How I learned to stop worrying and love central bankers (Part one)

Ben Traynor and I see the world differently.

Ben Traynor and I see the world differently.

Ben’s the editor of the Daily Reckoning. Since I started with Agora Financial this summer, a small highlight of my week has been after work markets and economics chat over a beer with Ben and Glenn Fisher, our associate publisher.

The big difference between Ben and me is over central banks and the stock market. I’m big on central banks – I think they’re doing a pretty good job. I don’t think they’re inflating a dangerous stock market bubble. And I think that now is a good time to invest in stocks.

Ben is skeptical of central bankers. He doubts that all this intervention in the market is going to end well.

What follows is a memo I sent around to a Ben and Glenn a couple of weeks ago. I wanted to get my thoughts down on paper in case for some strange reason they don’t come out clearly in a noisy Southwark pub.

Like I said, I think central bankers are doing a pretty decent job. Not many people seem to agree with me on that.

So to begin explain my point of view, I went back to the beginning, to the three basic schools of thought in central banking.

A short backgrounder on the three economic schools of thought.

Economists disagree a lot, but they broadly fall into just three camps.

The Austrian School: Austrians think that government / central banks can’t fix recessions. “When the economy tanks, the government should sit on its hands and wait for it to heal.”

The Keynesian School: Keynesians think that the government can fix recessions by spending money. “When the economy tanks, the government should spend more money on stuff like roads or tax cuts or welfare. The injection of money will heal the recession more quickly than doing nothing.”

The monetarist school: monetarists think the government can fix recessions by printing money. “When the economy tanks, the government should print more money (through the central bank, which is an arm of the government). The injection of money will heal the recession more quickly than doing nothing.”

Whoever wants to take a stab at running the economy, be they Austrian, Keynesian or Monetarist, the challenge is to keep inflation and unemployment low and stable. All the arguments in macroeconomics are about those two variables.

There’s a famous accounting identity which describes how it all fit together:


M = the money supply

V = velocity of money, or how quickly the money supply circulates through the economy

P = the price level

Y = output (which is closely linked with unemployment)

What MV=PY is saying is that the money supply, and the speed at which money gets spent, determines inflation and unemployment in the economy.

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MV = PY is most associated with Milton Friedman and monetarism.

Friedman’s idea was to keep PY stable by growing the money supply, M, at a stable and predictable rate. When he had the idea, V (the velocity of money) had always been pretty stable too. So, by keeping M stable, he reasoned, you could keep P and Y stable too.

Remember, P and Y are what matters. Inflation and output are what we’re trying to control.

In other words, Friedman thought that an unstable money supply caused inflations and recessions. This was a crazy idea at the time, because back then people didn’t think the money supply was all that important. Mainstream economists had all sorts of mad theories about what was responsible for inflation and recessions back then.

Friedman’s idea, of controlling the economy by stabilising the money supply, was called monetarism. It was tried in a limited way in the early 1980s, and it had mixed results. Friedman hoped that keeping the money supply stable would stabilise inflation and output, and do away with the need for central bankers at all. But this didn’t work out like that.

Around the time the system was implemented, V started to vary a lot more. So stabilising M on its own didn’t stabilise inflation and output.

Monetarism didn’t live up to Friedman’s hopes. But it did beat inflation in the UK and US in the early 1980s. And in a profound way, it changed the debate in economics. Even though a rule to control the money supply wasn’t quite right (because V proved to be variable), everyone came to accept that controlling the money supply was the way to stop inflation.

Friedman famously said “inflation is always and everywhere a monetary phenomenon.” When he first said it, most economists didn’t agree. Now, everyone does.

Monetarism, Take 1 convinced everyone that controlling the money supply could control inflation (P in the equation above). But it didn’t convince everyone that the money supply could be used to control unemployment.

So can printing money control unemployment? That’s the biggest debate in economics right now.


A few true believers have carried the torch since Friedman’s time. They believe that Friedman was onto something. They believe that it’s possible to get what we’re after (stable inflation and unemployment) without:

– The government spending money, like the Keynesians say (they’d print money instead)

– Central bankers setting policy on the fly (they’d use rules instead)

They think you can come up with a set of rules which do away with central bankers, do away with inflation, and do away with recessions.

Remember the problem monetarism ran into the first time it was tried – stable M on its own didn’t stabilise P and Y, since V proved to be variable. So what you need is a system which stabilises M times V.

That way, when the velocity of money speeds up you take some money out of the economy to stop the economy from overheating, which leads to inflation. And when V slows down you print more money to stop the economy from cooling down too much, which leads to recession and unemployment.

This would keep the economy in the “goldilocks” zone – not so hot that there’s inflation, not so cold that there’s unemployment.

In practice, how do you stabilise M times V? You ask the central bank to target something called nominal gross domestic product, or NGDP for short. It sounds jargon-y but it’s dead simple. NGDP is just the sum total of all the things produced in the economy in a year, with no adjustment for inflation. NGDP is a mixture of inflation and output in one number. NGDP is M*V.

And it turns out that over a very long period, it’s clear that 5% NGDP growth is the “goldilocks” level. 5% NGDP growth is what central banks would target.

The monetarists have high hopes for this plan. If having the central bank target 5% NGDP proves to be successful – no inflation, no recessions – it will be no less than the holy grail of macroeconomics.

Best wishes,

Sean Keyes

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