Mankiw's 9th principle


Theory v facts


© Christian Müller 2017


page 2

«home   Historically, money has assumed many guises such as gold and precious metals in general, pearls, stones, cigarettes, coins and notes and so on. It is tempting to label money according to these phenomenological attributes as metallic money, paper money or commodity money. These labels do, however, veil the fact that the crucial difference between any types of money lies with the institutions that justify the confidence in using money in the first place.  
    Let us consider gold, for example. Gold seems to be a «natural» choice for money because it serves most money functions very well. However, underlying the «value» that gold is associated with is a cultural institution that assigns this value. Cultures across the globe hold gold in high regard and this respect which is based on a culturally determined set of rules is what gold qualifies as money.3  
    But what is this «quality»? The essential quality is that any owner of gold can trust in anyone else to also share in the high regard for gold. This property even goes as far as being able to rely on the «value» of gold even if oneself, individually, does not have any respect for it. In fact, it is sufficient to believe, or better trust in anybody else holding gold in high regard to also accept and use gold as money.  
    A situation in which there is trust in money must hence be distinguished from a situation when there is no trust in money. For simplicity, let us assume that in the latter case, there is no money at all. The situation without trust in money is obviously associated with considerable uncertainty with respect to the outcome of the production and exchange process. This uncertainty arises because it is very difficult to gauge the eventual proceeds (if any) from producing and selling one's goods due to the necessity of the double coincidence. In contrast, money dissolves the need for the double coincidence which simplifies and eventually facilitates the exchange.  
    However, when accepting money with the intent to satisfy own needs the money holder depends on the confidence the potential seller has in that the money will serve him too, or in other words, that those third parties also trust in money.  
    Inflation can now be understood as a phenomenon that has its roots in the deterioration of trust. Trust can be diminished by pretty much everything that shakes the institutions which generate the confidence in money. Therefore, government crisis as well as strikes or the abuse of monopoly power can result in inflation. Printing too much money also has the potential to destroy the confidence in money. In contrast to the monetarist view, however, money «supply» is just one factor that affects the trust one has in the relevant institutions.  
    This observation is an accurate copy of the earlier statement that it is those who accept money who decide about its worth. Returning to Sargent's examples, we can now see that without the prospect of the money (Sargent, 1982, «unbacked of backed only by treasury bills”, p. 89f) being honoured by the government through taxation, there was no reason to believe that prospective business partners would accept it as a means of payment.  
    Therefore, and in contrast to Sargent's claims, one has to concede that it neither was the «the growth of fiat currency» nor the «increasing quantity of central bank notes» (alone) which caused inflation. Rather, the inflation was caused by the fast deterioration in the trust of money due to the apparent inability of the government to match its promises which were manifested as newly issued money with future revenues. It was this bleak prospect about the usefulness of the money which eventually created inflation.  
    According to the lessons from Sargent's examples as well as from the principle considerations, money as trust implies that the initial trigger for inflation will always be some impairment of the belief in the respective money's ability to satisfy needs. And in fact, wars, corruption and grave economic mismanagement usually cripple inflation infested economies first. The growth in money stock hence is a response to these ails and must be regarded as attempts to create more money in order to compensate for the loss in trust in the existing stock. Printing more money, however, is a sure means of destroying trust even further. Therefore, the excessive creation of money reinforces but does not cause an ongoing inflation.  
    When it comes to inflation, matters are apparently somewhat more complicated than the simplicity of Mankiw’s ninth principle suggests. Maybe as a sign of acknowledgement, Mankiw dropped the case study on Germany, Austria, Poland and Hungary starting with the third edition of his textbook (Mankiw, 2014). In its stead he refers to the case of Zimbabwe but only in passing (Mankiw, 2014, p. 11) and without any further elaboration. The more recent editions thus provide support for the ninth principle only on theoretical grounds (Mankiw, 2014, p. 590). In view of the full factual evidence, it would probably be even better not only to drop the mis-placed proof by example but to re-write the ninth principle altogether:  

Prices rise when people lose trust in money.

3 Note that scarcity alone is an insufficient explanation as there are precious metals such as palladium or platinum that are even scarcer and yet not regarded as highly as gold.
    Aristoteles (1951). Nikomachische Ethik, Artemis-Verlag, Zürich.  
    Aristoteles (1971). Politik, 2 edn, Artemis-Verlag, Zürich.  
    Mankiw, N. G. (2011). Economics, 2nd edn, Cengage Learning, Andover.  
    Mankiw, N. G. (2014). Economics, 3rd edn, Cengage Learning, Andover.  
    Sargent, T. J. (1982). The End of Four Big Inflations, in R. E. Hall (ed.), Inflation: Causes and Effects, University of Chicago Press, Chicago, pp. 41–98.  
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    © Christian Müller 2017