in CNBC Interview August 2022, Steve H. Hanke, a professor of economics at Johns Hopkins University, predicted that “a huge recession will occur in 2023.” In April 2023, he repeated the warning: “We know the recession is completely over,” he said. Many other economists also predicted a recession in 2023, but they were wrong.
Most recession predictions were based on the reasonable assumption that the US Federal Reserve would do whatever it took to bring inflation down to the central bank’s target level of 2%. During the Fed’s Great War on Inflation, which began in 1979, Fed Chairman Paul Volcker was asked whether tight monetary policy would cause a recession. He quickly replied, “Yes, the sooner the better.”
In another conversation in 1980, Mr. Volcker said he would not be satisfied “until the last rotary saw is silent.” This was in reference to the devastating impact of rising interest rates on the construction of homes, factories and office buildings.
In 2022, inflation could reach double-digit levels similar to what it did in 1979, and Fed watchers are rightly betting that the Fed will raise interest rates again, triggering a recession big enough to crush inflation. I expected it to be loud. Surprisingly, the Fed planned a soft landing that would reduce inflation without causing a recession.
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Mr. Hanke’s reasoning was more arbitrary, focusing on the U.S. money supply rather than interest rates.he held for a long time The Quantity Theory of Money is that it provides a close relationship between money and inflation. So, for example, helicopters would fly around the country and drop money from the sky, thereby doubling the money supply, doubling prices, and life would go on peacefully.
This simplified model has several problems. One is that it assumes velocity, or the ratio of gross domestic product to money supply, is constant. For example, if the ratio is 5, then, on average, $1 is used to purchase domestically produced goods and services five times a year. There is no reason why this ratio has to be 5 or any other specific number. Especially because money is used to buy many things that are not included in GDP, including intermediate goods, imported goods, stocks and other financial assets, and financial assets such as real estate. Existing real assets.
The second problem is that there is no clear best way to measure money. Like many other monetarists, Hanke favors M2, a measure that includes cash, various bank deposits, and retail money market funds. The idea of M2 is to measure the amount of money that is readily available to people if they want to spend it. The problem is that many purchases are made with credit cards, consumer loans, and business loans. There is no good way to measure how much these things are suppressing spending.
Nevertheless, Hanke has often relied on the quantity theory of money to argue that there is a close one-to-one relationship between M2 and inflation. for examplein 2023, he wrote that “the rate of growth and real output growth are very close to constant…the rate of money supply growth and inflation have an almost one-to-one relationship.”
its conclusion obviously wrongbut my concern here is that Mr. Hanke predicted in August 2022 that there would be an “outrageous recession” in 2023 based on slowing M2 growth.
“Monetarists love to blame the Fed.”
Hanke is far from the last monetarist living. A January 7th Motley Fool Article Noting that M2 has fallen by 2% over the past year, he warned that “historically a decline in M2 has been a precursor to a recession.” The article stated that the historical events (1878, 1893, 1921, 1931-1933) were quite old, but still gave an ominous warning: Unemployment rate will increase significantly. ”
Monetarists love to blame the Fed, but the U.S. central bank does not directly control monetary aggregates like M2. The Fed uses open market operations to manage the monetary base (non-bank currency and bank reserves). M2 and other monetary aggregations are endogenously determined by public decisions about how to allocate wealth among those included or not included in M2.
Another complicating factor is that while the US dollar is the official currency in some countries, it is an unofficial medium of exchange in many others and is widely held by central banks as foreign exchange reserves. Almost half of all U.S. currency It is currently held outside the United States.
The bottom line is that there is no compelling reason to tie M2 closely to the monetary base. Actually not. This figure for the ratio of M2 to the monetary base shows how loose the link is. The ratio of M2 to the monetary base fell sharply in 2008 because the Fed increased the monetary base to prevent the Great Recession from turning into a Second Great Depression, while M2 remained largely unchanged. Calling M2 the money supply as if it were controlled by the Fed is highly misleading.
These various considerations do not mean that the Fed is powerless. Certainly, central bankers can reduce liquidity, raise interest rates and cause a recession whenever they feel it is in our interest to lose jobs. These considerations mean that it is foolish to think that there is a close relationship between M2 and inflation or output, and that it is dangerous to make predictions based on fluctuations or fluctuations in M2. .
Gary N. Smith, Fletcher Jones Professor of Economics at Pomona College, is the author of dozens of research papers and 17 books, including most recently co-authored The Power of Modern Value Investing: An Index; Also includes “Argos, Beyond Alpha”. With Margaret Smith (Palgrave Macmillan, 2023).
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