Hayek and the "line of demarcation"

F. A. Hayek on the quantity theory, from How to deal with inflation:

I will admit that in its classic form, as now revived by my friend, Milton Friedman, this theory grossly oversimplifies things by making it all an issue of statistical aggregates and averages. Unfortunately the quantity of money is not a measurable homogenous magnitude but consists of a wide range of mutually more or less substitutable things of varying degrees of liquidity.

 

Reminds me of Hayek in A discussion with Friedrich von Hayek: 

I wish I could, at this point, go along with my friend, Milton Friedman, who believes he can solve the problem by fixing the annual rate of increase of Ml or M2 or M3 so that the discretion of the monetary authorities would be strictly limited. I believe that, in this case, a very eminent scholar has again been misled by the preoccupa­tion with statistics, that is, by the fact that, for statistical reasons, he has to draw a sharp line of demarcation between what he calls money and what he calls near-money or credit.

If such a clear line could be drawn, something might be said for strictly limiting what would be money under that definition.

 

The clear line can be drawn without effort. The difference between "money" and "credit" is the cost of interest. If you pay  interest on it, it's credit. (Or if you have to pay it back, it's credit.)

When you earn money, you do something of value for someone, and they give you money in exchange. They give it to you.

When you borrow, you promise to do something of value for someone, and they lend you money. They lend it to you. It is credit, not money.

When you earn money, it is yours free and clear. When you borrow, the only thing that's yours is the obligation to pay it back with interest.

The difference between money and credit is the cost of interest. Credit comes at the cost of interest. Money does not.

And it matters. It matters because as time goes by, policy, financial innovation, and natural inclination mean that more and more of our spending is the spending of credit rather than money. As time goes by, therefore, more and more of our transactions involve interest costs which must be paid, above and beyond the exchange of output for income. Slowly but surely, financial cost becomes unsustainable:

The graph shows the quantity of money we have borrowed
but not yet repaid, on which we pay interest,
relative to the quantity of money in the spending stream

As time goes by, an ever-growing share of our expenses goes to pay the interest on the money we borrowed to buy the things we bought. Not to pay for the things themselves, but to pay the interest on the borrowed money -- and to pay the sellers' interest costs, which are embedded in the things we buy.

 

Hayek is in error when he says

If such a clear line could be drawn, something might be said for strictly limiting what would be money under that definition.

The line is easily drawn; its essential purpose is to let us distinguish money that costs money to use, from money that does not. Furthermore, in order to prevent the financial cost of money from growing until it makes our economy an unsustainable system -- as it did in 2008 -- it is credit, not money, which must be strictly limited.

If and when policy limits the amount of credit use that can be constructed upon a dollar of money, the quantity of money can be increased without causing inflation. If we cut credit use from $35 per circulating dollar to half that figure, the quantity of money can be doubled, more or less, and these changes will permit roughly the same level of moneyandcredit spending as before, but at half the interest cost.

 

In addition, there must be some level of the credit-to-money ratio that is best for our economy, in that it best promotes economic growth. Our plan must be to reduce credit-use and increase the quantity of money until we get to that level, and then to remain at that level. If we think this gives us too much growth we can work less, and find other ways to amuse ourselves.

Based on past data for the US, the optimum ratio may be in the neighborhood of $6 of debt (or credit in use) per dollar of M1 money -- based on the pre-2020 definition of M1 etc. etc. etc.