The Reserve's Silly New Equation
BROCKWAY, GEORGE P.
The Dismal Science THE RESERVE'S SILLY NEW EQUATION BY GEORGE P. BROCKWAY IN his excellent and comprehensive book about the Federal Reserve Board, Secrets of the Temple, William...
...If no entrepreneur plans to produce a better mousetrap, if no consumers long for anything beyond their means, if no speculator schemes for a big killing, the banker sits idle...
...Let's go to the computer tape...
...The right-hand side of the equation presents different difficulties...
...In other words, it can surely reduce the money supply, but can't be sure of increasing it...
...Nevertheless, some number is chosen and fed into an equation that says the quantity of money, multiplied by the velocity of its circulation, is equal to the general price level, multiplied by the goods produced...
...if food, shelter, clothing, and transportation have anything to do with the cost ofliving, I'll sayit has gone upalot more than that...
...First, a bit of background...
...Monetarists say it is the consequence of failing to restrain M2 even further...
...2) pretax profits: down from 11.82 per cent of GNP to 6.92 per cent...
...MV is practically a single term...
...Culminating a century of deep thinking by deep economists, Irving Fisher of Yale promulgated, 80-odd years ago, an equation sometimes said to be the essence of monetarism...
...Friedman also tells us, "There is no unique way to express either the nominal or the real quantity of money...
...The active partners in the creation of money, and the uses it can be put to, are the borrowers...
...But we remember that reducing Q* increases the value of the Reserve's equation by increasmg P* (the price level...
...For reasons that have takenme the better part of abook(to be published by Cornelia and Michael Bessie for Harper&Row about a year from now —advt...
...Even if it makes borrowing easy, however, it can't make people borrow...
...Remembering a New Yorker cartoon of a couple of years ago, I expect the apparent light will turn out to be New Jersey...
...but they know in their hearts that if the Reserve had in fact restrained it any further, the interest rate would have gone God knows how high, and we would have spent the subsequent years in a rapidly deepening depression that would have made 1932 seem idyllic...
...V* is the determined constant, now with a suspiciously precise value of 1.6527...
...3)after tax profits (despite the best efforts of Ronald Reagan): down from 5.19 per cent of GNP to 3.94 per cent...
...It would be unfair to imply that the Reserve doesn't have a reason for its unnatural decision...
...But the prices of goods and services are already and necessarily included in the GNP...
...M2 consists—you don't have to pay attention here—of currency, traveler's checks, checking deposits, savings and ordinary time deposits, money market funds, and overnight Eurodollar deposits, but excludes time deposits of $100,000 or more...
...It turns out that the velocity (V) cannot be determined except by means of this equation...
...The money supply (M) is not the only term beset with difficulties...
...It starts again with MV = PQ...
...So taking the Reserve's equation at face value, we could hold the price level (P*) down either by decreasing the money supply (M2) or by increasing production (Q...
...Not much to learn from two centuries of study...
...Moreover, it cannot be expressed otherwise, for money is the sole relevant unit of measurement that applies to apples and oranges and tons of steel and all the rest...
...Whatever the case, in contrast with its usual practice, the Reserve has recently gone to considerable trouble to call attention to a new equation that is supposed to predict inflation levels two years or so in advance...
...Happily, the present formula is very elementary mathematicssomething that kids probably do today in kindergarten, and that you used to toss off in fifth or sixth grade...
...Faced with such an alternative, anyone who had not altogether taken leave of his (or her) senses would opt for increasing production, because after all that makes possible our standard of living...
...The Dismal Science THE RESERVE'S SILLY NEW EQUATION BY GEORGE P. BROCKWAY IN his excellent and comprehensive book about the Federal Reserve Board, Secrets of the Temple, William Greider properly fastens on the first word of his title, the Board being at least the third most secretive arm of the United States government...
...I have from time to time averred that the GNP, whether real or nominal, is less than it is cracked up to be, yet for the moment let's accept it at its face value...
...P* (or "P-star," as insiders say) stands for the price level a couple of years down the road...
...the trouble is, the "reason" is erroneous...
...So don't panic...
...By "money supply" I don't mean the gabble-gabble of items that make up M2...
...It is the sort of index I of ten grumble about, derived by combining the prices of a great variety of goods and services, each one weighted to allow its supposedly proper importance in the economy...
...That's what the Bureau of Labor Statistics says...
...More to the point, look at the figures that are left out of the Reserve's equation: (1) interest paid as a percentage of GNP: up from 4.59 per cent in 1951 to 19.19 per cent in 1987...
...Naturally, too, by making it difficult for people and businesses to borrow money, the Reserve can indirectly raise the interest they have to payGiven that interest is a cost of doing business and a cost of living, raising the rate (whether directly or indirectly) ups those costs, thus certainly inhibiting or reducing output (Q...
...Milton Friedman, in The New Palgrave (a four-volume economics encyclopedia I wish I could afford), assures us that monetarism is something else, and he's entitled to his opinion...
...True to its one idea, the Reserve next solemnly goes about further reducing M2 (which might be the money supply if ours were a mercantilist system instead of a capitalist system...
...The equation, written all in capitals, looks formidable (MV = PQ) but expresses a simple, even a simplistic idea...
...The Reserve, in fact, is not unlike one of my favorite characters in all literature, "The King of Korea/ [who] was gay and harmonious: / he had one idea / and that was erroneous.' The Reserve's one idea is to control the money supply...
...6) foreign trade balance on current account, from positive $884 million to negative $153,964 million...
...he Federal Reserve—the banker par excellence—can make it hard for ordinary banks to lend money, and hence hard for productive people to borrow money...
...As you remember from the fifth grade, you can reduce the value of a fraction either by reducing the numerator (113 is less than 2/3) or by increasing the denominator (1 / 3 is also less than 1 / 2...
...4) unemployment: up from 3.2 per cent to 6.1 percent...
...On the other hand, the Reserve can affect the interest rate, and that makes a difference the new equation does not take into account...
...As constant readers know, I am, like Adam Smith, skeptical of all alleged mathematical solutions to basic economic problems...
...Although bankers are often hyperactive in thinking up new financial "products" (index trading, etc...
...We are immediately struck by the fact that its face value is expressed in money...
...Fanciers of the theory contend that over the past many years V has been reasonably constant...
...they are passive partners in the work of the world...
...That is indeed the record the Federal Reserve Board has compiled since 1951, when it succeeded in abrogating its wartime agreement with the Treasury that kept the prime rate down to 1.5 per cent from 1939 to 1947...
...And in the capitalist economy everyone agrees we have, that is credit, the flip side of which is debit, or borrowing...
...to elucidate, the Reserve can very readily reduce the money supply —but it can't be sure of increasing it...
...Q* is the future "real" GNP, assuming a steady growth of 2.5 per cent a year...
...but it is Fisher's formula the Reserve starts with...
...Greider suspects, as I do, that the secrecy is useful mainly for instilling awe in us poor mortals...
...We are told that Chairman Alan Greenspan set a team of three economists to work on the problem when he took over in the spring of 1987, and that there is now light at the end of the tunnel...
...5)Federal budget: fromasurplus of 6.1 per cent of GNP to a deficit of 3.35 per cent...
...So we find the Federal Reserve deliberately reducing our standard of living and at the same time raising the price level...
...The textbooks say, I know, that bankers create money by lending it, yet actually they produce nothing except some useful services...
...Mainly because M2 yields a relatively constant value for V, which the Reserve wants, ?2 is selected as the quantity of money...
...That last assumption is of course the secret of the game...
...This is the reed the Federal Reserve leans on...
...I mean the money actually at work in the economy...
...He can refuse to support plans, longings and schemes, but the first and essential step in creating money is taken by borrowers...
...What, then, is the price level (P...
...Next, the Reserve pretties up the equation with some asterisks or stars, like this: P* = M2xV*/Q...
...The Reserve, I'm sorry to say, opts for decreasing the money supply...
...Q stands for the total of the goods and services produced—that is, the "real" (stated in things), as opposed to the "nominal" (stated in money), gross national product...
...By raising or lowering the Federal funds rate (the interest banks pay on temporary loans from each other, or from the Reserve itself) or the discount rate (the interest Federal Reserve banks charge commercial banks for short-term loans), the Reserve directly raises or lowers the interest banks have to pay, and consequently the interest they have to set...
...Many have therefore dropped ? from the equation, effectively reducing it to M = Q. Translating it back into English, we learn that the total money spent for goods and services equals the total prices charged for those goods and services...
...In the process, it manages both to restrict the national output and to keep the inflation fires burning...
...The abrogation was necessary, the Reserve argued, so it could befreetocontrolthemoneysupply(then said to be MI), as it dearly wanted to do...
...How long must we allow ourselves to be deluded by silly equations...
...The rationale for the secrecy is that billions of dollars can be made by uncovering what, if anything, the Reserve is going to do next...
...Dividing both sides of the equation by Q, it gets P = MV/Q...
...The paradoxical truth is that the "real" GNP can only be quantified "nominally...
...Since the fateful year of 1951, the price level has increased 436.9 per cent...
...The inflation-fighting Reserve wants the fraction to the right of the equal sign to be as small as possible, since it is equal to ?*, or the future price level...
...That is one sorry record...
Vol. 72 • June 1989 • No. 10
