Time and again, I am being told at present that money creation — which is what Modern Monetary Theory (MMT) quite correctly says happens every time the government spends money — must always lead to inflation because, so those making the claim suggest, there is a direct relationship between the quantity of money in the economy and the value of money in relation to the goods and services that it might buy. This, they say, means that when the quantity of money increases, the value of that money falls, giving rise to what we call inflation as a result.
The logic behind this claim is based on the so-called "quantity theory of money", promoted by someone who might be considered one of the earliest neoliberal economists, Irving Fisher, who was writing more than a century ago, and who might fairly be called the godfather, if not the founder, of monetarism.
The problem with Fisher's claim is that, like a great deal else within neoclassical and neoliberal economics, what it suggests is wrong. To explain this, I have added the following entry into the glossary associated with this blog, in the hope that this explains why the claims made about Modern Monetary Theory are incorrect.
This has, of course, to be the case because, in fact, MMT has explained what has been happening in our economy for more than 50 years now, and there have been no occasions within that period when inflation has been created by an excessive money supply, with all inflationary episodes being capable of explanation by one of the following:
- External supply shocks, for example, with regard to oil, war, or the reopening from Covid.
- The failure of international relations in monetary policy, for example, with regard to the European Exchange Rate Mechanism or global financial crises.
The quantity theory of money (QTM) claims there is a direct and proportional relationship between the money supply and the general price level in an economy. It is most famously expressed by the identity:
MV = PT
Where:
-
M = the quantity of money in circulation
-
V = the velocity of circulation, or how quickly money moves between transactions
-
P = the average price level
-
T = the number of transactions (or sometimes real output)
This equation is an identity: it is suggested that it must always balance because it describes what money does. The controversy comes with the theory attached to it.
From the late nineteenth century onwards, economists, most notably Irving Fisher, argued that V and T are constant in the short term. That assumption implies that if governments or central banks increase M, then P must rise in proportion. In other words, Fisher claimed that inflation is always a monetary phenomenon. Milton Friedman later made this claim the foundation of monetarism in the 1970s. It was used to justify austerity, the shrinking of government, and the deregulation of finance.
However, the theory fails when tested in the real world:
-
Velocity is not constant: in fact, it is highly volatile and collapses in crises, as it did in 2008 and did again during Covid, meaning that huge increases in the money supply often do not translate into inflation.
-
Output is not fixed. Economies can expand production when demand rises. If more money supports the production of more real goods and services, prices need not increase.
-
Banks create most money through lending; governments have a role, but it is often a lesser one, most especially in the post-cash era. Loans expand the money supply when issued, and shrink it when repaid. QTM says very little about this, which is a fundamental flaw in its argument.
-
Inflation frequently arises from non-monetary causes, whether they be supply shocks, wage suppression, profiteering, energy price spikes, or the exploitation of market power; all of these play significant roles.
QTM's most significant flaw, however, is its reverse causality. Instead of excess money causing inflation, it is inflation, driven by real-world constraints and power dynamics, that most often forces money supply to expand to keep the economy functioning.
Nevertheless, the theory remains popular with those wanting to limit the role of government. It provides a simple-sounding cautionary tale, suggesting that spend too much, and inflation will punish you. But simplicity is not truth. Modern Monetary Theory shows that what matters is real resources, and not arbitrary limits on money. Money is a tool we issue to mobilise the productive capacity we already possess.
Inflation is undoubtedly a challenge, but it requires real economic solutions, and not outdated monetary dogma. Those who offer that dogma always have one true agenda, which is to constrain the role of government within society.
Comments
When commenting, please take note of this blog's comment policy, which is available here. Contravening this policy will result in comments being deleted before or after initial publication at the editor's sole discretion and without explanation being required or offered.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
There are links to this blog's glossary in the above post that explain technical terms used in it. Follow them for more explanations.
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
Buy me a coffee!
“Everything has to be taken on trust; truth is only that which is taken to be true. It’s the currency of living. There may be nothing behind it, but it doesn’t make any difference so long as it is honoured.”
A rather difficult quote for seekers of truth, from Rosencrantz and Guildernstern are dead. Tom Stoppard RIP.
That clearly is true of money.
Money supply increases by the Bank was what i was taught in the 1950s.2008 and Covid proved it wrong
Agreed
“A significant and sharp reduction in productive capacity” is probably another cause to add to the list.
It doesn’t fall under the category of ‘external shock’.
What are you talking about?
You are narrowly outlining causes of inflation in the UK in the last half century. That’s understandable.
I’m pointing out that it may be worth expanding your list of empirically-validated causes of inflation generally to include my aforementioned suggestion, if only to preclude the usual Weimar/Zimbabwe strawman argument being rolled out.
A massive, sudden hit to productive capacity is technically an ‘internal shock’, and it can be highly inflationary. This is not covered in your narrow, exclusive list.
Noted, but let’s be clear, they are so outlying that they really are not relevant.
So again, we have a very ‘money centric’ view as with your post on trade. In both trade and inflation, the leading part is given to money, money at the centre of everything when in fact it is the supporting cast.
In this context, you can see why this country is so poor these days about investment. You have to spend to invest, spend to save even.
Talk about being self-defeating. No wonder we are in a mess.
Agreed
For all the reasons you state the “quantity theory” fails in practice…. but the quantity of money in existence does matter.
Each pound in existence is held by someone who is hoping to redeem it for real stuff at some point in the future. If confidence is lost and people become unwilling to hold money you will get asset price inflation and currency depreciation… and the “herd instinct” make these flows fast and furious leaving policy makers behind.
MMT is a correct description of money…. but these flows are the challenge that policymakers must be prepared to deal with.
So just trying to put this into an everyday context – masses of unmet needs, people fighting over fake-scarcity of housing.
If the government created money via MMT, and invested / funded / built truly affordable, life-long, decent homes for people – on a large scale.
Surely inflationary pressure on housing would go down, because all that need for housing would be met? House inflation would go down not up.
At the same time those people who are building the homes would be spending their wages in their local economies, and boosting S&M small local businesses, revitalising dead regional communities. Also a plus, no?
Correct me if I am getting this wrong.
Thanks for the question.
I think we need to start by turning the usual framing on its head. Governments do not sit there wondering whether they can afford to spend money, as if that were the primary decision. What a government actually decides is whether it wants to use resources that exist within the economy — people, skills, energy, materials, technology.
Money only comes into this after that real-world decision has been made.
If those resources are currently idle — unemployed labour, unused capacity, empty buildings, unmet needs — then the government can put them to work simply by issuing the money required to mobilise them. No one else was using that labour; nothing was being diverted. The net effect is new activity, new income, new value.
If, however, the resources the government wants are already in use — for example, private sector workers currently employed producing goods and services of less importance to society — then the government has to free up those resources. That is what tax is for. It removes spending power from some areas of the economy so that those real resources become available for public purpose instead.
So:
• Government decision: What do we want the economy to do? What real resources do we want to command?
• Operational question: Are those resources idle or already in use?
• Policy tool: Money creation mobilises idle resources; tax reallocates those already in use.
Seen this way, there is no automatic link between taxation and spending. Tax does not fund public expenditure. Tax instead creates the space for public use of resources when that space does not otherwise exist.
That is the essence of public purpose decision-making in a monetary economy. And it’s why talking as if everything must start with “how do we pay for it?” gets things back to front. The right question is:
– What do we need?
– Do we have the people and capacity to deliver it?
– And if not, how do we rearrange priorities so that we do?
This is about democratic choices over resource allocation — not household budgeting analogies.
Thanks again for asking the question — because getting this point understood is key to everything else.
And re your understanding – all I am emphasising is the resource decision comes first. And you may well be right on housing prices.
I spent my working life as a software engineer and have no formal economic expertise and so see problems in the form of logic flow diagrams … because of this I’m always surprised when economist present their ideas as a simple formula.
To me it would be far more useful to present, for example, a cause and effect diagram and using discreet formulas to determine the outcome at each node.
When applied to money creation, inflation could then be demonstrated as occuring as a result of one set of decisions, or not, if other policies are taken.
See page 410 and after in the Taxing Wealth Report.
Sorry, me again – with another query trying to understand another seeming division between yourself & Steve Keen, with whom you generally seem highly aligned. Namely trying to understand the very different positions you seem to have an the subject on Irving Fisher. You view him as “the godfather” of (yukky, nasty – obvs) Neoliberal economics, & someone who got the fundamentals very wrong. Yet Steve Keen not only frequently cites him as a key influence, but just looking at his latest video of this morning, I would go so far as to say he speaks of him in quite reverential terms, stating “… we need to go from the text book model to the real world, & when we do, it’s the approach to economics that I take, that comes out of the work of non-orthodox economists like Irving Fisher ….(et al)….. all these people have been trying to get realism into economics, & we’ve been prevented by neoclassical economists who want to simply hang on to a fictional model……” (starts around 8:50). I quite happily admit I have no in depth knowledge of Irving Fisher, just curious & somewhat confused as to how you can both see one person in such different lights (unless there are 2 Irving Fishers, of course….!). No criticism here at all – I’m just trying to wrap my head around this whole new (to me) “real” economics, & yourself & Steve Keen definitely seem like the people I want to be listening to, so I wouldn’t mind some help understanding how 2 people who seem so aligned have such different views on someone you both regard as very important, but yet seem to view so differently? Thank you!
Please ask Steve.
I tried to follow his video this morning and found it really difficult to do so. It is not very well edited. Sorry. I am bemused by his thinking Irving Fisher a good influence.
Is Steven Keene talking about Irving Fisher and his debt-deflation theory?
I don’t know. Ask Steve.
For me, a valuable post because of 1. Combining money creation of banks and of state in the MMT understanding. 2. Money supply should be seen mostly as a symptom not a cause of inflation. But, have you anything online on money into the land/property market and the inflation of property prices during credit booms? As building production has a delayed reaction to demand don’t the inflating prices show a money>inflation causation on that market? And if so doesn’t that mean a general ongoing inflation effect elsewhere in the economy?
Sorry – but I have done enough this weekend.
I have done a lot around this issue but little specifically of late and doubt I have time to do it now. But there have been some good comments about it here over the last day or two.