The British economist Charles Goodhart recognized in the 1970s that “as soon as a government tries to control certain financial indicators, they become useless as indicators of economic trends”. The phenomenon known since then as Goodhart’s law can be observed in many areas.
In 1975 Goodhart was concerned with monetary policy, and today, some 50 years later, it is again monetary policy that encourages an extension of Goodhart’s law. This could be: “As soon as the indicator previously used for control is no longer taken into account, it becomes relevant again.” Specifically, I am thinking of the importance of the money supply for inflation.
For years, many economists have been certain that the money supply plays no role in inflation. The connection between the money supply and inflation, which is immediately obvious to laypeople, is rejected because there is no reliable statistical connection between the two variables. Countless studies over the last few decades have shown that the development of the money supply in different definitions is not a suitable indicator for future inflation.
Even the Nobel Prize winner Milton Friedman, the founder of monetarism, i.e. the focus on the money supply, admitted at the old age of 91 in an interview with the “Financial Times” that he had concentrated too much on the money supply.
One of the difficulties of controlling the money supply is that there are different definitions of what counts as money. In the definition M3 of the euro system, the money supply consists, among other things, of cash, demand deposits of non-banks, savings deposits and shares in money market funds.
Everything changed with the pandemic
No wonder, then, that the central banks have given up trying to control the money supply. They also stopped paying attention to the money supply. The purchase programs for securities, so-called quantitative easing, did not aim to expand the money supply, but to depress medium- and long-term interest rates.
The logic seemed plausible: as long as inflation is low, monetary policy cannot be too loose. The consequences of this view were long years of falling and very low interest rates. These encouraged high levels of debt and rising asset prices, but did not actually lead to inflation.
That changed with the corona pandemic. The money supply rose significantly and, with some delay, so did prices. However, central banks and economists did not want to see a connection. Inflation, classified as temporary, is due to disrupted supply chains. It was only gradually that people realized that monetary policy played a significant role in inflation.
>> Read here: What is inflation? Definition, examples, meaning
Longtime Bank of England boss Mervin King says the cause is an “intellectual error”. The central banks had followed an academically developed approach that said inflation was entirely determined by inflation expectations. As long as these are low, there is no inflation.
In January, however, the Bundesbank had to concede that monetary policy played a part in last year’s sharp rise in inflation. The Bank for International Settlements (BIS) became clearer. In a study, the economists calculate that there is indeed a statistical connection between the money supply and inflation. However, this is only given in the context of higher inflation rates.
Money supply needs to be rehabilitated
Translated, one can say: As long as inflation is low, the money supply does not play a role, as soon as inflation picks up, it becomes relevant again and can also fuel the inflationary processes. The error of the economists in the inflation forecasts was particularly great in those countries and regions where the money supply has risen particularly sharply.
To argue for a return to monetary control would be wrong. However, the development of the money supply should be rehabilitated as an indicator of the risk of inflation in the real economy and the formation of bubbles in the asset markets.
More: IMF sees global economy “in an extremely uncertain situation” – Gloomy forecast for Germany