Saturday, May 21, 2011

Economics Prof says excessive money supply never causes inflation.

John T. Harvey is the Prof. of Economics at the Texan Christian University, and he claims in this Forbes article that money printing cannot cause inflation. I’m sure Robert Mugabwe would pay Harvey handsomely for his advice.

Anyway, the core of Harvey’s argument is on his page 3: paragraph starting “But perhaps the real nail in the coffin “money growth==>inflation” view is…” Here, he claims that excess money cannot be forced onto the private sector because monetary base gets into private sector hands via the purchase of government debt by the central bank from the private sector. And, so claims Harvey, no one can force a sale on anyone. Thus there is no way the private sector can be forced to hold more money than it wants.

The first problem with this argument is that there is not much difference between government debt and monetary base. The former is essentially just a form of interest paying deposit account. And there is a very simple way in which the government / central bank machine can force excess government debt onto the private sector: government just runs a deficit!

That is, the Treasury borrows $X from the private sector and gives the private sector $X of bonds. The Treasury then spends the $X of cash: i.e. the $X of cash flows back to the private sector. So the net result is that the private sector is now up to the tune of $X (in the form of government debt, or “bonds” or “deposit account” – call it what you will).

Assuming that prior to the above $X worth of deficit, the private sector had the assortment of assets it wanted, then after this bout of deficit, the private sector will have what it regards as an excess supply of “cash plus bonds”. It will try to run this stock of assets down by selling bonds and then spending the cash it gets for said bonds. Hey presto: demand rises, and assuming the economy was at NAIRU prior to the $X bout of deficit, then inflation will rise as well (assuming demand rises faster than the economy’s maximum potential non-inflationary level of output).

In the above process, “force” is certainly involved. It occurs right at the start, that is where government borrows $X. Government can pay whatever rate of interest is needed to attract the $X because government can confiscate any amount of money it needs to pay that interest from taxpayers: not that governments (PIG countries apart) actually need to pay exorbitant rates of interest. That is, a rate which is marginally above the going rate will do. Plus, if and when the central bank buys those bonds back, rates subside again.

Harvey then claims on his page 4 that central banks have to accommodate the private sector’s demand for money, the suggestion being the cause/effect runs from the private sector to central banks. Well it’s true that this cause/effect relationship exists. But it is false logic to claim that because there is a cause effect relationship running from A to B that therefor there is no cause effect relationship running the other way! I just spelled out “the other way” above!

Afterthough (22nd May, 2011). Another piece of false logic in John Harvey’s article is his claim at the end of the article that because the inflationary episode of the 1970s was cost push or “wage / price spiral”, that casts doubt on the “money printing causes inflation” idea. I fully agree that that inflationary episode was cost push or “wage / price spiral”, as do many others. But the fact that X can influence Y does not preclude Z (or other factors) influencing Y!


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