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The Quantity Theory of Money in Year Six After the Subprime Mortgage Crisis

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Financial Crises, Sovereign Risk and the Role of Institutions

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Abstract

This contribution traces the origins of the quantity theory of money and its applications. It is shown that the theory was flexible enough to adapt to institutional change and thus succeeded in maintaining its relevance. To this day, it is useful as an analytical framework, although it now has only limited potential to guide monetary policy and has consequently been abandoned by most central banks. Yet, it is still passionately discussed by both followers and sceptics. Lately, the measures taken by central banks to mitigate the effects of the ‘Great Recession’ triggered by the 2007 subprime mortgage crises in the US have led to a spectacular increase in the stock of money, but the following price inflation that is predicted by the quantity theory cannot be observed anywhere. Is inflation in the pipeline, inevitably to emerge soon or later, as the critics of ‘monetary easing’ keep claiming? Does the failure of inflation to materialise finally falsify the quantity theory? To answer this question, we first highlight the most important characteristics of the latest economic slump. Then, an empirical analysis drawing on data on 109 countries from 1991 to the present confirms that the theory still has predictive power. While the classical proportionality theorem does not hold, excess money growth is a significant predictor of inflation. At the same time, the effect, although positive, is now so low that the fears regarding inflation as a consequence of the recent monetary easing do not appear warranted.

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Notes

  1. 1.

    This contribution summarises the latest results of a continuous research programme; earlier publications that I liberally refer to are Graff (2000), Graff and Müller (2006) and Graff et al. (2013). My interest in this topic goes back to the years 2004-2010, when I had the privilege to work as a Senior Lecturer at Alexander Karmann’s Chair for Money, Credit and Banking at TU Dresden. The first of the above mentioned publications documents my research conducted at Alexander’s Chair.

  2. 2.

    For an authoritative representation of Bundesbank’s monetary policy since 1994, see Issing (1997).

  3. 3.

    Monetary targeting in Switzerland lasted from 1974 to 1999, with a suspension in 1978-1979; see Rich (1997, 2007).

  4. 4.

    Titled ‘The ECB’s monetary policy strategy’, the 8 May 2003 press release states: ‘… the Governing Council of the ECB has undertaken a thorough evaluation of the ECB’s monetary policy strategy … [T]he monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications coming from economic analysis. To underscore the longer-term nature of the reference value for monetary growth as a benchmark for the assessment of monetary developments, the Governing Council also decided to no longer conduct a review of the reference value on an annual basis.’

  5. 5.

    See von Hagen (1911). The same is claimed regarding the SNB (Mishkin 1999).

  6. 6.

    See e.g. Berger et al. (2006), who analyse the ECB’s statements and press conferences from 1999 to 2004 and find that the relative amount of space devoted to monetary analysis has decreased; implying that role of money has indeed been downgraded since 1999.

  7. 7.

    See Graff et al. (2013, Chap. 23).

  8. 8.

    Apart from the immediate effect to raise the tax bills for those who cannot or do not want to resort to tax havens – the majority of ordinary tax payers – the deliberate opacity created by tax havens undermines supervision, regulation and early warning and thus increases the likelihood and severity of financial crises, which again implies that the burden is borne by the ordinary people.

  9. 9.

    See Graff et al. (2013, Chap. 7, Appendix 2).

  10. 10.

    This paragraph is mostly based on Graff et al. (2013, Chap. 7, Appendix 1).

  11. 11.

    For this, see Gordon (1987), and others. According to Mundell’s (1998, 3) judgment, Oresmius’ ‘De Moneta’ (written during the reign of Charles V, when no less than 86 coin devaluations took place) is the first version of Gresham’s (1519–1579) Law, and the most important work on the theory of money in the period prior to the sixteenth century.

  12. 12.

    We note in passing that, given the knowledge of the nature of chemical elements at that time, alchemy was a rational attempt to fight the ‘bullion famine’, although – as we know now – it was doomed to fail.

  13. 13.

    Yet, let us recall that economic history provides a host of examples of monetary decay and disintegration, illustrating that organisational and institutional progress is reversible, as during regressions to a barter economy or a commodity money standard. Frequently cited in the economic literature are the ‘cigarette standards’ in Sicily, Germany and in the Pacific after 1944, see e.g. Radford (1945).

  14. 14.

    See also Sombart (1916, Vol. I: 424 ff.), who cites a considerable number of observers, reflecting how contemporary merchants greeted the improvement that the new money meant to trade and commerce.

  15. 15.

    See e.g. Born (1972) and Rittmann (1975, 483 ff.). The oldest known paper money circulated in China from the seventh century. However, at the end of the Ming Dynasty in the seventeenth century, it perished.

  16. 16.

    Initially, governments issued uncovered paper money in times of crisis, war or revolution. The first European issue of government paper money occurred in pre-revolutionary France; where after the revolution the notorious ‘assignats’ were emitted. Other early examples are the paper monies in North America during the War of Independence, in England during the Napoleonic Wars, and the greenbacks from the US Civil War. As Friedman (1994, 45) remarks, these emergency measures without exception quickly resulted in inflation and ultimately disruption of the paper currency, after which stability had to be restored under a bullion standard.

  17. 17.

    See Born (1976, 20 ff.). Robert Peel was Prime Minister of Great Britain from 1834 to 1835 and from 1841 to 1846.

  18. 18.

    See e.g. Friedman (1994, 47 and 195 ff.) and Hallman et al. (1991).

  19. 19.

    Schwartz (1973, 267) e.g. reports a correlation between π and g(M/Y) from 1952 to 1969 in a sample of 40 countries as high as 0.94. Notice however, that recent studies find that this result in mainly driven by a limited number of high inflation countries. We shall come back to this point below.

  20. 20.

    Traditionally, economics would not usually assume super-neutrality of money, as individuals easily err about the rate of inflation. Contrary to this view, ‘Neoclassical Macroeconomics’ today frequently refers to rational expectations of the expected rate of inflation, and money is therefore not only neutral, but also super-neutral; see McCallum (1990).

  21. 21.

    The latter conjecture is consistent with Friedman’s ‘luxury goods hypothesis’, according to which the preference to hold money is increasing disproportionately with income. Based on a meta-analysis of some 500 studies on money demand, Knell and Stix (2005) conclude that money is indeed a superior good. First estimates for the euro area (Brand et al. 2002) arrive substantially at the same conclusion, namely a trend towards moderate decline in the velocity of M3 around 0.5–1.0 %.

  22. 22.

    The latest figure is for June 2013, when the annual growth rate of M3 was as high 2.3 %.

  23. 23.

    The data are taken from the online version, assessed on 16 August 2013. Some missing values could be filled with corresponding data and estimates from the April 2013 International Monetary Fund World Economic Outlook Database.

  24. 24.

    After 1991, a limited number of transition and emerging market economies could be added to the sample, but the increase in country coverage is more than outweighed be the decrease in the years considered, so that our balanced sample of 109 countries from 1991-2012 maximises the number of observations in the panel.

  25. 25.

    The four outliers are Nicaragua 1991 and Brazil 1992-1994.

  26. 26.

    Collins et al. (1999, 7) explicitly mention New Zealand, the US, Canada and the UK.

  27. 27.

    See Dalziel (2000).

  28. 28.

    See Goodhart (1981, 5): ‘Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.’ For an in-depth discussion of Goodhart’s law, see Evans (1985).

  29. 29.

    Greenspan (2003) summarises: ‘… in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of measured money stock.’ See also Gomme (1998), who relates the failure of monetary targeting in Canada to this issue.

  30. 30.

    Notice that without demand for central bank money, not only would the foundation for monetary targeting be stripped from the central bank, but the bank rate policy would be obsolete too, so that this argument can also be brought forward against inflation targeting via the central bank rate.

  31. 31.

    See e.g. Svensson (2003).

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  1. ETH Zürich and Jacobs University Bremen, Bremen, Germany

    Michael Graff

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  1. Michael Graff
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Correspondence to Michael Graff .

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  1. Department of International Economics, University of Erfurt, Erfurt, Germany

    Dominik Maltritz

  2. Faculty of Economics and Social Science, Helmut-Schmidt-University Hamburg, Hamburg, Germany

    Michael Berlemann

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Graff, M. (2013). The Quantity Theory of Money in Year Six After the Subprime Mortgage Crisis. In: Maltritz, D., Berlemann, M. (eds) Financial Crises, Sovereign Risk and the Role of Institutions. Springer, Cham. https://doi.org/10.1007/978-3-319-03104-0_11

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