08 March 2011

The Missing Piece

There is this old idea in monetary theory called money neutrality. Money neutrality means that larger quantities of money ultimately manifest themselves in the form of higher nominal prices (and wages), and not on real quantities. No serious economist disputes the idea of long-run money neutrality.
Yes, what cost $1 in 1913 now costs $20. But so what? Money neutrality states that if you were earning $1 per hour in 1913, you are now earning $20 per hour (and even more, if labor productivity is higher).
So there you go, the Fed is responsible for increasing your nominal wage by a factor of 20. How do all you workers out there like them apples? Ron Paul wants to rob you of these wage increases!
Before I rebut this clown’s argument, I’d first like to point out his general inconsistency.  Note how he argues money neutrality, essentially saying that nominal increases in the price of goods are okay because they are matched by increases in pay.  This means that there is no raise, except nominally.  Then he turns around and claims that Ron Paul wants to rob people of their wages.  If money neutrality is correct, then Ron Paul literally cannot rob people of their raises, for said raises are purely nominal, not actual.

That aside, the money neutrality argument fails on two grounds.

First, money neutrality fails because it ignores micro cycles.  By this I mean that money neutrality theory ignores the short-run consequences of inflation.  Sure, money neutrality works in the long run.  Of course, it is also true that we are all dead in the long run.  Furthermore, a significant number of economic and financial decisions are made in the short term, and so it is foolish to assert that the long run success of money neutrality overcomes the negative side effects of its short term consequences.

Second, money neutrality ignores savings.  (By the way, savings are not synonymous with investment.)   If I saved $100 in 1913, it would have the purchasing power of $5 today.  There is no money neutrality for savings, and this is a significant oversight in the above analysis.  One of the reasons why inflation is so destructive is because it discourages savings, encourages spending, and encourages risky investing in order to preserve the value of one’s money.

Thus, money neutrality as a concept is nothing more than Keynesian bunk, once again exposed as utter foolishness.  In closing, I would simply like to say this:

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