Thursday, July 19, 2007

Robert Schiller's Liquidity Nonsense

Via Mark Thoma's Economist's view, I see this piece by Robert Schiller where he suggests that the term liquidity is more or less tautological with bubbly markets. Schiller sometimes writes good stuff, but this time he is dead wrong.

He writes:
"Traditionally, "awash with liquidity" would suggest that the world's central banks are expanding the money supply too much, causing too much money chasing too few goods.

But if that were the problem, one would cause all prices - including, say, clothing and haircuts - to rise.

That is what the US Federal Reserve Chairman Arthur Burns meant when he said that the United States was "awash with liquidity" in 1971, a period when the concern was general inflation.

But the recent popular use of the term "awash with liquidity" dates to 2005, a time when many central banks were tightening monetary policy.

In the US, the Fed was sharply raising rates. Central banks worldwide clearly have been behaving quite responsibly with regard to general inflation since 2005. According to the IMF, world inflation, as measured by consumer price indices, has generally been declining since 2005, and has picked up only slightly in 2007.

So it is something of a puzzle why people started using the term so much in 2005. If central banks are tightening and long-term rates aren't rising, one needs some explanation."

The fallacy should be obvious here. He is trying to disprove the existence of high money supply growth by invoking the false and disproven Friedmanite mechanical link between money supply and consumer prices. Even setting aside that official CPI likely underestimate true consumer price inflation due to so-called hedonic adjustment and similar things and the fact that consumer price inflation is likely to accelerate sharply as soon as last year's brief oil price peak is removed from the 12-month comparison, the non-existence of high consumer price inflation does not disprove the non-existence of high money supply growth. Instead it disproves the mechanical
Friedmanite link between these two things. Money supply statistics is not something derived from indirect indicators and are available directly. And these money supply statistics show that in virtually all mayor economies except Japan, money supply growth are at double digit levels. The United States and the Euro area with their "mere" 10% money supply growth have actually relatively slow money supply growth compared to other mayor economies except for Japan.

What makes Shiller's piece even more nonsensical is that the link between money supply growth and financial bubbles are generally the greatest when consumer price inflation is modest. When the receivers of new money uses them to bid up asset prices rather than consumer prices, this will mean that financial markets will be "awash with liquidity" due to monetary factors. Thus, not only do the monetary explanation of financial bubbles not presuppose consumer price inflation, but it is in fact only applicable to the extent new money aren't used to bid up consumer prices to any mayor extent.


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