Mankiw's 9th principle


Theory v facts


© Christian Müller 2017

    ... a scientist must also be absolutely like a child. If he sees a thing, he must say he sees it, whether it was what he thought he was going to see or not. See first, think later, then test. But always see first. Otherwise you will only see what you were expecting.
Wonko the Sane
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Putting it (too) simple

To call Nicholas Gregory Mankiw well-known is anything but a gross understatement of his popularity with professional academics and undergraduate students alike. For many of the latter, his best-selling textbook «Principles of Economics» is the first and sometimes also the last and closest approach to structured economic thinking they will ever encounter. Therefore, his influence on the thinking of what we may call lay economic experts cannot be underestimated.
    One of the many appealing features of Mankiw's textbook is the structuring of economics into ten easy-to-remember principles. Among them the ninth principle deals with the causes of inflation and goes as follows:  

Prices rise when the government prints too much money.

Mankiw (2014, p. 11)
    Mankiw further claims that in «almost all cases of high or persistent inflation, the culprit turns out to be the same - growth in the quantity of money.» (ibd.). Although this accusation is probably very widely accepted, it is nevertheless insightful to study it in more detail. In fact, it turns out that the ninth principle might better be re-phrased in order to more accurately reflect actual economic relationships.  

What Sargent supposedly said

To begin, let us take stock of how Mankiw supports this ninth principle. The first three versions of the textbook (the first edition, the special edition – the one that deals with the financial crisis – and the second edition) substantiate the principle by the hyperinflation examples of Germany, Hungary, Poland and Austria in the 1920s. Referring to an article by Sargent, 1982 «proves» the principle by means of illustration (Mankiw, 2011, p. 649f.)
    A closer inspection of Sargent’s (1982) paper shows, however, that Sargent stresses that all four countries «ran enormous budget deficits on current account» (Sargent, 1982, p. 43). Their currencies were not «backed» by the gold standard but «by the commitment of the government to levy taxes in sufficient amounts, given its expenditures, to make good on its debt» (Sargent, 1982, p. 45). Importantly, all four countries found themselves at the losers' side of the first World War which severely impaired their opportunities «to make good» on their debts. Germany, moreover, experienced a revolution after the war and its post-revolutionary moderate Socialist government «reached accommodations with centrers of military and industrial power of the pre-war regime. These accommodations in effect undermined the willingness and capability of the government to meet its admittedly staggering revenue needs through explicit taxation», Sargent (1982, p. 73) reports.  
    The final blow to the German government's illusion of fiscal sobriety was dealt by France when it occupied the Ruhr in January 1923. In response, the German government tried to stir passive resistance by «making direct payments to striking workers which were financed by discounting treasury bills with the Reichsbank» (Sargent, 1982, p. 73). At that time, the German Reichsbank was not yet independent and the government resorted to its central bank for financing its debt by issuing more money. However, due to the apparent impossibility «to make good on its debt» people naturally lost confidence in money. With newly printed money being ever less trustworthy the government had to make up for the loss of quality by issuing ever more quantity.  

What Sargent really said

Consequently and in striking contrast to Mankiw's ninth principle, Sargent (1982, p. 73) asserts that after «World War I, Germany owed staggering reparations to the Allied countries. This fact dominated Germany's public finance from 1919 until 1923 and was a most important force for hyperinflation.» (emphasis added). In other words, Sargent (1982) does not consider money growth as the main culprit behind the hyperinflation in Germany that Mankiw quotes in support for the general principle that money growth causes inflation.
    Rather, money growth must be viewed as a result of inflation which was triggered by the loss in trust in government finances and hence the rise in inflation which caused the money stock to increase. The government's demand for money rocketed as inflation took off. This causality is also reflected in Sargent’s statistics. While the price level started to double every month as early as July 1922, notes in circulation and treasury bills grew by only 12 percent at that time and reached 76 percent (treasury bills) in December 1922. Throughout the hyperinflation period, not only accelerated the rate of inflation way before the rate of money expansion, it also always exceeded money growth by a factor of roughly five (Sargent, 1982, p. 82). Thus, the causal order of how hyperinflation emerged is also born out by the empirical facts.  
    If it was not for the government's printing of money, how can we still make sense of the apparent and striking relation between (hyper)inflation and money growth? «Trust» may yield the appropriate answer.  

What the heck is money?

In order to understand this, one should first notice that money is an institution. This is because it only works as a set of rules followed by humans.1 Without these rules about accepting and valuing money there is no money. Second, money always solves the well-known problem of double coincidences in exchange. This problem arises because in exchange the offer of one party has to be met by a matching demand at the same time. Put simply, if a producer of cotton wants to exchange cotton against milk, the cotton producer has, in principle, to find a farmer who has a surplus of milk and concurrently is in need of cotton.
    Money does greatly simplify this exchange by allowing the cotton producer to sell his product for money and find someone who accepts the money in exchange for milk without time pressure.2 The most interesting part of this exchange story now rests with the fact the the cotton seller has enough confidence in the worth of the money that he accepts it as a compensation for his hard-laboured product. Therefore, the key question is why is he so confident?  
    The answer to this question can be given by interpreting money in institutional terms. The institution that matters most for money is the one that justifies the confidence in accepting money as an intermediate means of exchange.  
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1 In the words of Aristoteles: «To others, in turn, money is a nonsense and a pure legal fiction, in no way given by nature» (Aristoteles, 1971, p. 80) and further «So it is due to an agreement that money has become a substitute of the need.» (Aristoteles, 1971, p. 164, author's translations from German to English)
2 Aristoteles (1951, p. 164) observes: «For a future exchange [...], money is, in a manner of speaking, a bailer [...]» (author's translation from German to English)
    © Christian Müller 2017  
    Jacobs University Bremen