The Fed Is Not Independent | Steve Hanke and Jimmy Connor

Key Concepts

Quantity Theory of Money: The theory that changes in the money supply affect asset prices, real economic activity, and inflation.
Neoclassical Macroeconomic Model: The dominant macroeconomic model used by central banks, which does not include an aggregate measure for money.
Monetarism: An economic school of thought, championed by Milton Friedman, that emphasizes the role of money supply in influencing economic activity.
Interventionism: Government intervention in the economy, often through trade policies and industrial policy, which the speaker equates to socialism.
Neutrality of Monetary Policy: The principle that monetary policy should not favor specific sectors or income groups within the economy.
Money Supply Growth Rate: The rate at which the total amount of money in circulation increases.
Inflation: A general increase in prices and decrease in the purchasing value of money.
Asset Prices: The prices of financial assets such as stocks, bonds, and real estate.
Income Inequality: The unequal distribution of income among individuals or groups within a society.
Fiscal Policy: Government policies related to spending and taxation.
Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.

Critique of Central Banks and the Quantity Theory of Money

The primary motivation for writing the book "Making Money Work" is a critique of the US Federal Reserve and other central banks (Bank of Canada, Bank of England, European Central Bank). The core argument is that these institutions have abandoned the Quantity Theory of Money, which posits that changes in the money supply significantly impact asset prices, real economic activity, and inflation.

Historically, central banks paid close attention to money supply figures. For instance, during the 1980s, Federal Reserve Chairman Paul Volcker embraced the Quantity Theory of Money to combat stagflation and inflation. He believed that by "squeezing the money supply," inflation could be controlled. During this era, money supply data was widely reported and closely watched by the public and financial markets.

However, current central banks, including the Fed, have largely discarded this theory. They operate under a Neoclassical Macroeconomic Model that has not incorporated an aggregate measure of money for approximately 30 years. This leads to a situation where, if the money supply is deemed to have no effect, its measurement becomes irrelevant. The book aims to "modernize" the Quantity Theory of Money and reintroduce it into macroeconomic discourse, building upon the work of monetarists like Milton Friedman.

The book also critiques the failure of the Neoclassical model, suggesting it has "completely failed." It proposes that a comprehensive macroeconomic understanding requires combining Capital Theory (discussed in a previous book, "Capital Interest and Waiting") with the Quantity Theory of Money.

Money Supply Growth and Inflation: A Post-COVID Analysis

The transcript provides specific data illustrating the correlation between money supply growth and inflation, particularly in the context of the COVID-19 pandemic.

Pre-COVID (February 2020): The money supply in the US was growing at a rate consistent with the Fed's 2% inflation target, approximately 6% per year.
Post-COVID Acceleration: Following February 2020, the Federal Reserve significantly accelerated the money supply. The year-over-year growth rate peaked at an unprecedented 26%, the highest since the Fed's founding in 1913.
Inflation Lag: Approximately 12 months after the money supply peaked in 2021, inflation began to rise. By mid-2022, the inflation rate reached 9.1%. The authors, John Greenwood and Steve, had predicted inflation to reach as high as 9% based on the Quantity Theory of Money.
Monetary Tightening and Contraction: In response to high inflation, central banks began tightening monetary policy. Starting around April 2022, the money supply actually contracted. By the summer of the current year, the money stock was roughly at the same level as April 2022.
Current Situation: The money supply growth rate is currently around 4.8% in the US, which is considered "tight."

This sequence demonstrates a clear pattern: an increase in the money supply is followed by a rise in inflation with a lag, and a decrease in the money supply is followed by a decrease in inflation with a lag.

Reasons for the Fed's Disregard for the Quantity Theory of Money

Two primary factors are identified for the Federal Reserve's abandonment of the Quantity Theory of Money:

Dominance of Neoclassical Models in Academia: Young researchers at the Fed are trained in graduate schools that exclusively use Neoclassical models, which do not include the quantity of money. Their "toolkit" is thus limited to these models.
Political Leanings of Research Staff: The research staff at the Fed is overwhelmingly composed of Democrats (outnumbering Republicans by 50 to 1). Milton Friedman, a prominent proponent of the Quantity Theory of Money and monetarism, was considered an "enemy" of Democrats. This ideological bias, coupled with the historical dominance of Keynesian and later Neoclassical models, has led to the marginalization of monetarist ideas.

The book "Making Money Work" is presented as an effort to replace these outdated Neoclassical tools with a modernized approach to money and banking.

Interventionism vs. Free Markets

The discussion shifts to the increasing government involvement in the economy, contrasting it with Milton Friedman's advocacy for free markets and limited government.

Trade and Tariff Wars: The speaker points to ongoing trade disputes and tariff impositions as examples of government intervention.
Industrial Policy: This is described as a "cousin" to protectionism and trade interventions, representing a politicization of economic activity.
Socialism and Interventionism: The speaker argues that what was once called socialism is now rebranded as "interventionism," with politicians' "fingerprints all over everything."
Communist Manifesto: The speaker controversially suggests that the game plan of populist leaders, including President Trump, aligns with the principles outlined in the Communist Manifesto, despite their likely unfamiliarity with the document.

Milton Friedman's famous quote, "If you put the government in charge of the Sahara Desert in five years there would be a shortage of sand," is cited to illustrate his critique of government inefficiency. Friedman is remembered not only as a great economist but also for his likable demeanor and effective, concise rhetoric.

The Principle of Neutrality of Monetary Policy

A key principle put forth in "Making Money Work" is the neutrality of monetary policy.

Austrian School Perspective: Historically, the Austrian school of economics, to which the speaker aligns, has emphasized that money entering the system is non-neutral. It affects different sectors and stages of production (e.g., early manufacturing vs. final product assembly) and different income classes in disparate ways.
Consequences of Non-Neutrality: The greater the non-neutrality, the more the economy is "gummed up," slowed down, and its potential growth rate reduced.
Empirical Evidence: The authors have modernized this concept and gathered empirical data to support it. They demonstrate that changes in money supply and monetary policy (including bank regulations) affect neutrality.
COVID-19 Example: The increase in money supply post-COVID led to a surge in asset prices (stocks, real estate, land). Since wealthy individuals disproportionately own assets, their wealth increased significantly.
- Billionaire Wealth as a Percentage of GDP: This metric rose from 14.1% in January 2020 to 21.7% currently.
Income Inequality: This non-neutral monetary policy is identified as a major contributor to income inequality. The speaker criticizes those who lament income inequality without understanding that central bank actions, by inflating asset prices, disproportionately benefit asset owners.
Goal of Neutrality: The objective of monetary policy should be to ensure that increases in the money supply are as neutral as possible, not favoring any particular group, sector, or stage of production.
Expanded Goals for Monetary Policy: In addition to price stability and stable economic growth, the book proposes a third goal: neutral money.

The Swiss Model and Fed Independence

Switzerland as a Model: The Swiss central bank is cited as an example of a country that "makes money work." They tend to keep money supply growth within a range consistent with their inflation target (low end of which is zero), resulting in very low inflation.
Liechtenstein: This country is also mentioned as a stable economy that uses the Swiss Franc and does not have its own central bank or currency.
Fed Independence is a Fiction: The speaker argues that the Federal Reserve's independence is largely a "fiction." While legally it may have some autonomy, de facto, it is influenced by the White House and other institutions.
Presidential Influence: The example of President Reagan giving Fed Chairman Volcker a "blank check" to fight inflation is contrasted with President Trump's overt and direct attempts to influence monetary policy, which the speaker deems "not very helpful."
Counterproductive Interest Rate Policy: Trump's suggestion to lower the Fed Funds rate by 300 basis points is criticized as potentially counterproductive, as it could lead to higher long-term rates and increased interest payments on government debt.
Fiscal Policy and Debt: The discussion highlights the integration of fiscal and monetary policy. Deficits are seen as "deferred taxes," and the interest paid on accumulated debt is a significant and growing expenditure in the federal budget, representing a burden on future taxpayers.

Argentina, Venezuela, and Monetary Policy Failures

The conversation touches upon the economic crises in Argentina and Venezuela.

Argentina: The speaker asserts that if Argentina followed the principles in "Making Money Work," its peso would not be in its current problematic state.
Venezuela: The country's hyperinflation is attributed to a failure to manage the money supply.
Inflation as a Monetary Phenomenon: The fundamental argument is reiterated: "Inflation is always and everywhere a monetary phenomenon." The speaker states that no significant inflation (over 4% for more than two years) has occurred without a preceding substantial increase in the money supply.

The Big Takeaway from "Making Money Work"

The single most important takeaway from the book is that for anyone interested in macroeconomics and the direction of the economy, the Quantity Theory of Money is the only reliable model. The book emphasizes the importance of correctly measuring the money supply, noting that most central banks do not do so accurately. Furthermore, it stresses that money "dominates" and must be managed to ensure neutrality, preventing it from favoring specific groups or sectors.

The book is highly recommended for understanding the crucial role of money in the economic system and the strong correlation between money supply growth and inflation.