Forget What You Know About The Quantity Theory of Money
April 13, 2008 - 7:40pm — Mike
I'm sure when people imagine the professional world of economics, they envision stout white men with male pattern baldness, sitting in a room jabbering about the Nikkei and suppressing the proletariat.
In actuality, it's more like a grown up version of the real world - cliques, disses and hookups are more common than people think. Like Coral was the real world roommate you love to hate, the "Real Bills Doctrine", the theory about the value of money and the cause of real inflation has been the whipping boy of the economics world for years.
Henry Thornton (1801), David Ricardo (1810) and Lloyd Mints (1945), espousers of the widely accepted "Quantity Theory of Money" and critics of the Real Bills Doctrine are the cast members that will stop at nothing to drive their pariah housemate into economic obscurity. However T.R.B.D. has the advantage of logic on its side.
For those who don't know, the Quantity Theory of money says that Currency as we know it only has value as a means of exchange and when you boil it down an American dollar is inherently worthless (See Fiat Money). Hence any creation of money, no matter the circumstances is inflationary.
M x V = P x T
The equation above is the backbone of the Q-theory. It stands for the quantity of money in circulation, multiplied by the velocity (the number of transactions in which the currency is used) is equal to the nominal price level multiplied by the aggregate real value of goods and services used in exchanges.
This is a tautology tantamount to " the rain that falls from the sky is the rain that hits the ground." There is no causal link in this model between the creation of money and inflation, it is just assumed that any creation of money is inflationary.
The conceit in this is that the types of money used to calculate inflation (M1 and M2) are just a portion of the money that is created in North America every day. Credit cards, food stamps, coupons, IOU's and sometimes even specially designed store currencies(Canadian tire dollars anyone?) exist and are exchanged for goods of real value, yet we don't have a huge unexplained jump in inflation due to the creation and use of these currencies.
How can this be while the quantity theory of money holds true? According to the Q-theory all of this currency creation should be incredibly inflationary and yet to date it remains ignored. Where the Q-theory of money fails the Real Bills Doctrine picks up.
In a nutshell, the Real Bills Doctrine says: Money created in exchange for "Real Bills" is not inflationary. Or, to put it another way, if you were to go to the US Mint and say "here is 100USD worth of gold" and they printed you 100USD, the creation of this money would not be inflationary. Why? Because the creation of money moved in step with the amount of assets under lock and key.
So you see, money that is backed by assets has worth because of the real value of the underlying assets. Doesn't that make more sense than magic worthless money that is somehow valuable because unconsciously we all agree that it's useful? There is no such thing as Fiat money.
Inflation happens when the underlying assets are destroyed or devalued. If a crazy US Mint employee destroyed half of the gold you gave for your printed money, there would only be 50USD worth of gold laying claim to 100 US paper dollars, hence the purchasing power of the paper dollars would be halved. Isn't that simple?
I've attached the paper that brought me to this school of thinking and it explains T.R.B.D. much more elegantly than I can. Most convincing are the historical examples that Sproul draws upon. I assure you if you read and digest it, it becomes very difficult not to see the logic staring you in the face.
