The True Gold Standard (Second Edition)
Previous article: Reserve-Currency Inflation
To explain inflation in the United States, we need to include the increase in foreign official dollar reserves (dR); because this represents an excess supply of money which is prevented by foreign central-bank intervention from leaving the dollar market.
D – Q = dP = dM – dL +dR.
The change in official dollar reserves (dR) is “excess money.” In theory, we could think of it as equivalent either to increasing the money supply (M) or to reducing the demand for money (L). However, because the change in reserves works in the same direction as the money supply, and because it’s not always easy to think about a negative demand for money, LBMC treats foreign dollar reserves as if they were an addition to the money supply. The domestic monetary base (M) plus foreign dollar reserves (R) equals the World Dollar Base ($). So LBMC’s version of Rueff’s balance between total supply and total demand replaces dM with d$:
D – Q = dP = d$ -dL.
What this means (at least, at this level of abstraction) is that the “excess” World Dollar Base (d$ - dL) is not one cause of inflation in the dollar market – it is the only cause!
As for making this the basis of prediction, the question is whether we can measure the “excess” World Dollar Base. The answer, LBMC has found, is basically yes.
LBMC has its own proprietary method of measuring the World Dollar Base. But to know the “excess” World Dollar Base, we still need to know something about the demand for money (L).
According to Rueff, the demand for money should be directly proportional to the price level (P) and positively related to two other things: the volume of exchanges of non-monetary wealth (Q), and some residual “hoarding” factor (H) which is unrelated to P or Q. But according to Rueff, as an empirical matter this last factor should normally be insignificant. So if we ignore (H), we can approximate this by saying
L = kPQ
where K is a constant related the demand for money to the volume of transactions.
Graphs 1 and 2 were derived from the foregoing analysis. We took the increase in the World Dollar Base, as a percent of the initial dollar value of some measure of transactions. These proxies were total expenditures on food and energy commodities for Graph 1, and total personal consumption expenditures for Graph 2.
We compared this ratio – d$/PQ – with inflation (dP/P) for the same categories of goods, a bit more than two years later.
Graphs 1 and 2 show that LBMC has essentially confirmed Rueff’s theory of inflation: inflation can be explained as the result of a fairly well-defined excess supply of money over a fairly well-defined demand for money. But we have to take into account the dollar’s role as an official reserve currency.
The simplified approach used in Graphs 1 and 2 ignores two things: the demand for money that is not related to the state of the economy (H), and the change in the supply of goods (dQ) during the intervening two-plus years. What Graphs 1 and 2 show is that these two factors are not very important.
This is, in part, a vindication of Say’s Law, as restated by Rueff, against Keyne’s General Theory. The fact that the non-systematic factor (H) is relatively insignificant implies that apart from the inflationary process, unexplained variations in the demand for money have little impact in driving a wedge between total supply and total demand for goods. Or to repeat Rueff’s words, Say’s Law is “roughly correct” because “this residue is always limited, except during inflationary periods, relative to the portion of the demand which is provided by the supply.”
What may seem more surprising is that assuming perfect foresight about the change in the quantity of goods (dQ) during the intervening two years does not improve the forecast. Most of the “work” is done by the World Dollar Base, which makes it predictive by itself, even where proxies for PQ are not available (see Graph 3, for example). In fact, subtracting the actual change in supply of goods from the inflation forecast in Graphs 1 and 2 substantially worsens the forecast!
This is not because the further change in the total supply of goods doesn’t matter; rather, it’s because the economy’s process of adjusting to excess money takes time. So the change in supply of goods (dQ) matters for a time period different from the one we are observing – namely, for a following period, by which time this change in the supply of goods (dQ) is included in the total supply of goods (Q), and therefore is included in our measure of the “excess” World Dollar Base. (Perfect foresight about other factors would improve the forecast.)
The theory we have outlined assumes that the supply of goods (Q) or the subset of output (Y) is determined by factors independent of the money supply or the price level. This is true in the end; but as long as prices don’t adjust instantaneously to an excess money supply, it can’t be true during the period of adjustment. Before output prices adjust, excess money will lead to a temporary increase in output; but when output prices rise, as they must, the “real” value of money and claims is reduced, causing output to fall again. While causing fluctuations in output, merely creating more money cannot create any more wealth. The whole point of the excess money supply is that it represents demand for goods without any matching supply. In fact, by misallocating resources, the process of inflation reduces the efficiency of the economy and lowers output over time, on balance.
Next installment: LBMC's Growth Model
The Rueffian Synthesis