human action

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Is Inflation Always And Everywhere a Monetary Phenomenon?

Yesterday, I asked:

It is true that the equation I am referring to — MV=PQ, where M is the money supply, V is velocity, P is the price level and Q is output — is not exactly Friedman’s equation. It was initially theorised by John Stuart Mill, and formulated algebraically by Irving Fisher, but adopted by Friedman and his monetarist followers to the extent that Milton Friedman had it as his car number plate:

268621-127539779936939-Erwan-Mahe_origin

MV=PQ itself is a tautology that ties together three disparate variables — the money supply (M), the price level (P) and the output (Q) — by creating a quantity — velocity (V) — that is not observed directly, but is instead computed retrospectively from the three other variables. But, nonetheless, so long as we can overlook the fact that V is not directly observed (which ultimately we should not, but that is another story) it is true that MV=PQ accurately describes monetary reality.

Friedman’s famous quote seems to contradict his beloved equation:

Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.

Within the parameters of the equation, an increase in P can come from any of the other three variables in the equation — all else being equal a decrease in Q, or an increase in M, or an increase in V.

The only way that Friedman’s statement could be true is if V and Q were stable. Friedman did actually claim that V was largely stable, but empirical data rules this out. Here’s velocity:

velocity

And here’s output:

dGDP

Neither of these are constant, or even particularly stable, meaning that it is impossible within the parameters of Friedman’s own equation for inflation (changes in P) to solely be a monetary phenomenon. Inflation by Friedman’s own mathematical definition is a result of a combination of factors. And in the real world, it is far, far, far more complicated — a price index generalises a staggering array of human actions, each one the outcome of an equally vast array of psychological, social and economic influences.

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The Mathematicization of Economics

If one thing has changed in the last one hundred years in economics it has been the huge outgrowth in the usage of mathematics:

This is largely a bad development, for a number of reasons.

First of all layers of mathematics acts as a barrier to public understanding. While mathematics is a useful language for communicating complex ideas, those without training in mathematics will struggle to grasp what an author is trying to communicate if a paper consists mostly of equations untranslated into English. This is bad practice; it is easier to baffle with bullshit in an unfamiliar language than it is in plain English.

Second, mathematical models are always simplifications. Human action and economic behaviour is complex and unpredictable. While mathematical models can sometimes approximate a pattern quite well and so have some limited uses as toys, the complexity of human behaviour means that there are always unmodelled variables that can throw off a model’s output. Over-reliance upon or excessive faith in mathematical models can lead to bad forecasting and bad policy decisions. The grand theoretical-mathematical approach to economics is fundamentally flawed.

Third, attempting to smudge the human reality of economics into cold mathematical shackles is degenerative. Economics is a human subject. Human behaviour is not mechanical, it is not mechanistic. Physicists can very accurately model the trajectories of rocks in space. But economists cannot accurately model the trajectories of prices, employment and interest rates down on the rocky ground.

Economics would benefit from self-restraint in regard to the usage of mathematics. Alfred Marshall made some useful suggestions:

  1.  Use mathematics as shorthand language, rather than as an engine of inquiry.
  2.  Keep to them till you have done.
  3. Translate into English.
  4. Then illustrate by examples that are important in real life
  5. Burn the mathematics.
  6. If you can’t succeed in 4, burn 3. This I do often.

I hope the blowout growth in mathematics in economics is a bubble that soon bursts.