Interpreting Modern Monetary Reality

• Published date: 01 December 2021
• Author: Peter Stella
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/jacf.12475

IN THIS ISSUE:

Central Banks

and Public

Finance

VOLUME 33

NUMBER 4

FALL 2021

APPLIED

CORPORATE FINANCE

Journal of

8Interpreting Modern Monetary Reality

Peter Stella

24 Was Deng Xiaoping Right? A 40-Year Assessment of

China’s Adoption of Western Capital Markets

Carl E. Walter, Stanford University

39 On Monetary Growth and Ination in Leading Economies, 2021-2022:

Relative Prices and the Overall Price Level

John Greenwood and Steve H. Hanke, Johns Hopkins University

AMERICAN ENTERPRISE INSTITUTE ROUNDTABLE

52 Government Policies Reshape the Banking System

Panelists: Charles Calomiris, Bert Ely, Alex Pollock, and Richard Sylla.

Moderated by Paul Kupiec.

70 Will Fractional-Reserve Stablecoin Banking Replace Bitcoin

and Some Traditional Banking Payments?

Charles W. Calomiris, Columbia University

76 Looking for the Economy-Wide Eects of

Stock Market Short-Termism

Mark J. Roe, Harvard Law School

87 e GameStop Episode: What Happened and What Does It Mean?

Allan M. Malz, Columbia University

8Journal of Applied Corporate Finance • Volume 33 Number 4 Fall 2021

Some Background

During the last 13 years, the U.S. monetary aggregate known

as M1 has grown at an average annual rate of 12.7%,¹ while

ination has averaged just 1.6%. If a core tenet of the QTM—

that long-run average growth rates of money tend to equal

rates of ination—is correct, then dramatic changes will need

to take place during the next couple of decades in either the

rate of growth of money, the rate of ination, or both.²

Global nancial markets today appear to believe that there

will not be a dramatic sustained increase in ination. Despite

over a decade of double-digit annual rates of money growth,

the market expectations that inform today’s underlying TIPS

break-even rates suggest that U.S. annual ination will average

2.5% during the next 20 years,which in turn implies that

today’s capital market investors expect the rate of annual ina-

tion over the long run to average only 2.3%—not much of a

change from the past.

Market expectations of low ination and the prediction

that ination will equal money growth in the long run could

be reconciled by a reversal in money growth going forward.

But although not impossible, some basic arithmetic suggests

that a reversal of the size required is pretty unlikely. Even if

U.S. money growth were zero for the next 17 years, ination

would need to average 8% percent per year during that period

to bring its 30-year average in line with the average rate of

1 Underlying data is from the St. Louis Fed FRED database, and Federal Reserve

Board release H.6 (various).

2 Here I accept the assertion in Lucas (1995) that 30 years is a good approximation

of the “long-run.”

M1 growth through 2038.³ Viewed from another angle, the

QTM implies that the annual growth rate of money would

need to average a negative 5% over the next 17 years to make

it consistent with current market ination expectations. Yet the

fact that the 12-month growth rate of M1 has fallen below

-5% only once in the past 60 years (from April 1996 to 1997,

it was -5.4%) suggests that the probability is miniscule. And

although folk memory clings to the belief that Paul Volcker

brought down the rate of growth of money to break the back

of U.S. ination in the 1980s, the reality is that M1 growth

averaged 8.8% per year while he was at the helm of the Fed,

as compared to an average annual growth rate of only 5.8%

during the eight years that preceded his term.

Soon after the Fed responded to the Global Financial Crisis

with massive liquidity assistance, there were many respected

voices calling for an end to “excessive” money growth. But with

the passage of the years and virtually no uptick in ination in

the U.S., the eurozone, the U.K., Japan, or other countries

witnessing high rates of money growth, these voices have now

become few and far between. And I’m aware of no one today

who is projecting inationary doom along the lines of the

simple monetary arithmetic outlined above. Are there people

calling for shrinking central bank balance sheets to straighten

out the muddled money markets—yes, myself included. Are

3 In that case, M1 growth and ination would average 5.3% over the 30-year period

2008-2038.

4 According to Bindseil (2004), page 30, Goodhart (2001) suggests that the adop-

tion of monetary targeting language during the Volcker years was a red herring designed

to deect attention away from the Fed’s role in the recession caused by raising interest

rates—the genuine operational mechanism.

Interpreting Modern Monetary Reality

he Quantity Theory of Money, to which many monetary economists and some poli-

cymakers have professed allegiance since the 1960s, is among the most deeply

ingrained mental representations of an economic relationship in history. This remains true

even as the body of evidence piling up over the last several decades contradicting one of its

main assertions grows ever larger. In the pages that follow, I show how the hold of the QTM

on the collective imagination continues to distort the interpretation of modern monetary real-

ity while stressing the importance of incorporating scal policy into the analysis of ination.

by Peter Stella

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