American Indonesian Chamber of Commerce


Halloween, Inflation, and the Quantity Theory of Money

November 2022

Issue To Watch: Halloween, Inflation, and the Quantity Theory of Money

by Wayne Forrest

We’ve just experienced a Halloween in which frightful fantasies become reality as  the young seek happiness, expecting they are protected, but they are not.  Who knew that the American costume and candy holiday (at one time it raised funds for UNICEF) had become international and it could lead to the trampling of 151 in a Korean alley during a Halloween “meet-up”. Hindsight is 20/20, but surely more protection could have resulted in less pain and death. But does the same hold true for economies? Can governments protect us from “scary” inflation and high prices and why is Indonesia’s much lower than ours?

I admit some trepidation in wading into this complex topic, being a layman. So, beyond refreshing my understanding of the macroeconomics of John Maynard Keynes and Milton Friedman, I also turned to, of all people, Jon Stewart, the former host of The Daily Show.  His recent podcast on inflation featured Steven Hanke, Professor of Applied Economics at Johns Hopkins, whose work on national indicators, currencies, monetary supply, and many other topics goes back decades.  The last time Hanke came into view with Indonesia was during the Asian Financial Crisis of 1997-1998. At that time Indonesia’s currency was rapidly depreciating and Hanke held discussions with President Suharto’s economic team about installing a currency board as a stop gap measure. The plan –which has had success in other countries—was dropped after IMF and the US government raised objections. I well remember AICC banking members also didn’t believe Indonesia could pull it off. In 2005 Hanke wrote a compelling article restating the case.

Stewart and Hanke seem like polar opposites, but actually they agreed on one important thing, the Fed has been wrong on its approach to inflation; it’s way too interventionist. Hanke argues convincingly, that inflation has a positive correlation with money supply, an idea which the Fed, and its chairman do not. Stewart’s issues with the Fed have to do with its interest rate policies being overly generous to business. For Hanke its all about the quantity theory of money (QTM), an idea it turns out, that’s been around since the days of Copernicus, the ultimate Renaissance man, and later taken up in different ways by the likes of John Stuart Mill, David Hume, Karl Marx, Keynes, and Milton Friedman. The essence of QTM is the general price level of goods and services (inflation) is directly proportional to the amount of money in circulation, or money supply.

On the podcast Hanke basically presented the following arguments:

  • Inflation is not global, it depends on individual policies of central banks
  • A 5% increase in the money supply normally yields 2% inflation
  • Large changes in the money supply result in inflation 12-18 months in the future.
  • The relative change in prices of individual commodities due to supply and demand fluctuation does not correlate with general inflation
  • The pandemic, Ukraine War, OPEC price hikes did not cause the 8-9% US overall inflation; it was the large unfunded government spending.
  • 90% of money supply growth is driven by commercial banks
  • The stimulus checks created a government-generated 41% growth in the money supply since February 2020.
  • Had  the government off-loaded the debt to public bond holders, rather than the Fed, the money supply would not had grown as much and overall inflation lower.
  • The Fed is ignoring that currently money supply is not growing and this will push the economy into a recession in 2023.

On energy price hikes Hanke brought up Japan during the first OPEC price increases in 1973. Facing large increases in oil prices the Bank of Japan increased the money supply (MS) but general inflation still rose. In 1979, when prices went up again, they had learned from their mistake, didn’t grow MS and they had much less inflation. Hanke cautions us not to listen to the “noise” in the media about relative rise in commodity and supply chain prices when the real culprit (“signal”) is the large increase in the money supply.

Of course, Hanke and his fellow strict monetarists have their critics (Keynesians) -I won’t go into the weeds to present them-but I reflected on his theory when looking at Indonesia’s current experience. Its inflation (even with rising food and energy prices and a devaluating currency) was below 2% from February 2020 until January 2022, has been above 4% only since June, and is currently 5.7%.  The reasons are instructive. Indonesia’s central bank only once during the pandemic stepped in to buy government bonds, unlike the Fed. The government bought the “price rises” through subsidies and direct social assistance. They didn’t always get it right, stumbling over cooking oil, but by and large the government has shielded its people from the hyperinflation afflicting countries like Turkey, Pakistan, Venezuela, and Argentina and the 8% levels in the EU and the US.  Former Finance Minister, the US-trained economist Bambang Brodjonegoro, commented recently: “You cannot expect such an operasi pasar (market operation subsidies) to happen in the US, because in the US and in the EU, it’s all based on market mechanisms. That’s why the only ammunition from the US and EU perspective is the central bank.”

Maybe Perry Warjiyo and his colleagues at Bank Indonesia know a thing or two about the quantity theory of money and maybe his colleagues at the Ministry of Finance understand fiscal policy, and kudos to President Jokowi and his team for stabilizing what could have been a much “scarier” situation.