Interpreting Modern Monetary Reality

During the 1990s and 2000s, the quantity theory of money (QTM) fell out of favor both among policymakers and academics. Central bankers almost universally adopted short‐term interest rates as their policy instruments while money was often dropped entirely from the dominant theoretical macro models. The central bank response to the global financial crisis—which featured the large‐scale asset purchases called “QE”—breathed life back into the quantity theory and its adherents. The widespread, though in fact mistaken, belief that central banks were targeting an increase in money growth to stave off deflation elicited memories of Milton Friedman's famous claim that the Fed could and should have accelerated money growth to bring the U.S. out of the Great Depression. That belief also led to alarming predictions that central banks in the wake of the GFC were massively overdoing it. The Fed's policy led to a nearly fourfold increase in the U.S. monetary base from August 2008 to August 2014! But as things turned out, this monetary expansion turned out to be much ado about nothing. During the 13‐year period ending in December 2020 in which U.S. M1 grew by an annual average rate of 12.7%, inflation averaged just 1.6%. The prediction of QTM that inflation would mirror money growth over the long run has been wildly off the mark and, although things could change quickly, even today's capital market expectations for “long run” U.S. inflation appear to be running within a 2%‐3% band. In this article, the former IMF director of central banking explains why the QTM is no longer a useful “cheat code” for interpreting modern monetary reality. As the most promising replacement, the author offers the outline of a “fiscal theory of the price level” that has had more success in explaining global inflation during the past several decades. As its name suggests, the fiscal theory emphasizes that the underlying driver of inflation is government deficit spending while minimizing the importance of the instruments—whether money or debt—that governments use to finance their deficits. The QTM, by contrast, effectively assumes that whereas money finance is likely to be inflationary, bond finance is not. Among the most compelling features of the fiscal theory is to draw attention to the transformation of global capital markets during the past several decades that has brought government debt finance to the fore while diminishing the role of money finance. When assessing the inflationary consequences of permanent fiscal expansions, policymakers must consider both government monetary and non‐monetary liabilities. Because the policy response to the GFC involved primarily the exchange of bond financing for monetary financing without a significant increase in total sovereign debt, it did not prove inflationary. The response to the global pandemic, by contrast, has involved a significant deterioration in sovereign fiscal finances. But whether this turns out to be inflationary is likely to depend not on how the current deficits are financed in the moment, but on the commitment of sovereigns to shoring up their fiscal positions without resorting to a reduction in the real value of their own debt.