I’d first like to thank David for his very kind introduction. It’s an honor to be invited to do a stint as a guest blogger at one of my favorite blogs. I do plan to keep my other blog (TheMoneyIllusion.com) going, but at a reduced rate. I won’t be able to answer all the comments at both blogs, but will answer some.
I always get a bit annoyed when I hear people talk about investors putting money “into” markets. I suppose that at an individual level this might make some sense. You could take some of your money and purchase stocks. But is the money actually going “into” the stock market? If so, where does the stock market keep all the money that people invest? In a box? Or does money simply go through markets, as the person selling me the stock is presumably taking an equal amount of money out of the market?
On October 19, 1987, a record number of shares of stock were purchased on Wall Street. Does this mean that investors put a lot of money “into” the market that day? If so, why did stock prices fall by 22%?
Some might argue that the phrase “putting money into a market” is a harmless metaphor for describing rising asset prices. But why not just say “rising asset prices”? And I’m not at all sure that it is harmless. I also see people discuss monetary policy from the perspective of where the money goes, not just the supply and demand for money itself. And yet if existing money doesn’t actually go into markets, then newly created money doesn’t either.
Of course central banks generally inject new money by purchasing assets. So the effect of monetary policy might depend in some important way on the choice of assets being purchased. After all, doesn’t the law of supply and demand predict that an increased demand for an asset will raise its price?
At a recent conference Larry White mentioned that Milton Friedman had argued that the gold standard was wasteful, as it led to a higher real price of gold and thus socially unproductive gold mining activity. Larry pointed out that real gold prices actually rose after the government stopped buying gold at $35 an ounce. Friedman had forgotten that switching to a fiat money system might lead to higher inflation, which would encourage more private demand for gold (as an inflation hedge.)
The same process may occur when the Fed purchases Treasury securities. During the 1950s the Fed purchased relatively few Treasuries. Then during the 60s and 70s there was a dramatic increase in the rate at which the Fed bought Treasury securities. So what happened when the Fed put all this money “into” the Treasury market? Surprisingly, T-bond prices plummeted between the 1960s and early 80s. This occurred because monetary policy doesn’t just affect the Treasury market, it also affects the “money market”. And by ‘money’ I mean the monetary base, the type of money directly produced by the Fed. The base began increasing rapidly in the 1960s and 70s, boosting inflation and nominal GDP (NGDP) growth, which pushed nominal interest rates sharply higher. So talk of the Fed putting money “into” markets is not a harmless metaphor for rising asset prices, it can lead to very serious errors. People think that monetary injections boost NGDP because they raise bond prices, whereas they actually boost NGDP even more on those occasions where the policy reduces bond prices.