The last vestiges of monetarism may have been put to rest on June 28, 2007.
Wayne Angell, retired member of the Federal Reserve Board, appearing that night on Larry Kudlow’s show on CNBC, observed that the Fed was targeting the federal funds rate and, as such, implied that it could not control the money supply at the same time. Rather, Angell said growth in the monetary aggregates reflected the shifting demand for money, or in other words that the market determined the amount of money by demanding more (or less) of it.
Score one for the death of monetarism.
As Banking 101 instructs, loans create deposits and deposits require reserves. And as Economics 101 teaches, you can control the price of something (e.g., the fed funds rate) or the quantity of something (e.g., the money supply), but you can’t control both at the same time.
Take the example of General Motors, which must determine whether to set the price for Corvettes or the number of Corvettes to be produced. It can’t do both simultaneously. If it sets the price too high or too low, the amount of Corvettes demanded will fluctuate accordingly. If it sets the amount produced, the prices will fluctuate for the same reason.
Back to June 28. On that same day, the Wall Street Journal, in an editorial titled “The Fed and Liquidity,” focused on the relationship between the fed funds rate and commodity prices as measured by the now defunct Dow Jones Spot Commodity index. Relying on Arthur Laffer’s reconstruction of this index through the present day (I tracked this for Laffer for over ten years), the Journal concluded that the relationship between commodity prices and the fed funds rate reflected some rough measure of whether or not the Fed was easy or tight. The Journal went on to conclude that the cause of the current housing bubble was not easy money — i.e., a rise in the money supply — but low interest rates. The conclusion: The Fed’s policy of trying to control the money supply to affect the economy is kaput, while the use of short-term interest rates to affect the economy is mainstream.
Score two for the death of monetarism.
The Journal piece also included this revealing Laffer paraphrase on inflation: “The ‘velocity’ of money is soaring as the world demands more of it (money), [Laffer] says, so there is no inflation threat.” In other words, Laffer is implying that the demand for money is dramatically increasing, even though the Fed deserves high marks for controlling the growth in the money supply as measured by the monetary base.
Now here’s the point. If the economy decides to demand more money, as reflected by the “soaring” demand for it, how then does money supply matter? The Fed’s supposed tinkering with the monetary base as reported in the weekly data from the Federal Reserve Bank of St. Louis is meaningless. In fact, its tinkering has everything to do with maintaining the fed funds target rate and nothing to do with attempts to control the money supply. The “demand side” theory of money creation, or the “quality of money” theory, is in essence liquidity created by the system since the structure demands that liquidity. Effective money supply is determined by money demand, or velocity.
The idea that central-bank increases to the money supply are inflationary is debunked by the modern Japan example. The Bank of Japan (BOJ) lowered its policy interest rate to zero, without regard to controlling interest rates, in order to pump money into the economy. This surge in money supply was enormous, yet inflation in Japan was non-existent. In fact, the problem in Japan was deflation, even though central-bank-induced money supply was exploding.
The reason why the increase in money supply didn’t increase inflation was that money demand also was non-existent. No matter how much money the central bank “printed,” the liquidity wasn’t demanded by the private sector. Wayne Angell accurately described this phenomenon as the money-demand equation, or what Laffer calls the “velocity,” or rate of turnover, of money. (For more on the Japan example, and monetary demand, see my article: “Print More Money, Create Higher Inflation?”)
The primary implication of the extinction of monetarism is that the U.S. Federal Reserve is marginalized by the ability of the markets to function efficiently as reflected by the changing velocity of money. In some cases, it might take years for lowered interest rates to produce the desired effect — a stimulated economy — and only if a shift in the demand for money cooperates.