Who is Abdul Hafeez Shaikh trying to deceive?
In a recent press conference, Advisor to the PM on Finance (defacto Finance Minister) Abdul Hafeez Shaikh had this to say about inflation.
“The government does not want to take any step that increases inflation,” he said, adding that in this regard the government had stopped borrowing from the State Bank of Pakistan.
“This means that no new currency notes are being printed,” he said, adding that not a single rupee has been printed during the last four months.
The first paragraph about not borrowing from State Bank of Pakistan (SBP) is much ado about nothing as government is now borrowing from commercial banks. One lender has been replaced by a group of lenders.
Second statement about not printing rupees implies that government can stop inflation by not printing money which is clearly wrong.
The purpose of this post is to explain in brief why is it wrong. To avoid getting wonkish, pedantic or boring, I use the example of tomatoes as it is the flavor of the week.
All of us have read (or at least those who took Econ 101) the money equation
MV=PQ
where M is quantity of money or money supply, V is velocity, P is price or price level and Q is the quantity of goods/service or GDP. Increase in P is usually deemed as inflation.
Easier to explain with an example. Let’s say in a closed and cash-only economy, there is a tomato grower and a cook. And just one Rs.300 note, which is in the possession of cook (I could have gone with one Rs.100 note but cook wouldn’t be able to buy many tomatoes with it).
Cook goes to the farmer and buys one kilo of tomato (Q) for Rs.300 (P). This is shown by equation as
M (Rs.300 Note) x V = P (300) x Q (1Kg)
300 = 300
Money is used once so V=1. The money isn’t consumed. It can be re-used.
The same evening, the farmer goes to the cook and buys one plate of tomato curry from him for Rs.300 and hands him back Rs.300. The Rs.300 note has been used 2 times so the velocity becomes 2. The equation shows
M (Rs.300 note) x V (2 times) = PxQ = (1 kg x 300Rs)+(1 plate x 300Rs.)
600=600.
LHS (left hand side) = RHS (right hand side)
It should be stressed MV=PQ is an accounting identity equation and not a causality. It doesn’t say that an increase in money supply will lead to an increase in output Q or inflation that is increase in price level P. It can be rewritten as below without implying anything.
V=PQ/M
Q=MV/P
P=MV/Q or even
PQ=MV.
There is no guarantee that increase in P will lead to an increase in M or V or both or just a reduction in Q. All it says is when all said and done, this is the equation that will be satisfied. In Japan, for two decades, Central Bank has been pumping money (increasing M) into the market through quantitative easing but so far it hasn’t manifested into inflation (increase in P).
Digression
In hyperinflation, whoever has the money wants to get rid of it and buy goods quickly with it as P is rising rapidly reducing the value of money (same amount of money buys you less amount of goods). In our closed economy example, if there is hyperinflation, as soon as the cook gets the Rs.300 for selling his dish, he will walk over to the farmer while the farmer is in midst of his dinner and will ask him to sell him tomatoes right away for Rs.300.
While taking the money, the farmer will tell the cook, “as soon as I have finished dinner, I will come over and pay for tomorrow’s dinner in advance.” And the circle will continue. In the hyperinflationary environment, the money moves with hypervelocity.
A lot is going on in hyperinflation but stories of the hyperinflationary environments are always about people running around with bags of money trying to exchange it with goods. No one wants to keep the cash.
Alternatively, assume the velocity of money is zero. We should be wary of assigning causality but it implies that the right side of identity equation is also zero. Farmer may be growing tomatoes but cook isn’t buying because he expects lower prices tomorrow due to deflation.
The following day, the cook goes to buy tomatoes but they have expired. Farmer says to him “Tamatar sarh gaye. Ab Rs.300 ki batti bana lo”. So no more tomato growing and thus no more tomato curries and GDP falls to zero and economy goes into a slump (if it wasn’t already in one). That is why deflations are bad. In depression everyone is trying to hold on to money because prices of goods are falling. People stop buying stuff, output goes into a down and people hoard money.
Digression over.
One autumn day, farmer says to cook, “tomorrow night I will buy two plates of tomato curry from you because guests are coming over.” The cook now needs to buy Rs.600 worth of tomatoes but there is only one Rs.300 note and velocity of money cannot solve the problem here for logistical reasons unless the plan is to feed the guests one plate at a time.
The cook and farmer go to local mosque’s imam sb (in western version of such stories, a pub/tavern usually plays this role). Imam sb brings out his chanday ki raseedon wala kitaabcha, which was withering away as no currency note to spare in economy against which to issue receipt and says, “I will write Rs.300 on one receipt and sign it and you can treat this a currency.”
The farmer replies “Molvi sb, kin panchayaton mein parh rahay hain. FIA waalay utha ke lay jayein gay. Koi aasaan tareeqa bataein”. Imam sb takes out a register and records an accounting entry that cook owes Rs.300 to farmer. Now cook is able to buy 2kilos of tomatoes.
RHS of identity equation PQ now is Rs.600 (as two kilos of tomatoes bought). Velocity is 1 as single transaction has taken place implying M = 600. But there is only one Rs.300 note. By making an entry in the register, Imam sb has created Rs. 300 money out of thin air. Astaghfirullah. What about ZaidHamid and his theory of gold backed dinar and how islamic currency should be gold backed, you wonder. Imam sb doesn’t watch TV / youtube so doesn’t know much about laal topi wala and his crazy theories. The identity equation now shows:
M (Rs.300 note + Rs.300 deposit) x V (1) = P (300) x (2) Q
600=600
Money M in the economy is Rs.600 (Rs.300 note + Rs.300 deposit). The register will show loan of Rs.300 under Cook and deposit of Rs.300 under farmer. Imam sb is acting as a bank.
That’s how commercial banks create money out of thin air by making loans. Money supply section in econ textbooks talks about M0, M1, M2 etc and broad money. Rs.300 note is in M0 and then various types of deposits etc are included in other types of money.
Farmer hinted about interest on deposit but Imam sb shut him down saying “sood haram hai”.
In the evening, cook hands over 2 plates of tomato curry to the farmer and the loan is settled. The deposit in the farmer’s account is used to settle the overdraft in cook’s account. The money supply in the economy is brought down to Rs.300 (Rs.300 notes + 0 deposit).
Nobody tells molvi sb thathe is engaging in magic (which is also haram) by creating and destroying money with the stroke of his pen. To be clear (magic is haram, creating money isn’t). Commercial banks do this magic every day with click of a button.
Now you might say, “see..see.. there is causality. Increase in money supply increased output”. Ok. Let’s say farmer also comes to believe that too i.e., if the money M is increased, it’ll lead to an increase in output. Next day, he takes the cook to imam sb and says, “Imam sb give a loan of Rs.2700 to cook as I have invited my inlaws for dinner and I need 10 plates of tomato curry”.
Cook balks at this, saying “bhaiyya, aap ke bhai k paas aik hi choolha hai or sirf do haath hain. Ziada se ziada 2 plates bana sakta hoon. Capacity hi nahin hai”. So even if money M is increased 10 times, we have no idea how the other various variables will behave. Assuming cook only buys Rs.600 worth of tomatoes as that is the maximum he can cook, the equation now becomes
M (Rs.3000) x V (0.2) = P (300Rs.) x Q (2 kilos)
600 = 600
The velocity dropped to 0.2. Who would have thunk? One can forgive the farmer for getting carried away. He is not an econ PhD afterall.
To summarize:
- MV=PQ is an accounting identity equation and does not explain causality.
- Currency note is not the only form of money.
- Banks create money by making loans.
- If the government is borrowing from commercial banks, it is increasing money supply.
So when the de facto Finance Minister of the country (with a solid pedigree) says we are not printing money to stop inflation and we will be borrowing from commercial banks, who is he telling this to?
The usual caveats
Economies comprise of multiple actors and sectors and are complex, the example was simplistic, not all nuances were covered and last but not least, even I might have made a very fundamental error in my assumptions.
