A one-infant increase in the child–staff ratio requirement for infants is associated with a decrease in the cost of care of between 9 percent and 20 percent, which translates into a reduction in the annual cost of child care of between $850 and $1,890 for the average cost of care across states. This is from Diana W. Thomas and Devon Gorry, “Regulation and the Cost of Child Care,” Mercatus Working Paper, August 2015. Diana tells me that it was later published but that this working paper contains the essence of their findings. This is huge. Allowing just one more infant per care giver would dramatically reduce the cost of child care. If I had known about this study when I was fighting a proposed new property tax to pay for child care, it would have strengthened my argument. HT2 Vincent Geloso. (0 COMMENTS)

I have a confession to make. I’ve never understood military history. I don’t go out of my way to read military history, but while reading ordinary history I’ve often run across explanations of how the world’s greatest generals were able to achieve their success.  There is frequently a description of how a general would “outflank his opponent” and rout the enemy army. Or “seize the high ground”. Or engage in a “surprise early morning attack”.Here’s what I’ve never understood. Why don’t both sides try to do these things?I recently read an essay by Montaigne entitled, On the uncertainty of our judgement.  Unlike me, Montaigne does understand military history.  And he uses this essay to examine one example after another of where the same military strategy that worked in one case, failed in another.  So then in what sense can we say that reference to these strategies explain anything at all? I see the same problem in many areas of life: Politics:  When I was young, I recall George Romney’s 1968 campaign failing after a minor “blooper” about the Vietnam War.  This was frequently pointed to as an example of how running for president was a serious business and voters would not tolerate anything even slightly unconventional. And then Donald Trump came along. Sports:  We are often told that a certain strategy doesn’t work in the playoffs, until it does.  Or that a certain athlete is “clutch”, until he isn’t.  I’m told you need a big center in basketball, and then see big centers “played off the floor.”  The older I get, the less convinced I am by the conventional wisdom of sports commentators. Business:  Management classes are full of case studies showing which strategies work.  But the real world is full of both successes and failures associated with any given approach used by a CEO. Relationships:  We are told that Jack and Jill have a successful marriage because while they are very different; their personalities complement each other.  And we are told that Fred and Alice have a successful marriage because they have similar interests and personalities.  So which is it? Cinema:  A certain movie becomes a big hit.  Hollywood makes another movie in the same style and it flops.  One of the most famous sayings in Hollywood is William Goldman’s observation that, “Nobody knows anything.”  Markets:  We are told that speculative assets like Pets.com were obviously a bubble that would eventually collapse.  But then even more speculative assets like Bitcoin come along, and fail to collapse as predicted.  So do we actually know anything about bubbles? Banking:  We have a major banking crisis in 2008 because lots of commercial loans went bad.  We are told that banks need to invest in safer assets, such as government bonds.  Silicon Valley Bank does this and goes bankrupt when yields rise and bond prices fall. This is why government regulation is not well suited to solve problems such as excessive risk taking caused by moral hazard.  If commercial loans are too risky, and government bonds are also too risky, what’s left?  You could have a perfectly safe “narrow bank”, but the Fed refused to give a banking license to an entrepreneur who tried to create a bank that invests all its funds with the Fed. We (meaning pundits and regulators and politicians) think we understand the banking problem, but we don’t.  We have created a system that almost completely socializes the liability side of bank balance sheets.  Without market discipline, banks have little incentive to behave responsibly.  We then assume the solution is “regulation”.   How likely is it that regulation can solve our banking woes?  Consider the following analogy.  Give me a book on “How to be a General” and have me go up against someone like Alexander, Hannibal, Napoleon, Patton, etc.  How likely is it that I’ll succeed?  Now give a young inexperienced government bureaucrat a book on how to regulate banking and have them go up against JP Morgan. Good luck.  PS.  Matt Levine has an excellent post discussing the difficulty of regulating banks.  He points out that even the most basic questions are difficult to answer.  No one even knows whether higher interest rates are good for banks or bad for banks. PPS.  George Romney said that he had been “brainwashed” by generals he spoke with in Vietnam into believing the war was going well.  Apparently some voters didn’t understand that “brainwashed” can be a metaphor, and assumed that he had some sort of electrodes attached to his brain.  Yes, that was the “scandal” that cost him the presidency.  (Mitt Romney is his son.) PPPS.  Yesterday, a key NBA playoff game resulted in a lopsided 128-102 outcome.  When the score is that lopsided, it is often because one team doesn’t try hard enough.  So I checked the box score and saw that one team had 21 offensive rebounds while the other had just one.  And sure enough, the sports commentators almost unanimously criticized the losing team for a lack of effort.  But there’s just one problem.  It was the team with the lackluster effort that got the 21 offensive rebounds.  So what’s going on here?  I suspect that people infer effort from outcome.  Losing that badly makes it look like you didn’t even try, especially when you have the more talented team. BTW, I don’t mean to criticize the NBA commentators—that was also my impression while watching the game.  I’m increasingly of the view that all of us overestimate how well we understand the world.  But have no fear, soon all of the human commentators that are swayed by emotion will be replaced by simulated humans powered by GPT-4, who will crunch all the numbers and tell us what actually happened in the game. That’s what we all want—right? (0 COMMENTS)

A normative extension of standard economic theory is that an individual is the best judge of what is good for himself. At least, there is no way to determine who else would be a better judge, and especially who should be entitled to impose his own preferences by force. The choice of a consumer, producer (including worker), or participant in any voluntary social interaction is thus worthy of legal protection if not of respect. Not too long ago, virtually any mainstream or Austrian economist would have agreed with this normative presumption. Children were the only hard exception. The presumption applied only to adults. It is true that blacks or women (as well as proletarians with false consciousness in Marxist theory) were often viewed as exceptions too, but economists typically rejected this sort of philosophical discrimination between human adults. The “dismal science” label was apparently stuck onto economics for this sort of reason. (See my post “Is it OK to Use the R Word?”) In the classical-liberal tradition, moreover, it went without saying that nobody should be given the power to decide at what age a specific individual becomes an adult. Thus, the rule of law established a standard age, usually 21, and more recently 18. In our (Western or Westernized) countries, there are lots of things that a child cannot freely do with his body, including accepting certain kinds of employment at certain conditions, evading any sort of schooling, escaping from home, possessing guns and explosives, and so forth. In many countries, a child (and even a young legal adult!) is prohibited from buying cigarettes and alcohol. His parents do have to sign off, at least implicitly, on most of what he does. Sometimes, even the parents’ permission is not enough. The scandal of children being allowed, with the state’s complicity if not incitement, to submit to sexual mutilations is a relatively new phenomenon (see my post “Mrs. Grundy Against Ryan Anderson’s Book”). Girls’ clitorectomy or infibulation were rightly viewed as liberticidal and barbarian practices. If we follow the standard normative economic interpretation of individual choices, of course, an adult should not be forbidden to alter his own body. Wrote John Stuart Mill, “over himself, over his own body and mind, the individual is sovereign.” Children are another matter—until they are old enough to make their own choices. Viewed from this perspective, the so-called “Let Them Grow Act” just adopted by the Nebraska legislature appears rather moderate, if not too moderate (see Sections 14-20 of Bill LB574). It prohibits sexual mutilations on non-adults by way of surgery (altering or removing sexual attributes or features), while allowing some leeway for chemical puberty blockers and hormone therapy (which may have irreversible consequences). An opponent of the bill, state senator George Dungan, a Democrat, declared: We should not be in the business of telling people what they can and can’t do with their bodies. Indeed, people who oppose such a mild ban on mutilating children appear to be part of the same crowd that wholeheartedly approves most of the restrictions imposed on adults regarding the use of their own bodies, from the right to carry instruments of self-defense to the freedom to work for less than minimum wages that exclude them from employment, to use their hands or voices to express unfashionable ideas, to put or not put some substances in their own bodies, and to generally engage in “capitalist acts between consenting adults” (to quote Robert Nozick). As Miranda said in Shakespeare’s The Tempest: “O brave new world, that has such people in it!” (0 COMMENTS)

We’ve talked a lot about data over the years here, but this episode offers a unique take on data-driven decision making. EconTalk host Russ Roberts welcomed Bill James, an American writer whose work includes baseball history and statistics, has been extremely well accepted. His application of Sabermetrics and creation of ‘Moneyball theory’ have been transformative in baseball’s landscape. James also worked as a Senior Advisor of Baseball Operations for the Boston Red Sox for 17 years, earning four World Series rings during his time there. Roberts and James talk about the shortening of baseball games to save their entertainment value with James concluding there will always be time extending trade-offs with small-scale changes, like the pitch clock. Data and different approaches to winning are always evolving, and James and Roberts provide their take on the intrigue which the universe of baseball provides. Perhaps unlike many other things in life, it may be possible for someone to figure out the closed system of baseball. James stresses the importance of connecting all the dots and favoring science over expertise when making a conclusion, which can be applied well beyond baseball. We’re glad you’ve joined us in revisiting this episode, and we’d love to hear your thoughts about it today. Share your responses to the prompts below in the Comments, or use them to start your own conversation offline. We’re always happy to continue the conversation.     1- What’s the difference between science and expertise, according to James, and how can science protect against falsehoods brought about and by expertise? Roberts discusses people seeking reassurance and following anything derived from their trust in the credentials of an expert with the example of someone having to agree with F.A. Hayek about the validity of social security. Roberts argues that people have become blinded by the reassurance they seek in treating controversial topics, and that one’s credentials do not necessarily make their words truthful. What should be the role of expertise? How should ‘followers’ interact with the information they hear from experts in a thoughtful manner?   2- At the time this episode was recorded, Bill James proposed incentives which he believes would more effectively treat the issue of speeding up baseball than the rule changes which are present today. James identifies rule-changes like the pitch-clock as “pulling up the biggest weeds” as opposed to “mowing the lawn,” where the weeds will result in more weeds—more moments of monotony on the diamond. Is James, right? Would incentives like draft picks, additional television compensation, and home-field advantage be pressing on the team’s self-interest? Do today’s rule changes create more slow-downs, or do they function as agents not only for shorter games, but games with more appealing action?   3-James’ conception of baseball as a mini-universe is particularly striking. He argues that people are drawn to baseball because they can get a sense of figuring it out. Following James, how does the intrigue for the closed system of baseball and its intricacies relate to issues we all face each day? What other ‘closed systems’ or mini universes spark human interest?   4-James and Roberts discuss the prevalence of narrative building where people connect only the dots which serve their particular point. What kind of approach should individuals take when spreading information to protect against being ignorant of unlearned knowledge? Why are people so trusting of experts, and how can curiosity help to protect the validity and pursuit of knowledge?   5-James argues that Barry Bonds should be in the Hall of Fame because there were no specific rules against steroids at the time he was using them. Should Barry Bonds get into the baseball Hall of Fame? Can rules like the current drug policy be retroactive or should Major League Baseball recognize that players had an incentive to use steroids, and that there were no rules against them? When rules are not strictly enforced, and would you agree with Roberts and James that they are not rules, even if later they are enforced? (0 COMMENTS)

In a case that highlights the critical need for local housing and the lengths some people will undertake to profit from it, county officials say they are fining property owners Nicolas and Ana Ruvalcaba nearly $60,000 for renting out at least 62 illegal dwellings to farmworkers and their families on San Miguel Canyon Road in northern Monterey County. The county had at first estimated that about 100 people were living at the site, including women and children. Now that estimate is more than 200. Media reports indicate that the tenants were paying between $1,000 and $2,000 in rent each month. One tenant who was interviewed said she had no options beyond living at the site, but said she was treated with respect. Another woman who was interviewed echoed her comments. These are the opening paragraphs in Chris Counts, ” County busts landlord with illegal housing,” Carmel Pine Conc, May 19-25, 2023. The news story goes on to detail the ways in which the housing was substandard: The Monterey County Environmental Health Bureau reported that examples of site include units with “no heat, no smoke/ carbon monoxide sensors, no windows, the presence of “poor water quality, sewage discharge onto the ground and mold.” Point made: it’s low quality. But here’s the thing: every one of those tenants chose to live there. For them it appears to have been their best option. You don’t make people better off by preventing them from having the best of their lousy options. The person trying to take away that best option is not their friend. The news story points out that the government is requiring the owners to “demolish unpermitted units and utilities.” The fact that the government has royally screwed not just the landlords but also the tenants comes out in another paragraph: The executive director of the Coalition of Homeless Services Providers, Genevieve Lucas-Conwell told the newspaper that her group has interviewed about 30 of the former tenants, which [sic] she said mostly speak Spanish and Mixtec. Lucas-Conwell said her group is helping connect them with other groups that can provide services, such as temporary housing. But she conceded there is a bottleneck of people in need of housing. “It’s a tough situation,” she said. But it’s not tough for the government officials who are requiring that housing be destroyed.   (0 COMMENTS)

When there’s no vaccine on the market, people will look for other ways to be safe, including school closures and the handwashing of groceries. Listen as economist Casey Mulligan of the University Chicago talks with EconTalk’s Russ Roberts about the costs of delaying a vaccine, the hidden costs of FDA regulation, and what we learned […] The post Casey Mulligan on Vaccines, the Pandemic, and the FDA appeared first on Econlib.

Robert Lucas In response to my Wall Street Journal op/ed on the accomplishments of the late Robert E. Lucas, John Tamny wrote a response in Forbes that finds fault with much of what I wrote. His article is titled “When Did Market Intervention Become Chic to ‘Free Market’ Economists?” This is my fairly comprehensive response. Start with his title. Notice that Free Market is in quotation marks, the implication being, presumably, that neither Bob Lucas nor I was/is a free market economist. He never says why, though. Of course it’s possible that Tamny didn’t choose the title. But the title is certainly consistent with the content and tone of his article. Tamny’s first paragraph: “The sole use of money is to circulate consumable goods.” Those are the words of Adam Smith in The Wealth of Nations. Notable about what Smith wrote is that it’s a throwaway line in the book, so obvious was it. It’s still obvious. Money quite simply has no purpose absent production. Actually, Tamny’s last sentence is wrong. The reason we use money is to exchange. If people did no production but there were many goods that they just had (what we sometimes call in economics “an endowment”), there would be money. When he gets into the meat of his critique of me and, by implication. Bob Lucas, Tamny writes: With apparent excitement, Henderson wrote of how Lucas argued that “if the Federal Reserve increased the growth rate of the money supply to get a temporary reduction in unemployment, the policy would work only if the actual growth rate was bigger than what people expected.” Implicit here is that market intervention by non-market actors is a positive so long as the intervention is properly executed. And that’s not the only reason Henderson’s reverence is so puzzling. Tamny fails to make one of the most basic distinctions we have in economics: the distinction between the positive (what is) and the normative (what should be.) The positive issue is “What is the effect on unemployment of increasing the growth rate of the money supply?” That’s separate from the normative issue of whether the government should increase the growth of the money supply. Tamny then writes: Why, given the global nature of money and credit, would the central bank need to increase so-called “money supply” as is? This rates asking with the dollar top of mind. At present it’s the currency of business in Teheran and Pyongyang, among countless other countries, not to mention that you better have dollars if you want to buy a house in Argentina. The underlying point of all this is that money doesn’t instigate as Henderson alludes, rather it’s a consequence of production. In other words, the dollar isn’t in Iran because the Fed “supplied” those dollars to the Iranians, but because producers want roughly equal value for what they bring to market. Translated, a rial that’s been devalued 3,000+ times since 1971 is not fit as a facilitator of exchange, but the dollar is. Markets work. Not to economists, it seems. When he writes “The underlying point of all this is that money doesn’t instigate as Henderson alludes, rather it’s a consequence of production.” He seems to be saying that increases in the money supply don’t have effects (“money doesn’t instigate.”) I have no idea why he thinks this. He doesn’t tell us why. Indeed I wonder if it occurred to him to ask whether the number of rials printed by Iran’s central bank had any effect on the value of the rial. Didn’t that money “instigate” substantial inflation? And what’s with the “Markets work. Not to economists, it seems”? Where in my WSJ op/ed can he find even a hint that I think markets don’t work? The most charitable thing I can say about Tamny is that he is profoundly ignorant. Tamny then writes: To this day it’s accepted wisdom among Keynesians and Monetarists alike that per Milton Friedman, the Fed’s monetary “tightness” factored large as a cause of the “Great Depression.” Which is an impossibility for it implying that there are closed economies within the “closed economy” that is the world economy. There aren’t. I’m not sure whether Tamny is right in claiming that this is accepted wisdom among Keynesians. I think that’s true for some Keynesians and not others. It should be accepted wisdom. But not only does Tamny deny the causation but also he goes further, saying that it’s impossible for a large decrease in the money supply to have been a major factor in causing the Great Depression. Unfortunately, Tamny doesn’t tell us why or how he has come up with his impossibility result. Tamny writes: Lucas apparently also discovered that the “same tools, such as tax policy, used to achieve economic growth in rich countries could be used to generate growth in poor countries.” You think? Economies are individuals, and individuals are better off when taxed less. Still, even here Henderson seems engrossed in what government can do to achieve growth. In his first sentence in the above paragraph, Tamny at least seems to admit that Lucas has a point. He sarcastically asks “You think?” and he has a point. Peter Bauer, many years before Lucas, thought that the same factors that cause growth in rich countries also were important for poor countries. It took Lucas, though, to drive the point home. But then his last sentence is just odd. “Henderson seems engrossed in what government can do to achieve growth.” Yes, and the main things it can do are deregulate and cut taxes. Is Tamny not engrossed in understanding the often-bad effects of government? And if he’s not, is he saying that government policy doesn’t matter? What would Tamny’s readers think if he told them that one of the main points I made in my WSJ op/ed was that Lucas concluded that taxes on capital would be zero and that if we moved to a zero tax rate, capital would increase by about 35 percent? I bet they would be surprised. He doesn’t seem to want his readers to know what Lucas or I actually said. Tamny ends with this: Really, why all the thought? Why all the policy from the Commanding Heights? Free people prosper because they’re free, not thanks to allegedly wise central bankers, skilled tax writers, or brilliant “economists.” To read Adam Smith is to know he wasn’t an economist. He just had common sense. I’ll answer one by one. Why all the thought? Because thought is good; it’s much better than the opposite. Why all the policy from the Commanding Heights? Huh? Much of Lucas’s writing, and even more of mine, is on how government should climb down from the Commanding Heights, deregulate, cut government spending, and cut taxes. Does Tamny not realize this? Free people prosper because they’re free. Exactly. At least Tamny and I are on the same page here. not thanks to allegedly wise central bankers. Exactly, and did Tamny notice that I never praised central bankers? skilled tax writers Here he seems to be saying that the tax code doesn’t matter. But he should go back to his idea that people prosper because they’re free. The tax code takes away a lot of our freedom. So skilled tax writers can help get some of it back. or brilliant “economists.” Why the quotation marks? Is Tamny now even denying that Lucas was, and I am, an economist? And does he think that economic policy was never moved in good directions by economists? Does John Tamny not know that one reason he never had to face a military draft is that Milton Friedman had a large role in ending it and that economists Walter Oi and William Meckling used economics to argue against it? Somewhere in his mind Tamny probably thinks, “Oops, I just attacked brilliant economists; I’d better figure out a way of salvaging Adam Smith.” So how does he do it? With this: “To read Adam Smith is to know he wasn’t an economist.” So he takes one of the leading economists of the 18th century and defines him out of economics. Brilliant!   (0 COMMENTS)

John Cochrane has an excellent post discussing Bob Lucas’s contributions to macroeconomics. Here’s a point that I also keep harping on: The Fed often asks economists for advice, “should we raise the funds rate?” Post Lucas macroeconomists answer that this isn’t a well posed question. It’s like saying “should we cry wolf?” The right question is, should we start to follow a rule, a regime, should we create an institution, that regularly and reliably raises interest rates in a situation like the current one? Decisions do not live in isolation. They create expectations and reputations. Needless to say, this fundamental reality has not soaked in to policy institutions. And that answer (which I have tried at Fed advisory meetings) leads to glazed eyes. John Taylor’s rule has been making progress for 30 years trying to bridge that conceptual gap, with some success.   Lucas is the economist that launched the rational expectations revolution.  Much of the skepticism about “rational expectations” comes from a lack of comprehension about what the assumption actually means.  Here’s Cochrane: But “rational expectations” is really just a humility condition. It says, don’t write models in which the predictions of the model are different from the expectations in the model. If you do, if your model is right, people will read the model and catch on, and the model won’t work anymore. Don’t assume you economist (or Fed chair) are so much less behavioral than the people in your model. Don’t base policy on an attempt to fool the little peasants over and over again. It does not say that people are big super rational calculating machines. It just says that they eventually catch on.  I’d like to illustrate the issue with a hypothetical example involving a big glass jar of jellybeans.  You may recall a famous example cited in the “wisdom of crowds” literature, where an MBA class was asked to estimate the number of jellybeans in a large jar.  Most of the guesses were far from reality, but the median guess was surprisingly close, say with 1% or 2%.  In that case, how would I model the public’s jellybean estimates?  The least bad approach might be to estimate the actual number of jellybeans, and then assume that this figure was also the public’s estimate.  This approach would not work perfectly, but it’s hard to see any alternative that would be better.  Would you wish to assume the average guess is only 60% of the truth?  How about 150%?  If so, why? Now suppose I ask a mathematician how many ellipsoids with dimensions of 9 mm long and 6 mm wide will fit into a cylinder that is 8 inches tall and has a diameter of 5 inches.  The mathematician provides an equation that looks sort of complicated to the average person.  Does it make sense to assume that the average person uses that equation when estimating the number of jellybeans?  Obviously not.  But that equation gives you a good estimate of the actual number of jellybeans, and if we have no reason to assume the public’s estimates are biased, then it also provides the best model of the public’s estimate. Rational expectations models in macroeconomics are often full of scary looking equations.  The modeler then assumes that the public’s forecast of variables such as inflation is “consistent” with the model.  Thus if the model predicts 7% inflation, we don’t assume that the public forecasts 3% or 13% inflation—why would we?  We assume that the public also expects 7% inflation.  That may not be correct, but it seems the least bad approach unless we have specific knowledge that the public either over or under estimates the variable in question.  (Unfortunately, this is hard to test, as inflation is poorly defined.  The public’s estimates that show up in places like the Michigan survey probably reflect a definition of inflation that doesn’t include hedonic adjustments, and thus is a bit higher than the government inflation estimate.) Many people reject rational expectations because it seems to suggest that the public is composed of super intelligent calculating machines.  But that’s not at all what it means.  Bennett McCallum suggested that it would have been better to call the concept “consistent expectations”.  The claim is actually quite modest.  All the rational expectations assumption says is that if your model specifically implies that X is true; don’t assume the public believes that X is false, at least not without evidence for that claim.   (0 COMMENTS)

The current presidential election in Turkey gives an example of a phenomenon that is characteristic of politics and which is not absent from the American scene: unrestrained political competition is the ne plus ultra of the proverbial race to the bottom. As the main opposition candidate tries to defeat India’s populist strongman Recep Tayyip Erdoğan, the Financial Times reports (“Turkey’s ‘Desperate’ Opposition Plays Nationalist Card,” May 20, 2023): It marked the start of a jarring makeover for Turkey’s lead opposition candidate, whose campaign has swung from talk of spring, pictures of cherry trees and heart-shaped emojis to bellicose speeches promising to throw out millions of immigrants. … A Turkish journalist declares: When politicians in Turkey fall short or need quick results, they play the nationalism card. Compare politics and the market. Unrestrained market competition leads to the production of everything that somebody, however small his minority, is willing to pay for. Unrestrained political competition produces everything that powerful enough groups want and that can be forced onto somebody else. In politics, you win by fighting down to the bottom of the barrel. Nothing is perfect, of course, but imperfect liberty is better than imperfect tyranny. Whether political competition can realistically be “constitutionally” constrained is the crucial issue. One can interpret the work of James Buchanan or Friedrich Hayek as major attempts to provide a positive answer. The crucial and underestimated work of Anthony de Jasay suggests a negative answer (see also his Against Politics: On Government, Anarchy, and Order (Routledge, 1997). (0 COMMENTS)

The quantity theory of money (QTM) is a cornerstone of macroeconomic theory, and it states that changes in the supply of money have a proportional impact on the overall price level in an economy. It is most often associated with the 20th-century economists Irving Fisher and Milton Friedman. The theory has roots that go further back, however, as far as the writings of the Scottish philosopher David Hume in the mid-18th century and perhaps even earlier. The QTM is essential for understanding volatility in financial markets, as well as for judging the merits of changes to monetary policy by central banks. A more formal portrayal of the QTM is represented by the equation of exchange: MV = PQ. Here M represents the supply of money, V represents the velocity of money (i.e., the rate at which an average unit of currency is spent and respent as it is exchanged for goods and services), P represents the prices of goods and services, and Q represents the real quantity of goods and services produced in an economy. To begin to see the implications of the equation of exchange, imagine a situation in which the supply of money increases while the velocity of money remains constant. It is obvious that some combination of prices and real output—which together constitute nominal spending on goods and services—must increase too. Based on similar logic, Milton Friedman once argued for a rule whereby the money supply grows at a constant rate. Such a policy might make sense, since economic growth presumably benefits from increases in the money supply as this facilitates more transactions. In general, however, it is not safe to assume that the velocity of money is constant. Velocity is another way of describing the public’s demand to hold money. The slower the velocity, the greater the demand to hold cash and bank balances. Faster velocity means decreased demand for money: people spend their cash balances more quickly after receiving them. One of the main jobs of a central bank is to respond to the pessimistic; they often seek to hold greater money balances and also bonds, such as U.S. Treasuries, thereby putting downward pressure on interest rates. In order to avoid a recession, the Federal Reserve and other central banks respond by lowering the interest rate at which banks borrow from one another, as well as by increasing the supply of bank reserves and currency so that banks and the public can hold the money balances they desire. The QTM can also help us understand developments in modern cryptocurrency markets. As with the money growth rule Friedman advocated, the supply of crypto coins such as bitcoin or ether is often determined by an algorithm. The experience of cryptocurrencies suggests that an algorithmic approach would be problematic if it were adopted by national governments, however. The reason is that the simplest money growth algorithms do not respond to changes in the public’s demand for money, and this results in significant price volatility. Consider that when demand for bitcoins increases significantly, the price of bitcoin surges. When investors pull back, the price plummets. Such volatility helps explain why cryptocurrencies aren’t used in more everyday transactions. If bitcoin were used for as many transactions as the U.S. dollar is, imagine how many prices in the economy would have to adjust in response to the frequent ups and downs in bitcoin’s value. Stablecoins have emerged as one solution to price volatility in crypto markets. Like a currency board or a central bank with a fixed exchange rate, these cryptocurrencies are designed to maintain a stable price by linking their value to another asset—for instance, a fiat currency or a commodity such as gold. Tether and USD Coin are two examples of stablecoins pegged one to one with the U.S. dollar. Similarly, central bank digital currencies are digital versions of traditional fiat currencies that are issued by central banks. Like stablecoins, these currencies would aim to maintain a stable value to eliminate some of the volatility associated with cryptocurrencies. The equation of exchange sheds light on how these proposed solutions to price volatility in crypto markets work. Price volatility can be offset by having the supply of money respond to changes in the demand for money, thereby stabilizing the money’s value. In this way, when a central bank or cryptocurrency issuer increases the supply of its currency, the act is not always inflationary. In other words, it does not always lead to a general increase in prices. Instead, such “money printing” often simply offsets increases in money demand that would otherwise cause a general deflation. As these examples illustrate, a thorough understanding of the QTM is helpful for understanding the dynamics of modern financial markets. This is fascinating given the roots of the theory trace back hundreds of years. One insight of the QTM is that, in a growing economy, the quantity of money should generally increase in order to facilitate increased spending. Another is that, in order to keep the value of money relatively stable, the money supply should respond to changes in the public’s demand to hold cash or bank reserves. A critical challenge facing central banks, as well as cryptocurrency creators, is to address both of these related issues simultaneously. In a complex world, that is easier said than done.   James Broughel is a Senior Fellow at the Competitive Enterprise Institute with a focus on innovation and dynamism.  (0 COMMENTS)