In a 1984 advertising campaign, Wendy’s Hamburgers featured the character actress Clara Peller. Clara peers disappointedly at a burger from a rival chain that, while well stocked with bread, has remarkably little meat. Her rallying cry: Where’s the beef? was taken up as a political slogan by Vice Presidential Candidate Walter Mondale and it captured the imagination of a generation.
Today, as we stare at a Fed balance sheet of $4.5 trillion and rates of price change at or below 2% one can envisage a millennial Clara Peller metaphorically peering at a bloated Fed balance sheet and pleading; Where’s the inflation?
In a 2009 review of Akerlof and Shiller’s book, ‘Animal Spirits’, Greg Hill pointed out that I made the following claim: “History has taught that a massive expansion of liquidity will lead to inflation”. My review was designed to be critical of slavish applications of 1950s Keynesian remedies to twenty-first century problems. I stand by that critique. There is a reason we rejected Keynesian economics in the 1970s. It didn’t work the way it was supposed to. In particular, Keynesian economics had nothing to say about the most important economic issue of the 1960s and 1970s: the simultaneous appearance of inflation and unemployment for which the British politician, Ian Macleod coined the term ‘stagflation’.
In the 1960s, the U.S. government borrowed to pay for the Vietnam war, and rather than raise politically unpopular taxes, it paid for new military expenditures by printing money. Milton Friedman pointed out correctly, that printing money would eventually lead to inflation. If printing money leads to inflation, why has a more than fivefold expansion of the Fed balance sheet, from $800 million in 2006 to $4,500 million in 2017, not been accompanied by an increase in prices?
Modern theories of inflation are based on Milton Friedman’s celebrated restatement of the quantity theory of money. (Aside: If you are a student of macroeconomics and you have not read Friedman’s essay; you are being short-changed by your professor). Friedman was building on the earlier work of quantity theorists (see for example, Hume’s essay; Of Money) who built a theory of inflation around the definition of the velocity of circulation, v, as the ratio of nominal GDP to the stock of money:
(1) v = (P x Y)/M
Here, P is a price index, Y is real GDP and M is the quantity of money. According to the Quantity Theory of Money, Y is equal to potential GDP, Y*
(2) Y = Y*
and v is constant. If Y is growing at the growth rate of potential GDP and if v is a constant then the rate of price inflation is, mechanically, equal to the rate of money creation minus the growth rate of potential GDP. It was that fact that led Friedman to proclaim that “inflation is always and everywhere a monetary phenomenon”. But what if the velocity of circulation is not a constant?
Friedman’s restatement of the quantity theory of money improved over earlier versions of the quantity theory by recognizing formally that the velocity of circulation is a function of a spectrum of interest rates on alternative assets. In its simplest form, Friedman’s restatement implies that money is like a hot potato that is passed from hand to hand more quickly when the interest rate increases.
Figure 1 plots the velocity of circulation on the horizontal axis against the interest rate on three month treasuries on the vertical axis. This graph is upward sloping as long as the interest rate is positive. It is horizontal when the interest rate is zero, a feature that Keynes referred to as ‘the liquidity trap’.
The graph of velocity against the interest rate flattens out as the interest rate approaches zero because at zero rates, money and bonds become perfect substitutes. Like a glutton who has eaten so much he cannot stomach one more hamburger, at zero interest rates people are satiated with liquidity and have no further use for cash for day-to-day transactions. If the Fed buys T-bills and replaces them with dollar bills people will be content to hold the extra cash rather than spend it. This observation leads me to remark that what I should have said in my 2009 review of Akerlof and Shiller was that: “History has taught that a massive expansion of liquidity will lead to inflation: [except when the interest rate is zero]”.
A final word of caution. When reserves of private banks at the Fed pay interest, as they do now, the opportunity cost of holding money is not the T-bill rate. It is the T-bill rate minus the reserve rate. If the Fed raises the interest rate and continues to pay interest on excess reserves, the connection between velocity and the interest rate will remain permanently broken. In that case, the graph that I plotted in Figure 1 will not continue to characterize future data, even if the T-bill rate increases above zero. I wrote about that issue here where I pointed out that the impact of monetary tightening on inflation will depend very much on how central banks tighten. Stay tuned to this spot and don’t trust your favourite interpreter of the doctrine of Keynes. When the Keynesian prophets call for more of the same without explaining why their policies failed us in the great stagflation; take your cue from Clara Peller and ask them loudly: Where’s the beef?