Returning “money” to “economy”: Dan’s response …

Over at National Review, Dan McLaughlin considers why inflation is particularly difficult for Democrats. His article contains some interesting observations on how biased incentive policy forms decisions. In the case of money and inflation, however, McLaughlin misunderstands this: the four processes he discusses are not really about monetary policy.

McLaughlin began by promising: “When there is a lot of money behind very few products and services, the prices of goods and services go up.” I agree that this is the right place to start. Demand and supply are both issues. For the overall demand, the obvious culprit is monetary policy. For the overall supply, it is a combination of misguided regulatory policies and unfortunate global events – the chronic epidemic, the war in Ukraine – that makes production difficult in general. In this case, the available data strongly suggest liquidity, and so the money is in the driver’s seat.

This is where McLaughlin gets off-track. He’s just zeroing in on financial reasons. But then he presented four ways to “reduce the money supply”. Here they are:

1. Reducing public spending, so the government is injecting less money into the economy.
2. Raise interest rates, which puts recessionary pressure on the economy.
3. Tax increase Except Increasing spending, so the government is raising more money from the economy.
4. Encourage a shift from cost to savings, which reduces the amount of money behind products and services.

In fact, none of this is about monetary policy! Of the four, “raising interest rates” comes the closest, but it is also fundamentally misunderstood how monetary policy works.

The first point is about monetary policy. Government spending does not inject money into the economy. It is not monetary policy because it does not change the money supply. Instead, fiscal policy redirects the flow of expenditure. Since government spending is ineffective in expanding overall demand, its stimulus effect is low.

Point two seems to be about monetary policy. Economists and financial journalists talk about “raising” or “lowering” the Fed’s interest rates. They are all wrong. The interest rate in question, the federal funds rate, is set in the market for overnight bank loans. The Fed may influence this rate through open market operations or adjust the rate on deposits. It’s not Set Federal funding rate. The rate of federal funding is a goal, not an instrument. Do not confuse the car speedometer. Considering the rate of federal funds as a policy lever does more harm than good. About monetary policy MoneyNot the interest rate.

The error of point three is the same as one point. The government does not raise money from the economy when it raises taxes. Uncle Sam spends tax revenue on public spending, public investment, and interest on national debt. The purchasing power that exists in the economy is redirected from the spending path that was taken into private hands. If the government collects tax money and destroys it, then the money supply will be reduced. Taxes have other bad consequences, of course, such as discouraging employment and investment. But that too is not about monetary policy.

Points combine four points one and three to make mistakes. Savings reduce costs, but not financing or total spending. When we save, we keep our money in a bank deposit account or in a brokerage account with investment firms. They spend money on goods, services and resources. By saving, we redirect resources from cost to investment. Financial intermediaries help us to do this by connecting the surplus capital (business) with the surplus suppliers (family) of capital. Savings only shrink money supply if savers take money out of circulation এটি for example, stuff it in their mattress or bury it in their backyard. But it is so rare that its impact on the financing is negligible.

There is a way to recover parts of McLaughlin’s analysis. If the central bank fills the government’s deficit by buying bonds, the expansionary fiscal policy will push up prices. McLaughlin noted the tremendous increase in spending after the initial wave of covid. But in his view, government spending is direct. “[put] More money in the system. “This is wrong. The money in the system is what the Fed bought new bonds that financed this expenditure. If the Fed had not adjusted the revenue expansion, the revenue expansion would not have caused inflation. No – everything is working.

Despite his mistakes, McLaughlin’s conclusion seems to be correct: Democrats are uniquely vulnerable to public outrage over inflation. That’s because the Democrats are basically a simple money party. How many proponents of modern monetary theory have been Republicans? With pressure from central bankers, both formally and informally, to care more about climate change and social justice than monetary policy, Democrats sowed the seeds of the worst inflation in 40 years.

Inflation is a “complex problem,” as McLaughlin admits. And economists on both sides of the political spectrum should acknowledge their mistakes over the past two years. But the way we fix things is to carefully diagnose demand-side and supply-side issues. When the demand comes, we are talking about the activity of the central bank. Unfortunately, none of McLaughlin’s four points are in the ballpark.