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Theory v facts |
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© Christian Müller 2017 |
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... 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. |
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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: |
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Prices
rise when the government prints too much money.
Mankiw (2014, p. 11) |
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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. |
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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.) |
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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. |
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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. |
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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. |
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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. |
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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. |
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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.
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. |
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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.
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? |
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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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continue reading on page 2 » |
page 1 |
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Footnotes |
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© Christian Müller 2017 |
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Jacobs University Bremen |
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www.s-e-i.ch |
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