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Theory v facts |
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© Christian Müller 2017 |
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... a scientist must also be absolutely like a child. If he sees a thing, he must say he sees it, whether it was what he thought he was going to see or not. See first, think later, then test. But always see first. Otherwise you will only see what you were expecting.
Wonko the Sane |
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«home |
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To call Nicholas
Gregory Mankiw well-known is anything but a gross understatement of
his popularity with professional academics and undergraduate students
alike. For many of the latter, his best-selling textbook
«Principles of Economics» is the first and sometimes also the last and closest
approach to structured economic thinking they will ever encounter.
Therefore, his influence on the thinking of what we may call lay
economic experts cannot be underestimated. |
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printer friendly version » |
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One of the many appealing features of Mankiw's textbook is the structuring of economics into ten easy-to-remember principles. Among them the ninth principle deals with the causes of inflation and goes as follows: |
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Prices
rise when the government prints too much money.
Mankiw (2014, p. 11) |
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Mankiw further
claims that in «almost all cases of high or persistent inflation, the culprit turns out to be the same - growth in the quantity of money.» (ibd.). Although this accusation is probably very widely accepted, it is nevertheless insightful to study it in more detail. In fact, it turns out that the ninth principle might better be re-phrased in order to more accurately reflect actual economic relationships. |
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To begin, let us
take stock of how Mankiw supports this ninth principle. The first
three versions of the textbook (the first edition, the special
edition – the one that deals with the financial crisis – and the
second edition) substantiate the principle by the hyperinflation
examples of Germany, Hungary, Poland and Austria in the 1920s.
Referring to an article by Sargent, 1982 «proves» the principle by
means of illustration (Mankiw, 2011, p. 649f.) |
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A closer inspection
of Sargent’s (1982) paper shows, however, that Sargent stresses
that all four countries «ran enormous budget deficits on current
account» (Sargent, 1982, p. 43). Their currencies were not
«backed» by the gold standard but «by the commitment of the
government to levy taxes in sufficient amounts, given its
expenditures, to make good on its debt» (Sargent, 1982, p. 45).
Importantly, all four countries found themselves at the losers' side
of the first World War which severely impaired their opportunities
«to make good» on their debts. Germany, moreover, experienced a
revolution after the war and its post-revolutionary moderate
Socialist government «reached accommodations with centrers of
military and industrial power of the pre-war regime. These
accommodations in effect undermined the willingness and capability of
the government to meet its admittedly staggering revenue needs
through explicit taxation», Sargent (1982, p. 73) reports. |
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The final blow to
the German government's illusion of fiscal sobriety was dealt by
France when it occupied the Ruhr in January 1923. In response, the
German government tried to stir passive resistance by «making direct
payments to striking workers which were financed by discounting
treasury bills with the Reichsbank» (Sargent, 1982, p. 73). At that
time, the German Reichsbank was not yet independent and the
government resorted to its central bank for financing its debt by
issuing more money. However, due to the apparent impossibility «to
make good on its debt» people naturally lost confidence in money.
With newly printed money being ever less trustworthy the government
had to make up for the loss of quality by issuing ever more quantity. |
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Consequently and in
striking contrast to Mankiw's ninth principle, Sargent (1982, p. 73)
asserts that after «World War I, Germany owed staggering reparations
to the Allied countries. This fact dominated Germany's public
finance from 1919 until 1923 and was a most important force
for hyperinflation.» (emphasis added). In other words, Sargent
(1982) does not consider money growth as the main culprit behind the
hyperinflation in Germany that Mankiw quotes in support for the
general principle that money growth causes inflation. |
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Rather, money growth
must be viewed as a result of inflation which was triggered by the
loss in trust in government finances and hence the rise in inflation
which caused the money stock to increase. The government's demand
for money rocketed as inflation took off. This causality is also
reflected in Sargent’s statistics. While the price level started
to double every month as early as July 1922, notes in circulation and
treasury bills grew by only 12 percent at that time and reached 76
percent (treasury bills) in December 1922. Throughout the
hyperinflation period, not only accelerated the rate of inflation way
before the rate of money expansion, it also always exceeded money
growth by a factor of roughly five (Sargent, 1982, p. 82). Thus, the
causal order of how hyperinflation emerged is also born out by the
empirical facts. |
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If it was not for
the government's printing of money, how can we still make sense of
the apparent and striking relation between (hyper)inflation and money
growth? «Trust» may yield the appropriate answer. |
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In order to
understand this, one should first notice that money is an
institution. This is because it only works as a set of rules followed
by humans.
Without these rules about accepting and valuing money there is no
money. Second, money always solves the well-known problem of double
coincidences in exchange. This problem arises because in exchange the
offer of one party has to be met by a matching demand at the same
time. Put simply, if a producer of cotton wants to exchange cotton
against milk, the cotton producer has, in principle, to find a farmer
who has a surplus of milk and concurrently is in need of
cotton. |
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Money does greatly
simplify this exchange by allowing the cotton producer to sell his
product for money and find someone who accepts the money in exchange
for milk without time pressure.
The most interesting part of this exchange story now rests with the
fact the the cotton seller has enough confidence in the worth of the
money that he accepts it as a compensation for his hard-laboured
product. Therefore, the key question is why is he so confident? |
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The answer to this
question can be given by interpreting money in institutional terms.
The institution that matters most for money is the one that justifies
the confidence in accepting money as an intermediate means of
exchange. |
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Historically, money
has assumed many guises such as gold and precious metals in general,
pearls, stones, cigarettes, coins and notes and so on. It is tempting
to label money according to these phenomenological attributes as
metallic money, paper money or commodity money. These labels do,
however, veil the fact that the crucial difference between any types
of money lies with the institutions that justify the confidence in
using money in the first place. |
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Let us consider
gold, for example. Gold seems to be a «natural» choice for money
because it serves most money functions very well. However, underlying
the «value» that gold is associated with is a cultural institution
that assigns this value. Cultures across the globe hold gold in high
regard and this respect which is based on a culturally determined set
of rules is what gold qualifies as money. |
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But what is this
«quality»? The essential quality is that any owner of gold can
trust in anyone else to also share in the high regard for gold. This
property even goes as far as being able to rely on the «value» of
gold even if oneself, individually, does not have any respect for it.
In fact, it is sufficient to believe, or better trust
in anybody else holding gold in high regard to also accept and use
gold as money. |
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A situation in which
there is trust in money must hence be distinguished from a situation
when there is no trust in money. For simplicity, let us assume that
in the latter case, there is no money at all. The situation without
trust in money is obviously associated with considerable uncertainty
with respect to the outcome of the production and exchange process.
This uncertainty arises because it is very difficult to gauge the
eventual proceeds (if any) from producing and selling one's goods due
to the necessity of the double coincidence. In contrast, money
dissolves the need for the double coincidence which simplifies and
eventually facilitates the exchange. |
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However, when
accepting money with the intent to satisfy own needs the money holder
depends on the confidence the potential seller has in that the money
will serve him too, or in other words, that those third parties also
trust in money. |
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Inflation can now be
understood as a phenomenon that has its roots in the deterioration of
trust. Trust can be diminished by pretty much everything that shakes
the institutions which generate the confidence in money. Therefore,
government crisis as well as strikes or the abuse of monopoly power
can result in inflation. Printing too much money also has the
potential to destroy the confidence in money. In contrast to the
monetarist view, however, money «supply» is just one factor that
affects the trust one has in the relevant institutions. |
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This observation is
an accurate copy of the earlier statement that it is those who accept
money who decide about its worth. Returning to Sargent's examples,
we can now see that without the prospect of the money (Sargent,
1982, «unbacked of backed only by treasury bills”, p. 89f) being
honoured by the government through taxation, there was no reason to
believe that prospective business partners would accept it as a means
of payment. |
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Therefore, and in
contrast to Sargent's claims, one has to concede that it neither was
the «the growth of fiat currency» nor the «increasing quantity of
central bank notes» (alone) which caused inflation. Rather, the
inflation was caused by the fast deterioration in the trust of money
due to the apparent inability of the government to match its promises
which were manifested as newly issued money with future revenues. It
was this bleak prospect about the usefulness of the money which
eventually created inflation. |
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According to the
lessons from Sargent's examples as well as from the principle
considerations, money as trust implies that the initial trigger for
inflation will always be some impairment of the belief in the
respective money's ability to satisfy needs. And in fact, wars,
corruption and grave economic mismanagement usually cripple inflation
infested economies first. The growth in money stock hence is a
response to these ails and must be regarded as attempts to
create more money in order to compensate for the loss in trust in the
existing stock. Printing more money, however, is a sure means of
destroying trust even further. Therefore, the excessive creation of
money reinforces but does not cause an ongoing
inflation. |
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When it comes to
inflation, matters are apparently somewhat more complicated than the
simplicity of Mankiw’s ninth principle suggests. Maybe as a sign of
acknowledgement, Mankiw dropped the case study on Germany, Austria,
Poland and Hungary starting with the third edition of his textbook
(Mankiw, 2014). In its stead he refers to the case of Zimbabwe but
only in passing (Mankiw, 2014, p. 11) and without any further
elaboration. The more recent editions thus provide support for the
ninth principle only on theoretical grounds (Mankiw, 2014, p. 590).
In view of the full factual evidence, it would probably be even
better not only to drop the mis-placed proof by example but to
re-write the ninth principle altogether: |
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Prices rise when people lose trust in money. |
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Footnotes |
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References |
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Aristoteles (1951).
Nikomachische Ethik, Artemis-Verlag, Zürich. |
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Aristoteles (1971).
Politik, 2 edn, Artemis-Verlag, Zürich. |
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Mankiw, N. G.
(2011). Economics, 2nd edn, Cengage Learning, Andover. |
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Mankiw, N. G.
(2014). Economics, 3rd edn, Cengage Learning, Andover. |
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Sargent, T. J.
(1982). The End of Four Big Inflations, in R. E. Hall (ed.),
Inflation: Causes and Effects, University of Chicago Press, Chicago,
pp. 41–98. |
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© Christian Müller 2017 |
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www.s-e-i.ch |
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