by Gunther Schnabl*
The European Central Bank (ECB) continues buying securities. By the end of 2017, the balance sheet is expected to have further grown by about 800 billion euros. This corresponds to a growth rate of 20 percent per year, while real growth of the euro area is expected to be only 1.5 percent. Despite this tremendous monetary expansion, euro area inflation remains below the two percent target. This raises the question of whether the quantity equation, which Mark Blaug called “the oldest surviving theory in economics,” is still valid.
The quantity equation was formulated by Irving Fisher (1867-1947) based on the thoughts of John Locke, David Hume, John Stuart Mill and Simon Newcomb. In its most common form of (M * V = P * Y), it states that the amount of money M multiplied by the velocity of money V is equal to the real gross domestic product Y (i.e. all goods and services produced) multiplied by their prices P. The velocity of money indicates how often a unit of money is used in a period (usually one year) to carry out a transaction.
Milton Friedman deduced from the quantity equation the monetarist inflation theory that regards inflation as “always and everywhere a monetary phenomenon.” In the 1970s, inflation could indeed be predicted well with the growth of money supply. Therefore in 1999, the ECB calculated a reference value for money growth (M3) of 4.5 percent based on an inflation target of 2 percent, while assuming an average real growth rate of 2 percent and a decline in the velocity of money of 0.5 percent per year.
However, the link between money growth and consumer prices inflation seems to have already collapsed in the 1990s. In the euro area, money growth M3 grew by an average of 7.5 percent per annum between 1999 and 2007, well above the reference value of 4.5 percent, although inflation was close to the target value of 2 percent. The volume of the balance sheet of the ECB, the basis for the growth of money, has risen by an incredible 525 percent since January 1999, whereas the real domestic product is only up by 31 percent and the consumer price index (with which inflation is measured) has risen only by 36 percent.
There are two explanations for the discrepancy. From the point of view of modern dynamic general equilibrium models (in contrast to the assumption of Friedman), money is unstable and therefore redundant for stabilizing inflation. Central banks can keep inflation low with interest rate changes and the clear communication of their inflation targets. Low inflation rates in the industrialized countries since the mid-1980s seem to confirm the success of this strategy.
Alternatively, inflation has changed its face. The reason is that the low-cost liquidity issued by central banks has pushed up the prices of shares, real estate, gold, commodities and bitcoins, etc. in wild cycles (see Figure). For example, the German stock index DAX has risen by 160 percent since the start of the ECB’s monetary policy rescue operations in 2008. In Germany’s major cities, real estate prices are rising steeply. Similarly, government expenditures have grown rapidly without the quality of public services perceptibly having improved. Before the crisis, similar phenomena were observed in Southern Europe.
Development of Stock and Consumer Prices in G3 Countries
Source: IFS and OECD. Arithmetic averages for the US, Japan and Germany. After 1999 the CPI index for the euro area replaces Germany.
However, this type of “non-measured” or “hidden” inflation receives little attention from the central bankers. The ECB ignores exploding costs for public construction projects or financial market regulation. It covers in its harmonized consumer price index the regulated rents but not the sharp rise in real estate prices. Stock prices are not subject to measurement of inflation either. Central bankers insist that prices on the financial and property markets are outside their responsibility. Instead, regulators are expected to keep the asset prices in check and governments are admonished to keep expenditures under control.
Why the transmission of the monetary policy has changed can only be speculated. Inflation targets should prevent central banks from acting in favor of partial interests. The origin is that in the 1970s, the belief prevailed that inflation could promote growth and reduce unemployment by reducing real wages. But the trade unions responded to rising inflation with higher wage demands. At the end of the resulting wage-price spirals were stagnation, high unemployment and socially undesirable distribution effects.
The inflation targets as monetary policy rules should put an end to such excesses. However, according to Charles Goodhart, the introduction of a rule can lead to the collapse of the structural relationship on which the rule is based. In this case, the link between the growth of money and consumer price inflation has collapsed. The possible reason is that private financial institutions were able to generate speculative profits by redirecting the liquidity generated by the central banks into the financial and real estate markets.
If the cheap money issued by central banks would have been funneled into the goods markets as in the 1970s, an inflation rate above target would have forced central banks to tighten monetary policy. However, as liquidity was transmitted into the financial markets, the rule for the limitation of monetary growth was circumvented. The resulting financial market booms sparked the profits and bonuses among bankers. The financial crises that followed were confined by the central banks to the delight of the financial markets with even more cheap money. Being flushed by huge amounts of cheap money, the monetary policy was a paradise for bankers and hedge fund managers.
Meanwhile, the tide has turned. Many banks with a traditional business model suffer from the very expansive monetary policies because the spread between credit and deposits interest rates is depressed. Investment companies are faced with high risk because of high volatility in asset markets. Since financial crises have raised public debt to a record level in many countries, the central banks have to keep interest rates low by the extensive purchases of government bonds. Otherwise, many countries would have to default. This implies growing pressure from governments on central banks to keep monetary conditions loose.
The upshot is that anemic growth and low real wage increases, which were previously attributed to consumer price inflation, have also spread without consumer price inflation. The distribution effects of the ultra-expansive monetary policies in favor of the rich weaken the purchasing power of the middle class, the purchasing behavior that is modelled by the central bank’s consumer price indices. Rising prices for luxury goods, stocks, real estate and public goods, which indicate the dramatic improvement of the purchasing power of the rich, remain outside official measurement of inflation.
This shows one thing in particular. The link between money growth and inflation would still hold if inflation was measured with a broader index. However, this does not seem to be politically desirable, so that the inflation targets have more and more served to conceal monetary policy, which finances over-indebted governments.