The document, "Why monetarism does not work"
explains why the Quantity Theory of Money (QTM) formula (algorithm) is wrong. However, it did not explain the evolution in "asset entropy" which caused the QTM to become completely out of tune with reality.
Entropy is defined as the measurement of the energy in a system that is not available to do work. Asset entropy degree to which assets attract speculative "investment" driving down the investment supporting the work in supply side production.
During the last 50 years, the removal of financial regulations, algorithmic trading and technical innovation have increased the range of physical and financial assets which, since around 1990, have attracted more investment than supply side production. Since the QTM was never updated it continues to exclude assets as determinants. As a result, the reality of the rise in asset entropy resulting from quantiative easing, renders the QTM defunct.
This is why monetarists, contrary to central bank assertions based on the "logic" of the QTM, have lost the ability to manage the economy.
|The transition in the monetary environment 1970 to 2021
In 1970, Nichloas Kaldor wrote an article entitled "The new monetarism" in the Lloyds Bank Review, explaining why monetarists, and in particular Milton Friedman and his associates, were likely to have misinterpreted copious data they used to construct an explanation of cause and effect.
In reviewing Friedman's publications, Kaldor identified four propositions of the monetarists.
The interesting assumption of the monetarists was that by injecting money into the economy economic activity rises as a result of the injection increasing demand. Kaldor pointed out that a considerable amount of bank credit giving rise to more money was the result of demand for money by the supply side production sectors for investment. Since investment normally is associated with expanded plant and often technological advance, the resulting impact, albeit with delays, is for prices to remain stable or even decline as a result of enhanced productivity.
- Money alone matters in determining GNP and changes in prices while fiscal policies, taxation, trade union behaviour are not relevant;
- Whereas money cannot change real output it can disturb processes so as to alter the equilibrium interest rate, equilibrium wages and employment;
- Money supply impacts are subject to delays or lags in effect;
- Trying to run monetary policy in a counter-cyclical way to bring about stability is difficult. It is more productive to raise money supply at an ideal rate of around 2% per annum.
Kaldor therefore considered the monetarist's cause and effect statement to be the wrong way round because it was ignoring endogenous demand satisfied by bank credit. Indeed, monetarists considered their introduction of money to be exogenous.
In summary Kaldor pointed out that :
Our own research into real incomes perspectives support these contentions given that technology has a profound impact on the ratios of human resource inputs to productivity and real wages of employees. The "equilibrium" levels of consumption or GNP is dependent upon the wages paid by the supply side production sector. In this context, at that time, fiscal policy, taxation and trade union behaviour were important; technology and techniques determine what is feasible and not the amount of money injected into the economy.
- the direction of causation between money and output are more likely to be the reverse of that stated by the monetarists
- the ability of a central bank to control the quantity of money, at that time, was limited
Subsequent evolution in monetarism
Kaldor wrote this article before the following events occurred:
Each of these events was to change the monetary environment in specific ways and which led to circumstances which resulted in the monetary theory under the gold standard requiring constant modifications under the post-1971 fiat currency world, within which the events listed occurred.
- more than a year before Nixon came off the gold standard in 1971
- three years before Fischer Black and Myron Scholes published the article entitled, "The Pricing of Options and Corporate Liabilities"
- five years before the international petroleum crisis heralding slumpflation
- eleven years before the US Securities & Exchange Commission allowed companies to buy back their shares in 1982
- thirty one years before the Bank of Japan applied quantitative easing
The reality is that monetary theory and policy was never adjusted to accommodate the new realities resulting from these events. Even today, economists are applying the defunct Quantity Theory of Money (QTM) "logic", that could no longer "explain" or "predict" outcomes of policy under radically different circumstances. As a result, the current monetarism as the main component of macreoeconomic policy has no coherent theory to back it up. To clarify, the theory contains no quantitative formulae that express the necessary cause and effect relationships needed to relate any monetary policy instruments to real incomes, investment, productivity and inflation.
The objectives of monetary theory
The stated, and often not stated but assumed, objectives of monetary policy was to bring about price stability associated with targets for unemployment, national income, balance of payments and growth. One has to assume that price stability and unemployment levels related to the supply side goods production and services sectors which employed the majority of the work force in exchange for wages. However, the period 1970 through 2021 demonstrates how monetary policy became increasingly ineffective in maintaining real incomes of wage earners as a direct consequence of monetary policy decisions.
The endogenous-exogenous money trend
Organic growth in the economy is the combination of rises in technological productivity and the ability to produce more for less arising from innovation. As explained by Kaldor, the investment funds used to bring this about related to the demand for funds in the supply side and supplied through savings or bank loans. Since this investment was in response to the requirement of the companies concerned, just monetary injection was neither inflationary or exogenous. To be clear, inflation here is linked to the goods and services produced by the supply side.
Irrespective of interest rates or availability of savings, the actual requirements for investment funds are limited by the ability of the supply side to absorb the funds. This limitation is created by the limits on the scales and rates of investment and needs for human resources adjustments such as training and gaining experience or new technologies. Any endogenous funds, in excess of this requirement, become external to internal requirements or they become exogenous excess funds as far as the supply side sectors are concerned. Over the period 1970 through 2021, the balance between endogenous funds and exogenous funds has changed significantly from having been dominated by endogenous money and now dominated by exogenous money. This excess of exogenous money has ended up in physical and financial asset markets. Whereas the endogenous characteristics of supply side investment has, to a considerable degree, helped maintain relative price stability in goods and services the excess exogenous money has been associated with increasingly unstable prices in assets which have been subject to significant levels of inflation. This inflation is caused by the volumes of money flowing into speculative asset markets. This trend has been stimulated by the incentives created by the events listed at the beginning of this article.
As a result, exogenous funds, by the definition implicit in this article, do not flow into supply side production and work to produce goods and services but flow into non-productive encapsulated markets as an "asset entropy" characterized by rising prices.
Coming off the gold standard switched the monetary system to fiat currency and just a few years later a new class of financial assets (derivatives) expanded rapidly following computer-based hedging models and rapid trading algorithms. The growth was obscured by the international petroleum crisis which impacted supply side production with a severe cost-push inflation creating slumpflation. Rather than recognize this as a supply side technological challenge requiring low interest rates to invest in appropriate technologies, advice from monetarists was to raise interest rates. The result was higher inflation and unemployment but then a more depressed economy resulting in declining purchasing power and a generally depressed market eventually causing inflation to decline. Thus the fall in inflation was achieved at an exorbitant and avoidable social and economic cost.
By the mid 1980s a range of relaxations in financial regulations gave rise to an accelerating growth in derivatives and share buy backs resulting in these financial assets absorbing a large proportion of exogenous money. The constant flow of funds being injected created a momentum in financial asset prices and share price-earning ratios that indicated price discovery was no longer feasible although the driving force became anticipated higher prices for assets. The derivative market, that grew substantially since the mid 1970s became the grey market whose value exceeded GNP's and such assets were used as "reserve capital" to back loans creating a fantasy measure of economic growth with central banks not being fully aware or in control of this growth in financial assets.
The fine margins associated with large sub prime mortgage accounts being rolled up into derivatives and sold under false ratings led to the ever-rising assets price boom collapsing when the Federal Reserve raise interest rates in November 2007 causing the income flows on the sub prime derivatives to stop. This created the 2008 financial crisis with many banks holding bad financial assets.
During this period between 1970 to 2007 much of the exogenous money had also been used to invest offshore leading to the substitution of onshore national production by imported goods. This activity of globalization ended up running down industrial zones and industrial employment and investment causing declining growth and real incomes.
In spite of a poor track record of quantitative easing in Japan, this options was selected as the solution to the poor banks balance sheets by reducing interest rates close to zero and raising exogenous money injections into the economy. The negative impacts of QE have been covered in other articles on this site.
1 Hector McNeill is director of SEEL-Systems Engineering Economics Lab
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