The Unhappy Lot of the ‘M’-tarist and the Death of Monetarism Those economists who feel twinges of unease of varying degrees of intensity when observing the rapid growth of some broad monetary aggregate (M2 in the US, M3 in Euroland, M4 in the UK, M16 and AK47 elsewhere) may well be the victims of two fallacies: (1) the fallacy of misplaced concreteness and (2) the nominalist fallacy. According to Wikipedia – a fount of highly doubtful authority – the fallacy of misplaced concreteness, as described by the philosopher Alfred North Whitehead, involves thinking something is a ‘concrete’ reality when in fact it is an abstract belief, opinion or concept about the way things are. The nominalist fallacy is the belief that naming something defines its essence, and explains it. Every economist grows up learning and absorbing models in which something labelled ‘M’ has a unique role in the process determining the general price level. Some of us even teach the stuff. Even the most New-Keynesian follower of fashion believes in the long-run neutrality of ‘M’. Inflation is always and everywhere a ‘M’-tary phenomenon. Mapping that ‘M’ into some real-world counterpart is awkward. In fiat money economies, the monetary base – currency plus commercial bank deposits with the central bank – is probably the closest ‘real world’ counterpart. Currency is the most common numeraire and it is a means of payment and medium of exchange. It is also a store of value. The vast majority of analytical macroeconomic models ignore financial intermediation completely. The only financial assets are base money, government non-monetary debt and equity claims on real reproducible capital. There is also a complete contingent markets literature, which grafts base money onto an Arrow-Debreu complete markets model of a barter economy. This hybrid, although popular, is absolutely useless as a starting point for the analysis of monetary policy in the real world. While it has an exhaustively rich financial asset menu, there are no financial intermediaries and there is no financial intermediation in any meaningful sense. Where banks are considered, they tend to be a poorly motivated constraint on financial intermediation rather than a means for overcoming informational, monitoring, commitment and enforcement constraints. The same holds a-fortiori for non-bank financial intermediaries. No macroeconomic model I have ever seen creates a special role for the sight-liabilities of deposit-taking institutions (and their close substitutes) that make up most of M2, M3 and M4 in the real world, starting from reasonable primitive behavioural assumptions. Even more emphatically, there is no macroeconomic model that makes the case that that the real world M2, M3 and M4 play a role analogous to ‘M’ in the baby models we play with. My argument is quite different from the proposition that, if the monetary authorities use the short risk-free nominal interest rate as the instrument of monetary policy rather than the quantity of ‘M’, and if as a result of this, ‘M’ becomes endogenous, then all equilibrium prices and quantities that can be determined in the model can be determined without reference to the behaviour of ‘M’. This proposition goes through only if the economy is ‘block recursive’ in ‘M’, but this is the case for most of the models that litter the literature. When the interest rate is the monetary instrument, ‘M’ is all tail and no dog. However, in such models, the behaviour of ‘M’ over time itself may still be determinate (it will be so unless we are in a world with perfect price flexibility, in which case only the real value of ‘M’ is determinate). Ruling out this uninteresting special case, there would be a systematic relationship between the general price level and the endogenous stock of ‘M’. If in such a world prices had been rising for a long time by 2 percent per annum, real GDP by 3 percent per annum and ‘M’ by 14 percent per annum, we would all be scratching our heads. The world we appear to be living in is much more complicated than that. Not only is ‘M’ endogenous, it is unobservable, and is represented empirically neither by the broad monetary aggregates M2, M3 and M4 nor necessarily by the real-world monetary base or M0. We are clearly moving towards a world where the currency component of M0 can and probably will be displaced by private cash-on-a-chip and other networked or anonymous private and public payment mechanisms for retail and wholesale purchases of goods and services(except for use by the criminal community and by foreign demand from underdeveloped countries with high inflation). The bankers’ balances with the central bank component of M0 could easily be replaced by overdraft facilities or contingent credit lines with the central bank. Functionally M0 will survive – being a liability of a key agency of the state and often endowed with legal tender properties, it is hard to beat for liquidity, but its conventionally measured quantity (‘stock outstanding’ as opposed to unused overdraft facility or credit line) could easily vanish. The non-M0 component of M2, M3, M4 etc. is part of portfolio demand, boosted by expanding and deepening intermediation and financial innovation and by growing private sector financial wealth relative to income. In the UK households hold net financial assets (including housing, admittedly) equal to 8 times their annual income. The broad monetary aggregates no longer have any close, systematic connection with transactions demand, that is, with imminent spending on currently produced goods and services. It is not at all surprising that it has grown in line with household financial wealth rather than with GDP. New financial institutions and new financial instruments are created on a daily basis. For some reason, the new instruments have not displaced the conventional liquid financial instruments counted in M2, M3 and M4. Most of the new financial institutions have ended up holding at least some components of M2, M3 or M4 on the asset side of their balance sheets. When that happens, the broad monetary aggregates can grow way faster than nominal GDP for years on end without this implying any inflationary threat in the markets for goods and services. It need not even imply any inflationary threat in the ‘outside’ assets markets, those for equity, housing, land etc. Of course, since the growing financial wealth is sitting there and since a significant chunk of it is liquid, it could at short notice produce a hefty spending boom in either asset markets or markets for currently produced goods and services. The threat of asset market inflation, consumer price inflation or producer price inflation is always there. That’s what makes monetary policy so much fun these days. There could be an ambush around any corner. However, for that risk to exist, prior rapid growth of broad monetary aggregates, or of credit to ultimate spending units (households and non-financial firms) or even of financial wealth generally are not necessary. All that is required is that the ultimate spending units have liberal, easy access to credit, so they can run large financial deficits. The corresponding financial surpluses can be run by the state, the domestic financial sector or, in an open economy, the rest of the world. It therefore behoves the central banks to track carefully the growth of credit to the ‘ultimate spending units’ – households and non-financial enterprises. Unfortunately, looking at the historical record of credit growth, as of broad money growth, risk both false positives and false negatives. Households are growing their net financial wealth-to-income ratios and gross assets and liabilities may be growing even faster than net financial wealth. With longer life expectancies (especially lower remaining life expectancies at retirement) higher financial wealth income ratios can be a stable, non-inflationary feature of the world. On the other hand, even if broad money growth and credit growth to households and non-financial firms have been well-behaved in the past, the potential for runaway credit growth and sudden sharp increases in the demand for goods and services or for outside assets is always there when households are creditworthy or have collateralisable wealth and when financial markets and institutions are well-developed and full of people who, while smart, are not nearly as smart as they think they are. I am a monetarist (really an ‘M’-tarist), through and through. Unfortunately, I don’t have a clue as to what the real-world counterpart of the textbook ‘M’ is today. It seems pretty clear though, that whatever it is, it’s not M2, M3 or M4. The ECB, to the extent that it pays special attention to a subset of the liabilities of certain deposit-taking institutions, is barking up the wrong tree. To the extent that the problem is caused by the nominalist fallacy, part of the solution is to stop referring to M2, M3, M4 etc as ‘money’ or ‘monetary aggregates’. Let’s call them L2, L3 and L4 instead, and stop worrying about them.
Labels: Economics, Monetary Policy