John T. Harvey on Inflation

The frequently heard assertion that the Fed is “printing money” that will supposedly cause runaway inflation is grounded in the inapplicable quantity theory. In relation to the accounting identity, MV = PY, the assertion relies upon assumptions that: (i) the “money supply”, M, usually defined in this context as currency plus demand deposits, is exogenously controllable by the Fed; (ii) the velocity of money, V, is stable; (iii) prices, P, are determined under conditions of perfect competition; and (iv) output, Y, tends to its full-employment maximum.

The topic is highly relevant under current economic and political circumstances, and a source of confusion for many in the general community. In his latest Forbes blog, John T. Harvey provides an exceptionally clear and timely explanation of why none of the assumptions underpinning the quantity theory hold:

Money Growth Does Not Cause Inflation

An obvious implication is that a change in the “money supply” can correspond to alterations in output and/or the velocity of money without any necessary change in prices. The endogeneity of the “money supply” further implies that causation runs from prices to money, not the other way round.

A couple of previous posts at heteconomist are related to this topic: Misplaced Faith in Quantitative Easing and Critique of Riedl on Government Spending. See also the first part of Questions and answers 1 at billy blog.

38 thoughts on “John T. Harvey on Inflation

  1. Joan Robinson made a brilliant observation long back:

    “Quantity Theories Old and New, A Comment.” Journal of
    Money, Credit and Banking
    2 (November): 504-12, 1970

    If the quantity equation had been read in the usual way, with the dependent variable on the left and the independent variable on the right, though rather vague, it would not have been silly.

  2. There is an interesting side issue in the comments.

    “But trade flows are in general a secondary factor in moving exchange rates and those selling goods and services in the US are likely to also be concerned about protecting market share over profit margins.”

    Since John’s research area is exchange rates, I wonder if he’d be able to shed some light on the external sector assumptions in MMT. Does the floating exchange rate theory hold in practice and does it free monetary policy from defending the exchange rate.

  3. Peter

    Maybe this is not the place to ask this, but as you are knowledgeable about history of economic thought, hopefully you can answer this.

    Although Friedman himself was never an Austrian economist, he is considered as quite close to Austrianism.

    How does Friedman’s monetarism relate to Austrian thought?

    Very clear and instructive the post linked, as well. Thanks for that!

  4. Interesting question, Magpie. Unfortunately I would be way out of my depth trying to answer it. Maybe somebody else will be able to chime in.

  5. No worries, Peter. I found a post at Catalaxy Files that sort of makes the link.

    Inflation is a subject I find quite illustrative of the difficulty in establishing a dialogue with Austrians.

    The dictionary definition of inflation, for instance, is:

    “Persistent increases in the general level of prices. It can be seen as a devaluing of the worth of money. (…)”. The Penguin Dictionary of Economics. Fifth Edition.

    Note the words “persistent” and “prices”. Note also that this is the definition most people (including economists) have in mind.

    The consequences of this definition are stated in the Forbes post you linked to above: an increase in money supply does not need to bring a sustained increase in prices.

    However, this is how leading Austrians re-define the meaning of inflation:

    “Arthur Seldon defines inflation as ‘a fall in the value of money due to a persistent expansion in its quantity’. Ludwig von Mises wrote that ‘everyone knows’ that inflation is an increase in the quantity of money. Furthermore he wrote that ‘everyone knows’ that a general increase in prices is a consequence of inflation.” [*]

    Note that here the keyword is “quantity of money”.

    So, even if they consider that the inevitable consequence of the increase in the quantity of money is a sustained increase in the price level (in which they seem to partially coincide with Friedman), there is inflation by the mere fact that the quantity of money increases.

    It’s just bad luck if prices did not increase.

    Note also that they say: increase in quantity of money is the cause; a sustained increase in price is the inevitable symptom. Thus, I’d say they are supposed to be logically equivalent factors.

    How then is it to be explained that sometimes an increase in the quantity of money leads to a sustained increase in prices, and sometimes it does not?

    [*] What is inflation?
    http://catallaxyfiles.com/2011/05/18/what-is-inflation/

  6. It’s down to how much of the money remains stocked, how much is spent and how often during that accounting period.

    If you print a billion pounds and store it in a locked vault with the key in the Chancellor’s pocket, the quantity of money has clearly increased, but equally it can clearly have no effect on price inflation.

    Even storing it in bank vaults can have no effect, because banks lend on their capital base and are no longer restricted by reserves in a fiat floating system – at least not if the central bank wants to maintain control of its target rate.

    The current crop of people in charge are supply side wonks. They are convinced that there is pent up demand everywhere and all they have to do is turn on the taps a little more and everything will balance.

    As we’ve seen that isn’t what happens.

    The running joke is that economists make the Met Office look reliable forecasters. There is a reason for that. Economists are using a model that doesn’t work.

  7. Monetarists are/were a lot closer to Keynesians than Austrians–e.g. on the use of policy to stabilise the economy.

  8. Magpie, If Austrians define inflation as an increase in the quantity of money (and like you, I’ve come across examples of their doing this), then this is just another example of Austrian stupidity. The fact is that the word “inflation” is used by 99% of economists nowadays to refer to persistent and excessive price increases, or words to that effect.

    The word certainly USED to refer to a money supply increase. About thirty years ago the Oxford English Dictionary still gave this “money supply increase” definition. I contacted them and told them they were out of date.

  9. The Austrian and Chicago Schools

    The problem with classifying the Austrian and Chicago schools together is that although they both emphasize the universal beneficence of exchange, extreme individualism, and a doctrinaire advocacy of laissez-faire, they have methodological differences. The Austrians generally advocate a rationalist approach to economic theory, while Milton Friedman and his followers generally advocate an empiricist approach. Although it is currently very common in the academic economics profession to hear all extremely individualistic advocates of laissez-faire referred to as the “Chicago School,” it is probably more accurate to say that the more conservative wing of contemporary neoclassicism is about evenly divided between those who on methodological grounds follow the Austrian School and those who follow Friedman’s Chicago School. We do not believe these methodological differences to be terribly significant,17 so we shall consider these contemporary advocates of extreme laissez-faire together.

    This is an excerpt from E. K. Hunt’s The Austrians generally advocate a rationalist approach to economic theory, while Milton Friedman and his followers generally advocate an empiricist approach. It’s now out of print. I have a copy and recommend it highly.

  10. Oops. My copy paste didn’t work as I thought. Should be E. K. Hunt’s History of Economic Thought.

  11. Hunt is confused. Austrians are not neoclassicals; they are a heterodox school like the post Keynesians. The idea that there is no significant methodological difference between Austrians and neoclassicals of any description is not serious.

  12. Hunt claims that Austrians and conservative neoclassicals agree normatively and argue to the conclusion that they presume — that government is always an economic drag except in acting to protect property right and national security. They also agree that economics is a positive science that is universally applicable to all societies and cultures, i.e., it is based on the structure of human nature being a subset of nature.

    Hunt also points out that they disagree methodologically, — Austrians being rationalists and neoclassicals, empiricists.

  13. From your link:

    “it is probably more accurate to say that the more conservative wing of contemporary neoclassicism is about evenly divided between those who on methodological grounds follow the Austrian School and those who follow Friedman’s Chicago School. We do not believe these methodological differences to be terribly significant so we shall consider these contemporary advocates of extreme laissez-faire together.”

    And,

    “…Austrian and Chicago schools reduce all human behavior to rational maximizing exchanges”.

    If you read the comments, you’ll notice that Austrian school academics turn up to complain about being misrepresented.

  14. Thanks for the inputs, everybody.

    Tom,

    Great link, quite instructive.

    “The Austrians generally advocate a rationalist approach to economic theory, while Milton Friedman and his followers generally advocate an empiricist approach.”

    This seems to fit in well with what I’ve been able to gather on my own.

    However, although the remark about Friedman and his followers advocating an empiricist approach is true in theory, in practice it turns out to be rather hollow.

    There is an economist’s witticism for that, going something like this: Mixed evidence is evidence that does not support your hypothesis.

    Think of Robert Lucas and Eugene Fama, during the recent housing crash.

  15. Magpie, there is a post somewhere on the blogs where a student of Friedman told him to argue to his conclusions rather than finding them out. He was a rationalist in empiricist’s clothing, just like the other neoliberals that presuppose what they conclude.

    Economics is more a branch of philosophy than science in that presuppositions determine conclusions rather than hypotheses. Friedman was aware of that, and Austrians base their economics on it unabashedly.

  16. Tom,

    Agreed.

    Check this quote from an article at the Mises Institute:

    “Faced with statistical evidence that seems to contradict principle, Austrians do not abandon what has been demonstrated to be true.” [*]

    And this is no cherry-picking! Gordon holds a PhD and is the editor of The Mises Review and a senior fellow of the institute, so he’s respected among his peers.

    Further, you can find similar quotes at Mises’ “Human Action”. Only Gordon put it more concisely.

    You’ll find that, ironically, there’s a connection between this view and Friedman’s non-realistic assumptions that supposedly lead to accurate forecasts.

    Now, you’ll probably remember the famous quote attributed to Keynes: “When the facts change, I change my mind. What do you do, sir?”

    Well, Austrians simply do not change theirs (and may go on to argue why they are right in not changing their minds), while Friedmanites will just deny the facts.

    Is it possible to establish a dialogue when basic philosophies differ so much?

    [*] David, Gordon. Book Review: The Case for Big Government. By Jeff Madrick. Princeton University Press, 2009.
    http://mises.org/misesreview_detail.aspx?control=353

  17. Hi Ralph,

    Although I am just a lightweight in these matters and I could easily be wrong in this, my reading of Harvey’s article was a bit different.

    This is how you start your article (which is interesting, btw):

    “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” (my emphasis)

    And although the title of Harvey’s article (i.e. “Money Growth Does Not Cause Inflation!”) would seem to confirm that view, that was not what I understood from Harvey’s article, as you can see from a previous comment (18 May 2011 at 12:01 PM):

    “The consequences of this definition are stated in the Forbes post you linked to above: an increase in money supply DOES NOT NEED to bring a sustained increase in prices.”

    Have I misread Harvey’s article?

  18. It probably comes as no interest to anyone, but none of those four assumptions are actually made by neoclassicals.

    Neither does Tom’s link actually represent Austrian thought. Even its description of the Chicago School is cartoon-like.

    MMTers get very annoyed when others critique their positions without reading “the lit”. Apparently though, this obligation goes in one direction only.

  19. Hi vimothy

    “MMTers get very annoyed when others critique their positions without reading ‘the lit’. Apparently though, this obligation goes in one direction only.”

    Fair enough.

    Explain the Austrian position on inflation.

  20. Well, I can’t say that vimothy’s reply made me change my mind about inflation and Austrians…

    However, it was real concise! And this is appreciated.

    And it also made my point: dialogue with Austrians is kind of difficult.

  21. Sorry, Magpie. Had an exam yesterday and I’ve been busy revising.

    I don’t necessarily disagree with what you wrote about the Austrian take on inflation. I’m not an Austrian, BTW. I’ve certainly come across people who define inflation as an increase in the money supply, but I do know Austrians who take a monetary disequilibrium approach, for example, who obviously use modern definitions of inflation. So it’s not like every Austrian economist is a hardcore Rothbardian.

    I was objecting to John Harvey’s article, which rests on a straw man argument, and to the link Tom posted, which is so comically misguided, you have to hope that the author was stoned out of his gourd when he wrote it.

  22. Let’s discuss Mises’ position on inflation then, as opposed to Rothbard’s (quotes from Human Action. XVII. INDIRECT EXCHANGE: The Determination of the Purchasing Power of Money, pages 412-415, http://mises.org/humanaction/chap17sec4.asp).

    This is how Mises considers the quantity theory of money:

    “The main fault of the old quantity theory as well as the mathematical economists’ EQUATION OF EXCHANGE is that they have ignored this fundamental issue. Changes in the supply of money must bring about changes in other data too. The market system before and after the inflow or outflow of a quantity of money is not merely changed in that the cash holdings of the individuals and prices have increased or decreased. There have been effected also changes in the reciprocal exchange ratios between the various commodities”. (added emphasis)

    This quote, if it does not openly acknowledges the effect of increases of the quantity of money on output, stops just short of that.

    One might consider that Harvey’s critique of the exchange equation merely adds the velocity of circulation (V) and output level (y) to that among things that change.

    Further, the discussion in previous pages could easily be inserted in the MMT framework:

    “Let us assume that the government issues an additional quantity of PAPER money. The government plans either to buy commodities and services or to repay debts incurred or to pay interest on such debts. However this may be, the treasury enters the market with an additional demand for goods and services; it is now in a position to buy more goods than it could buy before. The prices of the commodities it buys rise.” (added emphasis)

    Notice here that it is assumed (although not stated explicitly) that an increase in money quantity cannot change the output level and that there is no lag between money injection and price rises.

    If one were to assume that output was at less than capacity, it obtains that an increase in output is possible without immediate effect on prices.

  23. Magpie,

    I’m not quite sure what you’re getting at. For Mises, money is non-neutral. E.g. see here: http://mises.org/mmmp/mmmp5.asp

    Your second quote describes what Austrian economists call “Cantillon effects” (after the 18th century economist Richard Cantillon): injections of money do not increase all prices in the economy at the same time; inflation occurs in the markets into which the money has been injected first of all, before spreading out to the rest of the economy.

    “If one were to assume that output was at less than capacity, it obtains that an increase in output is possible without immediate effect on prices.”

    Lots of things are possible. Most mainstream folk would agree with that statement anyway. Hence: monetary policy.

  24. As a practical matter, government has been injecting huge deficits into the economy for a decade, and the Fed has run historically low fates. No observable inflation from the demand side.

  25. Price stability is not zero rate of inflation but a constant rate of low inflation that promotes growth. Fed targets about 2%. The US has had a low inflation rate over the past decade regardless of high deficits and high private leverage.

    What the problem with low inflation and growing GDP? The problems lay elsewhere.

  26. Shouldn’t there be some correlation between inflation and capacity utilisation? How come the price level increases at such a constant rate?

  27. “How come the price level increases at such a constant rate?”

    Yes. If there was a percentage inflation shouldn’t it rise exponentially – like compound interest. That seemed to be what it was doing during the 70s.

    Constant rises surely suggests that the price inflation has been falling in percentage terms.

    Am I reading the index wrong?

  28. vimothy,

    “I’m not quite sure what you’re getting at.”

    Not hard to explain.

    With the first quote I intend to show that Mises himself considers that:

    (1) The equation of exchange, by itself, is a misleading representation of how an economy works.
    (2) This is so because, as you accurately pointed out, money is not neutral.
    (3) Other things, thus, might change with an increase in the quantity of money.
    (4) What Harvey does is to add V and y to this list of things that change.

    But the equation of exchange is a basic piece of Friedman’s monetarism. Thus, Friedman’s monetarism, if it leaves asides these considerations, is flawed.

    That was Harvey’s ultimate message, if I understood things properly.

    —————-

    With the second quote I intend to show that:

    (1) Indeed, price increases do not appear everywhere at the same time and in the same measure.
    (2) In some cases, in fact, it may occur that some prices fall and others rise. (These two things, I believe, fit the Cantillon effect you mentioned).
    (3) It is not impossible that a general increase in prices in some markets together with decreases of prices in some others result in an increase in output volume before a GENERAL (average) increase in prices takes effect. Thus my referene to lags.

    If 3 holds, then it is not impossible that Keynesian/MMT fiscal stimulus policies would work in increasing output (and presumably, employment).

  29. Neil,

    If you look at the series from say 1980 onwards, the slope is linear, i.e. it could be described by the function y = ax + b, so that dy/dx = a, where a is a constant > 0, and inflation = a/y. So you can see that the trend is that inflation has been falling since the ’80s (since y is increasing), but still positive. But why? Shouldn’t we have dy/dx = 0 or dy/dx < 0 whenever there is an output gap?

    I can't find year on year CPI growth in the Fred database, but here it is on the Cleveland Fed's site:
    http://www.clevelandfed.org/Research/data/US-Inflation/chartsdata/index.cfm?state1=1&state2=&state3=&state4=&startDate=01/01/1950&endDate=05/30/2011&datatype=2&freq=yearly

    Here is a series of % deviations from trend real GDP:
    http://4.bp.blogspot.com/-n4Hx6GfS9vo/TeF0RsPS8hI/AAAAAAAAAJ8/xzWnCKfUbpE/s1600/fig5-28-2.png

    There doesn't seem to be an obvious relationship between average behaviour of the rate of inflation and the behaviour of deviations of real GDP about trend.

  30. vimothy and all,

    For those interested in Austrian thought and criticism, there is a discussion here that may be useful:

    Questions for Austrians Before you Debate Them
    http://socialdemocracy21stcentury.blogspot.com/2011/06/questions-for-austrians-before-you.html

    And I say “may be useful” because I’m no expert on the matter. However, whatever its limitations, it does offer some taxonomic criteria, if the term applies.

    (From vimothy’s comments, I gather that although people speak of an Austrian school, as if it was a monolithic, homogeneous entity, in reality there are different sub-schools of thought within the Austrian school.)

    The post linked above, with whatever accuracy it may have (I can’t judge) alludes to the different sub-schools within Austrian thought.

  31. Shouldn’t we have dy/dx = 0 or dy/dx < 0 whenever there is an output gap?

    Vimothy, isn’t this the result of growth in wages? Which, in turn, is a result of people expecting to be paid more even when their productivity does not rise?

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