Central Bankers, Remember Copernicus

Jan Matejko: Nicolaus Copernicus. Sketch to the Painting "Astronomer Copernicus, or Conversation with God" // Public domain

The work and ideas of the Polish astronomer, mathematician, and economist Nicolaus Copernicus (1473-1543) are worth studying, not only for those who still believe that the Earth is flat but also for anyone interested in intellectual revolutions. Among his achievements is the identification of the real causes of inflation, which has been no less of an intellectual revolution.

Copernicus challenged the prevailing idea that our planet was the center of the universe. The Polish scientist substantiated the Heliocentric Theory, demonstrating that the Earth revolves around the Sun and not vice versa. This fundamentally changed the way people saw the world.

But his achievements went beyond astronomy. In the early 16th century, Sigismund I the Old, who ruled Poland, invited the scientist to contribute to the reform of the country’s currency. This inspired Copernicus’ interest in monetary affairs.

For more than half a century, three different currencies circulated in the country: that of the Kingdom of Poland, that of Royal Prussia, and that of the Teutonic Order. It was the Teutons who were notorious for issuing extremely cheap money, which led to high inflation and made trade more difficult.

In his 1526 article “On the Principles of Coinage” (Latin: Monetae cudendae ratio), Copernicus concluded that bad money has the property of displacing good money. This is because people tend to keep and save the more valuable money and spend the cheaper money. In this way, depreciated money is more likely to enter circulation. In the days of the Polish Kingdom, this was the case with Teutonic money.

It was in the context of this reflection that the Polish economist formulated an early version of the Quantity Theory of Money (QTM). His insights into the relationship between the quantity of money and the growth of inflation laid the foundations for the subsequent debate on monetary policy.

We in our sluggishness do not realize that the dearness of everything is the result of the cheapness of money“, wrote Copernicus.

Recognizing that inflation complicates all economic activity, he stressed the importance of sound money. These recommendations were used by both Polish and Prussian leaders at the time to stabilize the value of the currency, and Copernicus’ ideas laid the foundations for further research.

The relationship between quantity of money and prices was explored in great detail in the 18th century by the classics, such as the Scottish philosopher David Hume and the British economist David Ricardo, while the modern version of the QTM was developed in the last century by the American economist Irving Fisher. His equation shows that if output and velocity of money remain unchanged, a given increase in the quantity of money will always lead to a proportional increase in inflation. This idea was established in the science of economics by the famous American economist Milton Friedman. In his studies, he examined a century of inflation in the United States and found a clear link between money “printing” and price increases.

But just one loophole has allowed critics of the theory to rubbish all its achievements. That gap is the assumption of perfect correlation.

The modern QTM thought it could predict inflation based on the idea that a given increase in the quantity of money would always lead to a proportional increase in consumer prices. However, they forgot that inflation can take many forms, not just an increase in so-called consumer prices. For example, some of the new money may be channeled into the stock markets. Some of the price increase may be “absorbed” by the businesses, which face higher producer prices. People may choose to save some of their money, so that inflation can occur with a long delay. It is precisely the fact that the “printing” of new money has not always raised the price level uniformly that has led critics of the QTM to believe that it can be printed indefinitely.

We saw virtually limitless “printing” of money during the COVID-19 pandemic. Since the start of the coronavirus, the amount of money in the euro area has increased by a quarter, and in Lithuania by almost a half. This means that, while our economy has hardly grown at all, a much larger amount of euros has been used to pay for the same amount of goods. However, as inflation shot up, the focus was on causes linked to disruptions in supply chains, Russia’s war in Ukraine, and accusations of “greed” in business. But such magnitude of price increase was explained 500 years ago by Copernicus – our money just got cheaper.

Sometimes good ideas and the right explanations need to be remembered, not discovered. There will always be those who explain that the Sun revolves around our planet, that the Earth is flat, and that a drastic increase in the quantity of money will have no effect on prices. As long as it is limited to debate, it is freedom of speech. The problems start when ignoring elementary truths becomes a public policy decision, reduces purchasing power, and hits everyone’s pocket.

Written by Leonardas Marcinkevičius – an expert at Lithuanian Free Market Institute.

Article was originally published at IQ magazine.

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