Inflation, again
Inflation, has been a burning question in economics the whole of my adult life. In my youth, the press was full of articles discussing the pitched battle between the Keynesians and the Friedmanites, and especially the latter’s attachment to the (much older) Monetarist theory of inflation.
Both theories seem to have some intuitive appeal. The Keynesians argued that when the output gap was positive, in other words when resources were lying idle, ramping up demand would have no effect on the price level. The economy would just take up the slack of unemployment. At some point, when we hit ‘full employment,’ attempts to buy more stuff would not produce any change in output, but would bid up the price of the fixed quantity of stuff that had previously been produced.
The Monetarist idea was that people have a certain level of money in their wallet (e.g. their weekly wage), which they spend in a fixed period of time (e.g. one week). When the quantity of money in the economy goes up, the nominal amount of spending goes up correspondingly, but this has no effect on (real) output and so prices respond in a one-to-one fashion.
Both theories have big problems. Nobody knows how to measure the output gap. Monetarists never stopped arguing about how to measure money in a fiat currency regime with floating rates. Neither theory seemed very successful at actually predicting inflation, or at coming up with a painless way to get it lower (or higher).
John Cochrane has come up with a new theory which, to me, sounds a lot more plausible. He identifies money as the aggregate level of all government debt, not some small part of it (such as reserves held by commercial banks at the central bank). More daringly he looks at the actual value of the money stock, viewed as an asset, much like a stock or a bond.
The problem with Monetarism is that inflation is influenced not only by the quantity of money in circulation, but also by the willingness of individuals to hold it. For a country like Zimbabwe, nobody wants to hold the (local) currency for more than a few hours. For a country like Switzerland, people are happy for Swiss francs to sit in their numbered bank accounts indefinitely.
So, what is the difference? It’s not that the Swiss National Bank doesn’t print money. It’s that everyone believes that the Swiss government is probably running a budget surplus now and even if it isn’t now it will within a couple of years. In the case of Zimbabwe, not so much. Hence the CHF is highly valued, and you can buy a lot of Big Macs with it. For the Zim. Dollar, well let’s say that tax collecting, and servicing the national debt are not the most highly developed abilities of the Mnagwaga government.
Of course, the value of a currency relates directly to the rate at which you can exchange it for another currency. Unsurprisingly, a strong currency leads to a low inflation rate. The dollar has experienced a golden period, with the world believing that US will not only not default on its obligations in nominal terms, but will at some point start to run surpluses (or at least deficits lower than those run by other OECD countries: it’s all relative).
Cochrane’s theory suffers from limited falsifiability (how do we measure expectations?), but it is (to me) much more intuitively appealing that the longer established theories of inflation but as J Poww said recently, we now understand how little we understand about inflation.
This is important because currency is the unit of account for measuring investment performance. We are sometimes unaware of how important the general price level is for all securities, even though we know that prices of similar assets (e.g. stocks) are highly correlated, to the point where beta completely swamps beta. Foreign exchange is the only market where we are acutely aware that a price is simply the relative value of two assets, but its really just the same for all assets. The dollar is such an important unit of account because nearly all exchange rates are quoted relative to the USD, and of course the US debt and equity markets represent about half the world’s market cap. The mantra “Don’t fight the Fed!” is important for a very good reason.
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