Dear Friends,
It seems to me that Milton Friedman’s theory of inflation and money supply presupposes a frictionless plain. A frictionless plain in economics is absolute lasses fair economic conditions. Friedman was a great proponent of lasses fair economics. I think he understood that his theory of money was effected by the economic environment of any given country. If an economy has lasses fair then Friedman’s theory is absolutely true, however, under normal economic conditions… his theory needs to be qualified. This has direct and important implications for the economic theory of money and it’s applicability to present and future economic circumstances. Our economic well being is directly effected by this theory and the qualifications on it.
The first aspect of his theory is, as the money supply is expanded beyond the actual economic growth of a country, the inflation rate will have a one to one ratio. If GDP was expanding at a rate of 1% and the money supply increased at a rate of 2% then there would be 1% inflation in that economy. This is a pretty self evident idea and is verified by graphing economic conditions in several countries over several years.
The other aspect of his theory, is that under conditions of recession where potential capacity is less than full utilization, then an expansion of the money supply may draw the economy closer to full capacity. By pulling in underutilized resources to feed the increase in demand that the additional money creates. Like the US FED has tried to do with QE1, QE2 and TWIST. The ECB (European Central Bank), has begun similar initiatives. These policies by the FED and ECB to expand the money supply, to bring the World economy closer to full utilization, have failed, and in fact have hindered economic expansion. Not due to any deficiency in Friedman’s theory but to an under accounted for facet of economics.
The under accounted for factor is the friction that regulation and political favor play in any economic expansion. To make the point, lets consider two economies that are operating at far less than optimal output. In the first, regulation is at a very high level, and political favor is required to start or expand a business. In this case the increase in money supply will not increase the utilization of that country’s infrastructural capacity. The friction that the regulation creates will keep potential businesses from hiring more employees to increase output to meet the demand.
We saw this happening in the US in the 1970s. The money supply increased, but economic output didn’t, even though the economy was operating far below it’s potential. Unemployment was high but inflation was also high. We can say that the friction, that regulation and political favor generated, stood in the way of utilization of the extra money, and so the increase in the money supply only fed into the inflation.
In the other possible scenario, we have an economic system that has lasses fair… and is underutilized due to recession. In this case if the money supply is increased then it would be easy for firms to hire more employees and increase output. This is because the friction to business is low in a country that allows it’s markets to function unfettered of government interference. We saw this in the 1980’s. After the stagflation of the 1970’s, under Carter’s government centered model of economics, Ronald Reagan instituted more lasses fair economic policies, and the economy regained it’s full productive capacity… and began growing at a fast rate.
This is why I say that Friedman’s theory of money supply is dependent on the economic conditions of the country in question. If the government implements government centered economic policies, then additional money only feeds into the inflationary feedback loop, due to the difficulties of bringing people and productive capacity back online. If however, the economic conditions in a country are such that bringing under utilized plant and workers back into production is easy, then we will see that Friedman’s theory works as stated.
Therefore, if a country’s economy is underutilized due to recession, and an expansion of the money supply is used as a means of increasing GDP, then for it to work, that country must lower the level of government interference or friction, else that expansion of the money supply will feed into an inflationary spiral, or if the economic expectations are too pessimistic, then we will see the money sit in the banking system, until economic conditions are more favorable to economic expansion. Then all of the inflation that has been banked will emerge and lower the value of every unit of currency in the economy. Inflation will appear where there appeared to be none… perhaps even hyper inflation.
Sincerely,
John Pepin
