The money supply and the price level: a broken link?

Por Nicolás Cachanosky. Publicado el 7/4/16 en:


This past week, The Association of Private Enterprise Education (APEE) held its annual conference in Las Vegas, Nevada. As always, it was a very interesting event and I would like to take this opportunity to encourage young scholars who are serious about academic research and interested in promoting economic freedom to attend.

At the first monetary policy session that I attended, Sound Money: Are Central Banks Necessary?, it was suggested that the link between the money supply and the price level is broken. This really stood out to me. While this view wasn’t articulated by all of the presenters, it was certainly held by many of the economists in attendance.

“A new model is needed, even if we don’t know what the model should look like yet.”

Although such a statement has come from the mouths of many notable economists, there are theoretical and economic reasons why I disagree with the notion that a new model must (or should) be developed.

The theoretical reason is that the inverse of the price level (1/P) is the price of money. Therefore, to maintain that the “link is broken” is to say that the supply and demand analysis does not hold to money anymore. However, as long as money is considered an economic good, the law of supply and demand still applies. The USD is still used to buy goods and services, which means it has a value; this in turn means that supply and demand is still the link between money and its price.

One question that was posed at the session was, “What does the price level depend on if the price of money does not depend on the supply and demand of money?” This is not a trivial question. After all, money is the economy’s most important good.

One cannot maintain that money is an economic good used to buy other goods and services while maintaining that the supply and demand model is broken.

The empirical reason for this is that even though base money (BM) increased significantly with the financial crisis, the M2 monetary aggregate did not. The reason for this is that the Federal Reserve is paying banks to not lend money to the market. In other words, the Fed is moving two variables at the same time: it is increasing BM at the same time that it is reducing the money multiplier. The result is the fairly constant evolution of M2 we observe in the data. This does not mean that the model is broken, or that we need a new one, but rather that the Fed is moving different variables of the model at the same time. It is true that since 2008 M2 has increase faster than the price level. But has been the case since the mid-1990s, not since 2008.

But there is another general issue that I find troubling. Semantics implicitly exculpate the Fed from any wrong doing. While I believe that this concept was partially explored by the panel, I am now speaking more broadly. Semantics, of course, prize the Fed for any positive outcomes. The implicit message sent to the public is that the Fed can only do good. For instance, to say that today the “money supply does not depend on the Federal Reserve, but on commercial banks” or that “the Fed has no power to set interest rates” sends the hidden message that the Fed is not the cause of the poor economic performance since the crisis because the Fed does not control the relevant variables.

Of course, banks are the source of the secondary creation of money, but the Federal Reserve remains the primary source of the money supply. The Fed asked Congress for permission to pay interest on reserves, and is still doing so. To pay interest on reserves is like paying the banks to reduce the money multiplier. Surely, money creation stops at the banks, but this the result of the Fed’s policy and not a sudden change of behavior by the banks themselves. I would suggest that this policy was put in place for two reasons: First, to provide liquidity to banks while cleaning their balance sheets from “toxic assets,” and second, because the Fed is buying toxic assets, it cannot sell them back to the banks to keep base money on check. So, instead of taking reserves away from the balance of the banks, it’s paying the banks to hold them. Unless supply is vertical, if we start paying to keep reserves sitting at the Fed, then more reserves will be kept sitting at the Fed. This way the Fed avoids the high inflation that we would have seen if the expansion of base money would not have come hand-in-hand with a fall in the money multiplier.

Assume hypothetically that the Fed decides to stop paying any interest on reserves to the bank. Do you expect that all reserves would remain in the banks endlessly, or you expect that banks would start putting money back in the market? If paying interest on reserves has no effect at all, why would the Fed continue to do this?

Another hypothetical situation to consider would be the result of placing this policy (plus the demand for USD by other central banks around the world) on a demand and supply chart. What we would see is a more horizontal demand of base money than we are used to. An increase in the supply of base money would have a minimal effect on the price level. Changing a parameter of the model (or the slope of demand) is very different than saying that the model is broken and that we need a new one. Supply and demand did not disappear– they changed their slopes. We don’t need a new model as much as we need to revise how policy makers are changing the model’s parameters.

Similar deviation of attention from the Fed’s effects on the economy can be perceived when we maintain that the Fed has no power to set interest rates. If that truly were the case, it would mean that the Fed has been targeting a useless variable for years.

Again, there is a grain of truth in such a statement, but it begs contextualization.

Surely, the Fed only has limited, if any, control over real interest rates. Eventually, changes in the money supply would affect the nominal interest rate through the Fisher effect. The federal funds rate is decided by banks through inter-bank lending, not by the Fed itself. But this doesn’t mean the Fed has no power to affect interest rates in the short-run– even if it did, the short-run might be long enough to produce significant distortions. The Federal funds rate depends on the supply and demand of federal funds. The Fed does not fix the federal funds rate the same way we think of fixing prices under a price control regime. What the Fed can do, however, is change the supply/ demand of federal funds until the federal funds rate is at the desired level. To say that the Fed has no control on interest rates in the short-run is like saying that the Fed has no power to change the price of bananas in the short-run, but can “print” as many bananas as it wants until the price of bananas is at the desired level. Then, when something bad happens in the market of bananas, we don’t think of the Fed because our semantics imply that the Fed has no power to affect the price of bananas.

Such logic is simply not sound.

The monetary situation of today was not caused by a broken model or link; it was caused by discretionary central bank policies around the world– especially those orchestrated by central bankers at the Federal Reserve. If the Federal Reserve, or any other central bank, is powerful enough to do so much good, it is also powerful enough to do great harm. We do a great disservice to the cause of sound money if we promote the idea that the Fed is unable to do harm to key monetary variables.


Nicolás Cachanosky es Doctor en Economía, (Suffolk University), Lic. en Economía, (UCA), Master en Economía y Ciencias Políticas, (ESEADE). Fué profesor de Finanzas Públicas en UCA y es Assistant Professor of Economics en Metropolitan State University of Denver.

FIFA Scandal Calls For More Transparency Not More Government

Por Alejandro Chafuen: Publicado en:

The front pages of leading newspapers around the world are full with news about the alleged corruption in FIFA, the world soccer federation. There are less headlines in the United States, where the Justice Department brought a 47 count indictment against key authorities and a handful of businessmen. International attention is assured: Soccer is the most popular sport and FIFA is so large that it has more members than the United Nations. After achieving independence, several countries, especially in central and eastern Europe, asked to be affiliated with FIFA even before asking to become members of the U.N.

Among the FIFA officials charged for racketeering and wire fraud were two of the organization’s vice presidents, Eugenio Figueredo and Jeffrey Webb, as well as José Maria Marin, former president of the Brazilian Football Association, and Rafael Esquivel head of the Venezuelan soccer association. Most of the charges refer to activities of the South American FIFA subsidiary, CONMEBOL, and its North American counterpart, CONCACAF.

As a good Argentinean, Gustavo Lazzari, an economist and policy advocate with theLibertad y Progreso think tank, follows soccer as much as the battles to preserve the few economic freedoms that remain in Argentina. Argentina was the runner up in the last World Cup, but was ranked 169 out of 178 in economic freedom. As Argentines are so exposed to corruption and soccer, and he lectures frequently for free-market think tanks on the topic, I asked him about his views. He said, “FIFA is the closest thing to a multilateral agency, like the World Bank, but with the additional power to regulate a formidable business. The economic and political appeal, especially when the global contests are organized in countries with weak rule of law, creates immense temptations for corruption.”

All of the FIFA authorities who were detained were from the Americas, and mostly from countries with weak rule of law. But the fact that the accusations surface after the process that selected Russia and Qatar, with frequent but unproven bribery accusations, assures worldwide attention. President Putin questioned U.S. involvement.

Corrupt dealings which damage non-U.S. citizens can still be brought to justice here. In a piece, “How Did He Get So Rich”, I wrote about an Argentinean businessman who ended up in jail mostly because his partner was based in the United States and they used American financial institutions for their dubious operations. In this case, CONCACAF is based in the United States, so there is an additional justification to act. This is not enough to satisfy Putin who, as a piece in Forbes reported, blamed America for another attack on Russian interests.

What will happen next? Lazzari argues that this scandal might refresh the debate about what is more relevant: a world cup of soccer teams or a world cup of national teams. Libertarian globalists, tend to prefer the former, libertarian “nationalists” prefer the latter. I think there is room for both. Lazzari points out that national teams, like Barcelona and Real Madrid (Spian), Chelsea (U.K.), Juventus (Italy), and many others, have fans and followers across the globe. “Barcelona soccer shirts with Messi’s name, and Real Madrid’s shirt with Ronaldo’s name, sell all over the world, much more than national team’s jerseys.” Messi and Ronaldo play outside their native countries and are some the best strikers that the world has ever seen.

Those who love freedom even more than soccer hope government will not get more involved. Magno Karl, of the think tank Ordem Livre in Brazil, has been highly critical of state interference and subsidies for sporting events. He argues that “the involvement of governments in the game should remain restricted to tightening vigilance over private entities that engage in criminal activities and prosecution of those accused of crimes. It is unlikely that more involvement in the organization of sporting events would produce more accountability. Instead, it would probably produce more $900 million empty stadiums in developing countries, such as the National Stadium of Brasilia, in Brazil.”

U.S. civil society and its government are familiar with private sector for profit and nonprofit sport leagues. Incomes and profits on those events are regulated by the same laws that regulate non sportive efforts. Violations, therefore, warrant prosecution, even if they might offend Putin.

Luis Loria, a think tank leader from Costa Rica, commented that the revelations and detention of his compatriot Eduardo Li, calls for increased transparency. Loria said, “The capture of Li, in Switzerland, has caused a media earthquake in the small ‘Central American Switzerland’ as some label Costa Rica. Until a few month ago, Li was considered as a role model and named the 2014 person of the year by the prestigious newspaper La Nación.” Loria is the founder of IDEAS Network which is creating an internet platform “The Crystal House” to increase transparency in government affairs. Eugenio Figueredo, from Uruguay, one of the FIFA Vice Presidents also detained, had been accused and suspected before. Uruguay, like Costa Rica, is also regarded as a regional “Switzerland.” FIFA’s president and headquarters are Swiss, so the comparison is not totally unfounded.

The battle against cronyism and corruption continues, this time in world soccer. No sector seems immune. Who knows what comes next, but please, counter it with transparency, not more regulations.

Alejandro A. Chafuén es Dr. En Economía por el International College de California. Licenciado en Economía, (UCA), es miembro del comité de consejeros para The Center for Vision & Values, fideicomisario del Grove City College, y presidente de la Atlas Economic Research Foundation. Se ha desempeñado como fideicomisario del Fraser Institute desde 1991. Fue profesor de ESEADE.

Why Does The U.S. Economy Sag? Look No Further Than The Number 17

Por Alejandro A. Chafuén. Publicado el 25/9/13 en

The significant efforts in recent years to measure economic freedom did not come from universities. They came from think tanks. These efforts are a powerful proof that think tanks are an essential institution in civil society. More than that, the “freedom truths” they affirm are vital for the world and the United States. This is crucial information that we all need to know.

The two main efforts to document the benefits of economic freedom have been led by think tanks—namely, the Fraser Institute and Heritage Foundation.

For most of its indices, Fraser Institute relied on the expertise of James Gwartney and Bob Lawson. Gwartney is a past president of the Southern Economic Association and former chief economist of the Joint Economic Committee of the U.S. Congress. Lawson holds the Jerome M. Fullinwider Endowed Centennial Chair in Economic Freedom, at the Southern Methodist University, in Dallas, Texas. The new edition of the Fraser Institute’s report, released just last week, also included Joshua Hall (West Virginia University) and scholars from Austria, Germany and Spain. They spearheaded an effort with economists at Fraser and at think tanks across the globe.

Another major effort has been the very influential work of the Heritage Foundation. Several economists collaborated to refine the economic-freedom index prepared by the Heritage Foundation. I personally followed with special interest the effort of Dr. Gerald O’Driscoll, currently a senior fellow at Cato Institute, who had experience as an academic (NYU), government (chief economist for the Dallas Fed), and banking (Citigroup). After his pass through Heritage, and the continued efforts of those who succeeded O’Driscoll, the methodology of the Heritage effort has achieved increased respect. Measurements in social sciences are never perfect and competition should continue to lead to improvements.

Measuring freedom is not perfect and not easy.Freedom House had been compiling a freedom index for some time, but it neglected its economic aspects. The Fraser Institute, in collaboration with the Indianapolis-based Liberty Fund, a private operating foundation, began to focus on the core question: Can we develop a definition of economic freedom that can be measured? Fraser’s motto is, “if it matters, measure it.” Obviously, the effort fit well with its mission. The early meetings attracted Milton Friedman and other talented economists. These high-level discussions led to gradual progress and the development of a workable framework which is still the basis of the index.

The Heritage Foundation also got into the game of assessing economic liberties across the globe. It had a specific goal in mind: try to gauge if U.S. foreign aid had been of any help or if it had been squandered in socialist experiments and failed economic policies.

Despite the different methodologies used by Fraser and Heritage the results were quite similar. The first indices were released in the 1990s. They worked separately and still show a very high correlation. In 1997, when I first studied the results, the correlation between the indices of Fraser (Economic Freedom of the World, EFW) and Heritage was 0.86 (a 1.00 would mean a perfect match). Since then, many more countries were included in the sample. The most current figures, using the latest comparable indices, show a correlation of 0.79. This number correlates well with the top 10 countries in each index. Seven of the top countries in the EFW index are on the top 10 in the Heritage-Wall Street Journal index (HWSJ): Hong Kong, Singapore, New Zealand, Switzerland, Canada, Australia, and Bahrain. On the losing side, the 10 countries at the bottom of the rankings in this new Fraser Institute index also appear in the bottom 20 percent of the HWSJ index. The U.S. continues to decline in both measurements, scoring 77 out of 100 in the EFW (17th place), and 76 in the latest Heritage index (10th place).

Overall, the scores of the Fraser Institute show a world with more economic freedom (an approximate world average of 69 percent as compared to 62 percent with the HWSJ index). The major divergence between the scores of Fraser and HWSJ are caused by the prevalence of corruption across the globe. The countries that had over 10 points of difference had an average rate of transparency of three out of 10: highly corrupt. It is a possibility that corruption, like in Argentina, where government manipulates most prices and data, reduces the accuracy of the indices.

Those of us working at other think tanks and with our own areas of knowledge began using the indices to make comparisons with other trends. In my research, I focused on corruption and inequality. Others have focused on economic freedom and democracy, economic freedom and poverty, and other relevant issues. Some of these studies have been published by Fraser and Heritage. Using similar models, think tanks in Canada, the United States, Spain, and Argentina, have created indices to measure economic freedom within the regions and provinces of their countries. The Fraser Institute keeps track of most the scholarly and other relevant articles that have used and cited its index. The list is very large. It shows all the different aspects of an empirical science of economic freedom.

If we do not know where we are, it is hard to know how to get to our destination. These indices are getting better at showing us where we stand. Now they are being used to show us where to go: the Heritage Foundation recently released its 2013 Global Agenda for Economic Freedom. Based on what they learned from the index, researchers at Heritage’s Center for International Trade and Economics divided the world in seven regions and made specific recommendations about how to move forward in each.

So far, the effort to measure economic freedom has placed think tanks ahead of universities. It has also placed think tanks ahead of the for-profit sector. I forecast that for-profit companies and universities will develop competing and complementary measurements.

“If it matters, measure it.” If it really matters, let many measure it—and let the world learn it.

Derek Carter, an economics, mathematics and finance major at theUniversity of Alabama, conducted research for this article.

Alejandro A. Chafuén es Dr. En Economía por el International College de California. Licenciado en Economía, (UCA), es miembro del comité de consejeros para The Center for Vision & Values, fideicomisario del Grove City College, y presidente de la Atlas Economic Research Foundation. Se ha desempeñado como fideicomisario del Fraser Institute desde 1991. Fue profesor de ESEADE.