Modern Money and Inflation

Milton Friedman was a powerful magician. His words charmed people into believing that night was day, against the evidence of their own eyes. Friedman’s maxim that “inflation is everywhere and always a monetary phenomenon” is widely believed by economists, even though it is abundantly obvious that costs of production, especially energy costs, play a major role in creating inflation.

Pinochet meets Friedman (STF/AFP/Getty Images)

Today, inflation is soaring around the globe. Economists under the spell of Friedman search for, and find, monetary causes. Central Banks around the world pursued vastly expansionary monetary policies to combat the Great Recession which followed the Global Financial Crisis of 2007. To the great surprise of many top-ranked economists, there was no inflationary impact. Emboldened by this experience, Central Banks again poured money into a stuttering economy during the COVID era. Again, inflation did not respond. But now, after the end of all this monetary expansion, high inflation has suddenly hit. Since Friedmanites believe that inflation must have monetary causes, they are forced to think that the fifteen years of monetary expansion since 2008 suddenly caused soaring inflation in 2022.

If we open our eyes to global events, we can find much more obvious sources for the current inflation. The COVID crisis led to the collapse of global supply chains. As global economies recovered, and demand increased to pre-COVID levels, producers found it necessary to turn to alternative, more expensive, suppliers. USA’s intensifying trade wars with China have increased costs of production in both countries. Soaring energy prices in Europe due to the Ukraine War have crippled industry and led to massive price increases USA, Europe, and China are the three largest economies that produce more than 60% of global output. None of these factors have anything to do with the money supply or interest rates. A policy lesson for Pakistan would be to put maximum priority on developing indigenous alternatives for energy production. Not only would this counter imported inflation, but it would also combat climate change which has had disastrous impact in the form of floods.

We will conclude this article by discussing some simple economic theory, which continues to baffle Friedmanites. Friedman’s views are based on a very simple idea of classical economics. Given a fixed amount of goods, if we double the amount of money in the economy, then prices will also double. Keynes observed that this did not hold during the Great Depression, when the production levels were very low relative to what they could be. He noted that pouring money into the economy would lead to increased production. If we double the goods and double the money, then no inflation would result. Friedmanites (monetarists) reject this basic Keynesian idea. They argue that inflow of money does not lead to increased production, so inflation will result from the increased money supply. Empirical experience strongly supports Keynes against Friedman. In contrast to monetarists, Modern Monetary Theory (MMT) builds upon, and sharpens, this Keynesian insight, as we discuss below.

Historical experience showed that expansion of money supply by the Central Bank did not necessarily reach the sectors of the economy where there was high unemployment. Instead, the money might flow into sectors operating at full capacity and cause inflation, contrary to Keynesian views. This phenomenon was termed “stagflation” – unemployment together with inflation. MMT suggests that money should be targeted at unemployment, to prevent this from happening. The key policy recommendation of MMT is a Job Guarantee Program. The most valuable unemployed resource in an economy is the labor. If we spend money on providing a productive job to an unemployed laborer, then the increase in money will automatically be offset by the increase in production. More money combined with more output will not lead to inflation. Job Guarantee programs have been successfully tried in Argentina, India, Sweden, Ethiopia, China, Tunisia, and many other countries. Crafting an effective Job Guarantee program requires ensuring that Central Bank-created money goes to productive labor, not to idle consumers who will increase demand without increasing production. Our youth is the most valuable resource Pakistan has. The most important challenge facing our policymakers is to apply MMT to provide all of them with productive jobs.

Above article was published in DAWN on Nov 12, 2022:     

For related articles, see Class-Conflict Theory of Inflation and The Veil of Money

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