesen sei. Er beklagt, dass die EZB den Banken jetzt kostenlos Geld leiht, und wirft ihr gleichzeitig vor, dass sie die „Profitabilität der Geldhäuser massiv unter Druck“ bringe. Die Nullzinspolitik, so die „Welt“, setze alle Regeln des Marktes außer Kraft.

Wie reagiert der gute Ökonom auf solchen Unsinn? Ein guter Anfang ist wie immer bei Milton Friedman zu finden.

Jeder weiß, dass Friedman den Monetarismus begründet hat. Das ist jene Doktrin, der zufolge die Zentralbank für ein möglichst konstantes Wachstum der Geldmenge zu sorgen hat. Wenige wissen, dass Friedmans Monetarismus eine einfache Regel für den optimalen Nominalzins impliziert. Das optimale Zinsniveau beträgt – die Spannung steigt – null.

Das Argument, warum der Nullzins optimal ist, sollte nicht schwer zu verstehen sein. Die Regel für die optimale Bereitstellung von Geld ist dieselbe wie die für die optimale Bereitstellung von Wiener Schnitzeln. Die privaten Grenzkosten des Schnitzelkonsums (also die Menge an anderen Gütern, auf die die einzelne Konsumentin verzichten muss, wenn sie ein zusätzliches Schnitzel isst) muss gleich sein den sozialen Grenzkosten der Schnitzelproduktion (die Menge an anderen Gütern, auf die die Gesellschaft verzichten muss, wenn sie ein zusätzliches Schnitzel produziert). Die optimale Geldmenge ist erreicht, wenn die privaten Kosten der Geldhaltung gleich den sozialen Kosten der Geldproduktion sind. Die privaten Kosten der Geldhaltung sind die nominalen Zinserträge, auf die ich verzichte, wenn ich mein Vermögen in Form von Geld halte anstatt in Anleihen und andere Wertpapiere zu investieren. Die sozialen Kosten der Geldproduktion sind praktisch null. Euroscheine zu drucken kostet fast nichts, digitales Buchgeld zu schaffen genau nichts. Ergo sollte die Zentralbank genau so viel Geld bereitstellen, dass der Nominalzins auf null sinkt.

Aber was ist mit Inflation? Heizt eine Nullzinspolitik nicht die Preissteigerung an? Nein. Die Inflation wird, zumindest langfristig, vom Wachstum der Geldmenge bestimmt und nicht von ihrem Niveau. Eine Nullzinspolitik ist vereinbar mit einer wachsenden, fallenden oder gleichbleibenden Geldmenge und daher mit Inflation, Deflation oder perfekter Preisstabilität. (Friedmans ursprüngliche Analyse verlangt im Optimum eine leichte Deflation.)

Und die Banken? Werden die durch die Nullzinspolitik nicht zu immer riskanteren Investitionen gedrängt? Wieder daneben. Ich bin eine Bank. Investition A garantiert eine Rendite von 4% jährlich. Investition B bringt 10% oder 0% mit gleichen Wahrscheinlichkeiten. Wenn ich, solange der Leitzins bei 1% lag, Investition A gegenüber Investition B bevorzugt habe, warum sollte ich meine Präferenz ändern wenn der Leitzinssatz auf 0% sinkt?

Damit hier kein falscher Eindruck entsteht sollte ich vielleicht darauf hinweisen, dass Friedmans Regel eher wenig mit der jüngsten Zinsentscheidung der EZB zu tun hat. Mario Draghi weiß bestimmt, dass diese Regel, obwohl hilfreich als eine erste Annäherung an gute Geldpolitik, in unserer komplexen Realität nicht ganz optimal ist.

Wenn er an eine Regel denkt, dann wohl eher an die Taylor-Regel, die grob besagt, dass der Nominalzinssatz sich an der Inflation und der „Outputlücke“ (Differenz zwischen tatsächlichem BIP und seinem „natürlichen“, d.h. idealen Niveau) orientieren sollte. Gemäß der Taylor-Regel sollte der Leitzinssatz schon seit geraumer Zeit nicht null, sondern negativ sein. Weil aber der Nominalzins nicht negativ sein kann (der Beweis dieser Aussage ist dem geneigten Leser überlassen!), ist null die nächstbeste Alternative.

Wie dem auch sei, die EZB-Politik der Nullzinsen steht durchaus im Einklang mit der ökonomischen Lehrmeinung. Das heißt selbstverständlich nicht automatisch, dass sie auch richtig ist. Aber die Hysterie, mit der sie in deutschen Medien diskutiert wird, basiert weitgehend auf ökonomischem Analphabetismus.

(Die andere geldpolitische Entscheidung der EZB, den Aufkauf von Staatsanleihen auszuweiten, steht auf wesentlich dünnerem Eis – aber davon ein andermal.)

What Does “Easy Money” Even Mean?

Gerald brought up a really good question in my last post on ECB monetary policy stance since the crisis. I’m afraid Buttonwood got a bit trampled there, which in retrospect seems somewhat one-sided, since a big deal of his post is actually very good. Anyways, to the question:

What do you think a really easy monetary policy by the ECB would look like? Is it mostly about increasing the inflation target? Or would your rather have the central bank buy the debt of troubled economies like Greece?

At first I wanted to rush straight into it, but then I noticed that is pointless without clearing up what my definition of “easy money” is in the first place. I’ve spent quite a bit of time in this blog arguing that monetary policy all around the world, but particularly in the eurozone, is much too tight no matter which way you look at it. Let’s see what the ECB announcement brings today. A big issue i have with a lot of the current discussion, particularly in the Media, is that the currently historically low nominal interest rates are assumed to, by themselves, prove that money is “easy”, which is just wrong. So let me try and clarify some of the issues involved from my perspective.

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Alan Greenspan on The Daily Show

First of all, Jon Stewart is awesome. I have no idea how I could have gone so long without ever stating this here. If you are even remotely interested in American politics and enjoy good comedy, The Daily Show is as good as it gets.

If you’re here just for the economics, you can always just skip the first part and scroll right to the interview, which starts at around 14:00. Clearly, The Daily Show is not the platform for overly wonkish, in-depth policy discussion, but still very worthwhile. From what I’ve read on his new book, the degree to which Greenspan has changed his views since the financial crisis seems to be fairly limited, but no real comment on that for now.

PS: It seems I cannot embed the second part of the interview. Here’s the link to the Daily Show directly.

On Growth Rates and Growing Levels

Monetary economics, as any other academic field, requires basic agreement on a limited but vital set of definitions in order to be able to debate in a meaningful way. For central banks, two important terms are the distinction between monetary policy targets and monetary policy instruments. At the risk of stating the obvious, the targets of a central bank is generally a fairly easily verifiable variable that is supposed to be influenced by the central bank in the hope of achieving good economic outcomes. In most cases this target currently is the inflation rate, but other might also be nominal GDP, a monetary aggregate or even an exchange rate. The influencing of this target involves adjustments to the instruments of monetary policy, which include things like open market operations, the discount rate and reserve requirements.

In the choice of the target it is also of vital importance to specify whether we are talking about a growth rate target or a (growing) level target. Our current system works using growth rates: no matter what happened in the past, the central bank tries to get inflation rate back to its target of generally 2%. This is a sort of let-bygones-be-bygones policy. A growing level target, such as the one championed by Scott Sumners with NGDP level targeting, on the other hand, tries to get the target variable back on track to reach its pre-crisis trend level, meaning in the case of a depression would require considerably stronger monetary easing than a mere growth rate target. A mix of sloppyness and lack of clarity on my side has sometimes led me to muddle the two together in the past. “Basically, it is a central bank’s role to stabilize NGDP growth, and it should do whatever it takes to do so” is clearly a bit ambiguous, so let me try and set some of that straight by shortly going into why this difference is important

McCallum (.pdf) for one, in a survey of the literature on the topic, seems to favor a growth rate target. He stresses that, again by essentially ignoring the past, such a target essentially introduces a kind of random walk into the time series, and theoretically allows for the target variable to wander arbitrarily far away from any predetermined path. But then again, it wasn’t the point to begin with to follow any predetermined path. A growing levels target, on the other hand, by often requiring a more activist monetary policy in response to shocks, would tend to increase cyclical swings in demand, potentially increasing the variability (note: not the variance! I am not quite sure how accurate the term “variability” is, but I’m sticking to McCallum’s definition here) of variables such as real GDP in the process. In his words, “variability in output or other real aggregative variables is probably more costly in terms of human welfare than is an equal amount of variability in the price level about a constant or slowly-growing path”. Also, if what the economy just experienced turned out to be a permanent shock, stubbornly clinging to a predetermined growing level path would clearly be counterproductive.

The argument concerning the permanence of shocks is well-taken and important. As he notes, “although it is not entirely clear that fully permanent shocks are predominant, most time-series analysis seems to suggest the effects of shocks are typically quite long lasting – indeed, are virtually indistinguishable from permanent”. As far as I can tell this depends not so much on the nature of the shocks analyzed but rather on the policy response to that shock. If a central bank has a growth rate target, and thus does not try to force the economy back to its pre-crisis growth path, the obvious result would be to make a shock permanent even if it actually was not. How permanent a shock is would therefore seem to depend in practice, more often than not, on the adequacy of policy response to that shock rather than on the shock itself. Also, just because an economy experienced a “permanent” shock in one area doesn’t mean that with adequate policy another area of the economy can take up the slack. The bursting of a housing bubble might well be a permanent shock to the housing market, yet there is no reason it has to be a permanent shock to the economy as a whole.

And what the variability argument is concerned, I would also not agree that a lower but more stable level of economic activity, as we are currently experiencing, would be more preferable to a few years of increased variability after which we can then return to operating at full capacity. Sure, variability is a issue, but so is demand shortfall. When increased variability comes from an upswing it would seem like the lesser of the two evils. Further, the mere announcement that the level and not just the growth rate would be targeted implicitly states, as already mentioned, that a central bank is aiming to be more activist, which in an of itself might reduce the magnitude of downswings and thus variability through its effect on expectations. In any case it would seem sensible to, as generally with monetary policy, err on the side of doing too much rather than doing too little, and as such a growing levels target seems to be the superior choice.

Let’s get Europe off the Gold Standard. Again.

Bear with me for a second – I obviously do not mean that literally. But at the same time, it wasn’t really strictly literally back then either. As Christina Romer puts it, what we needed back then and what we need now is a regime shift – while the precise nature of that regime shift is considerably less important. What the gold standard did was essentially limit the ability of central banks – which in many cases back then hadn’t even existed for all that long – to ease monetary policy when times most required it. In other words, it was a monetary regime that might work fairly well as long as everything else works fairly well. Put differently, it works at times when we might be just fine having no central bank at all to begin with. In that sense, the current strict inflation target by the ECB in particular (but also inflation targeting in general, as many other central banks around the world face similar issues) is actually remarkably similar, even if it does represent a vast improvement. The Fed’s fairly sluggish action in late 2007 and the beginning of 2008 was in large part due to fears of rising headline inflation. The ECB’s failure to act now is largely due to overall inflation in Europe remaining fairly stable – even while unemployment keeps rising and rising. Back in the 30s, central banks were held back by the supply of a metal the worth of which, for most intents and purposes, has baffled economist for centuries. Today’s central banks are held back by a basically randomly chosen number linked to a just as arbitrary basket of goods and services that is supposed to stabilize the overall economy – and yet has proven not to do so when needed the most.

As such, today, just as in the 1930s, what we need is for central banks to get rid of the chains that prevent them from doing their job when we need them the most. Let’s get off the gold standard. Not literally, of course – but it’s time, once again, to face the fact that our current way of doing things means, just as it did back then, strongly restrictive monetary policy when monetary policy should be loose. As pointed out by Katharina in the comments to one of my previous posts, having countries leave the Euro would of course be an option. I don’t think we have to go with the nuclear one though. Giving the ECB at least a dual mandate like that of the FED would be a start, if only a timid one. Nominal GDP targeting would certainly help as well.

The importance of overshooting monetary policy

The general concept that monetary policy should react in a strong fashion to try and bring an economy back on track is fairly widespread. In fact, it makes up a big part of how even John Taylor, nowadays on the very hawkish side of things when it comes to monetary policy, thinks central banks should proceed when they feel the need to act. In particular, the Taylor principle states that in order for a central bank to cool an economy it perceives to be overheating, it needs to raise interest rates by more than the expected rise in inflation. If inflation, for instance, deviates from the central bank target rate by 1%, the central bank should raise interest rates by something like 1.5%. Of course this basic prescription follows the idea that the real interest rate equals the nominal interest rate minus (expected) inflation. If you want to reduce economic activity by raising real rates, you clearly have to raise nominal rates by more than expected inflation. But the importance of this basic notion goes far beyond this almost trivial explanation, and more so in the case of current policy. Kugman’s concept of “credibly promising to be irresponsible” (.pdf) is also aimed in this direction. Overshooting, or “doing more than strictly necessary”, is essential not only for monetary policy to be truly effective, but also for it to remain effective in the future. Ryan Avent over at The Economist discusses the issue with regards to the current debate surrounding the FED’s “tapering”:

I understand that the Fed is generally uncomfortable with unconventional monetary policy and has concerns about the side-effects from large-scale QE. That’s eminently reasonable. The trouble is that the Fed seems not to have learned that aiming to overshoot on the pace of employment growth and inflation is the safer, more conservative route. Overshooting maximises the chance that monetary policy will maintain its potency the next time trouble hits. Overshooting provides the best means to safely and quickly end growth in the balance sheet. Overshooting is the sustainable route to healthy increases in interest rates. But overshooting, the Fed has made entirely clear, is the one thing the American economy should not expect.

And the risks involved in not overshooting have become even more clear in the aftermath of the recent crisis, as discussed by Yichuan Wang, who seems to hit the nail on the head with this statement with regards to how the FED got stuck in the liquidity trap in the first place:

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. […] The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. [T]he decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

In a way monetary policy (and not just by the FED) made the same mistake as fiscal policy in the aftermath of the crisis – it tried to be optimistic, “on the safe side” of things, and ended up providing stimulus that ended up being massively inadequate. Not only does this mean it now faces a much deeper slump than necessary, making its job much more difficult. It also means that the very ability of it to do its job is put in question. Just like the “failure” of the Obama stimulus plans to keep unemployment in the single digits has been the main argument against fiscal stimulus in general, monetary policy being stuck in a “liquidity trap” that it to some degree helped create in the first place has also been the main argument for those who say monetary policy can’t do anything more either!