The science of economics is different from natural science.
In natural science, it is possible to detect regularities in the form of “When A, then B” or “If A rises by x percent, B changes by y percent.” As a result, in natural science it is in principle possible to come up with more or less reliable quantitative predictions. This is impossible in economics, for there are no quantitative regularities, or behavioral constants, in the field of human action comparable to those to be found in natural science. Different people—and even the same people—at different instants of their lives react differently to the same external stimulus.
At the same time, however, there are inexorable economic laws such as the law of supply and demand or the law of diminishing marginal utility. These laws govern human action and can be logically derived from the irrefutably true proposition that “humans act.” It is in this sense that we can know the outcome of various modes of action in qualitative but not in quantitative terms. Take, for instance, the case of the central bank increasing the quantity of money in the economy.
More money in the hands of acting man will, other things being equal, lead to a decline in the marginal utility of the additionally received money unit, meaning that other vendible items will, from the viewpoint of the actor, gain in marginal utility. This, in turn, leads acting man to exchange his money unit, which he considers to be of lower value, against vendible items which he considers to be of higher value. And as more money is exchanged for goods and services, the money prices of said goods and services go up. This economic law will no doubt always and everywhere make itself felt in real life.
However, it might not always be easy to detect it, for in real life the law of diminishing marginal utility of money typically unfolds under “special conditions.” For instance, the rise in the quantity of money may be accompanied by an increase in the demand for money (for whatever reason). If this is the case, the rise in the quantity of money may not be accompanied by a rise in money prices of goods and services—because the rise in the demand for money, the “special condition,” prevents goods prices from going up. They would have increased had it not been for the increase in the demand for money. This has important implications for making inflation forecasts.
A Cause for Inflation Concern
As a reaction to the politically dictated lockdown, central banks are churning out ever greater amounts of money. In the US, for instance, the Federal Reserve (Fed) monetizes debt on an unprecedentedly grand scale. Not only is the monetary base growing strongly, but also the monetary aggregates M1 and M2: in the middle of May 2020, M1 grew by 31.4 percent year over year (y/y), M2 by 22.3 percent y/y. To most people this looks inflationary. Mainstream economists, however, downplay any inflation concern by saying that the “velocity of money” has declined, so the rise in the money supply will not make goods prices go up.
What they have in mind is the so-called transaction equation: M*V = Y*P, where M = money stock, V = velocity of money, Y = production, and P = price level. The velocity of money—the frequency with which a money unit is used to finance the nominal transaction volume—is: V = Y*P / M. It is obvious that V declines if Y drops and M rises, and if P remains constant, falls, or rises by less than Y declines, and M rises. The important question is: What is the relation between V and P? In the US, for instance, the decline in the velocity of M2 since 1994 was accompanied by rising prices across the board. The same holds true for the euro area. The lesson to learn is that a declining velocity of money does not necessarily prevent goods prices from rising!
Putting Things in Perspective
In view of the “lockdown”-driven economic collapse and central banks’ monetization schemes, it might be helpful to take a look at a simple numbers game to put things in perspective. Fig. 1 depicts real gross domestic product (GDP) falling by an assumed 10 percent in 2020 against last year. In 2021, GDP recovers 80 percent per cent of its previous loss. The money stock rises, say, 25 percent in 2020. Fig. 2 shows the corresponding “monetary overhang,” defined as GDP minus the money stock. As we can see, the monetary overhang would go up significantly in 2020, coming down somewhat in 2021 as the economy recovers but remains at an elevated level.
If we assume that the monetary overhang is what drives the level of the money prices of goods (perhaps with a time lag), the purchasing power of money would be falling quite substantially: in this scenario it will have lost around 30 percent after five years, implying an annual rise in money prices of vendible items of around 6.5 percent per annum—a number which, as should be noted, refers to the combined effect of rising consumer goods prices as well as rising asset prices (such as the prices of stocks, bonds, and real estate). In view of current circumstances, this appears to be a rather positive scenario—and people may be well advised to prepare for something worse than that.
The simple example indicates that much depends on the rise in the quantity of money relative to the decline in production: The higher this “gap” is, the higher the upward price pressure and the more severe the loss in purchasing power can be expected to be. Of course, the velocity of money plays an important role. Although it is currently declining (as Y (production) has fallen and M (money stock) has risen, and P (the price level) has remained relatively stable), the question is: Will it remain that low, and will it force prices down? Or will it not fall enough to prevent prices from inflating?
These questions cannot be answered with scientific reliability. However, the chances seem to be relatively high that the latest increase in the quantity of money will ultimately push money prices higher, eroding the purchasing power of money. It is not that likely that the additionally created money stock will be matched by an equal increase in the demand for money—simply because incomes have fallen and interest rates are very low, and may even go further into negative territory in inflation-adjusted terms, all of which makes holding money less attractive.
Finally, central banks’ policies are meant to prevent the financial and economic system from collapsing; this goal has priority. So price inflation as a result of ramping up the quantity of money is considered to be “acceptable collateral damage.” This is, in fact, the cold-hearted political strategy which Ludwig von Mises (1881–1973) in January 1923 captured succinctly in the following words: “As serious an evil as inflation is, it is not considered the most serious. If it is a choice of protecting the homeland from enemies, feeding the starving and keeping the country from destruction, then let the currency go to rack and ruin.”
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Author: Kit Daniels
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