I usually chat with a friend of mine who studies psychology about how there can be so many people suffering from hunger around the world. Obviously both of us find it difficult to think about it, but one day she came up with a cute solution to this:
-If the problem is that there are people who don’t have enough to eat, why don’t we give them money and that’s it?
-But, where would this money come from?-, I asked her.
-Let’s make it, after all it’s just paper!
No matter how simple this idea may seem, you can’t deny it’s well expressed; when we say there are people who “don’t have enough to eat”, we are saying they don’t have enough money to buy food. So, if the problem is that they have no money, and we are “lucky” that nowadays money is not a precious metal but just a handful of printed bills; why don’t we make more money and give it to the people who need it so that they can at least go to the market and buy something to eat?
This question has two very interesting sides that, in my view, are a bit different; on the one hand there is money creation and, on the other, its distribution.
In this post I want to speak about the first one, that is to say about why the idea of printing money as a solution to poverty makes no sense. Even though this topic may sound absurd, and regardless of the first ideas that may come to our mind (for example: if printing money means generating wealth, then we should create a lot of money so that all the people can have a lot; or even, if now that there is so much money in the world there is still a lot of poverty, what would make us think that, if there were more money, it would help us in any sense?), it seems to me that there’s a lot confusion about it, so I would like to focus on the relation between money creation and price level.
Money Creation and Inflation
Before introducing the topic, I consider important to highlight the following: one thing is reflecting on whether money creation is fair, about who should do it or even about if it is convenient or not, and another completely different thing is speaking about the effects of this creation on price level. About this last case there is a whole discipline, economics, focused on studying this kind of phenomena and specifically inflation is a topic in which there has been a great deal of progress; moreover, and most interestingly, it is a topic where there is a strong agreement (especially about the relationship between money creation and inflation). This agreement is strongly supported by what has happened in different countries over time. That means; there is strong empirical evidence about the high positive correlation between the growth rates of money and the increase in price level. Weber &McCandless’ article shows a great deal of this evidence, after which the authors conclude “In the long run, there is a high (almost unity) correlation between the rate of growth of the money supply and the rate of inﬂation”.
How is Price Level determined?
Let’s move on to try to understand why we can say that when the amount of money increases, so do prices. Perhaps you may have the idea that the more money in circulation, the easier will be for people to buy goods, but let me tell you this is not always the case (otherwise my friend would be right: make more bills and that’s it!). The simple fact that the amount of money increases in the economy doesn’t mean that real resources are also rising. If there were just three apples being produced, worth $5 each, no matter there were ten people who had $5 (or more) it would be factually impossible that more than three people could eat his apple.
As it happens with goods, the value of money is established by supply and demand (the only difference being that money is worth according to what can be bought).
Thus, a bigger quantity of money can be understood as an increase in its supply, so if the demand for money –which depends on the activity level and the interest rate- didn’t vary in the same magnitud there would be an excess of supply in the money market. That would diminish its value, and saying that the value of money decreases is equal to saying that with the same quantity of money we can buy fewer things (which ultimately means that prices are rising).
Maybe it’s easier to think of it in terms of shortage: if there is big quantity of certain goods (a big quantity in relation to what people want), we can expect they won’t be worth much. And the more of these good there is –and fewer people want them- the lesser their value will be. Likewise we can think that when a lot of bills are printed, their value will start diminishing (inflation). We can also apply this reasoning to the dollar; if the gap between the quantity of pesos and dollars increasingly widens (shortage of dollars related to pesos), and also (or as a result) fewer people want to have pesos, we can expect that more pesos will be needed to buy one dollar.
Back to inflation. One of the main economic theories about this issue is the quantity theory of money, expressed as p.y = m.v which basically refers to a relation between money quantity (m), product level (y), price level (p) and velocity of money circulation (v). From there, we can see that a change in money quantity has an impact on product and/or price. Therefore we should expect that an increase in money quantity will cause product and/or price increases; more specifically, if the increase in m is greater than the increase in y, we can expect that this difference will result in a rise in p. In this way, we can also understand the debate about inflation and growth which I exposed in my previous post (the above work also offers evidence of this relation: “In the long run, there is no correlation between the growth rates of money and real output”). As we were saying, nobody can think our production will increase simply by creating money, that’s why when we pretend to increase the product simply by issuing money, it’s no wonder that this increase in m will go to p in stead of y, i.e. that here will be higher prices and no growth.
In this graph contributed by G. Bozzoli in Foco Económico we can find some historical data about the quantity theory of money for Argentina between 1875-1990.
Let’s even try to apply this now: there has been a money creation level between 30-35% in the last few years, with a GDP growth level of 7-10%. Guess how much the inflation is!
**A Good Economist
I want to insist on something that seems important to me: we are not arguing about ideological issues, we are trying to understand a knowledge shared by a scientific community. Claiming “money growth causes inflation” (or it often does so, under certain circumstances) goes beyond saying whether issuing money is right or wrong, it simply refers to the consequences of that decision. If we are willing to print more money to maintain a certain level of expenditure, or whatever, it is a decision in which each one can have its own vision, but what we cannot do is ignore the direct and indirect consequences of this decision.
As Hazlitt would say in his Lesson: “In this lies almost the whole difference between good economics and bad. The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences.”
Can we just ignore all the knowledge developed by a discipline?
I don’t mean to say that economists should decide what has to be done and what not -first because they don’t know, and second because that is up to politicians-, but what is economists’ task is to warn about possible consequences of different economic policy measures (both short and long-term) and to communicate them as best they can to policymakers (and to society?) so that they can know the effects of each option and decide what they believe is the best for society as a whole.
Regarding this, it is essential to understand that economics is not merely a set of beliefs or ideologies but a social science, and as such it is dedicated to studying various phenomena -to understanding/explaining them- in order to predict the future effects of the different economic measures to be applied.
What is, otherwise, economics? Which is the value of all the knowledge that has been developed?