The Quantity Theory of Money

I just read a pamphlet by Friedrich Hayek published in 1976 titled, “Choice in Currency: A Way to Stop Inflation.”  It is relevant today because Ron Paul, who is running for US President, is advocating the same thing. Hayek argues that governments should not have a monopoly on the issue of money.  Instead, everyone should be able to use whatever they want for their money.  

His argument is shown to be absurd by Douglas Jay in the same pamphlet with a simple example.  “But suppose I offer one paper rouble in payment of a bus fare, and the conductor refuses to accept it; what happens?  Is the bus stopped while the conductor and I seek a ruling which nobody can give?  And imagine the controversies in the bus over the latest exchange rate between one currency and any other.  Professor Hayek’s new scheme would produce chaos and slow down the whole business of production and exchange in a welter of disputation.  That is why history has forced governments to legislate on legal tender” p. 27.

Hayek bases his argument on the quantity theory of money.  It says that an increase in the money supply will cause a general rise in prices, while a decrease in the money supply will cause a general decline in prices.  If we want price stability, then we need the money supply to be stable.

The quantity theory of money assumes that there is already enough money.  It says nothing about the quantity of money that would be neither too little nor too much.  That is, it says nothing about the amount that would be enough money.  If there is not enough money, an increase in the money supply would be good and not inflationary.  Only where there is already enough money, is a further increase not necessary.

Let me use an analogy.  Suppose an accident victim shows up in the Emergency Room bleeding profusely.  Imagine that the doctors there are using the quantity theory of blood as economists use the quantity theory of money.  They would say to each other, we must not give the patient a transfusion because that would increase the general amount of blood that the patient needs.  Let the body’s own “free market” decide how to distribute the remaining blood.  That patient would surely die. Our bodies need enough blood, neither too much nor too little.

Hayek sees inflation and concludes that the only cause of inflation is too much money.  He never considers that the problem is that there is no quantity on money.  Imagine that every note about length was followed by the word “meter” but there were no meter sticks.  What would the statement, “This room is 10 meters,” mean?  Would we have a quantity theory of length that said the more notes in circulation, the shorter the meter would become ?  That would be nonsense.  Given what we do when we measure length, we would say, we need meter sticks so that everyone can measure length accurately.  The same is true of money.

We need to wed time and money.  We need Hour Money.  We can then judge price with clocks.  That is the proper way to stop inflation and deflation.  That is how we move all wages and prices to their actual price, namely, the work time it took to produce goods and provide services.  People can always negotiate variations if they think such variations are justifiable.  That’s a free market that can be a fair market.