Paul Kaplan: I'm Paul Kaplan, Director of Research at Morningstar Canada. I'm pleased today to have a conversation with Larry Siegel on several topics of importance to investors. Larry is a leading thinker and prolific author on investment topics. In the late 1980s and early 1990s, Larry and I worked together at a small consulting firm called Ibbotson Associates, which Morningstar acquired in 2006, and I have been friends with him ever since. After his time at Ibbotson, Larry served as the Director of Investment Research at The Ford Foundation. Since then, he has been the Gary P. Brinson Director of Research for the CFA Institute Research Foundation. Larry, thanks for joining me today for this conversation.
Laurence Siegel: You're very welcome.
Kaplan: In 1997, we co-authored an article titled "Good and Bad Monetary Economics, and Why Investors Need to Know the Difference". In this article, we relied heavily on Milton Friedman's version of the quantitative theory of money. This theory says that inflation occurs when the supply of money grows faster than the price-adjusted demand for money. We, as did Friedman, embraced Irving Fisher's theory that nominal interest rates embody in part expected future inflation. More recently, you have embraced an alternative theory, the fiscal theory of the price level, which ties inflation to a government's fiscal policy. First of all, what does Friedman's theory say? And what do you find wrong with it?
Siegel: Well, Friedman's theory is very powerful in explaining a great deal of what has happened to prices around the world and over very long periods of time. So, you have to really find something wrong with a long-established and well-tested theory in order to suggest that maybe you should use a different theory. I went to the University of Chicago at a high school partly because Milton Friedman was there. I didn't study with him directly for a really lame reason, which was that I found out in the first few weeks that he was a very tough grader and that my chance of getting a grade better than a C was minuscule. So, I took other economics courses, but I learned basically Friedman's work.
What happened – two things happened. One is that the quantity theory of money failed on a couple of occasions, which I'll go over in a minute. The other is that it really only explains prices when money in Friedman's formal sense of noninterest bearing cash and bank deposits, and perhaps a few other things is the only medium of exchange in the economy. And when he did his work between, let's say, 1935 and 1970, and then he spent the rest of his life for finding it, money was about the only thing that was circulating in the economy that you could buy things with. And this began to change. I was sitting around with a bunch of people having dinner a while ago, and the bill came.
It was very large. And I was asked to put in a few 20s, quite a few 20s. And like everyone else, I said I don't have any money. All I have is credit cards. In other words, bank credit, which Friedman did not count as money. But it contributes to the demand for whatever we were eating, and the new theory has to have a much-expanded definition of money, or else you can't use it. So, now, we have money market funds, crypto, hedge funds, shares of hedge funds or the S&P 500 could be money. The home equity line of credit that I have could be money. And so, the theory becomes out of date that way. But you could fix it by redefining money. And what John Cochrane, Eric Leeper and a later time, Coleman and I have been saying though is that there is a different effect at work, and it is a true attempt to overturn Friedman, which I say with great trepidation because he was one of the two greatest economists of my lifetime. The other was Gary Becker.
What the quantity theory did not do is to explain the low inflation rates after the massive monetary stimulus of 2008 and 2009, 2010 and so on, really through the very recent past. Until about the last year or two we basically didn't have any inflation and the quantity theory of money would have said that inflation should have been very large and dramatic and should have come quickly, the lag between the monetary stimulus and price rises being historically about nine months, not decades. And I'm going to credit Leeper and Cochrane with this because Tom Coleman and I are really just advocates for it. We didn't think of it. What they said is that if you go back to Adam Smith, he said that what makes money valuable is the willingness of governments to accept it in payments and the payment of taxes. Now, this sounds trivially stupid because money has a million other users that are more important than that. But that's the use that gives money the effect that it has on prices according to the fiscal theory of the price level because money is a form of government-issued security.
Now, how do you analyze a security? You look at the backing of the security, which in this case is the ability of the government to raise funds through taxation that are more than it spends, the primary surplus of the government. So, the present value of all the future primary surpluses of the government is the fundamental value of a government bond, a government-issued security. And in today's environment where deposits pay interest, that's just another form of government bond with a shorter duration. I told you this was complicated. So, the fiscal theory basically just says that if you can estimate somehow or get from an external source the present value of all those primary surpluses, that equals the total stock of government bonds divided by the price level. In other words, it's the real value of the bonds. So, that's the fiscal theory. It tells you the price level. B/P = the number of bonds divided by the price level is the real value of the bonds which is S, which is the present value of all future surpluses.
Now, what evidence is there that this works? It's hard to know what that present value of the surpluses is, because it's an estimate of what governments are going to do in the future, and the governments will basically do as they damn please. But we have evidence from the past. In 1923 and 1924, Germany went into hyperinflation because the government was printing money to pay its bills. It had failed at the normal way of paying its bills, which is to tax people at a rate that was sufficient to pay the bills. So, they just printed money and paid the bills with that money. What happened was that the economy slipped into hyperinflation. And not like we're having, it's pretty bad. But this is where you could have a wheelbarrow full of Reichsmarks and you thought you were going to do all your grocery shopping with the wheelbarrow. But by the time you got to the grocery store, all you could buy was an egg. So, the monetary system fell completely apart.
At some point in late 1923, the German government led by their, I guess, President Stresemann decided to stop spending more than the tax collections, because they decided based on something that this would end the hyperinflation and it did. It came to a halt almost literally overnight. Prices became stable. And that would not have been predicted by the quantity theory of money because the money supply continued to expand. What happened was that the fiscal situation became supportive of a stable currency. So, the fiscal situation having been rectified, the currency became stable, and Germany began to recover from the hyperinflation. So, this is the event that really set off people looking for an exception to the quantity theory of money. When you have an exception like this, that's very large and obvious, you start wondering if the theory is any good in the first place, and that's where Leeper and Cochrane got their idea for a fiscal theory although there were some precursors. If you look back in the history of economic thought, you see little bits and pieces of it from Adam Smith and many other old timers like him.
Kaplan: Thank you, Larry, for this very interesting discussion. Thank you for taking the time to talk to me on these issues and look forward to talking to you again.
Siegel: It's my pleasure. And let's talk again as soon as possible.
