Home > Macro/Monetary Theory > Is it Dedication to High or Low Inflation Which Leads to Communism?

Is it Dedication to High or Low Inflation Which Leads to Communism?

Nick Rowe has a post about the line between fiscal and monetary policy which largely reflects my sense of the matter which essentially is that the line is not very clear.  However, this part was the opposite of how I see it (sort of).

Too dedicated a pursuit of low inflation and the optimum quantity of money leads to communism, with government ownership of everything.

Also Scott Sumner echoed the same sentiment.  Since both of those guys are “at least as smart” as I am and have been at this a bit longer, this has got my wheels turning trying to reconcile their conclusion with my own and I think it raises several important points about the way I am thinking about this thing relative to them (and probably nearly everyone else).

First, I apparently don’t know what Sumner (and probably nearly everyone else) actually means when they say “fiscal policy” since I recently said something to the effect of: clearly a helicopter drop is monetary policy, but then in the comments, Sumner says this.

I’m strongly opposed to helicopter drops. I favor monetary stimulus when NGDP is too low. There is never any need for fiscal stimulus, even at the zero bound, and a helicopter drop is fiscal stimulus. It is wasteful and inefficient.

So I’m not sure where Scott’s line is.  To me, if the central bank printed money and dropped it from a helicopter, it would increase the supply of base money and this would be monetary policy.  Perhaps Scott is thinking that the government “borrows” from the central bank and then drops the money (or whatever they do with it), and so this increases the deficit and this makes it fiscal policy which may or may not then be offset by some monetary policy.  If that is the case, it is just a matter of who we are imagining doing the “dropping.”  To me this is splitting hairs, and not that important (which is basically the point of Nick’s post).   This post also deals with helicopter drops.

On a side note, I am not sure why Sumner objects on the grounds of inefficiency.  It can’t be a matter of changing the income distribution since he is such a bloody utilitarian after all.  This got me very puzzled so I went on his blog and looked for posts about helicopter drops and found this one which raises two possibilities for inefficiency.  One is based on the expectation that the government will someday raise taxes to pay off the money it dropped.  This also explains why it counts a fiscal policy.  The other is that it may cause peoples’ expectations about inflation to become unhinged and cause hyperinflation.

But that’s not really what I am interested in.  I’m not arguing for helicopter drops.  I’m trying to get at why we are at the ZLB in the first place and how monetary policy relates to the central bank ultimately owning stuff.  And I think this helps bring things into focus.

But if the Fed did accompany the drop with an explicit price level target, then the optimal helicopter drop would be less than zero.  Indeed if the Fed committed to say 4% inflation, the public would not want to hold even the current $2 trillion in base money (unless they were paid to do so with an interest on reserve program.)

That makes perfect sense.  If you hold the money supply constant, and increase expected inflation, people will want to hold fewer dollars at the current price level and so they will try to get rid of them by spending them which will drive up the price level.   Or at least this is how you would see it if you take the money supply as exogenous.

If you take nominal rates as exogenous, then an increase in inflation expectations, holding the nominal rate constant, will lower the real interest rate which will cause people to borrow more in order to buy stuff (both investment and consumption).  This drives up the price level and increases the money supply.  However, the interest rate regime can mimic the outcome in the money supply regime by raising the nominal rate to the point that the money supply doesn’t change.  Similarly, the money supply regime could expand the money supply until the nominal rate remained unchanged (or either of them could do something in between….or not in between for that matter).  That is not the important difference.

Either way you want to think about it, you have a tradeoff between the size of the money supply that is required to maintain a given price level and the expected rate of inflation.   If you are trying to hit a certain price level in the very short run, you can get there with a smaller money supply if people expect higher inflation in the longer run.  This seems to be the tradeoff between tight money and socialism that Nick and Scott have in mind and it is perfectly valid at any given point in time.  This instantaneous effect can be seen in my model as well (I’m pretty sure, although I can’t verify it right now due to technical difficulties…)

So essentially I have no argument with the way monetary policy functions in the short run.  My issue is about whether there is a stable long-run equilibrium.  This is where the relationship between money and debt becomes important.  If you think that money just floats around and has value solely because everyone believes that everyone else will always be willing to trade for it, then you imagine a demand for real money balances which depends only on the interest rate and output.  So if you can raise inflation, you can raise interest rates along with it and this will put you on a path where the desired money holdings will be smaller relative to the nominal value of output at all times.  Or in other words, the money supply will be higher but prices will be more higher and so the size of the central bank’s balance sheet in real terms will be smaller.

The point I am trying to make is that there is a sort of financial position that the economy gets into vis-a-vis the central bank when the central bank expands the money supply by expanding credit.  When they do this, they are essentially increasing the money supply by convincing people to lever up.  This can be done by either offering a lower nominal rate or convincing them that prices will be higher in the future.  Either one lowers the real rate of interest and makes it more attractive to go deeper into debt.  But this is not just more money floating around, it is more money and more debt which means that the public’s claim on the total money supply actually diminishes.

As an individual borrower, this works out fine as long as the central bank produces the anticipated inflation (0r more).  Then your income increases enough to repay the loans as expected and everybody wins.  But if everybody tried to repay their debts, the money supply would shrink which would mean that prices wouldn’t go up as anticipated.  So the central bank has to keep this from happening.  This means that they get into a pattern of perpetually lowering interest rates to further increase the money supply by increasing leverage and eroding the financial position of the overall economy.

Then one day they fail to produce the expected inflation, maybe because they hit the ZLB or maybe because they made a mistake, or maybe because people saw the ZLB coming and acted preemptively, or whatever and everything falls apart.  The reason it falls apart is because of the financial position of the economy.  It isn’t just that everyone suddenly thinks prices will only rise 1% instead of 2% so they start “hoarding” cash balances because the extra liquidity becames attractive at the lower inflation rate and this creates a death spiral (which is only “deathy” because prices can’t adjust fast enough to keep people from being laid off and output from falling).

It is that they think prices will only rise 1% instead of 2% and they took on a bunch of debt in anticipation of their income rising 2% which they now become concerned that they won’t be able to repay.  They start “hoarding cash” to repay the debts.  If they don’t, they will go bankrupt and lose real goods.  Since everyone else is in the same situation, everyone tries to grab the existing cash and pay off debts which causes the money supply to contract and prices to fall further until some combination of things restores the financial position of the economy to a point from which it can continue onward.

These things include:

1. Defaults.  This destroys debt without “destroying” money, which increases the ratio of money to debt.

2.  “Fiscal policy.”  This keeps the debt growing but it puts it on the government, so it can be done coercively (it doesn’t have to be individually rational).  This puts more money in circulation without increasing private debt.

3.  “Unconventional” monetary policy.  For instance a “monetary helicopter drop” by which I mean the central bank dropping money into the economy (a “fiscal helicopter drop” would then be when the government borrows money and drops it, in which case see number 2 above).  Or the central bank buying junk off of banks’ books for more than it is worth (this has some element of number 1 involved) or “adding zeroes” to their accounts, or buying up goods and services (rather than debt).  All of this will inject more money into the economy without increasing debt.  (We can throw dividends paid by the central bank into this category.)

So my point is that you can’t have what I would call a “long-run expansionary monetary policy” based purely on expanding credit.  You will need some combination of the above three things to keep the financial position of the economy on a sustainable path or to bring it back to such a path if it drifts away (as it is bound to do if you try to avoid those things for any extended period).

So in my model, it is not just about the willingness to hold cash balances, it is about the willingness to hold cash (or I would say “money” to include all balances denominated in dollars, or whatever) balances and the willingness to hold debt.  So to me the tradeoff between expansionary monetary policy and “socialism” is not just about how big the central bank’s balance sheet will have to be relative to the nominal value of output in a stable long-run equilibrium.  It is about how much of number 2 and 3 you would need relative to the value of output in a stable long-run equilibrium.  And I suspect that the more “expansionary” (the higher the intended rate of inflation), the more of this you will need in order to keep it from crashing.

Unfortunately, because of the previously mentioned technical difficulties, I  can’t show this in the context of the model at the moment.  But notice that there would be no such “socialism” necessary if there were no central bank in the first place and the money supply consisted of an exogenously determined quantity of some commodity like gold or silver.  In that case, there would almost certainly be some amount of deflation as the quantity of that commodity would most likely grow more slowly than output. (Or a better way of putting it: the rate of return on holding that commodity would have to be equal to the real rate of interest minus the liquidity premium and this would most likely be positive.  The selection of commodities which increase in quantity relatively slowly compared to output as money would happen endogenously.)

In this case, the private (excluding the central bank but not necessarily the government) claim on the money supply would always remain at 100%.  It is the adoption of a central bank which promises to create inflation by growing the money supply (by increasing credit/debt) which creates the gap between the money supply and the monetary wealth in the economy which has to be filled by some kind of non-credit injection of money or else closed by a wave of defaults.

Similarly, if the central bank just kept the rate of inflation (deflation) and the nominal interest rate equal to what they would be if it didn’t exist, it would do nothing, credit would not expand, the financial situation of the economy would not be eroded in any way and no “socialism” would be necessary.  It becomes necessary when they endeavor to expand the money supply by expanding credit.  The more inflation they want to create, the more they will have to do this and the more they will erode the financial condition of the economy in the absence of the three things mentioned above.  Or in other words, the more they will have to do those things to keep it going.  Or in still other words,  too dedicated a pursuit of high inflation and the optimal quantity of money leads to communism with the government owning everything.

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  1. August 1, 2014 at 1:17 pm

    Assume the central bank issues only currency, which pays 0% nominal interest. So the opportunity cost of holding currency, which is the difference between the interest rate paid on other assets (like bonds) and the interest rate paid on currency, is simply the nominal interest rate. The higher the nominal interest rate, the smaller the quantity of currency demanded, other things equal.

    Assume the demand for currency (M), for a given nominal interest rate, is proportional to NGDP. So M/NGDP is a negative function of the nominal interest rate.

    Assume that in long run equilibrium, higher inflation causes higher nominal interest rates. That means a fall in inflation causes higher M/NGDP.

    Assume the central bank holds assets A equal to the value of currency M. So the lower is inflation, the higher is A/NGDP. And assume the central bank is owned by the government, so the government owns the central bank’s assets.

    In the limit, as inflation and nominal interest rates get lower and lower, people would rather hold central bank currency than any other asset. A/NGDP gets higher and higher, until the government owns all the assets in the economy. (I rent my car and house from the central bank, and hold all my wealth in currency.) That’s communism.

    • Free Radical
      August 3, 2014 at 7:09 pm

      Nick,

      Yes, I think I understand the argument, that is what I was trying to indicate here.

      ” If you think that money just floats around and has value solely because everyone believes that everyone else will always be willing to trade for it, then you imagine a demand for real money balances which depends only on the interest rate and output. So if you can raise inflation, you can raise interest rates along with it and this will put you on a path where the desired money holdings will be smaller relative to the nominal value of output at all times. Or in other words, the money supply will be higher but prices will be more higher and so the size of the central bank’s balance sheet in real terms will be smaller.”

      But that is why I think that is not a fully satisfactory way to think about money. I am trying to draw a distinction between monetary policy that works by expanding credit and monetary policy that works by expanding the money supply without expanding credit. It is the latter that I am treating as “socialism” but I am trying to argue that the former creates a need for the latter and the more inflation you try to create, the more you will need. But I think it’s impossible to see in the context of a money supply which is entirely detached from debt.

  2. Tom Brown
    August 4, 2014 at 3:11 pm
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