Mitt Romney Part II

This blog began in response to an article on the WSJ,  “What Is Money and How Do You Destroy It?“.  In it, Mitt Romney says Mr. Bernanke’s policies have “over-inflated” the currency.”  I have shown, in “The Fed Management Of Inflation” that Bernanke’s policies have held price inflation lower than his predecessor.  I also showed that inflation must be more than zero.  So, at least in terms of price inflation, the statement isn’t correct.

In my opening page, I point out that Mitt is, in fact, not speaking of price inflation.  He is speaking of monetary inflation, the amount of currency in the economy.  The question is, what does “over-inflated” mean.  While Mitt’s comment doesn’t indicate what “over-inflated” means, I must take it that he is saying that it will lead to price inflation.  For now, though, the problem with Mitt’s statement is that nobody cares, at least not directly, about monetary inflation.  As long as monetary inflation never leads to price inflation, there is no issue.  As long as there is never any price inflation, no one will ever care.  So, for Mitt’s comment to be true, that the Fed has “over-inflated” the currency, it would be necessary to prove that it will lead to price inflation.

To understand this, we need to understand the connection between the amount of money and inflation.  In theory, it is fairly simple.  Suppose we have an economy of ten people. Let us make this a very simple economy, with a few farmers and a grocer.  The grocer buys corn, rice, bacon, and other farm output from the farmers. The farmers go to the grocery store to purchase their personal weeks worth of groceries, a few ears of corn, some bacon, a pound of rice, and other good.  The grocer then uses the money to purchase farm output for another week.  Every week these ten people receive $10 in wages.  And every week they purchase $10 in groceries.  For this economy to function, it will require $100 total.  It is using $100 a week.  The velocity of money is $100 per week.

This simple model is the basis for the concern that monetary inflation will lead to price inflation.

Consider that this economy has twice as much cash in it.  Instead of $10 a week in wages, paid for by the grocer, each farmer receives $20.  Now, hypothetically, prices will rise such that a basket of groceries costs $20. And this economy is now churning with $200.  And, it is running with a velocity of money of $200 per week.

This quantity of money is measured by the Federal Reserve, or rather it is estimated.  There are a number of measures of how much money is in the economy that differentiates between where the money is.  Some money is in cash, some in checking accounts, some in savings, and some is in 401K plans.  These measurements are MB, M0, M1, M2, M3 and MzM.  If you are interested in the differences, an explanation is available on Wikipedia.

The significant feature of each type is what it is immediately available for use for.  Cash can be used immediately for spending on stuff.  Savings has to be moved into a checking account before it can be used for buying stuff.  Money in a 401k cannot be withdrawn without penalty and is not easily available for buying stuff.  The hypothesis[1] is that, if an individual has $30 in their wallet to buy DVDs, they will easily spend all of it but won’t go to the bank and transfer money from their savings.  As such, the price of DVDs is dependent on the availability of cash, but not savings.  On the other hand, people save to purchase a house so housing prices are dependent on the availability of money in savings. Automobiles are also dependent on savings.

We now have an understanding of price inflation, monetary inflation, the quantity of money, the consumer price index, the velocity of money, and wage inflation.  The quantity of money is how much money is in the economy.  There are measures of different types, cash and savings being two of these types. Basically, M1 is available cash and M2 is savings.  Monetary inflation is an increase in the money supply.  It is an increase in M1, M2 or both.  It is an increase in any of the measures.  The velocity of money is how fast the money turns over in the economy.  Hypothetically, as the money supply increases, prices rise as long as the velocity remains constant.  This rise in prices in price inflation and is measured by the consumer price index.  Never the less, as long as the velocity of money remains constant, then wages must also increase along with prices.

So, even if there is monetary inflation, we find that we do not care.  Mitt is wrong because he is concluding that monetary inflations leads to price inflation.  But, by the same model, it also leads to wage inflation.  Even if there is monetary inflation, neither price or wage inflation has occurred.  One is left to wonder why he believes that there is monetary inflation.  And, in fact, there has been monetary inflation.  M2 has increased while M1 has not.

It is here that my personal considerations diverge from the issue at hand.  I have show that Mitt is wrong, at least in terms of what is actually occurring.  The simplified economy described above is only a little over simplified.  Some people have savings while other’s don’t.  Some people get raises while others don’t.  The price of corn isn’t that same as the price of rice.  Different people get paid different amounts on different pay schedules and spend money at different rates at different times.  Someone may very well decide to take the money out of savings and spend it on goods.  M2 can increase while M1 does not.  The quantity of money hypothesis may be correct in terms of M1 while failing in terms of M2.

The fact of the matter is that both physics and economics do depend on building from simplified models, deducing principles, then making things more complicated.  So this quantity of money hypothesis is appropriate.  But, it is also over simplified.  We will look at M1 and M2 later and will see that, while M1 has not increased, M2 has.  Without adding to the model specifically, we can certainly imagine that there is an avenue by which M2 can increase M1 later which will then lead to price inflation.

But, we are now taking our simplified model that says that monetary inflation leads directly to price inflation, ignoring that it also says that it leads to wage inflation with no real change in spending power, and then using it to say that it must indirectly lead to price inflation at a later date.

What we really need is to take this simplified quantity of money model and make it more complicated.  This is actually a real pain the rear.

Another path to follow is examining the measures of M1 and M2 to see what if means in terms of price and wage inflation.  For now, this is my preference.


[1] On a note of vocabulary, you will find that I use the work, “hypothesis” where you might expect “theory”.  I come from a physics and engineering background.  In physics and engineering, the term “theory” is nearly identical to the term “law”.  A law or theory is proven.  There is the law of gravity and Einstien’s Theory of Special Relativity.  When a scientific law or theory is used, the circumstances under which it is applied is so clear as to make the theory or law absolutely and unmistakably correct.  A hypothesis is a supposition of what may be true but remains to be proven.  The proof, though, often depends on defining the circumstances.  And, all to often, the circumstances of economics are to messy to be well defined.  Rather than call an economic supposition a theory or law, and then misapply to circumstances under which it is not true, I will simply refer to them as hypothesis.


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